Hybrid mismatch rules – practical implications | KPMG | UK
Share with your friends

Hybrid mismatch rules – practical implications

Hybrid mismatch rules – practical implications

The hybrid mismatch rules, which have applied from 1 January 2017 whatever a group’s year end, are aimed at counteracting tax mismatches where the same item of expenditure is deductible in more than one jurisdiction or where expenditure is deductible but the corresponding income is not fully taxable (or the income is taxed at a beneficial rate or is deferred to a future period).


Also on KPMG.com

The rules are complex, which is illustrated by the draft of HMRC’s guidance running to almost 400 pages. As a practical matter, a good starting point is to identify a mismatch in the tax treatment within an arrangement. In order to do this, it will be necessary to fully understand the corresponding overseas tax treatment to each transaction. If there is a mismatch, this can then be tested to see if it is of a type which is within the scope of the rules.

The rules are mechanical in operation and do not contain a purpose test, and so can apply to wholly commercial transactions.

Whilst the rules can apply to all types of deductions, including intra-group fees and payments for goods and services, in the context of M&A activity, we have considered the application of the rules to financing transactions, as illustrated by the following examples.

UK subsidiary disregarded for US tax purposes

Suppose a US parent company receives interest on a loan to its disregarded UK subsidiary. There is a mismatch if the interest expense is deductible in the UK but the corresponding interest income is not taxable because, for US tax purposes, the UK subsidiary and the loan do not exist.

More surprisingly, we recently advised on a situation where the rules were found to apply to loans between two UK group companies (subsidiaries of US group companies) even though there was no mismatch in tax treatment either in the UK or the US. 

The situation involved a loan between two UK companies both of which were disregarded for US tax purposes. In the UK, the interest expense and income would be both allowable and taxable as recognised in the accounts, so there is no mismatch in the UK tax treatment. Within the US, the structure of the wholly owned group was such that, within the consolidated tax return, both the interest expense and interest income would be separately recognised, so there would also be no mismatch in the US tax treatment. 

Whilst it might not be expected that the hybrid mismatch rules would apply in these circumstances, as there is no mismatch, their application is triggered because the interest expense on the borrowing is deductible in both the UK and the US. 

Even where there is a mismatch within the scope of the rules, there is no disallowance of the interest expense in the UK to the extent there is income in the UK borrowing company which is taxed both in the UK and the US. However, in this case, as a practical matter, there is expected to be no such income in the borrower. Although the interest income on the lending is taxable both in the UK and the US, this arises in the UK lender not the UK borrower, and so there is no relief from the mechanical application of the rules. 

Having identified the issue, it was possible to restructure the arrangements but if the issue had not been identified there would have been a material downside with the UK sub-group being taxed on the interest receipt with no relief for the corresponding interest deduction.

Mismatch occurs outside the UK

The hybrid mismatch rules are not only relevant to the type of mismatch between a UK company and its direct counterparty, as illustrated above. In particular, in order to assess whether the rules are relevant, it will be necessary to fully understand the chain of any linked transactions and the overseas tax treatment throughout this chain.

Suppose that a UK subsidiary has borrowed on interest bearing terms from its Luxembourg parent company. The interest expense is deductible in the UK as recognised in the accounts and the corresponding income is recognised in the accounts of the Luxembourg parent company and taxed at the standard rate. As a result, there is no mismatch in the treatment of the loan interest between the UK and Luxembourg and the group may (mistakenly) believe that the Hybrid rules will not apply.

A common arrangement is where the Luxembourg parent company is financed by preferred equity certificates (or “PECs”) issued to its shareholders who are private equity investors. In Luxembourg, the PECs are accounted for as debt and the coupon recognised in the accounts is tax deductible. As a result, the Luxembourg parent company is effectively taxed on a small margin.

If there is a mismatch in the treatment of the coupon on the PECs between Luxembourg and for the private equity investors, the UK company may be required to self-assess a disallowance of the interest expense on its borrowing from the Luxembourg parent company.

The key point here is that a good understanding of the tax treatment of each private equity investor will be required to determine whether it is reasonable to suppose there is a mismatch and its nature; perhaps the mismatch is only one of timing if the investor is a US company which is taxed on a receipts basis, or of non-taxation if the income is received in a tax haven or a territory were a tax exemption applies.

Interaction with the corporate interest restriction regime

Note to reader: This section examines the interaction between the hybrid mismatch rules and a measure removed from Finance (No. 2) Bill 2017. We understand that these measures are intended to be reintroduced at the earliest opportunity post-election. 

Taken together with the new corporate interest restriction regime, which will apply from 1 April 2017, business will be faced with an onerous additional compliance burden in addition to the existing rules which can potentially disallow interest deductions. Accordingly, it will be necessary to find a practical approach to apply the various rules.

In some respects, it is helpful that there will now be no overlap between the existing worldwide debt cap regime, which ceased to apply on 31 March 2017, and the corporate interest restriction regime. However, both regimes, are based, in part, on interest amounts taken from the group accounts. So, if a group’s accounts straddle 1 April 2017, it will be necessary to apportion the group results pre and post this transition date. The version of the draft legislation in Finance (No. 2) Bill 2017 now includes an apportionment mechanism for both sets of rules. It may be worthwhile considering how this will be applied in practice.

What are the practical implications?

The interaction of the hybrid mismatch rules with the corporate interest restriction rules is less straightforward because both regimes provide for disallowed amounts to be potentially deductible in later periods. 

For example, in the context of the shareholder debt described above, as a practical matter, it might be sensible to first allocate any disallowance under the corporate interest restriction rules to the shareholder debt to avoid testing the application of the hybrid mismatch rules. The compliance burden may be high given that the tax treatment of the various investors needs to be considered, particularly where the investors are in the form of partnerships as it may be difficult to obtain information on the tax status of the partners. It had been hoped that HMRC might simplify the interaction. However, in a change proposed to be made to the hybrid mismatch rules in Finance (No. 2) Bill 2017, it has been made clear that the hybrid mismatch rules must be applied before the corporate interest restriction rules. It therefore appears that groups will need to fully test the application of the hybrid mismatch rules even where it is clear that there is insufficient capacity under the corporate interest restriction rules to deduct an equivalent amount of interest.

Finally, it is noted that there is no grandfathering treatment and so existing arrangements will need to be considered.

Connect with us


Request for proposal