The BMG today publishes its submission to the OECD discussion paper on Hybrid Mismatch Arrangements (HMAs). HMAs involve legal entities or instruments that are treated differently under the rules of different countries, e.g. an entity that could be a partnership and a company, or a financial instrument that could be a loan or an equity contribution. These enable a payment which is tax deductible in the country of the payee to be not subject to tax in the hands of the recipient, or even to be deductible twice.
The problem of HMAs is probably the most technical and potentially complex issue to be addressed in the BEPS Action Plan, and hence one that might be neglected by those not closely involved. In our view, this would be a mistake, as we consider that it has as much importance as any of the BEPS issues. We commend the OECD for having produced a technically sophisticated analysis and proposed solutions which are carefully and elegantly designed.
However, we point out that it is the `separate entity’ principle in tax treaties which not only allows but encourages multinational corporate groups to develop complex structures such as those using HMAs. Many of the proposals now being considered in the BEPS project, including these relating to hybrids, attempt to counteract these techniques by overriding the separate entity principle, but only in specifically defined circumstances. Hence, they can at best hope to provide only temporary palliatives to a system which desperately needs a more fundamental cure.
Multinationals raise their capital on global financial markets, using the `offshore’ system, which greatly reduces their cost of capital. Since the 1990s, investment banks and other tax planners have devoted enormous resources to devising complex structured financing arrangements, which reduce the cost of capital even more. Many of these arrangements are tax driven, i.e. primarily designed to minimize tax, and HMAs are central among these techniques. Even if the rules are patched up by states, the separate entity principle will continue to drive tax planning.
The OECD approach can only hope to be effective with much closer and continuous coordination between states. In our view, the current proposals on HMAs demonstrate this. Although they are put forward as proposals for changes only to domestic tax laws, on closer examination it is clear that they will need to be closely coordinated.
In our view, a much more effective approach would be the replacement of the `separate entity’principle with a `unitary’ approach to multinational corporate groups. This does not require a radical shift to a fully-fledged unitary taxation system with apportionment based on pre-fixed formulas. This should, however, be the long-term aim, beginning now with a clear recognition of the need for a unitary approach. Indeed, this is implicit in the mandate to the OECD from the G20 world leaders, that reform of international tax rules should ensure that firms are taxed `where economic activities take place and value is created’.
The financial structures of MNCs are the source of a large proportion of the problems of BEPS. Adopting a unitary approach could provide a comprehensive solution not only to HMAs, but also to other problems, notably base erosion via interest payments (Action Point 4), and transfer pricing problems of allocation of capital (Action Point 9). OECD states have used various forms of proportionate allocation of joint costs, including financing costs. In our view, the BEPS project should build on and refine these. Such an approach would recognise the economic reality that the MNC operates as a unitary firm, and simply eliminate all the effects of the artificial corporate structures and contractual arrangements, including hybrids. This would provide the basis for a solution which would be more comprehensive, simpler, clearer, and easier to administer.
2 May 2014