Taxation is at the core of every country’s sovereignty, but the interaction of domestic tax rules at the international level can lead to gaps and frictions resulting in the erosion of the tax bases of the countries involved. Hybrid mismatch arrangements exploit differences in the tax treatment and/or legal characterization of an entity or instrument under the laws of two or more countries and by so doing, achieve double non-taxation.
Action 2 Report (“the Report”) identifies three types of hybrid mismatches in tax outcomes.
- Deduction/no inclusion outcome (“D/NI”): arrangements that create a deduction in one country, but avoid a corresponding inclusion in the taxable income in another country.
- Double deduction outcome (“D/D”): arrangements where a deduction related to the same contractual obligation is claimed for income tax purpose in two different countries.
- Indirect Deduction/no inclusion outcome (“Indirect D/NI”): when the tax payer has already entered into a hybrid mismatch arrangement and shifts the effects of that mismatch to a third country.
The Report sets out recommendations for the design of domestic rules with the aim of improving the consistency of corporate income taxation at the international level. These recommendations take the form of linking rules that align the tax treatment of an instrument or entity with the tax treatment of the counterparty jurisdiction. The rules have a certain order, the primary rule and the secondary or defensive rule, and are designed to prevent more than one country from applying the same rule to a single arrangement and also avoid double taxation.
The primary rule is that countries deny the taxpayer’s deduction for a payment that has not been included in the taxable income of the recipient in the counterparty jurisdiction, or that is also deductible in the counterparty jurisdiction. If the primary rule is not applied, then the counterparty jurisdiction can apply the defensive rule, requiring the deductible payment to be included in income or denying the duplicated deduction, depending on the nature of the mismatch.
The Report also sets out recommendations for the development of model double tax treaty provisions that would nullify the effects of hybrid mismatch arrangements. These are aimed at ensuring that hybrid instruments, hybrid entities and dual resident entities cannot be used to improperly benefit from tax treaties.
In conclusion, countries remain free in their policy choices. It will now be up to Barbados to decide how best to approach the issues addressed in the Report and what strategies would be the most appropriate in the context of, and the most consistent with, our own legislative framework.