Introduction to Part II of Multilateral Convention | Hybrid Mismatch

Part II of the Multilateral convention comprising of Article 3 to 5 covers ‘Hybrid mismatch arrangements’. ‘Hybrid mismatches’ refers to differences in the tax treatment of financial instruments, entities, and transfers between two or more jurisdictions. Cross border tax planning often involves exploiting hybrid mismatch, which provides double deduction and non-taxation avenues, helps defer, reduce or eliminate the overall tax.

Hybrid Mismatch as per BEPS Action Plan 2 and Part 2 of Multilateral convention

History about Hybrid Mismatch

Hybrid mismatch arrangements assist in achieving double non-taxation by:

Double deduction – deduction for the same payment in two jurisdictions
Deduction without corresponding taxation – Deduction in payers jurisdiction without corresponding income taxed in payee’s jurisdiction

The hybrid mismatch has been vastly used in the global business environment, resulting in substantial erosion of the countries’ tax base. To increase the coherence of corporate income taxation at the international level and remove distortions in competition, efficiency, transparency, and fairness, the OECD and G20 countries developed BEPS Action Point 2. BEPS Action Plan 2 – ‘Neutralising the Effects of Hybrid Mismatch arrangements’ tackles hybrid mismatches.

Target of BEPS Action Plan 2

BEPS Action Plan 2 targets mismatches arising from

Use of hybrid Entities

Entities that are disregarded or treated as transparent entities for tax purposes in one jurisdiction and opaque in another

Use of Hybrid Financial Instruments

Financial instruments involving a conflict in characterization, such as debt in one country and equity in another.

Recommendations of BEPS Action Plan 2

BEPS Action Plan 2 aimed at neutralizing the effects of hybrid mismatch arrangements through domestic rules and treaty provisions. It seeks to end the multiple deductions of a single expense, deductions without corresponding taxation, and eliminate various tax credits.

Recommendations of BEPS Action Plan 2 are:

Changes in domestic tax laws through primary and defensive rules result in non-reliance on other countries’ tax laws to neutralize hybrid mismatch.
Changes to treaty provisions ensure that hybrid arrangements are not used to obtain unduly the benefits of tax treaties.

The changes to treaty provisions recommended by BEPS Action Plan 2 and recommendations of BEPS Action Plan 6 (Preventing the Granting of Treaty Benefits in Inappropriate Circumstances) are incorporated in Part II of the MLI, which deals with Hybrid mismatches.