Neutralizing the Effects of Hybrid Mismatches in Cross Boarder Taxation


Alibaba Group Corporate Structure, which exploits hybrid mismatches 

By gatuyu Justice

Multinationals look at tax treatment of an entity or instrument under the laws of various tax jurisdictions and use the one that would lead to double non-taxation or long-term deferral. 


Sovereign states do set their municipal tax systems as they deem fit. They determine entities or instruments which are subject to income taxation, which are exempt and the manner of taxation.

In this sovereignty of determination, arises a problem. It leads to differing arrangements between countries in regard to characterization of instruments or entities under jurisdictional laws. Varying characterization results to a mismatch in tax outcomes.

One of the instrument which is notorious for receiving mixed characterization is the preferred share. Here it is an equity instrument. There it is a debt instrument. It matters, for where is a debt instrument, interest on debt is, for tax purposes, an allowable expense, subject to thin capitalization rules.

This, in international tax law, will be called Hybrid mismatches. Countries are just holding different views on the qualification of an entity or instrument for taxation. It has impact on cross boarder trade. It has become a facilitator of international tax evasion schemes.

Multinationals exploit hybrid mismatches. They look at tax treatment of an entity or instrument under the laws of various tax jurisdictions and use the one that would lead to double non-taxation or long-term deferral.

These arrangements have in recent years become widespread, resulting in substantial erosion of the taxable bases of the countries concerned. The result has been impacting negatively on competition, efficiency, transparency and fairness in international trade.


There is a companies X. It has two subsidiaries; intermediary Subsidiary 1 and a local subsidiary 2 in countries A and B respectively. Let’s say intermediary Sub 1 provides funds to Local Sub 2. Country A may qualify such funds as a capital investment and any return on that investment is likely to be non-taxable there. However, country B might qualify the investment as a loan under its domestic tax rules resulting to any return paid on the investment to be considered as interest. The interest payments would consequently reduce the taxable base of Local Sub 2. These arrangements on different qualification on what qualifies as ‘investment’ or as a ‘loan’ brings is a case of hybrid mismatch. It creates tax deductible payment in country A. It avoids a corresponding inclusion in country B.

We have seen from our illustration. One of the key factors in determining the issue of mismatches is the qualification rules. Given the complex nature of qualification rules, many countries offer companies the possibility to get upfront certainty about a country’s qualification of an international element for corporate income tax purposes.

This certainty could be obtained from the local tax authorities, such as our Kenya Revenue Authority, either through a tax ruling, tax agreement or comfort letter setting out the tax consequences in the country that prescribes the rule.Our Tax Procedures Act 2015 allow this.

Hybrid Mismatch structures

Countries are not obligated to adopt the outcome of another country’s qualification rule. They are free to determine their own set of qualification standards. The different qualification rules between countries may result in “qualification mismatches” which lead to either non-or double taxation of income.

Such a situation is not in line with an ideal corporate tax system from a tax planning perspective. In tax planning, several strategies have developed which leverage on hybrid mismatches that result in non-taxation. As we have seen in the illustration, financing arrangement was used to reduce the taxable base in Country B.

It is for these reasons whey the OECD,a club of rich countries, in their 2015 Base Erosion and Profit Shifting (BEPS) Project report classified ending the problem of hybrid mismatches as an action plan number 2. The report identified the following arrangements as typical hybrid mismatches used in international tax planning structures. These include:

a) Hybrid entities: these are entities that are treated as transparent (non-taxable partnerships) for tax purposes in one country and as non-transparent (companies)in another country;

b) Hybrid instruments: these are instruments which are treated differently for tax purposes in the countries involved, most often as debt in one country and as equity in another country. We gave preference shares as an example;

c) Hybrid transfers: these are arrangements that are treated as transfer of ownership of an asset for one country’s tax purposes but not for tax purposes of another country, which generally sees it as a collateralized loan; and

d) Dual residence entities: this is where entities are resident in two different countries for tax purposes. Dual residence is typically based on the fact that some countries tax system are based on incorporation and some other countries tax based on place of establishment.

Neutralizing the mismatches

The effect of hybrid mismatch arrangements is they it leads into double deduction schemes, where a deduction related to the same contractual obligation is claimed for income tax purposes in two different countries.

Such a situation may arise where the hybrid mismatch arrangement is a result of dual residence companies, which are considered subject to tax in two different countries. If a dual residence entity is in a loss situation and benefits from a tax consolidation or group relief system is in two countries, the loss can be offset against the income in both countries.

Secondly, the arrangements may lead to ‘deduction and no inclusion schemes’. These arise in circumstances where there is a deduction in one country, typically a deduction for interest expenses, but no corresponding inclusion in the taxable income in another country.

The Starbucks has used this structure by having several types of partnerships in various countries which are transparent for corporate income tax purposes.

Neutralizing effects of hybrid mismatch arrangements, in particular on non-taxation, as we have earlier explained, is a key action point under the OECD BEPS projects. Under Action point 2, Neutralizing the Effect of Hybrid Mismatch Arrangements detail various recommendations to address hybrid mismatch arrangements. Part I of the recommendations is on domestic law rules to address hybrid mismatch arrangements and Part II contains recommended changes to the OECD Model Tax Convention.

The recommendations in Part I include “specific recommendations” and “hybrid mismatch rules.” The specific recommendations are modifications to provisions of domestic law to avoid hybrid mismatches and achieving alignment between domestic law provisions and their intended tax policy outcomes.

Hybrid mismatch rules aim at neutralizing one of the following three mismatches in tax outcomes:

  • Payments that give rise to a deduction with no taxable inclusion arising from a hybrid financial instrument (including a hybrid transfer), a disregarded payment made by a hybrid entity or a payment made to a reverse hybrid;
  • Payments that give rise to a double deduction arising from a deductible payment made by a hybrid entity or a dual resident; and
  • Payments that give rise to an indirect deduction with no inclusion arising from an imported mismatch.

The hybrid mismatch rules are divided into a primary response and a secondary or defensive rule. The defensive rule only applies where there is no hybrid mismatch rule in the counter-party jurisdiction or where the rule is not applied to the particular entity or arrangement. Each of the hybrid mismatch rules has its own specified scope of application.

The United Kingdom has already proposed to introduce new ‘hybrid mismatch’ rules as from 2017 in response to Action 2 of the OECD BEPS project. The rules provide that: the UK to impose additional taxable income when a UK corporate taxpayer receives a payment that would otherwise give rise to a mismatch; or the UK to deny tax deductions, or limit their use, when a UK corporate taxpayer makes such a payment. This will impact on multinational groups and have them make less use of hybrid mismatch arrangements.


Once translated into domestic and treaty law, the OECD recommendations under Action 2 of the BEPS Project will neutralize hybrid mismatches by putting an end to multiple deductions for a single expense, deductions without corresponding taxation or the generation of multiple foreign tax credits for one amount of foreign tax paid.

By neutralizing the mismatch in tax outcomes, the rules will prevent these arrangements from being used as a tool for base erosion and profit shifting without adversely impacting on cross-border trade and investment.

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