Prevention of hybrid mismatches as a justification

Prevention of Hybrid Mismatches as a Justification?

I. Introduction

In the current scenario of international tax law, characterized by the acceleratedpace of intersections among..different tax systems, cross-border tax arbitrage re­presents a central challenge for the European Union and other countries aroundthe world, due to the fact that the inherent differences in the tax rules of severaljurisdictions created unique opportunities for taxpayers to engag.e in tax planningstrategies. The potential opportunities for tax arbitrage, in which a taxpayer relieson differences between two tax systems to structure a cross-border transaction,has sharply increased in recent years due to the expansion of international tradeand the promotion of international investments.!

An active source of cross-border tax arbitrage involves the use of hybrid mis­match arrangements, which can be defined as tax structures designed to exploitasymmetries in the tax treatment ofhybrid financiaI instruments, hybrid entities,and hybrid transfers in different jurisdictions, with the goal of obtaining doubledeductions, deduction with non-inclusion or foreign tax credits.2 Recently, hy­brid mismatch arrangements have become an extremely sensitive political issue,3especially in the light of the initiatives of the OECD4 and the European Union5 totackle harmful tax practices and aggressive tax avoidance. In this respect, theBEPS project represents a substantial attempt towards the elimination of doublenon-taxation stemming from base erosion and profit shifting, which reflects thecurrent view that international standards may not have kept pace with changes inthe global corporative business environment.6

In the context of the European Union, on 20 June 2014, the European Union'sEconomic and FinanciaI Affairs Council (ECOFIN) reached political agreementon a proposed amendment to the Parent-Subsidiary Directive, which aims at pre­venting double non-taxation derived from deduction and non-inclusion schemesobtained through the use of hybrid mismatch arrangements. 7 In particular, thelegislative amendment focuses on cross-border tax arbitrage that exploits differ­ences in the characterization of income derived from hybrid financiaI instru­ments in two Member States, in which the remuneration paid qualifies as a tax-

H. D. Rosenbloom, The David R. Tillinghast Leeture International TfL'< Arbitrage and The Interna­tionaI Tax Regime, Tax LalV RevielV 2000, pp. 142-143.

2 R. de Boer/M. Nouwen, The European Unioll'S Struggle lVith Mismatches and Agressive Tax Planning(The Hague: EIeven International Publishing, 2013) p. 6.

3 A. de Graaf, International Tax Poliey Needed to CounterbaIanee the Exeessive Behaviour ofMultina­tionals, EC Tax RevielV 2013, p. 108.

4 üECD, Hybrid Mismatch Arrangements: Tax Po/icy and Comp/iance Issues (Paris: üECD, 2012).üECD, Neutra/ising the Effects ofHybrid Mismatch Arrangements (Paris: üECD, 2014).

5 European Comission, Action Plan to Strengthen the Fight Against Tax Fraud and Tax Evasion (Brus­seIs: European Comission, 2012).

6 üECD, Addressing Base Erosioll and Profit Shifting (Paris: üECD, 2013) p. 47.7 A. P. Dourado, The Base Erosion and Pro/h Shifting (BEPS) Initiative under Analysis, Illtertax 2015, p. 4.

Tomazela Santos

- b 'd' nd as a tax-exemptd ductible interest expense at the levei of the su SI Iary a 8 The fit distribution at the leveI of the parent company in the oth~r .count~. . e~:: provision was inserted into Article 4.1 (a) of the Parent-Subsldlary DlrectlVe,and reads as followS:9

bl" h t b irtue ofthe association ofWhere a parent eompany or its pe:n:anent es~a I~. m~~, ~v fit the Member Statethe parent eompany with its subsldlary, reeelves Istn ute pro I sbl" h t hali ex-of the parent eompany and the Member. State of its permanent esta IS men s ,ee t when the subsidiary is liquidated, elther: .

p . f m taxin sueh rofits to the extent that such profits are not deduct~ble bya) ~~~r~:~s~~iary, anJ tax sJch profits to the extent that such profits are deductlble by

the subsidiary; or d h nent estab-h rofits while authorising the parent eompany an t e perma .

b) ~~~~:nt fo deduet from the amount of tax due that fraction of the e?rporabtl?d~ taxd 'd b th subsidiary and any lower-tler su SI lary,

related to those pr?~ts an pai y. e d' 1 wer-tier subsidiary falisubjeet to the condltlon that at eaeh tler a company an ItS o. .d dwithin the definitions laid down in Article 2 and meet the req~lrements proVI efor in Article 3, up to the limit ofthe amount ofthe correspondmg tax due.

In eneral terms, the Parent-Subsidiary Directive deaIs wit~ th.e ta~ treatment ofpn~fit distributions between parent and subsidiary compa~les I~ .dl~f~~e~fd~~~~ber States with the objective of eliminating both economlC an )un lCa f d' .taxation. It seeks to abolish tax obstacles to th~ cross-borde.r p~ymeFtho . ~Vl~dends within groups of companies, thus improv~~g the.functl~nmg o tem .er

I ket Upon the fulfilment of certain condltlOns, It provldes an exemptlOnna mar . f h b 'diary on out-from the withholding income tax levied in the country o t e su SIb d d' .dends 10 as well as the obligation for the state of the parent company toe~~~nat~V~ouble'taxation.n Member States are free to decide b~tween the exemp~tion method and the credit method, depending on the tax pohcy adopted. In order to avoid double taxation, Article 4(1) provides that the Men:be~ ~tate of/he

arent company must: (i) refrain from taxing the dividends recelve exemp lOn~ethod)' or (ii) tax the dividend received, allowing the parent company tOfjoffset,against i~s corporate income t~x, ~he tax gaid by the subsidiary on the pro ItS outof which the dividends were dlstnbuted.

After the 2014 amendment, the Member State ofthe parent company must onlyrefrain from taxing distributed profits to the extent that such profits are n~tdeductible by the subsidiary. On the other hand, the Member State must tax t e

8 L. de Broe, At Last, Some üutput on the Fight against Double Non-Taxation, EC Tax RevielV 2014,

pp.310-311. N b 2011 (reeast) amended by: Council Direetive 2013/9 Council Direetive 2011/96/EU of 30 ovem er ,13/EU of 13 May 2013 and Council Direetive 2014/86/EU of8 July 2014.

10 Artide 5 of Couneil Direetive 2011/96/EU of 30 November 2011 «reeast».'1' . 2011/96/EU of 30 November 2011 reeast.

11 Artide 4 of CounCl DlreelIve L 6' d'l' n (Alphen aan den Rijn: Kluwer Law Interna-12 B. J. M. Terra/P. J. Wattel, European Tax aIV, e 110

tional, 2012) p. 312.

