To address the most common forms of aggressive tax planning, two key European Council Directives set forth minimum standards that should implemented in the domestic income tax laws of all European member states. See European Council Directive (EU) 2016/1164 amended by Council Directive 2017/952 (the Anti-Tax Avoidance Directives, ATAD I and ATAD II respectively, together referred to as ATAD).
ATAD constitutes a coordinated EU implementation of some of the recommendations from the Organization for Economic Co-operation and Development (OECD) initiative against Base Erosion and Profit Shifting (BEPS), in particular BEPS Action 2: Neutralizing the Effects of Hybrid Mismatch Arrangements.
Hybrid mismatches are differences between tax systems that can be exploited to achieve a double non-taxation, a double deduction, a deduction without inclusion or a non-taxation without inclusion.
ATAD provides rules to counteract hybrid mismatches arising between EU member states and third countries, including imported mismatches, reverse hybrid mismatches and tax residency mismatches.
The implementation of hybrid mismatch rules by the member states was due by Dec. 31, 2019, to be applied as of Jan. 1, 2020. Anti-reverse hybrid mismatch rules are due by Dec. 31, 2021 to be applied as of Jan. 1, 2022.
One of the targeted mismatches is a payment by a European hybrid entity that gives rise to a deduction in the European country without an income inclusion in the related entity’s country. The mismatch arises because the payment is disregarded under the laws of the payee jurisdiction. Under ATAD, a mismatch arises with respect to this category of mismatch only to the extent that the payer jurisdiction allows the deduction of the payment or deemed payment to be set off against an amount that is not classified as dual-inclusion income. Dual-inclusion income means any item of income that is included under the laws of both jurisdictions where the mismatch outcome has arisen.
In general, payments from European hybrid entities do not create a hybrid mismatch if the payment is disregarded under the laws of the payee jurisdiction as a specific item of income. This is the case as long as it has not also been included as a cost position (i.e., the total amount of included income has not been reduced by a deduction in the first place).
However, some European member states have limited the exemption for dual-inclusion income more than originally provided by ATAD. For example, the pending ATAD implementation in Germany (draft bill) limits the exemption for dual-inclusion income to countries that do not avoid double taxation through foreign tax credits. Therefore, U.S.-owned holding structures that include hybrid entities may be targeted by domestic implementations of ATAD, although the deduction would be set off against an amount of income that would qualify as dual-inclusion income.
A U.S. corporation owns a German GmbH. The German GmbH is treated as disregarded entity for U.S. tax purposes and taxed as a corporation in Germany. The German GmbH pays interest on a shareholder loan to the U.S. corporation. Based on the proposed German implementation of ATAD, a hybrid mismatch arises and the exemption for dual inclusion income does not apply. As a result, the shareholder loan-related interest payments cease to be deductible in Germany.
Most European member states have already partially or completely implemented ATAD anti-hybrid rules. Given domestic variations of their implementation, we highly recommend reviewing any U.S.-owned European holding structures and assessing the impact of the new rules to avoid negative tax consequences.
Potential U.S. tax implications
If the application of the anti-hybrid rules is as a result of an intercompany payment from a hybrid entity (i.e., a foreign corporation that is disregarded for U.S. federal income tax purposes), there are several solutions that can be considered. First, the U.S. multinational may elect to be treated as a regarded entity in the U.S., provided the entity is not barred by the 60-month entity classification rule. However, this option may result in the cancellation of the tax losses from a local country perspective. From a U.S. federal income tax perspective, consideration should be given to the potential stranding of branch taxes, dual consolidated loss recapture rules as well as the branch loss recapture rules. Another option would be to increase the transfer pricing margin to capture more dual inclusion income in order to manage the expected anti-hybrid application. When adjusting transfer pricing, the loss is essentially shifted to the United States; thus, consideration should be given to the foreign tax credit rules, as the pro rata sourcing of income may change. Finally, the U.S. multinational could consider the removal or adjustment of intercompany charges.
Application of the anti-hybrid rules which results in the disallowance of a loss may affect the U.S. multinational’s global effective tax rate, so these rules should be considered when reviewing the international portions of a tax provision. Specifically, the disallowance of losses could potentially increase foreign taxes depending on whether the hybrid entity is profitable. If the US multinational is eligible for a US foreign tax credit for the additional foreign taxes, then the taxpayer is in a tax neutral position. However, depending on the foreign tax credit position of the organization, the additional foreign taxes may not be immediately creditable and subsequently carried forward. If the enterprise anticipates, based on its foreign source revenue projections, that it will be limited in its ability to use the foreign tax credit in future years, a required valuation allowance potentially has a negative impact on the global effective tax rate.
There are multiple variables that affect planning for these rules. Please contact your tax advisor with specific questions you may have or for more information.