Circularity between measures Questions regarding financial instruments Daniel Gutmann Professor at the Sorbonne Law School (University of Paris-1)

Simple case COUNTRY A COUNTRY B A Co Hybrid Financial Instrument Payment B Co

International response OECD 2012 Report on hybrid mismatches : best policy option = coordination between tax systems rather than GAAR, SAAR or harmonization BEPS Action 2 : develop model treaty provisions and recommendations regarding the design of domestic rules to neutralise the effect (e.g. double non- taxation, double deduction, long-term deferral) of hybrid instruments and entities. European Union Reform of the parent-subsidiary directive Draft “BEPS” directive

How to ensure coordination between tax systems? OECD Report, 2012, identifies a problem of circularity Finally, it is worth mentioning that in principle operating rules that link the tax treatment in one country to the tax treatment in another country may also require introducing a “tie-breaker” test to solve issues that may arise when both countries’ tax laws look at the treatment in the respective other country e.g. if the country of the payer denies the deduction if the income is not included in the taxable income of the recipient and the country of the recipient denies the exemption if the payment is deductible in the country of the payer. Country rules linking the domestic tax treatment to the foreign tax treatment do not generally contain a tie-breaker test for cases where the other country involved has similar rules. Although the matter may become more relevant as more countries introduce similar rules, it appears that to date this has not caused major issues. This is likely due to the fact that only sophisticated taxpayers engage in such arrangements and they generally avoid using arrangements where they see a risk of double taxation.

Hybrid mismatch rules / BEPS action 2 OECD 2014 solves the circularity problem Hybrid mismatch rules are linking rules that seek to align the tax treatment of an instrument or entity with the tax outcomes in the counterparty jurisdiction but otherwise do not disturb the tax or commercial outcomes. To avoid double taxation and to ensure that the mismatch is eliminated even where not all the jurisdictions adopt the rules, the recommended rules are divided into a primary response and a defensive rule. The defensive rule only applies where there is no hybrid mismatch rule in the other jurisdiction or the rule is not applied to the entity or arrangement.

Hybrid mismatch rules / BEPS action 2 OECD recommendation The primary response should be to deny the deduction in the payer’s jurisdiction to the extent it gives rise to a D/NI outcome. In the event the payer jurisdiction does not respond to the mismatch, the OECD recommends the jurisdictions adopt a defensive rule that would require the payment to be included as ordinary income in the payee's jurisdiction Differences in the timing of the recognition of payments will not be treated as giving rise to a D/NI outcome for a payment made under a financial instrument, provided the taxpayer can establish to the satisfaction of a tax authority that the payment will be included as ordinary income within a reasonable period of time.

Implementation in our simple case Primary rule (in State B) There should be a rule in State B providing that payment is not deductible if it is not taxable under the law of State A State B does not have to care whether a linking rule exists in State A Defensive rule (in State A) If payment has been deducted in State B, there should be a rule in State A providing that even though the payment is exempt in principle, it is nevertheless taxable because State B has allowed deduction and has not implemented a primary rule

EU approach Consistency with BEPS? Draft BEPS directive, art. 10, 1st version “Where two Member States give a different legal characterisation to the same payment (hybrid instrument) and this leads to a situation where there is a deduction in the Member State in which the payment has its source without a corresponding inclusion of the same payment in the other Member State, the legal characterisation given to the hybrid instrument by the Member State in which the payment has its source shall be followed by the other Member State”. Opposite to OECD approach : if the source State grants deduction, its domestic legislation should apply first and the other State should tax  no primary response “OECD style” Draft BEPS directive, art. 10, 9th version (24 May) “To the extent that a hybrid mismatch results in a deduction without inclusion, the Member State of the payer shall deny the deduction of such payment” Back to BEPS

French reform : introduction of a linking rule Brief description of Art. 212 FTC (after Budget Law for 2014): Goal of the rule : deny double dip structures where interest is deductible in France without being taxed in the recipient’s State, mostly because of different characterization (dividend), Interest paid to a related entity is deductible to the extent that is subject to sufficient taxation at the level of the recipient, Sufficient taxation means 25% of French CIT which would have been paid under ordinary French rules: 25% x 33,1/3% = 8,33% Specific rules apply to transparent structures and to collective investment vehicles: No taxation at their level  not in the scope as such; However, partners in the scope if dual test is met : debtor is related to the fund + fund is related to partners

General comment and questions There is now a linking rule in France It is a primary response according to the OECD doctrine However it goes far beyond the OECD recommendation because it applies even where the payment is not tax exempt in the payee’s juridiction French legislation does not make it clear that linking rules in the payee’s jurisdiction should be ignored in the payer’s juridiction  unclear whether circularity is avoided If the payment is made to an entity which is located in the European Union and the linking rule of the parent-subsidiary directive applies, should we consider that France has to ignore the linking rule of the directive?

French reform : practical issues Interpretative issues Sufficient taxation of interest : Gross interest vs net interest Ex. : no tax paid in the country of the lender because the lender also deducts interest Tax base does not matter... What about beneficial ownership? Notional interest deduction : in the scope? Check-the-box : in the scope? Burden of proof: Debtor must prove sufficient taxation at the level of the lender Problem of timing of taxation Risk of recharacterization of interest? No

French reform, BEPS and EU Law Compatibility of the new rules with higher standards: EU Law: The text applies regardless of State where the recipient is established (i.e. also if the recipient is subject to French CIT) : enough with respect to EU Law standards? No safe harbor clause Treaty Law: Non-discrimination clause applicable?

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