164 Dziurdí/Marehgraber (Eds), Non-Diserimination in European and Tax Treaty law . ., . . European and Tax Treaty lawDziurdí/Marehgraber (Eds), Non-Dlscnmlnatlon In 165

Prevention of Hybrid Mismatches as a Justification?Tomazela Santos

Against this background, many EU countries, such as Denmark 16 17Italy, Austria18 and the United Kingdom 19 have alread' I 'd Germany,

I b E, ,ylmp emente anti-hybrid:~ ~s ev~n e

hore th~ ~me~dment of the Parent-Subsidiary Directive, for purposes

ded~~~;~ t ~ par~I~I~atlOn exemption where the correspondent payment was

so t tY2~ e su sldlary company from the corporate income tax levied in the

urce s a e.

Original ProposaI by Approved textthe Commission

"refrain from taxing such profits to the "refrain from taxing such profits to theextent that such profits are not deduct-ible by the subsidiary of the parent

extent that such profits are not deduct-ible by the subsidiary of the parent

company".company, and tax such profits to theextent that such profits are deducti-ble by the subsidiary",

dividends received to the extent that the corre d' ­from the corporate income tax paid by the sPbo~d,mg p;hmenlt was deductedamendment is tackl' d d ' SU SI lary. e cear goal of thebr'd fi '. mg e uctlOn and non-inclusion schemes derived from hle~el ~~~ncIaI msttruments, whose ~emuneration is classified as dividend at t~~

e paren company and as mterest at the leveI of the subsidiary.13

~t is.imp~rtant to cla~i~ that the final version of the text approved by the ECOFINeVlates rom ~he ongmal proposal of the Commission, in which Member

were not effectlvely required to tax the dividend 'd h States, 1 s recelVe ,as t e text of the o .~a p{oposal for amending the Parent-Subsidiary Directive did not oblige ~~-. em er State to exercise its right to tax under the domestic law 14 Th fi 1 e

s~o~ of t~e ne.w anti-hybrid rule embedded in Article 4(l)(a) of'the P:r~~:_Sver­shldladrybDlreCtlVe now clearly establishes the obligation to tax apparently en/

b­

t e e ate as to whether the M b S h " mglity to tax 15 The d'fE, , emher tate~ ave an obhgation or a mere possibi-

d. b 1 erence m t e wordmg of the original proposaI and the

approve text can e seen below:

1314

151617

181920

L. de Broe, EC Tax Review 2014, p. 311, FN 8.C. Marchgraber, Tackling Deduclion and Non-Inclusion SchCommission, European Taxation, p. 136. emes - The ProposaI of lhe European

L. de Broe, EC Tax Review 2014, p. 311, FN 8.

~:~::~~;~ ~~:~~ ~~~h~rI~~~~ ~axCI, AasCalm(Eendked by Law No. 344, of 18 April2007,c d"" 111 ommensteuergesetz - EsIG) Th h' ..lor IVldends in § 8b(I) of lhe Corporale Income Tax A I (K" h ft . e malc mg pnnclpIeSeclion 10 (7) of lhe Auslrian Corporale Income Tax AccI orpersc a sleuergeselz - KSIG).

Seclions 931B(c) and 93ID(c) of lhe Corporale Taxation Acl (CTA)OECD, Hybrid Mismatch Arrangements: Tax Policy and Complianc~ Issue 18s, p. .

11. Hybrid Arrangements in the Internai MarketIn order to understand the reasons why the European Union decided to tacklehybrid mismatches arrangements and to examine possible justifications, it isnecessary first to analyze in detail how these tax planning structures may hamperthe achievement of the objectives of the single market.

First, hybrid mismatch arrangements may result in a significant loss of tax reve­nue, caused by the reduction of the overall tax liability.21 As a consequence oftheir impact on tax revenue, the Member State concerned may be required to ei­ther reduce public spending or shift to other revenue sources.22 This may increasethe volatility of income tax revenue and affect state budgets, in particular becauseaggressive tax planning strategies make it difficult for governments to predict thetax receipts. In the current economic crisis in Europe, the impact of hybrid mis­matches can be even more significant, forcing governments not only to cut publicexpenses, but also to increase the statutory corporate income tax rates. However,an increase of tax rates, in the current economic climate, is undesirable on thepath towards recovery from the economic and financiaI crisis, This reduction intax revenue may also contravene the intention of domestic law and lead to a gen­eral increase in taxes levied on wages, salaries, and consumption in an effort topass on the costs to domestic taxpayers. The problem is that the high Mpendencyon tax revenue derived from immobile factors, such as labor and local consump­tion, is aIso questionable from a tax policy perspective, because it may cause neg­ative consequences in terms of economic activity (increase labor costs andprices).23 Thus, the alternative of combating the loss of tax revenues through thecrackdown on hybrid mismatches was probably the only feasible option availableto the European Union,

Second, hybrid mismatches may distort competition on the single internaI mar­ket, as particular types of companies may have a competitive advantage throughthe use of hybrid financiaI instruments.24 In particular, it distorts competitionbetween companies with different opportunities to avoid taxes, which is againstthe goal of ensuring a leveI playing field for market participants. Furthermore, theincrease of the profit margin through aggressive tax planning may hide the realeconomic performance of the company, not only allowing it to maintain ineffi­cient business or operational practices, but aIso discouraging improvements in

21 OECD, Hybrid A'fismatch Arrangements: Tax Policy and Compliance Issues, pp. 11-12.22 S. Barsch, Taxation ofHybrid Financiai Instrwllents and the Rel1HlIleration Derived Therefrom in an

Intemational and Cross-border - Issues and Options for Reform (Berlin/Heidelberg: Springer VerIag,2012) p. 52.

23 A. Sleichen, Tax Compelilion in Europe or The Taming ofLevialhan, In: W. Schon (Ed.), Tax Com­petition in Europe (Amslerdam: IBFD, 2003), pp. 53-58.

24 R. de Boer, Preliminary Observations on lhe European Comission's Slralegy for Tackling HybridMismalch Arrangemenls, in: R. de Boer/M. Nouwen (eds.), The European Union's Struggle wi/h Mis­matches and Agressive Tax Planning (The Hague: EIeven Inlernational Publishing, 2013) p. 51.

166 Dziurdz/Marchgraber (Eds), Non-Discrimination in European d Tan ax Treaty law Dziurdz/Marchgraber (Eds), Non-Discrimination in European and Tax Treaty law 167

pn)(lllcti,on capacity or technological innovation. The tax savings obtained by theexploitation of cross-border tax arbitrage may also be used to eliminate competi_tors and other market players, which contrasts strongly with the essential ideathat the internaI market should ensure a fair competition environment in whichcompanies are able to compete on an equal footing.

