Printable versionSend by emailPDF version
March 2, 2017

The U.K. has introduced new anti-hybrid rules that are effective from 1 January 2017. These represent the U.K.’s implementation of the recommendations arising from Action 2 of the Organisation for Economic Co-operation and Developments (“OECD”) Base Erosion and Profit Shifting (“BEPS”) project. Her Majesty’s Revenue and Customs (“HMRC”) have now published draft guidance which was open for comment/consultation until 10 March 2017. It has become apparent that the remit of these provisions is wider than originally anticipated by taxpayers.

On 22nd August 2016 the OECD published an additional consultation document extending the recommendations made by Action 2 to cover mismatches arising from the use of branch structures. However, the U.K. had already decided to go one step further than the original OECD recommendations and had already included provisions in their draft legislation covering mismatches arising from permanent establishments.

It is important to note that these provisions do not just apply to financing, they apply to ANY
payments / deemed payments made such as management recharges, royalty payments and stock option payments. They can apply equally to payments made to third parties if the group has deliberately put in place a structure to ensure it benefits from a mismatch.

The rules are complex and require an understanding of both the direct relationships the U.K. companies have in the structure and how payments are taxed in the recipient and onward transactions in the group. This may also require the need to understand how ultimate investors are taxed on income included in their own tax returns, information that may be unavailable or sensitive in a number of instances.

This Tax Advisor Update provides a high level overview of the new rules which will apply to in-scope entities for payments / deemed payments made on or after 1 January 2017.


Broadly, the rules impact the U.K. operations of groups whose tax affairs include arrangements involving mismatches arising from financial instruments, hybrid entities, permanent establishments or dual resident companies resulting in payments that are tax deductible, with the corresponding income not being fully taxed, or duplicate tax deductions for the same payment.

U.K. operations may be impacted where they are directly party to a payment under a mismatch arrangement, or where they are party to a payment that is indirectly connected with a mismatch arrangement elsewhere in the wider group (“an imported mismatch”). For example, a U.K. company may have a loan from another group company where the interest expense is deductible in the U.K. and the interest income taxable in the recipient. In this case there is no direct mismatch. However, if the group has used a mismatch arrangement to indirectly fund the loan to the U.K. which, had the U.K. been a direct party to the transaction, would cause a mismatch under the rules, the mismatch is imported into the U.K. and interest may be disallowed.

HMRC have made it clear in their guidance that entities that are not subject to tax (e.g. haven territories) or are subject to tax at a rate of zero percent do not have taxed income for these purposes and hence a mismatch will arise. In this scenario it is then necessary to consider whether the hybrid nature of an entity is causing the mismatch. 

In certain Chapters of the legislation, even if the hybrid nature is not causing the mismatch it is deemed to be causing the mismatch either as an absolute assumption or when certain counterfactual assumptions are applied. Therefore, transactions with a hybrid entity that is not subject to tax (e.g. a haven company or U.S. LLCs transparent for U.S. tax purposes) can also be brought into these provisions purely by the hybrid nature of the entity.

This is inconsistent with the original OECD recommendations and indeed the original draft U.K. legislation which included “permitted reasons” which assisted taxpayers in cases where the mismatch would have arisen regardless of the hybrid nature. Some taxpayers have transferred income from a haven to a Barbados entity paying tax at a quarter of a percent to try to align with the OECD’s policy intention when considering what should be covered by hybrid provisions. Others are relying on Texas franchise tax, a privilege tax imposed on each taxable entity formed or organised in Texas or doing business in Texas, being sufficient to bring amounts into the charge to tax.

As with all recent new legislation, there is a broadly drafted anti-avoidance provision to stop groups from either trying to “tweak” an existing structure to make it fall outside the rules or implement a new structure that is designed to deliberately fall outside the rules, where in concept, it looks like a hybrid arrangement exists. The anti-avoidance provision would bring those structures into these provisions too.

The rules apply to companies that are subject to corporation tax in the U.K., so the rules do not currently apply to Non Resident Landlords (“NRL’s”), although HMRC are currently consulting on bringing NRL’s into the charge to corporation tax.

What happens if you are in the rules

The U.K. will deny deductions for payments if they relate to the mismatch arrangements. In addition, if receipts in the U.K. are not taxed but deductions are taken in another jurisdiction, if the overseas jurisdiction does not apply similar rules to disallow the deduction, the U.K. will instead tax the income.

There is some allowance for timing differences relating to when territories tax income – for example some might tax on a receipts rather than an accruals basis. If the receipt is taxed within 12 months of the end of the period in which the deduction is claimed, there is no mismatch. However, if taxed after this period the deduction is denied but may be claimed in a later period when the income is taxed. This potentially impacts long term projects where the deductions are taken on an accruals basis and the income is taxed at some end point / exit.

A&M Taxand says

The rules are exceptionally complex and mechanical in nature with no purpose test and as a result many transactions that are a low BEPS risk (for example arising because of a transfer pricing requirement in the overseas jurisdiction to recharge costs to group companies) can be impacted. We have found a number of groups are facing double taxation, particularly those with transactions with U.S. members of the group, where the U.K. did not consider it had entered into something that was a mismatch arrangement.

Our experience to date has shown that for some groups obtaining the information needed to work out, whether they are in the provisions either directly or via the imported mismatch rules, is either exceptionally difficult or impossible due to the potentially significant amount and often sensitive nature of the information required. 

HMRC have now published their draft guidance. Based upon a number of conversations we have had with HMRC we were expecting it to cover a number of the more complex areas. However, despite the fact the guidance is over 400 pages it does not include any of those items and hence does not necessarily add much to understanding the legislation.

The only thing that is clear is that HMRC are interpreting certain definitions more narrowly (e.g. what is dual inclusion income) and others more broadly (e.g. when a financial instrument causes a mismatch) than expected.

What comes next?

Our recommendation is that all groups assess all payments being made out of the U.K. and all amounts on cross border transactions where a tax deduction is available in the U.K. and determine whether it could be impacted by these rules. It is important to understand if the recipient is taxing the income at full rates for that territory. If it is not, it is necessary to get a full understanding of the exact mechanics of how the territory gives effect to a reduced rate of tax as this is critical in determining whether or not the rules apply.

Even if the immediate recipient is fully taxing the income a group also needs to consider whether this is ultimately being funded via a mismatch arrangement further up the structure. That is often more difficult to determine as it potentially requires a significant amount of information relating to the group structure from both a legal entity and funding perspective as well as a detailed understanding of the tax treatment of these arrangements at that level.

Where a group is facing double taxation, immediate restructuring is required to bring the structure into a form that is acceptable under the rules.