Hybrid Entities and Hybrid Mismatches: A Study on Tax Evasion

This research focuses on the hybrid entities and hybrid mismatches used by international organizations for tax evasion. It discusses the motivation of the study, research questions, methodology, and the application of BEPS actions to a case study. The study aims to provide an understanding of the effects of interest deduction on financial accounts and the consequences of BEPS actions.

BUSINESS TAXATION AND
ADVANCED FINANCIAL
ACCOUNTING

TABLE OF CONTENTS
TABLE OF CONTENTS................................................................................................................2
1. INTRODUCTION.......................................................................................................................1
1.1 Motivation of the Study.........................................................................................................1
1.2 Research Questions................................................................................................................1
1.3 Delimitation...........................................................................................................................2
1.4 Methodology..........................................................................................................................2
3. MAIN BODY..............................................................................................................................2
3.1 Introduction of OECD's BEPS and its potentials. ...............................................................2
3.2 Defining the Hybrid entities and the interest expense limitation rules .................................3
3.3 Application of BEPS actions to case study............................................................................4
3.4 Reference to the case law......................................................................................................7
3.5 Effects of the rulings on financial accounts that are based on IFRS.....................................7
3.6 Social impacts of such rulings ..............................................................................................8
3.7 Probable amendments or changes in BEP guidelines............................................................8
4. CONCLUSION............................................................................................................................9
REFERENCES..............................................................................................................................10

1. INTRODUCTION
The research is related to the hybrid and hybrid mismatches that are undertaken by the
international organisations for evading the tax effects. The hybrid entities are using the benefits
double deduction of interest in countries in which they are operating. Seeing the tax evasions by
companies various rulings and regulations are laid by government authorities. Report is based
over the US tax systems on hybrid entities and hybrid mismatches. US has laid down Section
267A under Internal Revenue Code for preventing arrangements involving t hybrid transactions.
1.1 Motivation of the Study.
 Main motive of the study is to clarify that it is undesirable for the companies to allow
double deduction of the interest expenses. Companies are being allowed to deduct the
interest expense via hybrid entities. The practice is causing tax evasions by international
companies.
 The study will be providing the understanding about the hybrid entities and the hybrid
mismatches under BEPS actions. OECD G20 Base Erosion & Profit Shifting Project is
OECD/G20 project for establishing an international frameworks for combating with tax
evasion by multinational companies with the use of base erosion & profit shifting. Project
is led by Fiscal Affairs Committee of OECD that started in 2013 with G20 countries and
OECD in context of tax affairs and financial crisis. Project is aiming at mitigating tax
codes loopholes and inconsistencies from one country to another. It prevents company
from shifting the profit from countries with high tax rate to low tax rate countries. In
particular the practice of double taxation is generally legal but there are critical
maneuvers in tax laws. BEPS is expensive foe all companies that are involved in saving
the firm. The study will provide understanding about the effects of interest deduction on
financial accounts of companies.
1.2 Research Questions
Research will consider the tax and rulings that are prevailed in US regarding the hybrid
mismatches. Research question deals with the tax ruling wit the authorities allowing it to deduct
some interest payments twice via making arrangements of hybrid entity structures. Questions
requires the possible outcomes because of this access. The relevant and specific actions of
OECD's BEPS that have affected the arrangement will be discussed in the study. It will also
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provide about the effectiveness of the Actions against the hybrid entity structures and the
consequences of these actions over the financial accounts.
Sub Research questions
Further it will provide about the extent to which the double deduction have been
prevented from the actions of BEPS in respect of interest payments via the hybrid structures.
1.3 Delimitation
Present study will be focusing over the guidelines and applications of particular BEPS
actions for the interest deductions and the hybrid entities. It will further be analysing the possible
consequences over the tax accounts and financial accounts of companies. The regulations
regarding the hybrid mismatches are covered under the sections 245A(e) and 267A of Internal
Revenue Code regarding the hybrid transactions and hybrid entities.
1.4 Methodology
The given research will be based over the argumentative analysis about the BEPS action
of OECD project application including the possible amendments and reforms. It will include the
decisions and arguments about the double deductions of interests.
2. MAIN BODY
2.1 Introduction of OECD's BEPS and its potentials.
Following financial crisis suffered in 2008 G20 countries kept tax on the top of the
agenda. It started the fight against avoidance and evasion of taxes. BEPS is Base Erosion &
Profit Shifting for planning strategies for taxes and is used by international organisations
exploiting mismatches and gaps in taxation rules for avoiding tax. Developing nations rely
highly over the income tax and therefore they have to suffer disproportionately from BEPS1.
OECD/ G20 with more than 130 countries & jurisdictions are working together for
implementing the 15 measures undertaken for tackling the tax avoidance. They also aim at
improving the coherence to global tax rules and ensuring more transparency in tax environments.
Project of OECD started in year 2013 and the reports were delivered in 2016 for implementation
on full phase in 116 involved countries. Project aims that the practices which are used for tax
evasions and avoidance are recognised and eliminated. International companies were shifting
1 Xerri, M., 2016. Selected BEPS Action Plan: countering harmful tax practices more
effectively, taking into account transparency and substance, how is it likely to change the
international tax landscape (Master's thesis, University of Malta).
2