Third, cross-border tax arbitrage may interfere with the principIe of tax neutral_ity, as an investment carried out abroad becomes more attractive than a domesticequivalent investment because of its tax consequences.25 IdealIy, tax rules shouldneither create economic distortions nor affect economic judgments of rationaltaxpayers. Thus, the tax rules should aim to achieve the highest degree of neutral­ity possible, without affecting the allocation of production factors at the leveI ofthe economy.26 The problem is that the objective of creating hybrid mismatchesin cross-border transactions may interfere with the capital structure of the com­pany, especially in relation to the choice among different modes of corporatefinance (retained earnings, new equity issues, or debt capital). In addition, in aninternational context, the concept of tax neutrality implies that the decision onwhere to invest should not be distorted by taxes. Instead, the choice of the juris­diction in which to invest should be determined by other economic factors, suchas geographical benefits, pre-tax interest rate, labor costs, degree of economicdeveIopment, and political stability. The non-taxation obtained through the useof hybrid arrangements leads to an inefficient incentive to invest in pure cross­border transactions with specific jurisdictions, rather than equivalent domestictransactions. The taxpayer will have a stimulus to use the same formula severaltimes to create the hybrid mismatch, generally using the same financiaI instru­ment and the same foreign jurisdiction.

Fourth, hybrid mismatch opportunities are more readily available for taxpayerswith income from capital, rather than labor. 27 In fact, the main objectives soughtby taxpayers with international tax planning structures are usually exploitedthrough income arising from capital. In brief, the main tax planning goals pur­sued by taxpayers are: (i) avoidance of the taxable event ("escape"); (ii) deferral oftaxes to a later date, taking advantage of the cost of money over time ("di./fer");(iii) transference of the tax liability to another legal entity ("shift"); or (iv) reclassi­fication of the income to another category, which is subject to a more favorabletax treatment ("convert").28 These aspects affect the fairness of the tax system,which requires the taxpayers to contribute to the public expenses based on their

25 S. Barsch, Taxatíon ofHybrid Financiai lnstruments and the Remuneration Derived Therefrom in anlnternational and Cross-border, pp. 44-52.

26 S, Barsch, Taxation ofHybrid Financiai lnstruments and the Remlmeration Derived Therefrom in anlnternational and Cross-border, pp, 44-52,

27 R. de Boer in: R. de Boer/M. Nouwen (eds.), The European Union's Struggle with Mismatehes andAgressive Tax Plamling, p. 51.

28 E. J. Mccaffery, lncome Tax Law (New York: Oxford University Press, 2011), p. 27.

Tomazela Santos

--, 'd ' f double non-taxa-. . From a tax policy perspective, the avOl ance o . . .ab1h~y to P~~~l for the achievement of equality in the determinatlOn o~each~nd{dtion 1S esse 's tax burden. In order to promote tax fairness, law~a ers s .ou.vidnal t~xpahe~les exploited by taxpayers through cross-border arbltr~ge, ~~1ch 1Sremove oop . d b ditional market forces. The promotlOn o mter­nnlikely to b~ c~nstrame ~ ~:: overnance supports the EU initiatives againstnational tax Justlce a~d gooh g tt . based on the idea that multinational

ressive tax planmng, w ose mo o 1Sagg . should pay their fair share of taxes. 29compames .

Even though it is possible to r~~s~ d:~b~~o~th~~;et~;l ~~~~~rd~f:~etr~:~J :~~siderations discussed above, ~e:tt::~emb:r States, together with the Europeanmatches arrangements promp . der to tackle their negative effects for theCommission, to adopt tax measures m o~. considerations will have to be takensingle m~rket. ~or .thishreaso1n, tt:~:fpo~~~ble grounds of justification to the dis­. to cons1deratlOn m t e eva ua 1~~iminatory tax measures adopted by the Member States.

111. Restrictions of Fundamental Freedoms andDiscriminatory Measures

h . . I of conferral 30 Member States still have sovereignty in theBased on t e pnnClp e . I' b when the European Union was cre­area of direct taxation, in partlCu ar ecause, .d ed to be a relevant goal toated, the harmonization ~~ di~ect tax~~ w~~ ~:~~~~1S::tes were (and still are) re­be achieved through pos1tlve mtegr~ lOn. direct taxes In the absence of far­luctant to renounce national sovere1gn? over. ' la~ provisions for directreaching harmonization, the ~ost re e~aFt ~~::rywhich establish limits andtaxes ended up being the fun amenta . r~e . ' .. ') 32

boundaries for exercising national tax junsd1ctlOn (negat1ve mtegratlOn. .

. I for alI Members States m theIn this context, the introductlOn .of com~on ru es h the creation of secondaryfield of direct taxes has been mamly reahzed throug . b ni-

EU law.33

AccforlIdiMngemtobAe;t~~:t:sl~s~~:~ir:~~i~:Sr~~et~ ~:{~nor;~eci t:~~~on,mous vote o a ,

, I 'n A ainst Aggressive Tax Planning and Harmful29 M. Nouwen, lnternationaI and Supranatlona ~c~~ Sta~e of Play of Recent Work of the OECD and

Tax Competitlon IS Gammg Momentum Fast. ;he European Union's Strugg/e with Mismatehes andthe EU, in: Reinout de Boer/MartlJ~ ~ouweI~ternational Publishing, 2013) pp. 13-15.Agressive Tax P/anmng (The Hague. even

30 B.). M. Terra/P.). Wattel, European Tax taw, P'f4'D'rect Taxation in' Michael Lang/Pasquale Pis-31 L. Adamczyk, The Sources of EU L(a; R)~ e~a~uc~~on Ito Eur~pean Tax' Law 011 Direet Taxation, 3rd

tone/josef Schuch/Claus Starmger e s. n ro

edition (Vienna: Linde, 2013) p. 25. I p' /j f Schuch/Claus Staringer (eds.) lntroduetíon to32 L Adamczyk in: Michael Lang/Pasqua e Istone ose

E;lropean Tax Law on Direet Taxation, rpp2;-25i)osefSchuch/Claus Staringer (eds.) lntroduetíon to33 L. Adamczyk, in: Michael Lang/Pasqua e IS one

European Tax Law on Direct TaxattOn, p. 25.

