Press Room

22 Apr 2021

Hybrid Mismatch Rules: Heads I lose, tails you win


When considering the title for this article (often the hardest part of the entire process) we thought this must be how some US groups think the UK’s hybrid mismatch rules work.

By way of swift recap, the hybrid mismatch rules are designed to stop multi-nationals from playing one tax system off against another to obtain either:

  1. a double deduction; or
  2. a deduction but with no corresponding taxable income.

These mismatches were felt to be so widespread and leading to such a significant loss of tax that stopping them was made the second action of the OECD’s project relating to base erosion and profit shifting.

The following example illustrates the problem in its simplest form:

  • a US Inc owns a US LLC (transparent for US tax, opaque for UK);
  • US LLC in turn owns a UK Ltd;
  • UK Ltd has checked the box for US tax, such that it is transparent for US tax purposes (for UK purposes it remains, of course, opaque);
  • US LLC now lends money to UK Ltd, on which it pays interest;
  • the US doesn’t ‘see’ a loan as the LLC and UK Ltd are both disregarded entities and the US Inc can’t lend to itself; and
  • there is a tax deduction in the UK for the interest payment but no income pick-up in the US to match it.

Hybrid mismatch rules either disallow the interest or impute income depending on which side of the transaction the country is sitting. In the above example, the UK would disallow the interest deduction until the mismatch was removed – in other words all of it.

The intent of the rules is to provide certainty which results in them being very mechanical, and because they are trying to cover many different, often complex, scenarios they can be unbelievably complicated. To make matters worse, the UK’s rules operate in such a way that we adopt the role of world’s policeman in that they seek to make an adjustment even if the UK is not the disadvantaged party!  This occurs if the UK believes that the other jurisdiction in the transaction is not taking action and can even make an adjustment if the UK is not a party to the actual transaction causing the issue – just being somewhere in the chain can be enough.

Furthermore, and quite remarkably, the UK has decided, of its own volition, to go further than the OECD or EU asked for (when the UK was part of the EU that is).

Relief at last

As the rules apply mechanically, they can lead to some sort of adjustment, even if there was no tax avoidance or, incredibly, if the “hybrid” leads to more tax being paid overall, just not in the hybrid “link” (which we have seen happen in practice).

HMRC is finally taking action to remove a number of these skewed scenarios and, in a welcome use of retrospection, is in some cases making the changes with effect from when the rules were introduced on 1 January 2017.

The particular relief this article covers is the one that is probably of most use to US groups.

In our example above, if UK Ltd lent the money on to a UK subsidiary (UK Sub) as part of a linked chain of loans, UK Sub would pay interest to UK Ltd, which would be ‘flat’ in the UK (i.e. a matching deduction and income), but would also show in US Inc’s US return as being a taxable receipt. This is called ‘dual inclusion income’ as it is taxed twice (in the UK and the US). It matches the deduction of the interest paid by UK Ltd to US LLC and cancels it out. There is no overall mismatch and the UK takes no action.

Now, consider possibly the second most common US/UK scenario:

  • The structure is the same as above, but instead of receiving a loan, UK Ltd provides services to the US LLC for a cost-plus fee. Any third-party costs (wages, rent, etc.) of the UK Ltd are allowed both in the UK and the US (in the accounts of the Inc). The income of the UK Ltd is only taxed in the UK as the US ignores the payments as the Inc can’t pay itself.

This structure leads to a mismatch as the third-party deductions are allowed twice but the relevant income is only taxed once and the UK will disallow deductions until the mismatch is removed. The ‘dual inclusion income’ relief mentioned above is not available as the income received in the UK is only taxed once, but it is “special”. As mentioned above, the US ignores the income received by UK Ltd but, crucially, it also ignores the deduction in the LLC, so there is income that is being taxed (in the UK) where there is no matching deduction.

Up to now, the UK’s answer to this issue has been “tough noogies” and the UK Exchequer has quietly pocketed the tax windfall. However, the UK is finally addressing this issue and will treat this ‘inclusion/non-deduction income’ (to give it its technical name) as dual inclusion income and allow it to cover relevant mismatches. This then matches the third-party costs and the UK takes no action.

This change is one that will helpfully be available in respect of inclusion/non-deduction income from 1 January 2017 and, although companies will have to wait until the Finance Bill takes effect to make a claim for relief, help is finally on its way.

We should also point out that the hybrid mismatch rules are due to be amended in other ways via the new Finance Bill, but given that there are 18 different amendments, we will cover other interesting changes in later editions.

If you have any questions regarding hybrids and the UK, please contact Andrew Parkes and Miles Dean.


Andrew Parkes

Andrew Parkes

Andrew is a highly experienced international tax specialist who worked at a senior level in HMRC’s international teams for over 10 years. He has a wealth of experience and technical knowledge.

Email: Andrew Parkes