United States: Hybrid Mismatches: Where U.S. Tax Law And A.T.A.D. Meet

Last Updated: October 2 2018
Article by Alev Fanny Karaman and Beate Erwin

This article focuses on the interaction between certain hybrid mismatch provisions of A.T.A.D. 2 and certain provisions of U.S. tax law. As will be shown in later examples, A.T.A.D. 2 can be seen as a concerted E.U. effort to target overseas earnings of U.S. multinationals.


European Council Directive 2016/1164 ("A.T.A.D. 1") was adopted on July 12, 2016. It lays out the rules against tax avoidance practices directly affecting the functionality of the E.U.'s internal market.

It contains the following provisions, some of which were inspired by U.S. tax law, while others appear to have inspired the 2017 Tax Cuts and Jobs Act ("T.C.J.A."):

  • An interest deduction limitation rule very similar to revised Code §163(j)
  • Exit tax provisions that resemble the underlying logic of Code §367
  • Controlled Foreign Corporation ("C.F.C.") provisions that resemble U.S. C.F.C. provisions
  • Hybrid mismatches arising in transactions involving the corporate tax systems of E.U. Member States1

A.T.A.D. 2, adopted on May 29, 2017, entirely replaces the hybrid mismatch rules of A.T.A.D.1.2 It includes rules on hybrid mismatches with non-E.U. countries, where at least one of the parties involved is a corporate taxpayer, or an entity in an E.U. Member State. This follows a request by the Economic and Financial Affairs Council of the E.U. for "rules consistent and no less effective" than those recommended by the O.E.C.D. under the B.E.P.S. initiative.3 In addition, A.T.A.D. 2 adds provisions on reverse hybrid mismatches, or imported mismatches, and tax residency mismatches. 4


Hybrid mismatches exist in the following situations involving taxpayers or entities:5

  • Hybrid Transactions: Certain payments under financial instruments that give rise to an income deduction in the hands of the payor but no income inclusion in the hands of the payee constitute hybrid mismatches. Payments fall under this category when (i) they are not included in the payee's income within a reasonable timeframe6 and (ii) the mismatch in treatment is due to differences in the characterization of the payment or the underlying instrument. For this purpose, a financial instrument is defined as any instrument giving rise to either a financing or an equity return subject to tax laws relating to debt, equity, or derivatives under the laws of either the payor's or the payee's jurisdiction.7
  • Hybrid Entities: Payments to hybrid entities that give rise to an income deduction in the hands of the payor and no income inclusion in the hands of the payee constitute a hybrid mismatch where there is a difference in the allocation of the payment between the jurisdiction in which the hybrid entity is established or registered and the jurisdiction of any person holding an interest in such hybrid entity.8 For purposes of both A.T.A.D. 1 and A.T.A.D. 2, a hybrid entity is defined as an entity or arrangement treated as a taxable entity under the laws of one jurisdiction and whose income or expenses are considered belonging to one or more other persons (entities or individuals) under the laws of another jurisdiction. An example for a hybrid entity falling within the scope of this rule would be an entity treated as a taxpayer under the laws of an E.U. Member State that made an election to be treated as a partnership or a disregarded entity for U.S. income tax purposes.
  • Permanent Establishments: Certain payments to or from permanent establishments give rise to hybrid mismatches.
  • Disregarded Payments: Deductible payments by hybrid entities that are not included in income by the payee because the payment is disregarded under the laws of the payee's jurisdiction are another form of hybrid mismatch.

    • Such payments only constitute hybrid mismatches if the jurisdiction of the payor allows the deduction from income that is not included in both the payor's and the payee's hands.
    • Double Deductions: Certain payments resulting in double deductions constitute hybrid mismatches if the jurisdiction of the payor allows a deduction from income that is not included in both the payor's and the payee's hands.
      For this purpose, a double deduction or a deduction without inclusion does not constitute a hybrid mismatch unless it arises
      • between associated enterprises,
      • between a taxpayer and associated enterprises,
      • between a head office and a permanent establishment,
      • between two or more permanent estabalishments of the same entity, Or
      • under a structured arrangement.9

    Generally, for hybrid mismatch and reverse mismatch purposes, an associated enterprise is defined as follows:10

    • An entity in which the taxpayer has a direct or indirect voting, capital, or profits interest of 50% or more
    • An entity or individual holding a direct or indirect interest by vote, capital ownership, or profits in the taxpayer of 50% or more
    • An entity that is part of a consolidated group for financial accounting Purposes
    • An enterprise in which the taxpayer has a significant management influence
    • An enterprise that has a significant management influence in the taxpayer

    Further, for purposes of defining associated enterprises, a person acting with the owner of the voting rights or the capital of an entity is deemed to own all the voting rights or the capital of such owner.