168 DziurdZlMarchgraber (Eds), Non-Discrimination in European and Tax Treaty law . . . E ropean and Tax Treaty lawDziurdz/Marchgraber (Eds), Non-Discrimmatlon m u 169

44

4041

4243

Prevention of Hybrid Mismatches as a Justification?

with the objective of approximating national tax mIes which directly affect thefunctioning of the interhal market. Thus, a directive is the only binding legalinstmment available for harmonization of direct taxes.34

Member States are obliged to implement the directives into nationallaw within agiven timeframe. If a Member State fails to do so, the provisions of the directivemay become directly applicable and enforceable.35 The actual wording ofdomesticlaws lies within the competence of Member States, which have a certain degree ofdiscretion in the process of the transposition of the directives in the national taxsystem. In fact, although the general provisions contained in a directive have to betransposed into effective tax mIes, the implementation procedure leaves a certainleeway for the Member States concerning the definition of the procedure to be fol­lowed for its application in concrete cases. For this reason, it is possible to identifythree different leveIs of outcomes for the process of transposition of EU directivesinto domestic law: conformable, partially conformable and non-conformable.36

Therefore, the first type of issue that may arise involves a potential conflict betweenthe national anti-hybrid mIe and secondary EU law, due to their partial conformityor non-conformity with the Parent-Subsidiary Directive. The actual application ofthe domestic anti-hybrid mIes may violate the Parent-Subsidiary Directive,depending on the transposition procedure adopted by the Member State.

However, even if domestic law is in accordance with the amended version of theParent-Subsidiary Directive, the question that arises is whether the rules intro­duced are compatible with the fundamental freedoms. The EC] already decidedthat the Member States are allowed to make use of the options provided for by thedirectives, to the extent that the implementation ofsuch mIes into domestic law isin line with the fundamental freedoms. 37 This confirms that it is not sufficient toimplement anti-hybrid mIes in accordance with the provision of the Parent-Sub­sidiary Directive. Rather, it is aIso necessary to comply with primary EU law.Thus, the second question involves a potential conflict between the national anti­hybrid mIes and the fundamental freedoms.

In fact, national anti-hybrid mIes, even when based on the Parent-Subsidiary Di­rective, may exceptionally be in conflict with the fundamental freedoms. The di­rectives do not grant immunity to domestic tax measures, which could also con­stitute a breach of the key principIe of non-discrimination. 38 This implies that,

34 B. J. M. Terra/P. J. Wattel, European Tax Law, pp. 16-17.35 M. Helminen, The International Tax Law Concept ofDividend (Alphen aan den Rijn: Kluwer Law In­

ternational, 2010) pp. 34-35.

36 T. Kõnig/L. Mãder, Non-conformable, partial and conformable transposition: A competing riskanalysis ofthe transposition process of directives in the EUI5, European Union Politics 2013, p. 46.

37 Judgments in Bosal Holding, C-168/01, EU:C:2003:479; Keller Holding, C-471104, EU:C:2006:143.38 N. Strelnikova, Assessment of'Anti-Hybrid' Approach to the Problem of Aggressive Tax Planning in

the light ofthe European Comission's proposal to amend Article 4(l)(a) of the Parent-Subsidiary Di­rective, Master Thesis - Master's Programme in European and International Tax Law (Sweden: LundUniversity, 2014) p. 22.

Tomazela Santos

- d~bY~~~ffh' the European Union framework, tax measures a op 1 'thwit m. order to counteract hybrid mismatches arrangements must comp y WlStates III f' l'd'ty

f damental freedoms, under the penalty o lllva 1 1 .~W . .

f this a er it is assumed as a starting point that natlOnal antl­For the purposes ~ h P P '. f the fundamental freedoms, hindering cross-b .d ules restnct t e exerClse o . d

~~r~~r :CtiV~ti~: ~~~~~lth::u~~f~~nf~rn~o;~;~:~t~~~:h:r~:~::::'~nd:d:c~~~~tlC contex~~ ~~~ subSidi: a~d as dividend for the parent compa~y, as .the ;pph­

eXb~;::x~mIes on the cl?:sification of financiaI instrumentshare l~e~t\~al.·t J~~ca tance of this premise is necessary because the focus of t e tOplC 1S lml eaccep d f' 'fi f 40the investigation of possible groun s o Justl lca lOn.

IV. Justifications in the area of direct taxation

A. Rule of Reason . .in challen e faced by the EC] in the area of direct taxation conslsts III rec­

The.~a . g i n in the exercise of taxing powers and the fundamen-o~~llmâ natl~ln;~:o~~th~sá"eveloped the doctrine of justification (:ule ofre~so~)ta ree oms. h 1"t the fundamental freedoms and justify dlrect and mdl-

fO:t~~:~~:~~a~~~a;a~~~ularlyin the tax area.. In t~e Cassis de D,ijon c.a~e,42 th~~ec] developed, for the first time, u~writ~en justlficat~on g;o~n~~~~:~:::~grr::-

ns of public interest) for restrictlOns m the exerClse o te. f;oms 43 Thereafter EeJ case law has gradually developed over tlme a s,rstem o

{~~~~'~~t~~~r:~~~nt:~a~les~~:~t: ~:~a~~:i:~~~:~i~~eU~;;~~: ~~t~:wc~om:e~~ther restrict the fundamental freedoms nor to discriminate agalllst economlCplayers without adequate justification.44

From the different types of unwritten justification g:ounds th~t have. alrlea.fY~b~:ted or re'ected by the EC] in concrete cases, thlS paper wl11 partlcu aI y o

~~c:~e balanc~d allocation of taxing rights, the cohesion of t~e ~ationalta~ d~~~and the prevention of tax abuse, which are those most cose y connec e

----,.- /A L' "The New German DCL and Dividend Matching Rules and EU Law", Intertax39 O. Thommes . mn, ,

2014, p. 33. . . J' D' Maria in this volume.On the comparablhty test, see eSSlca I d h B I d Allocation of Ta;,: Jurisdiction, IntertaxM. POllIsen, Freedom of Estabhshment an t e a ance

2012, pp, 200-201. G C-120/78 EU:C:1979:42, para. 8.JlIdgment ltl Rewe-Zentral A, d' .'D' k Ehlers (ed.) European Fundamelltal Rights alld Free-A. Epiney, Free Movement ofGoo s 1lI. h1rft Veria s 2007) p. 249.doms. (Berlin: De Gruyter Rechtswls~et:c ~ Te: Ince;ti~eswithin the Single Market in: 1. Richelle/E. Traversa/B. Vintras, The Terllntor~a 1 j,o p~lVers withill the Europeall Ullion (Berlin/Heidelberg:W. Schõn/E. Traversa (eds.) A ocatmg axSpringer Verlag, 2013) p. 175.

170 Dziurdz/Marchgraber (Eds), Non-Discrimination in European and Tax Treaty Law Dziurdz/Marchgraber (Eds), Non-Diserimination in European and Tax Treaty Law 171

Prevention of Hybrid Mismatches as a Justification?----::...:.~.:....:...::....:.:.:..:..:.:.::..::.:::..:..:.::...=::..:~~~~------

hybrid arrangements:45 Then, it will address the need to counteract hybrid ar­rangements as a posslble new ground of justification.

