Jelena Bartule, of BDO Latvia, analyzes the scope of the hybrid mismatch rules now that the EU anti-avoidance directive (ATAD 2) has been introduced in Latvia.
The Latvian Corporate Income Tax (CIT) Law implemented changes on February 11, 2020, regarding Council Directive (EU) 2017/952 of May 29, 2017, amending Directive (EU) 2016/1164 as regards hybrid mismatches with third countries.
Action 2 of BEPS Action Plan called for recommendations regarding the design of domestic rules to neutralize the effects of hybrid instruments and entities.
The amendments made to the CIT Law are intended to transpose the provisions of Directive (EU) 2017/952 regarding hybrid mismatches. The rules included in the amendments are intended to prevent the possibility of tax planning using transactions that give rise to hybrid mismatches (due to the different legal characteristics of payments (financial instruments) or entities, and these differences result from the interaction between the legal systems of the two or more jurisdictions).
Hybrid mismatch consequences are often the double deduction (i.e. deduction of expenses in both countries) or the deduction of income in one (payer) country and its non-inclusion in the tax base of the other (income receiver) country.
In particular, in one jurisdiction, expenses are deducted for CIT purposes, but the relevant income is not included in taxable income in the recipient’s jurisdiction. By transposing the provisions of Directive 2016/1164 on combating hybrid mismatch into the CIT Law, Latvia also eliminates tax evasion through the use of hybrid instruments.
Impact of the New Anti-Hybrid Measures
Taking into account Directive (EU) 2017/952 hybrid mismatch neutralization measures are applied to transactions also with persons in third countries. The provisions of Directive (EU) 2017/952 are already contained in the CIT Law, in view of the fact that the Latvian CIT model stipulates that the profit of the company is not taxed by CIT until the distribution of dividends, not at the time when profit is obtained (as is usually the case in other countries) by paying tax for each tax period. However, in order to ensure full transposition of the provision of the Directive (EU) 2017/952, the Latvian CIT Law has included additional provisions and requirements arising from Article 5 of Directive 2016/1164.
Directive 2016/1164 aims to counteract hybrid mismatches not only by interacting with EU member states’ CIT legislation, but also where the transaction involves a third country and at least one of the parties is a taxable person or, in the case of reverse hybrids, an entity which is made in an EU member state.
Substantially, the hybrid mismatch neutralization rules apply only to transactions between associated enterprises, between the parent company and secondary establishment, or between two or more establishments of the same entity, as well as to hybrid mismatches resulting from arrangements where the mismatch is priced into the terms of the arrangement.
To neutralize hybrid mismatches, Directive 2017/952 requires EU member states to prevent a taxpayer from deducting a payment:
- in so far as the payment is not adequately included in the taxable income of the counter party (recipient abroad); or
- if this payment is simultaneously deducted also from the taxable income of the counter party (investor abroad).
If the primary rule is not applied (for example, if the transaction is with a partner located in a third country, which has no binding provisions with EU law), the EU member state taxpayer must increase CIT taxable income on that amount of deduction or non-deduction.
The provisions of Directive 2017/952 are taken over by Article 71 of the CIT Law, thus paragraph 12 of paragraph Six of this Article also includes the definition of related companies (which was removed from the CIT Law in 2018 and renewed with new CIT Law amendments in 2020 regarding hybrid mismatches).
A financial instrument (any funding mechanism) may create a hybrid mismatch if it is defined differently under the laws of different jurisdictions (such as a loan in one jurisdiction and equity in another jurisdiction). Although, there is also a difference in the tax treatment whereby, in one jurisdiction, expenditure is deducted on the basis of the CIT, but the relevant income is not taken into account in determining the taxable income in the other.
A hybrid transfer may occur when counter parties in different jurisdictions consider themselves to be the owners of the same financial instrument. As a result, the different tax treatment is applied, which results in a deduction without inclusion.
Hybrid mismatches between permanent establishments (PE) occur when the PE and the domicile of the head office have different rules on the distribution of income and expenses between units of the same entity. This includes cases where the outcome of the non-compliance is that under the law of the domicile jurisdiction it is considered that a PE is not formed, whereas, under the jurisdiction of the domicile of the head office, the PE abroad is a representative office.
Hybrid Mismatch Settled in Accordance with Certain Principles
The new amendments of the CIT Law are similar to the provisions of the Directive that defines six possible definitions of deduction without inclusion.
In cases where the two jurisdictions involved in the transaction are EU member states, the member state in which the expenditure is incurred shall be prohibited from deduction without inclusion. In the case where the counter party has not made the primary adjustment and, for example, is in the third jurisdiction (as the EU member state is likely to apply the initial adjustment), it is first necessary to clarify which is the payer’s jurisdiction. If the taxpayer has jurisdiction in the member state, it denies the deduction, whereas if the taxpayer has jurisdiction in the third country, the member state has to ensure that the tax is properly included in the taxable income.
If hybrid mismatch the consequences will be as a deduction without inclusion:
Primary correction—The taxpayer (if the Republic of Latvia is the payer’s jurisdiction) will increase the tax base by a deduction amount that is not adequately taken into account for tax purposes abroad for tax purposes.
Secondary correction—The taxpayer, if the tax jurisdiction of the recipient is the Republic of Latvia and tax base abroad is not increased by the amount of the deduction, increases the tax base by the amount of income that was not taken into account in calculating taxable income.
It should be noted that Latvia has opted the right, provided in the derogation provided in Directive 2017/952, by exempting from the application of the secondary adjustment in certain cases, specifying the cases in which the taxable person does not have to apply the secondary adjustment.
The double deduction may occur in transactions made, for example, with a hybrid entity, and when the payment is offset against the income of another group entity under the group’s CIT regime, as well as in the case of unrecognized PEs.
If the hybrid mismatch results in a double deduction:
Primary correction—The taxpayer (if the Republic of Latvia is an investor jurisdiction) will increase the tax base by a deduction amount that is deducted from taxable income abroad as well.
Secondary correction—The taxpayer (if the Republic of Latvia is the payer’s jurisdiction) will increase the tax base by the amount of the deduction if the taxable amount in the investor’s jurisdiction is not increased for tax purposes. The taxpayer will, in the first instance, be entitled to reduce any double deduction income, if any, arising during the tax or post-tax period.
It should be noted that where the counter party is located in a third country, the result of the hybrid mismatch (double deduction) must be eliminated in the member state, irrespective of whether the deduction originated in the member state or in the third country.
A framework has been put in place for reverse hybrid mismatches as well.
The CIT Law stipulates that an entity established in the Republic of Latvia which is considered to be transparent in Latvia, whereas in the jurisdiction of a related party it is considered as opaque (in the jurisdiction of an investor), Latvia shall treat that entity as a resident of Latvia and apply tax obligations accordingly.
In order to ensure the application of this provision, the existing CIT Law was supplemented by stipulating that a company which is not generally considered to be a CIT payer will be considered as such if the transaction of such company (private pension funds, investment funds, and alternative investment funds) creates a hybrid mismatch (the provision will apply from January 1, 2022).
In accordance with Latvian CIT Law requirements, the first corrections regarding the hybrid mismatches will need to be completed by January 20, 2021—this means that there is still a year to explore and reorganize the structure to reduce unnecessary tax risks.
The regulation is new, which means that value-added tax and transfer pricing rules have to be analyzed additionally in every situation.