    The general treatment of hybrid mismatches with respect to payments that involve at least one party based in an E.U. Member State under A.T.A.D. 2 is as follows:

    • If a hybrid mismatch results in a double deduction, the state of the recipient of the payment must deny the deduction. If the recipient's state does not deny the deduction, the payor's state must deny the deduction. The latter could occur when the recipient's state is not an E.U. Member State, such as the U.S.
    • If a hybrid mismatch results in a deduction for the payor with no income inclusion for the recipient, the payor's state must deny the deduction. If the deduction is not denied, the payment must be included in income in the recipient's state. The latter could occur when, for instance, the payor is located in the U.S.
    • A state can disallow a deduction for a payment when the payment directly or indirectly funds a deductible expenditure giving rise to a hybrid mismatch through a transaction or series of transactions between certain related parties or entered into as part of a structured arrangement, except to the extent that one of the jurisdictions involved has already made an equivalent adjustment with respect to the hybrid mismatch.

    Accordingly, an ordering rule sets forth which state will first make an adjustment, such as a denial of deductbility. A.T.A.D. 2 includes limitations to the scope. More specifically, it makes the following clarifications:

    • The adjustment to the mismatch shall be limted to the "extent of the resulting undertaxed amount."11
    • Any adjustments that are required to be made under A.T.A.D. 2 should, in principle, not affect the allocation of taxing rights between jurisdictions laid down under a double taxation treaty.12
    • Where mismatches are subject to adjustments under the Directive or neutralized under similar rules, no further adjustments under A.T.A.D. 2 shall be required.13

    In this context, it will be interesting to see how, once A.T.A.D. 2 becomes effective, the ordering rules will be aligned with these limitations in practice.

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    1 A.T.A.D. 1 must be implemented by E.U. Member States by December 31,2018.

    2 Article 9 of A.T.A.D. 2. A.T.A.D. 2 must be implemented by E.U. Member States by December 31, 2019. Only reverse hybrid mismatch rules are subject to an extended deadline for implementation of December 31, 2021.

    3 Preamble of A.T.A.D. 2 at (5) with reference to the O.E.C.D. Report on Neutralizing the Effects of Hybrid Mismatch Arrangements, Action 2 — 2015 Final Report ("O.E.C.D. B.E.P.S. Report on Action 2").

    4 Article 9a of A.T.A.D. 2.

    5 Article 2(9) of A.T.A.D. 2.

    6 For this purpose, a reasonable timeframe means either (i) an inclusion within 12 months of the end of the payer's tax period or (ii) a reasonable future inclusion expenctancy, when the terms of the payment are arm's length.

    7 An exception will apply if these rules would lead to unintended outcomes in the interaction between the hybrid financial instrument rule and the loss-absorbing capacity requirements imposed on banks. Without prejudice to State Aid rules, E.U. Member States should be entitled to exclude from the scope of A.T.A.D. 2 intra-group instruments that have been issued with the sole purpose of meeting the issuer's loss-absorbing capacity requirements and not for the purposes of avoiding tax. Preamble of A.T.A.D. 2 at (17).

    8 However, if the payee is treated as a tax-exempt entity under the laws of its country, this rule should not apply since this would result in a hybrid mismatch in any event. The same principle should apply to a deduction without inclusion in the case of payments by disregarded permanent establishments. Preamble of A.T.A.D. 2 at (18) and (19).

    9 Article 2(9) of A.T.A.D. 2.

    10 Article 2(4) of A.T.A.D. 2.

    11 Preamble of the A.T.A.D. 2 at (16).

    12 Preamble of the A.T.A.D. 2 at (11).

    13 Preamble of the A.T.A.D. 2 at (29) and (30).

    The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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