It is worth mentioning that the grounds ofjustifications analyzed henceforth mbe invoked jointly by the Member State concerned.46 The EC] took this appro ai:for the first time in the Marks & Spencer case,47 where it stated that the th .ac'fi' d ree JUs-

tI lcatIOns nee to be examined together in order to constitute overriding reasoi~ the public interest compatible with the EU law.48 Since then, the EC] has esta~~~lsh~d a new method for assessing whether a discriminatory national tax law isJust~fiable und:r the E.u law, based on a careful analysis of the situation and a col­lectIve evaluatIOn ofdlfferent grounds ofjustifications.49

B. The Balanced Allocation of Taxing Powers

A possible justificati?n already accepted by the EC] consists in the preservation ofthe balance~ al~ocatIOn b~tw~en Member States of their powers to impose taxes,the und~rlymg ldea of whICh lS that, based on its tax sovereignty, a Member Statehas th~ nght to effectively exercise its taxation power over an element (tax subject,tax ~bJect or ~oth) that.has a genuine link with its tax jurisdiction.50 This justifiesthe mtroductIOn of natIOnal tax rules to protect its tax claims against several fac­tors that may affect the allocation of taxing rights in a cross-border context andhence the exercise of its tax jurisdiction.51 In certain circumstances, the need top.rotect the bal~nced allocation of taxing rights seems to overlap with the cohe­SIOn of the natIOnal tax system, as well as with the principIe of territoriality.52~onetheless, in the X Holding case (C-337/08),53 the EC] accepted for the firsttIn:e the need t~ s~feg.uard.the balanced allocation of the power to impose taxesby Itself as a vahd JuStIficatIOn for discriminatory rules,54 regardless of its combi-

45

46

4748

49

50

51525354

J. Bundgaard, Hybrid Financiai Instruments and Primary EU Law - Part 2, European Taxation 2013pp.587-594. '

M. Lang, The Marks & Spencer Case - The Open Issues Following the ECT's Final Word EuropeanTaxatlOn 2006, p. 59. 'Judgment in Marks & Spencer, C-446/03, EU:C:2005:763.D. Pezzella, Final Losses under EU Tax Law: Proposal for a Better Approach, European Taxation2014,p.72.

M. Hilling, Justifications and Proportionality: An Analysis ofthe ECJ's Assessment ofNational Rulesfor the Prevention ofTax Avoidance, Intertax 2013, p. 296.J. M~nsenego, Taxation ofForeign Business Income Within the European Internai Market (Amster­damo IBFD, 2012) pp. 33-38; R. S. J. Martha, The Jurisdiction to Tax in International Law: TheoryandPractlce ofLeglslatlve Fiscal Jurisdiction (Deventer: Kluwer Law International and Taxation Publish­ers, 1989), p. 19.M. Hilling, Intertax 2013, p. 298, FN 49.B. J. M. Terra/P. J. Wattel, European Tax Law, p. 24.Judgment in X Holding, C-337/08, EU:C:201O:89.V. E. Engl~air, The Relevance of lhe Fundamental Freedoms for Direct Taxation in: Michael Lang/Pasqu~le Plstone/Josef Schuch/Claus Stannger (eds.) Introduction to European Tax Law on DirectTaxatlOn, 3rd edIllOn (Vienna: Linde, 2013) p. 78.

Tomazela Santos--nation with other reasons. It was also accepted as a separate ground o~ justifica-. l'n the National Grid Indus case (C-371/l0) 55 The balanced allocatIOn of tax-tlon '. .

ing rights is to some extent connected with the preservation of tax base mtegntyin a cross-border context,56 mainly in order to prevent the transfer of tax basesbetween Member States.57

At a first sight, it would seem that hybrid arrangements may be considered to betax planning strategies adopted to disconnect the taxation of income d~rivedfrom cross-border transactions, thereby jeopardizing the balanced allocatl~n.oftaxing rights between Member States. However, it should be noted that the Jomtinitiative of the OECD and the European Union against hybrid mismatches is ad­dressing a problem caused fundamentally by the lack of coordination ?f tax sys­tems between Member States,58 which is an inherent feature ofEU law m the areaof direct taxation. The absence of tax neutrality between the treatment applicableto equity and debt in different Member States is precise~y the re~s~n why numer­ous tax planning schemes can be successfully created wlth hybnd mstruments.

It follows that, although the national tax authorities tend to invoke almost automat­ically the balanced allocation of taxing rights as a justification for re.strictiv~ taxmeasures in striving to maintain tax revenues, it is doubtful whether thlS ,ffectIvelyplays a role on the issue ofhybrid mismatches. Anti-hybrid rules patterned on theParent-Subsidiary Directive are applicable by the residence state of the parent com­pany, which has the obligation either to tax or to exempt the amount recei~ed, de­pending on whether the payment was deducted or not from the corporate l.n~on:e

tax due at the level of the subsidiary situated in another Member State. ThlS mdl­cates that anti-hybrid rules do not exactly preserve the tax jurisdiction or the alloca­tion of taxing rights from the perspective of the residence state, but rather changesthe way by which taxing rights are exercised in a cross-border cont~xt, merely t.oavoid the loss of tax revenues from one Member State to another. It IS also practI­cally impossible to define what balanced allocation of taxing rig~ts a~ti-hybrid rulesare willing to ensure, which is a particularly criticaI and challengmg Issue, as EU lawdoes not set out objective criteria for the distribution of taxing rights betweenMember States.59 The crucial point of the balanced allocation of taxing rights, as aground of justification, relies on the protection of the right granted to MemberStates to exercise their taxing rights on elements (tax subject or tax object) that havea sufficient economic link with its tax jurisdiction, in accordance with internationalcustomary law. Thus, it aims to ensure that an item of income that should be taxedin a specific Member State, in accordance with the ability-to-pay or the benefits

55 Judgment in National Grid Indus, C-371/10, EU:C:2011:785.56 B. J. M. Terra/P. J. Wattel, European Tax Law, p. 462.57 M. Hilling, Intertax 2013, p. 298, FN 49.58 R. S. Avi-Yonah, Advanced Introduction to International Tax Law (Cheltenham: Edward EIgar Pub-

lishing, 2015) pp. 90-105.59 M. Hilling, Intertax 2013, p. 298, FN 49.

