Hybrid Mismatch Arrangements:

Multinational groups of companies are in a position to be able to take advantage of the different tax
regimes in which they operate in order to reduce the overall tax payable by the group. Part 6A TIOPA
2010 contains anti-avoidance rules which aim to prevent companies taking advantage of hybrid
mismatch arrangements to obtain a double deduction for a single expense or to obtain a deduction
with no corresponding income item. The legislation is divided into chapters, with Chapters 3 to 10
each dealing with a different type of hybrid mismatch arrangement and Chapter 11 dealing with
what is called imported mismatches.

Hybrid mismatch arrangements include the following:

• Hybrid financial instruments, under which the payer can deduct payments as interest, while the
recipient is able to treat the receipt as an exempt dividend;

• Hybrid entities, which are treated as transparent under the rules of one jurisdiction and opaque
under the rules of another, so that a deduction might be obtained at the level of the partners in the
former jurisdiction and at the level of the entity itself in the latter jurisdiction or the entity in the
latter jurisdiction does not suffer tax on an amount in respect of which a deduction has been
obtained in the former jurisdiction;

• Dual resident companies, which may be able to obtain a deduction for an expense in each of their
territories of residence; and

• Arrangements involving permanent establishments, where the permanent establishment is

recognised by one jurisdiction but not the other, so that the former jurisdiction applies its tax rules
to the permanent establishment (and allows deductions for expenses), while the latter disregards its
income or profits.

Where the rules apply, they operate to deny the tax advantage by changing the treatment of either
the payment or the receipt, depending on the circumstances. The rules work regardless of whether
both countries involved in a cross-border transaction have introduced hybrid mismatch rules, by
providing both a primary and a secondary response.

Thus, for example, the primary response in the case of a double deduction involving a hybrid entity is
for the jurisdiction of the parent company to deny a deduction to the parent company. If that
jurisdiction does not provide for this disallowance, the secondary response is for the jurisdiction in
which the hybrid entity is resident to deny the deduction to the hybrid entity.

Where the hybrid mismatch involves a deduction with no corresponding income item, the primary
response is to deny the deduction to the payer. If this does not occur, the secondary response is to
bring the receipt into charge for the recipient.

Unlike the anti-arbitrage rules which these rules replace, the hybrid mismatch rules apply regardless
of the purpose of the arrangement (i.e, there need not be a tax avoidance motive), and must be
applied by the company in preparing its self-assessment tax return rather than relying on a notice
being issued by HMRC.

The hybrid mismatch rules do not contain a priority rule but HMRC are of the view (as expressed in
their manual) that the rules will need to be considered whenever a mismatch within the scope of
Part 6A TIOPA 2010 arises, unless the application of other rules removes the mismatch entirely.
HMRC would expect to apply the hybrid mismatch rules in priority to the corporate interest
restriction rules and the distributions exemptions. In the context of transfer pricing, HMRC explain
that the same result is achieved whether one makes a transfer pricing adjustment first, followed by
the application of the hybrid mismatch rules to any remaining mismatch or one applies the
mismatch rules first, followed by a transfer pricing adjustment to any non-arm’s length amounts
remaining after the adjustment for the mismatch.

 Illustration 1

This example illustrates the application of the rules to a hybrid financial instrument. Salisbury Ltd, a
UK resident company, is the wholly owned subsidiary of Washington Ltd which is resident in Utopia.
Washington Ltd makes an arm’s length, interest bearing loan to Salisbury Ltd on terms that it ranks
after the other creditors of Salisbury Ltd and that, if Salisbury Ltd does not meet certain conditions
as to its solvency, it does not have to discharge its duties under the loan. The UK treats the loan
agreement as a loan relationship so that Salisbury Ltd is able to deduct the interest it pays to
Washington Ltd in the computation of its taxable profits. However, under Utopian law, Washington
Ltd treats the loan as a share subscription in Salisbury Ltd so that what it receives from Salisbury Ltd
is treated as a dividend. Utopia does not tax dividends and neither does it have hybrid mismatch
rules. There is therefore a deduction/non-inclusion mismatch and the UK will adopt a primary
response and prevent Salisbury Ltd from deducting the interest under the loan relationship rules.

 Illustration 2

This example illustrates the application of the rules to a hybrid entity. Boston Ltd, a UK resident
company, is the wholly owned subsidiary of Tokyo Ltd which is resident in Oceania. Under UK law
Boston Ltd is a legal entity separate from Tokyo Ltd, but under Oceanian law Boston Ltd is regarded
as a permanent establishment of Tokyo Ltd without a separate legal identity. Tokyo Ltd makes an
arm’s length, interest bearing loan to Boston Ltd. The UK treats the loan agreement as a loan
relationship so that Boston Ltd is able to deduct the interest it pays to Washington Ltd in the
computation of its taxable profits. However, under Oceanian law, Tokyo Ltd does not tax the interest
receivable from Boston Ltd as it regards it as an intra-company receipt (ie a payment from itself).
Oceania does not have hybrid mismatch rules. There is therefore a deduction/non-inclusion
mismatch and the UK will adopt a primary response and prevent Boston Ltd from deducting the
interest under the loan relationship rules.

 Illustration 3

This example also illustrates the application of the rules to a hybrid entity. Devon Ltd is a UK
resident company which wholly owns Utah Ltd, a company resident in Ufaria. For UK tax purposes
Utah Ltd is regarded as a transparent entity whereas in Ufaria it is regarded as having a separate
legal identity. Utah Ltd, in turn, has a wholly owned subsidiary, Maine Ltd, which is also resident in
Ufaria. Utah Ltd and Maine Ltd form a group in Ufaria and the Ufarian group relief rules operate in
broadly the same ways as the UK group relief rules. Utah Ltd takes out an arm’s length, interest
bearing loan from a Ufarian bank. The interest on the loan is deductible in computing the profits of
Devon Ltd under the UK loan relationship rules as the loan is regarded as having been taken out by
Devon Ltd itself. The interest is also deductible in Ufaria either by Utah Ltd itself or by way of group
relief to Maine Ltd. There is therefore a double deduction mismatch and the UK will adopt a primary
response and prevent Devon Ltd from deducting the interest under the loan relationship rules.

 Illustration 4
This example illustrates the application of the rules to arrangements involving permanent
establishments. Exeter Ltd, a UK resident company, is the wholly owned subsidiary of Seattle Ltd
which is resident in Ruritania. Seattle Ltd also has a UK permanent establishment (UKPE). The UKPE
supplies services to Exeter Ltd for which it is paid a fee of £1m. Seattle Ltd supplies services to its
UKPE for which it is paid a fee of £1m. Under the tax laws of Ruritania the profits of a PE of a
company resident in that country are exempt from tax and any amounts received by such a company
from its PE are not considered in computing its Ruritanian profits. Ruritania does not have hybrid
mismatch rules. The UK will take into account the £1m received by the UKPE of Seattle Ltd in
computing and charging the UKPE’s profits to corporation tax; the UK will also allow a deduction in
computing those profits for the £1m paid by the UKPE to Seattle Ltd. Ruritania exempts the profits of
the UKPE and the sum of £1m received by Seattle Ltd from the UKPE is left out of account in
computing Seattle Ltd.’s Ruritanian profits. There is therefore a deduction/non-inclusion mismatch
and the UK will adopt a primary response and prevent the UKPE of Seattle Ltd from deducting the
£1m payment to Seattle Ltd in computing the UKPE’s profits chargeable to corporation tax.