handbook-tb

Neutralizing effects of hybrid mismatch arrangementsDiscussion Draft on BEPS Action 2 — Domestic Issues involve investorsdeducting foreign expenses against their domestic source income. 125Unlike the OECD recommendations, the effect of the aboveoption is not to deny a deduction and the rule is a uniform rule irrespectiveof the country of the investor. This is a prime method bywhich source States can seek to ensure that foreign service providersare not indirectly granted a better tax treatment than local service providers.By contrast, the OECD recommendations seek to cherry pickcertain payments for the denial of a deduction. This could be particularlydistorting and difficult to administer. OECD recommendationsoften require that the tax treatment in the payer jurisdiction dependson who holds an investment. Therefore, changes in circumstances ofthe investor and transfers of an investment (something over which thepayer may have no control) may result in a changed tax treatment of thepayer (denial of a deduction). In turn, this could have a serious impacton the terms and interest rate on which instruments are issued. 126At a more extreme level, source States might consider introducingor broadening the scope of their earnings stripping rules. Manycountries already have rules that deny a deduction for excessive interest.Some of these are based on transfer pricing (borrowing beyondan arm’s length amount), debt to equity ratio (thin capitalization) orearnings stripping (interest beyond a set proportion of prefinancingexpense income) methodology. 127 However, interest payments are onlyone way in which a source-State tax base may be eroded. In particular,it is possible to modify an earnings stripping approach to cover alltypes of base-eroding payments. The total of deductions granted forpayments made to entities with limited tax liability might be restricted125Wolfgang Schön, “International Taxation of Risk,” (2014) Vol. 68,No. 6/7 Bulletin for International Taxation, 280-94, at 284, notes the “asymmetry”in setting foreign expenses against domestic source income.126OECD, Part 2 of a Report to G20 Development Working Group on theImpact of BEPS in Low Income Countries, supra note 121, section 3, does consider“base eroding payments” but only in the context of developing countries’denying deductions for payments between related parties.127For example, see Johanna Hey, “Base Erosion and Profit Shifting andInterest Expenditure,” (2014) Vol. 68, No. 6/7 Bulletin for International Taxation,332-45, at 335-36.249