Interaction of the best practice approach with hybrid mismatch rules under Action 2
- 199. Where a country has introduced a fixed ratio rule, the potential base erosion and profit shifting risk posed by hybrid mismatch arrangements is reduced, as the overall level of net interest deductions an entity may claim is restricted. However, this risk is not eliminated. Within the limits imposed by a fixed ratio rule, there may still be significant scope for an entity to claim interest deductions in circumstances where a hybrid financial instrument or hybrid entity is used to give rise to a double deduction or deduction/no inclusion outcome. Where a group ratio rule applies, there is also a risk that hybrid mismatch arrangements could be used to increase a group’s net third party interest expense, supporting a higher level of net interest deductions across the group. In order to address these risks, a country should implement all of the recommendations under Action 2, alongside the best practice approach in this report.
- 200. Rules to address hybrid mismatch arrangements should be applied by an entity before the fixed ratio rule and group ratio rule to determine an entity’s total net interest expense. Once this total net interest expense figure has been determined, the fixed ratio rule and group ratio rule should be applied to establish whether the full amount may be deducted, or to what extent net interest expense should be disallowed.
- 201. The OECD Report, Neutralising the Effects of Hybrid Mismatch Arrangements (OECD, 2014) stated that rules which grant deemed interest deductions for equity capital, or have similar effect, would not be considered under Action 2, but should be considered further either separately or in the context of Action 4. As set out in Chapter 2, deemed deductions which are calculated by applying a specified percentage to the equity capital of an entity are not treated as being interest or a payment economically equivalent to interest for the purposes of this report. However, these rules should be considered further by the OECD in separate work.