172 DziurdílMarchgraber (Eds), Non-Discrimination in European and Tax Treaty Law Dziurdz/Marchgraber (Eds), Non-Discrimination in European and Tax Treaty Law 173

principle,60 w~ not be intentionally transferred to another Member Stat ft~ufl~ses.~n ~lmple terms, taxpayers should not be free to transfer tax ba:es

o; ta)(

ne e~ er tate to another, choosing where their income will be rOI1la.s mentlOned before, anti-hybrid mIes are not desi ned to rotect taxed. ~o,:ever,tlOn of a single Member State or its ability t t g ~ , ~.e tax Junsdic_

'th" , 61 o ax economlC actIV1tIes cond t dWl m 1tS te:ntory. Indeed, irrespective of the fact that the onus of uc, edouble taxatlOn or double non-taxation falls on th'd preventmg, e reSl ence state of the pcompa~y, 1t appears that the cornerstone of anti-hybrid mIes is th ' arenttax aVOldance within the European Union as a whole 'th t d' e preventlOn of

~oY~~~db~ncedallocabtion of taxing rights in a single Me':be~~t:te.l~~~r~~::r~e~~~~. r es cannot e regarded as a protection for a Member State ,1-

nght to tax activities carried out within its territo 62 'd to ensure theRewe Zentralfinanz case (C-347/04).63 ry, as reqUlre by the ECJ in the

F,u~t?ermore, the decisive characteristics for the tax classification ofhybrid fiCla ms~mments are part of important considerations in formulatin man­tax 'pohcy.. There is no clear policy path on the distinction betwe g corporate

;~~:\~~:r.~~;,c;;~~t~f:::;;s:~~,~~::'~;~:: ~~~:;:~:Yd~;:e::,~~::n{!~~~,at~~pra~ tax systems ofMembers States, it is highly doubtful whether the EC~e. C~l­~~~:r a~oEa~cl:~ ~~e bala;teddallocation of taxing rights as a valid jUstificatio~.l~~petences and the e:, n~ ar owfn dany general criteria for the attribution ofcom-

, . e 1mmatlOn o ouble non-taxation amon Memb S

:~l~~~t:~:::~~~~;:;d~~:~~~~~~:~i~~;~:~d~r~~b:~ea~~~~c:!:~~c~~~~ ?}~:~~a Member State to tax activities carried out in its territory is~ot ha~per:l16~ t of

C. The Cohesion of the National Tax 5ystemThe h' f hr co es~on, o t, e n.ational tax system was accepted for the first time as ag ound ofJustIficatlOn m the Bachmann case (C-204/90) 66 ' h' h hheld

dthe existence of a connection between the deduc;ibi;7;o~cc t : iC~.up­

ma e by employees and the right to tax the amounts payable b th ~n n u lOnsder pension and life assurance contracts.67 The cohesion ofth tY e msurers un-e ax system presup-

6061626364

656667

MR. SH'~11~i-YOnah, Advaneed Introduetion to Interrzational Tax Law pp 3-7

, I mg, Intertax 2013, p, 298, FN 49, ' . ,J, Bundgaa,rd, European Taxation 2013, p, 589, FN 45.Judgment m Rewe Zentralfinanz, C-347/04, EU:C:2007:194, para 42P. Harns, Corporate Tax Law - Strueture P [' d P . . .Press, 2013), pp. 9-11. ' o /ey an raet/ee (Cambridge: Cambridge University

O. Thõmmes/A, Linn, Intertax 2014, p. 30, FN 39.Judgment in Baehmann, C-204/90, EU:C:1992:35, para. 21.M. Lang, Chapter 2 - The Binding Effeet of the EC FundGassner/M. Lang/E. Leehner (eds.) Tax Treaties and EC~men(t~1 F~edoms on Tax Treaties, in: W.1997), pp. 27-28. aw on on: Kluwer Law International,

Tomazela Santos

poses that the deduction of contributions made to pension schemes or life assur­ance plans should be offset by the taxation of pensions, annuities or capital sumspayable by the insurers.68 For this reason, the ECJ held that the discriminatoryBe1gian tax mIe that only allowed the deduction of contributions made to Belgianinsurance companies was justified based on the cohesion of the national tax sys­tem, due to the absence of a proper mechanism to guarantee and enforceBe1gium's right to tax the amounts pay by foreign insurers,69

Although the ECJ has since addressed the fiscal cohesion on several occasions,7°it is still difficult to extract from case law a well-defined concept that specifiesthe parameters for its application in concrete cases and shapes the contours andboundaries of its definition. 71 At the core of this diffuse concepf2

seems to bethe idea of preserving the symmetry between the right to tax an item of incomeor profit and the right to deduct the corresponding expense or loss, at least ini­tially in relation to the same taxpayer and the same tax.73 Indeed, in the Bosalcase (C-168/0l), the ECJ held that fiscal cohesion requires, within the scope ofthe same taxpayer, a direct link between the tax advantage and its further offset­ting by a fiscallevy, both of which related to the same tax.74 This decision re­duced the relevance that fiscal cohesion could have achieved in tax matters.

75

However, it should be remembered that, in the Manninen case (C-319/P2), AGKokott argued in her Opinion76 that a single taxpayer is not always a p;econdi­tion for the application of fiscal cohesion, as its essential concept may also befulfilled where the tax is imposed on the same item of income or the same eco­nomic process, even if it is not charged on the same taxpayer.

77

As noted earlier, hybrid mismatch arrangements exploit differences in the taxtreatment of financial instmments, entities, and transfers between two or more ju­risdictions, with the ultimate goal of reducing the overall tax burden. A fundamen­tal characteristic of these tax planning stmctures is that they may well comply withboth the letter and the spirit of the domestic law of each Member State concerned,

68 M. Jannm, "Chapter 3 - How Does the EC Law Affeet Benefits Available to Non-Resident Taxpayersunder Tax Treaties" in: W. Gassner/M. Lang/E. Leehner (eds.) Tax Treaties and EC Law (London:

Kluwer Law International, 1997), p. 64.69 M. Lang in: W. Gassner/M. Lang/E. Leehner (eds.) Tax Treaties and EC Law, p. 28.70 Judgments in Wieloekx, Case C-80/94, EU:C:1995:27I, para. 31: Asseher, C-I07/94, EU:C:1996:251,

para. 51.71 M. Lang in: W. Gassner/M. Lang/E. Leehner (eds.) Tax Treaties and EC Law, p. 30.72 Opinion of Advoeate General Kokott in Manninen, C-319/02, EU:C:2004:164, point 51.73 M. Dahlberg, Direet Taxation in Relation to the Freedom of Establishment and Free Movement of

Capital (The Hague: Kluwer Law International, 2005), p. 256.74 Judgment in Judgment in Bosal Holding, C-168/01, EU:C:2003:479, para. 29.75 L. Hintsanen, Non-Discrimination under EC Law, in Raffaele Russo (ed.) The Attribution ofProfits to

Permanent Establishments: The Taxation ofintra-company dealings (Amsterdam: IBFD, 2005), p. 469.76 Opinion of Advoeate General Kokott in Manninen, C-319/02, EU:C:2004:164, point 61.77 M. Dahlberg, Direet Taxation in ReIation to the Freedom of Establisllment and Free Movement of

Capital, p. 321.