their profits to the low tax countries. This was losing trust of citizens in the taxation system due
to tax evasion practices at large scale. In developing nations revenues were trimmed where the
trust on corporate taxes was high and this was keeping states underfunded2.
Project is also serving as alternative for preventing deterioration of norms of international
taxation. Project will prevent both double taxations and double non taxations and the countries
that are undercutting revenues of other nations through lower tax rates for attracting the business.
Cooperation of the countries will be yielding better outcomes rather than non cooperation.
Ongoing implementation of the OECD's BEPS have helped it in achieving various realisations
some of which are :
 BEPS inclusive frameworks bring around 116 nations and jurisdictions to participate on
equal footings on project, that represents over 95% of global GDP.
 It has reviewed more than 175 regimes and in that around 130 regimes have been
abolished or amended or are under process for amendment and abolishment. It has
exchanged and identified information over more than 17000 taxation rulings.
 50 jurisdictions have started exchanging financial accounting information till 2017,
September and around 50 will start exchanging in 2018, September.
 Additional revenues of around 414 million US dollars have been generated with less than
4 million US dollars of cost through (TIWB) Tax Inspectors Without Borders.
2.2 Defining the Hybrid entities and the interest expense limitation rules
Hybrid Entity
In simple words Hybrid entity is defined as company that is taxed as different entity in
every other country. For instance a company may be taxed as partnership in US where the same
entity may be treated as corporations in foreign country. This will result in hybrid entity that
pays tax in foreign country of its own, but in US tax attributes of entity flow to the owner who
will pay the tax. Reverse hybrid entities are just opposite that re treated as flow through company
in foreign country & corporation in US. For the US tax purposes hybrid entities are fiscally
2 Duff, D.G., 2019, July. Interest Deductibility and International Taxation in Canada
After BEPS Action 4. In Report of the Proceedings of the Seventieth Tax Conference:
2018 Conference Report (Toronto: Canadian Tax Foundation), Forthcoming.
3

