Director Huw Griffiths explains that UK tax professionals continue to neglect hybrid mismatch rules.
The UK introduced its hybrid mismatch rules with effect from 1 January 2017 as part of its response to the OECD’s actions to counteract Base Erosion and Profit Shifting.
The broad aim of the hybrid mismatch rules is to counteract advantages obtained by multinational groups where national tax systems take differing views on whether a person is a separate taxable person and/or whether instruments are equity or debt in nature. These mismatches can lead to either:
- two deductions for the same economic expense; or
- a deduction in one territory without any corresponding income being included to the other.
Example of how a hybrid mismatch disallowance can arise
The following example illustrates the problem in a relatively simple (and typical) form:
- a US Inc owns a US LLC (this is a transparent entity for US tax purposes but an opaque/separate entity for UK tax purposes);
- US LLC in turns owns 100% of a UK Limited Company;
- UK Ltd has ‘checked the box’ for US tax purposes so that it is transparent for US tax purposes but, of course, remains opaque for UK tax purposes;
- US LLC lends money to UK Ltd on which interest is paid;
- the US doesn’t see the loan as the US LLC and UK Ltd are both considered transparent entities and US Inc cannot lend to itself; and
- there is a tax deduction in the UK for the interest payment without a corresponding inclusion of income in the US.
Taxpayers and advisers slow out of the blocks
We are now five years past the introduction of these rules and on due diligence we are continuing to see a great number of UK companies that have submitted returns without any consideration of these rules.
Even though the anti-hybrid rules are mechanical, the rules are incredibly complex and on most occasions the tax return preparer will have to understand the overseas tax position to ascertain if there is a tax mismatch.
There is no SME-type exemption or ‘de minimis’ threshold from these rules, so we regularly see small UK subsidiaries of US parent companies being dealt with by relatively small firms of accountants who are unlikely to have the technical expertise to deal with the issue. In many cases, the hybrid legislation is not even known to the accountants.
Another misconception amongst companies and their accountants is that these rules can only apply to related party expenses; however, this is not the case.
For example, if a UK company in a group is an internal service provider which has its costs reimbursed by a US group company a hybrid disallowance could arise for third-party rental payments made by the UK company as follows where both the UK and US entity are checked for US purposes:
- the UK and US see a deduction arising in the UK company for the rental expense;
- the UK taxes the income arising in the UK company from the reimbursement of costs by the US company;
- however, the US disregards the reimbursement of costs by the US company to the UK entity transaction as both parties are checked and the recipient and payer are the same person;
- a mismatch arises as the deductions on the rental expenses are allowed in the US and the UK but the income from the recharged costs is not taxed twice (notwithstanding that no deduction arises in the US in respect of the transaction giving rise this UK income); and
- a disallowance is made in the UK company for the rental expense under the hybrid rules to address this mismatch.
While steps have been taken to address this particular scenario, the relieving provisions only apply for accounting periods beginning on or after 10 June 2021 and we are seeing adjustments failing to be made for prior periods. Furthermore, the rules may still bite where there are third party expenses paid by a UK holding company whose income, usually from subsidiaries, is not recognised by the US regarded parent.
The consequences of failure to consider and apply the rules can be summarised as follows:
- Additional UK corporation tax becoming payable from expenses previously claimed becoming disallowed under the hybrid rules (and debit interest for late payment, where relevant).
- Tax geared penalties where the company has not taken reasonable care (up to 100% where the taxpayer behaviour leading to the inaccuracy was deliberate and concealed).
- Loss of value where any adverse change in the UK position has a potentially beneficial impact on any overseas tax liability and the overseas position is closed to amendment.
- In a M&A situation, uncertainty can lead to significant delays, price chips or even the collapse of the deal.
- Additional professional fees in undertaking the analysis and rectifying the position in both the UK and relevant overseas territories.
If you are responsible for the tax returns for a UK company within an international group (as preparer or signatory) please consider the anti-hybrid rules.