174 DziurdílMarehgraber (Eds), Non-Diserimination in Europe d Tan an ax Treaty Law Dziurdz/Marehgraber (Eds), Non-Diserimination in European and Tax Treaty Law 175

Prevention of Hybrid Mismatches as a Justification? - Tomaze/a Santos

while still resulting in low or non-taxation in a cross-border context,78 In additiohybrid mismatches resúlt from differences between tax systems and the lack ofc~ordinati~n ~it~in the EU. In~eed, as the framework of EU law does not requireharmollIzatlOn m the area.ofdlrect taxation, the Member States have sovereignty .d ·· th· . In

eSlg?mg elr own tax system. Thus, it is not surprising that, from the perspective~f a smgle Member State, the tax treatment applicable to the financiaI instrumentIS completely symmetrical, without affecting the fairness or cohesion of the tax sys­tem.

79This implies that unilateral countermeasures adopted by a Member Stat

against hybrid mismatch arrangements may lead to an untenable contradictio ewith the structure and principIes of its tax system. To sum up, the fiscal cohesion o~a single tax system is not distorted through the use ofhybrid financiaI instruments.

It is true that, from the perspective of fiscal cohesion, it is possible to establish a di­rect link between the deduction of interest expenses by the subsidiary and the sub­sequent taxation of the dividends by the parent company, as long as possible differ­ences in :ax rates ~re neglected. However, the most problematic issue is the require­ment, lmd down m EC] case law, that the correlation between the tax deductionand the taxation must be verified in relation to the same taxpayer and the same taxwithin the same Member State.80 Indeed, from the standpoint of a single Membe:State, the use of a debt instrument already creates the possibility of tax base reduc­tion, because the interest paid to the lender - foreign or national- is usually dassi­fied as a tax-deductible expense. The treatment of the remuneration derived fromthe same financiaI instrument as dividends in the other Member State is a mereconsequence of the underlying tax policies adopted, without any dear relation tothe preservation of the cohesion of the national tax system of the former MemberState. Therefore, Members States cannot rely on the cohesion of the national taxsystem as a justification for tackling hybrid mismatch arrangements, because it~rongfully ignores the basic parameters of EU law, such as fiscal sovereignty, thenght to use tax planning, and the disparities in the area of direct taxation.

Despite this, it seems reasonable to analyze the cohesion of the tax system from abroader perspective, which would cover the European Union as a whole. In theDanner case (C-136/00)81, the EC] examined fiscal coherence not from the microleveI of the nationallegislation ofa Member State, but from the larger macro leveIof two Member States that signed a tax treaty.82 On this basis, it might be possible

78

7980

8182

R. de Boer, in R. de Boer/M. Nouwen (eds.), The European Union's Struggle with Mismatehes andAgressive Tax Planning, p. 50.H. D. Rosenbloom, Tax Law Review 2000, p. 143, FN 1.

N. Bammens, The Principie ofNon-Diserimination in International and European Tax Law (Amster­dam: IBFD, 2012) p. 1000: Dennis Weber, An Analysis ofthe Past, Current and Future ofthe Coher­ence of the Tax System as a Justification, EC Tax Review 2015, p. 54.Judgment in Danner, Case C-136/00, EU:C:2002:558.M. Dahlberg, Direet Taxation in Relation to the Freedom ofEstablishment and the Free Movement ofCapital, p. 132.

to establish a direct link between, on the one hand, the deductibility ~f the remu­neration derived from the hybrid instrument at the level of the Subsldlary, and, onthe other hand, the taxation of the corresponding amount at th~ leveI of the ~ar­

ent company. The preservation of a direct link between deductlOn and taxatlOn,in a broader cross-country context, may be accepted by the EC] as valid ground ofjustification to guarantee the coherence among the different tax system.s, as the ~UTreaties constitute the legal basis for analyzing the subject from an mter-natlOn

erspective, whereby co-equal sovereign nations endeavor to receive their fair~ortions of a shared tax base.83 In this perspective, it should be kept in min~ that,. the Manninen case (C-319/02), AG Kokott already attempted to estabhsh anIn dh . I ..'mmediate link between the coherence of the tax system an t e smg e tax pnnCl-~le, by observing that it "generally means no more than avoidi.ng .double taxationar ensuring that income is actually taxed, but only once (the princIpie ofonly-oncetaxation)".84 The extension of the same reasoning to a cross-country contextwould allow the justification of restrictive domestic rules designed to prevent taxarbitrage with hybrid instruments, as provided for in Artide 4.1 (a) of the Parent­Subsidiary Directive.

In this sense, it is worth remembering that, over the years, the EC] has alreadyturned aside the requirement that the fiscal coherence must be assesse4 in rela­tion to a single taxpayer.85 It would be necessary to once again shift the angle formeasuring the fiscal coherence from the national leveI to an intra-CommunityleveI, in which case national anti-hybrid rules may be justified.

D. The Prevention of Tax AbuseAccording to EC] case law, the need to counteract tax abuse may be put for~ardby the Member States as a justification for discriminatory measures, provldedthat the domestic rule affects only wholly artificial arrangements.86 In the CadburySchweppes case (C-196/04), the EC] held that the prevention of tax abuse mayserve as a justification for national tax measures affecting the fundamental free­doms that reach exdusively wholly artificial arrangements87 which aim at circum­venting the application of a Member State's tax law.88

It follows that, in order to a restriction on the freedom of establishment to be justifiedon the ground of prevention of abusive practices, the specific objecti:e ?f such a restnc­tion must be to prevent conduct involving the creation of wholly artifiCIal arrangementswhieh do not ref/eet economie reality (. ..).

83 On inter-nation equity, see: A. C. lnfanti, lnternation equity and human development, in: Y. BraunerlM. Stewart (Eds.), Tax, Law and Development (Cheltenham: Edward EIga, 2013) pp. 212-213.

84 Opinion of Advocate General Kokott in Manninen, C-319/02, EU:C:2004:164, point 51.85 )udgment in Danner, C-136/00, EU:C:2002:558, para. 41.86 )udgment in Test Claimants in the Thin Cap Group Litigalion, C-524/04, EU:C:2007:161, paras. 72-73.87 M. Hilling, Intertax 2013, p. 296, FN 49.88 )udgment in Cadbury Sehweppes, C-196/04, EU:C:2006:544, para. 51.

176 DziurdZ!Marchgraber (Eds), Non-Discrimination in European and Tax Treaty Law DziurdZ/Marchgraber (Eds), Non-Discrimination in European and Tax Treaty Law 177

-Prevention of Hybrid Mismatches as a Justification?

while still resulting in low or non-taxation in a cross-border context.78 In additihybrid mismatches result ftom differences between tax systems and the lack of on,ordination within the EU. Indeed, as the framework of EU law does not requ~O-h '.. h fd' IrearmomzatlOn m t e area o 1rect taxation, the Member States have sovereignty .d ·· th· 1lleS1g~mg e1r own tax system. Thus, it is not surprising that, from the perspective

?f a smgle Member State, the tax treatment applicable to the financial instrument1S completely symmetrical, without affecting the fairness or cohesion of the tax sy _tem.