transparent for the US tax purpose but are not fiscally transparent for the foreign taxation
purposes.
Hybrid Mismatches
Hybrid entities & Hybrid transactions are targeted by multinational intergovernmental
organisation OECD as international taxation planning tool. BEPS has focused on ''Hybrid
mismatch transaction '' along with currently released recommendations that are designed for
making it harder for entities form taking advantages of most favourable taxation planning
opportunities. Corporate structures that are properly planned with use of hybrid entities arr
creating beneficial tax situations that help these companies in deducting certain transactions in
many countries. The structure is also maximising foreign taxation credits enabling the companies
to avoid tax payments in countries having higher tax rates. At the same time if structure is not
properly planned than it could result in taxation of income multiple times, losing deductions,
waste of foreign tax credit and loss of benefit arising from treaties of tax between nations.
2.3 Application of BEPS actions to case study
Action 2 - Hybrid Mismatch arrangements
Action states that there is an interaction between the hybrid mismatch arrangements and
work on interest. They both are related to preventing the erosions and profit shifting through
instruments giving rise to the interest deductions. Strong interest limitation rules are essential as
they provide protection against the intra-group mismatch arrangement. It is essential for
companies to consider the issues regarding the interest deductions. The action 4 provide group
wide allocation of interest as per the countries. For instance, group wide interests allocation rule
if introduced consistently by the countries will significantly be reducing risks posed by the
hybrid financial instruments. It is essential for the companies to have certain risks that are
resultants of the hybrid mismatch financial instruments, these rules are required to be addressed
using anti hybrid rules3.
3 Spies, S., 2017. Taxability of non-resident online retailers in South Africa and the
OECD’s BEPS action plan (Doctoral dissertation, Stellenbosch: Stellenbosch
University).
4

If country introduces the rules of interest limitation and anti-hybrid it is having two
options:
Option 1:Anti-hybrids rules apply first. General interests limitation rules may further restrict the
deductions of interests, if the interest expense of company is still high than limits under group
wide tests or fixed ratio test.
Option 2: A general interest limitation rule applies first, limiting interest deductions by reference
to the group position or a fixed ratios. Anti-hybrid rules can even further restrict the interest’s
deductions if entity is party to the hybrid mismatches arrangements.
Key difference between two of the option is that in option 1 entity would be suffering
only one dis allowance ( whichever is higher under to set of rules), and under option 2 entity
would be suffering 2 dis-allowances (collective effect of the dis-allowances under the both set of
rules). Option 1 is suggested to be sufficient for addressing the base erosions and the profit
shifting risks in maximum cases4.
Hybrid mismatch arrangements were used for achieving the unintended double non
taxations or tax deferral long term through, creation of two deduction for single borrowing to
generate deduction without corresponding to income inclusions, misusing overseas tax credits
and participation in exemption regimes. Rules of countries giving choice to tax payers for tax
treatments of foreign and domestic entities facilitating hybrid mismatches5.
Concerns of BEPS were associated with entities and hybrid instruments arising from
mismatches under domestic laws, main outcome of working on Action 2 will be resulting from
works of the Working Party 11 on recommendation regarding designing of domestic rules for
neutralising effects of hybrid instruments & entities.
In the given case if the company is allowed to have double deduction of the interest
expenses it would be affecting the actions of the BEPS as it does not allows for the double
deduction of the interests under hybrid mismatch arrangements. This is undesirable under section
2 as it will be allowing the companies to make benefits in taxation purposes through the hybrid
4 Action 4. 2019. [Online]. Available through : <https://www.oecd.org/tax/beps/beps-
actions/action4/>.
5 Oguttu, A.W., 2016. Tax Base Erosion and Profit Shifting in Africa –Part 1:
Africa’ s Response to the OECD BEPS Action Plan (No. 12802).
5

arrangements. If the BEPS actions have been effectively implemented under the national laws
than as per current law company should not be allowed to deduct the interest expenses twice.
Action 4 - Limitation over the Interest deductions
Recommendations in Action 4 aims at limiting the base erosion by using interest expense
for achieving excessive deductions on interest or for financing production of deferred or exempt
income. Work by Inclusive Frameworks on Action 4 brought 2015 OECD report on interest
deduction and financial payments6.
Multinational entities were achieving favourable tax result through adjustment of debt amount in
group entities. BEPS risks can arise in following basic three scenarios.
 Entities placing debts of third party at high levels in countries with high tax.
 Companies making use of intra-group loans for generating interest deduction in excess of
actual interest of the third party of the company.
 Companies using intra-group or third party financing for funding generation of exempted
income.
The relevant tax provisions related to the interest limitations are given under Section 163 (j) and
are allocable to '' Non expected'' T/B. Electing real property T/Bs, Electing farm T/Bs, certain
regulated utilities and performed services as employees are excepted from Section 163(j).
Section 267 A is enacted under Tax reform of the US legislations and referred as Tax Cuts and
Jobs Act at end of 2017. Legislation denies deduction for some amounts accrued or paid to
related parties in a hybrid transaction or through hybrid entity.
In the international taxation planning using third party & the related party interests is among the
most simplified profits shifting techniques. Fungibility and fluidity of money has made it a
simpler exercise for adjusting the debt equity mixes of controlled entities. It is important to
consider the action as interest expense will be giving rise to the twice non taxation over both the
outbound and the inbound investment scenarios 7.
6 Kim, S.M. and Kim, J., 2018. Flags of Convenience in the Context of the OECD BEPS
Package. Journal of Maritime Law & Commerce. 49(2).
6

In the present case it will allow the deduction of interest payment against taxable profits
of operating companies and the interest incomes will be taxed at comparatively lower rates of tax
or may not be taxed at level of recipient. In fact there are situations where the multinational
companies do not have any external debt or have very small debt. The action is not effectively
restricting the tax avoidance as the approach includes 3 elements that is fixed ratio rules based
over the benchmark EBITDA / net interest ratio, group ratio rule that allows entities to deduct
more interests expenses depending on relative EBITDA / net interest ratio of worldwide group,
and the targeted rules for addressing the specific risks.
3.4 Reference to the case law
CASE – Morrissey vs Commissioner , 296 US 344 (1935)
In the present case argument delivered opinion that income taxes have been contested for years
1924 to 1926 on the basis that trusts is illegally treated as association. Circuit Court of Appeals
affirmed decisions Board of Tax Appeals that sustained ruling of Commissioner of the Internal
Revenue. Conflicts were based on the distinction between association and pure trust and left the
state of confusion. Is stated the standing of company should be transparent and not misleading. It
should not be used for misleading the tax provisions. Court of Appeal for Ninth circuit reversed
Tax Courts and held that in valuation of the interest of the estate in closely held corporations,
sale of minority interest in stock of the corporation among distant members of family are good
evidence of the fair market value.
3.5 Effects of the rulings on financial accounts that are based on IFRS.
The financial accounts of the company are prepared for recording the transactions of
company and for calculating the tax liability of the company of the relevant year. After the
OECD ruling there are significant changes made by the companies in US following GAAP.
Companies are required to calculate the EBITDA of the group. Companies are required to
perform the analysis of the transactions that are incurred by companies. It has laid down separate
7 Action 4. 2019. [Online]. Available through : <https://www.oecd.org/tax/beps/beps-
actions/action4/>.
7

procedures for items to be included in interest income & expense, items included in depreciation
& amortisation, treatments for dividend income and share of group earnings, treatments on gains
over fair values. Companies are now not able to make arrangements bringing tax benefits to the
company 8.
3.6 Social impacts of such rulings
Corporations complaints about 35% federal tax rates where the effective tax rates paid
by them after taking advantages of the loopholes is around 147% as per the research conducted
by Government accountability office. This is transferring the pressures over middle class
families and the small businesses. People are suffering real harm because of the corporate tax
dodging : students are priced out of the universities, commuters driving potholed highways,
seniors are being denied from home care and nursing. The budget proposal from Congress and
White House promise deep reduction in public services, it would not be reduced if the
corporations would have their part of taxes fairly. Companies can deduct tax up-to certain limits
that does not affects the other tax provisions. The benefit of double deduction should be
transferred by the entities to the society. The double deduction should not merely be used for tax
evasions disturbing the tax structure transferring the burden to society. Entities should create
more opportunities and employment to the society by the benefits they are deriving through
double deduction.
3.7 Probable amendments or changes in BEP guidelines.
For neutralising the mismatch arrangement amendments are proposed.
Hybrid mismatch arrangements were used for achieving the unintended double non
taxations or tax deferral long term through, creation of two deduction for single borrowing. To
generate deduction without corresponding to income inclusions, misusing overseas tax credits
8 McCann, P.J., 2015. The relevance of the OECD BEPS action plan 2 recommnedations
for selected aspects of cross border arbitrage through selected hybrid instruments and
entity arrangements in South African Income Tax Law (Doctoral dissertation, University
of Cape Town).
8

and participation in exemption regimes. Countries are implementing regulations regarding the
hybrid mismatches 9.
Concerns of BEPS were associated with entities and hybrid instruments arising from
mismatches under domestic laws, main outcome of working on Action 2 will be resulting from
works of the Working Party 11 on recommendation regarding designing of domestic rules for
neutralising effects of hybrid instruments & entities.
4. CONCLUSION
From the above study it could be concluded that such an tax treatment is undesirable for
the tax accounts as it is allowing them to take benefits of double non taxation. Companies were
making tax evasions and avoidance by making arrangements like hybrid entities and hybrid
instruments. It was shifting the tax revenues from country to country. They were shifting their
tax burden to countries with low tax rates. Seeing the evasion practices BEPS has framed 15
action to be followed by international companies so that tax avoidance and evasion could be
eliminated.
9 Joseph, A., 2017. Global trading and transfer pricing: Application of the transfer
pricing methods and OECD BEPS Action Plan 9 to global trading of financial
instruments by MNE groups in the financial services sector (Doctoral dissertation,
University of Cape Town).
9

REFERENCES
Books and Journals
Duff, D.G., 2019, July. Interest Deductibility and International Taxation in Canada After BEPS
Action 4. In Report of the Proceedings of the Seventieth Tax Conference: 2018
Conference Report (Toronto: Canadian Tax Foundation), Forthcoming.
Joseph, A., 2017. Global trading and transfer pricing: Application of the transfer pricing
methods and OECD BEPS Action Plan 9 to global trading of financial instruments by
MNE groups in the financial services sector (Doctoral dissertation, University of Cape
Town).
Kim, S.M. and Kim, J., 2018. Flags of Convenience in the Context of the OECD BEPS
Package. Journal of Maritime Law & Commerce. 49(2).
Markham, M., 2019, September. A taxpayer conundrum: choosing the most advantageous tax
treaty dispute resolution mechanism in the wake of the OECD’s BEPS Action Plan-the
Mutual Agreement Procedure, Arbitration, or APAs?. In The 28th Annual Tax Research
Network Conference.
McCann, P.J., 2015. The relevance of the OECD BEPS action plan 2 recommnedations for
selected aspects of cross border arbitrage through selected hybrid instruments and
entity arrangements in South African Income Tax Law (Doctoral dissertation, University
of Cape Town).
Oguttu, A.W., 2016. Tax Base Erosion and Profit Shifting in Africa –Part 1: Africa’ s
Response to the OECD BEPS Action Plan (No. 12802).
Spies, S., 2017. Taxability of non-resident online retailers in South Africa and the OECD’s BEPS
action plan (Doctoral dissertation, Stellenbosch: Stellenbosch University).
Xerri, M., 2016. Selected BEPS Action Plan: countering harmful tax practices more effectively,
taking into account transparency and substance, how is it likely to change the
international tax landscape (Master's thesis, University of Malta).
10

Online
Action 2. 2019. [Online]. Available through :
<https://www.oecd.org/tax/beps/beps-actions/action2/>.
Action 4. 2019. [Online]. Available through :
<https://www.oecd.org/tax/beps/beps-actions/action4/>.
11