79This implies that unilateral countermeasures adopted by a Member Sta:

against hybrid mismatch arrangements may lead to an untenable contradictio ewith the structure and principIes of its tax system. To sum up, the fiscal cohesion ~~a single tax system is not distorted through the use ofhybrid financiaI instruments.

It is true that, from the perspective of fiscal cohesion, it is possible to establish a di­rect link between the deduction of interest expenses by the subsidiary and the sub­seque~t taxation of the dividends by the parent company, as long as possible differ­ences m ~ax rates ~re neglected. However, the most problematic issue is the require­ment, la1d down m ECJ case law, that the correlation between the tax deductionand the taxation must be verified in relation to the same taxpayer and the same taxwithin the same Member State.80 Indeed, from the standpoint of a single Membe:State, the use of a debt instrument already creates the possibility of tax base reduc­tion, because the in~erest paid to the lender - foreign or national- is usually dassi­fied as a tax-deductlble expense. The treatment of the remuneration derived fromthe same financiaI instrument as dividends in the other Member State is a mereconsequence of the underlying tax policies adopted, without any dear relation tothe preservation of the cohesion of the national tax system of the former MemberState. Therefore, Members States cannot rely on the cohesion of the national taxsystem as a justification for tackling hybrid mismatch arrangements, because itv:rongfully ignores t~e basic parameters of EU law, such as fiscal sovereignty, thenght to use tax plannmg, and the disparities in the area of direct taxation.

Despite this, it seems reasonable to analyze the cohesion of the tax system from abroader perspective, which would cover the European Union as a whole. In theDanner case (C-136/00)81, the ECJ examined fiscal coherence not from the microleveI of the nationallegislation ofa Member State, but from the larger macro leveIof two Member States that signed a tax treaty.82 On this basis, it might be possible

78

7980

8182

R. de Boer, in R. de Boer/M. Nouwen (eds.), The European Union's Slruggle with Mismatches andAgressive Tax Plalllling, p. 50.H. D. Rosenbloom, Tax Law Review 2000, p. 143, FN 1.

N. Bammens, The Principie ofNon-Discrimination in International and European Tax Law (Amster­dam: IBFD, 2012) p.l000; Dennis Weber, An Analysis ofthe Past, Current and Future ofthe Coher­ence of the Tax System as a Justification, EC Tax Review 2015, p. 54.Judgment in Danner, Case C-136/00, EU:C:2002:558.M. Dahlberg, Direct Taxation in Relation to the Freedom ofEstablishment and the Free Movement ofCapital, p. 132.

Tomaze/a Santos--to establish a direct link between, on the one hand, the deduetibility?f the remu-neration derived from the hybrid instrument at the leveI of the Subs1dIary, and, onh other hand, the taxation of the corresponding amount at the leveI of the par-~n~ company. The preservation of a direct link between deduction and taxation,in a broader cross-country context, may be accepted .by the ECJ as valid ground ofjustification to guarantee the co~erence amo~g the differ:nt tax system.s, as the ~UTreaties constitute the legal bas1s for analyzmg the sub)ect from ano lnter-~atlo.n

rspective, whereby co-equal sovereign nations endeavor to rece1ve theIr fa1r~~rtions of a shared tax base.83 In this perspective, it should be kept in min~ that,. the Manninen case (C-319/02), AG Kokott already attempted to estabhsh an~:mediatelink between the coherence of the tax system and the single tax princi-

le by observing that it "generally means no more than avoiding double taxation~r ;nsuring that income is actually taxed, but only once (the principIe ofonly-oncetaxation)".84 The extension of the same reasoning to a cross-country contextwould allow the justification of restrictive domestic rules designed to prevent taxarbitrage with hybrid instruments, as provided for in Artide 4.1 (a) of the Parent­Subsidiary Directive.

In this sense, it is worth remembering that, over the years, the ECJ has alreadyturned aside the requirement that the fiscal coherence must be assessed ip rela­tion to a single taxpayer.85 It would be necessary to once again shift the angle formeasuring the fiscal coherence from the national leveI to an intra-CommunityleveI, in which case national anti-hybrid rules may be justified.

D. The Prevention of Tax AbuseAccording to ECJ case law, the need to counteract tax abuse may be put forv:ardby the Member States as a justification for discriminatory measures, prov1dedthat the domestic rule affects only wholly artificial arrangements.86 In the CadburySchweppes case (C-196/04), the ECJ held that the prevention of tax abuse mayserve as a justification for national tax measures affecting the fundamental free­doms that reach exdusively wholly artificial arrangements87 which aim at circum­venting the application of a Member State's tax law.88

It follows that, in order to a restriction on the freedom of establishment to be justifi~d

on the ground of prevention of abusive practices, the specific objective ofsueh a restnc­tion must be to prevent conduct involving the creation of wholly artificial arrangementswhich do not reflect economic reality (...).

83 On inter-nation equity, see: A. C. 1nfanti, Internation equity and human development, in: Y. Brauner/M. Stewart (Eds.), Tax, Law and Development (Cheltenham: Edward EIga, 2013) pp. 212-213.

84 Opinion of Advocate General Kokott in Manninen, C-319/02, EU:C:2004:164, point 51.85 Judgment in Danner, C-136/00, EU:C:2002:558, para. 41.86 Judgment in Test Claimants in the Thin Cap Group Litigation, C-524/04, EU:C:2007:161, paras. 72-73.87 M. Hilling, Intertax 2013, p. 296, FN 49.88 Judgment in Cadbury Schweppes, C-196/04, EU:C:2006:544, para. 51.

176 Dziurdz/Marchgraber (Eds), Non-Discrimination in European and Tax Treaty Law Dziurdz/Marchgraber (Eds), Non-Discrimination in European and Tax Treaty Law 177

b h' an arrangement is artificial, the objectivey t e apphcab~e fundamental freedom needs to be taken into account, asl-'lw.lrSllPrl

the partIcular Clrcumstances of the concrete case Essentially th h . ell asof ~ tr~ns~ction.as a wholly artificial arrangem~nt depend~ o: ~~~~~~~Z~tionsubJectIve. llltentIOn to achieve a tax advantage (subjective element) and fa.r

s. the

comply wIth the purpose of the fundamental freedom under discussio I.ure. toelem~nt).8~ It follows that the national Iegislation cannot be applied e~~~~~~tIveany sltuatIOn, base~ on an absolute legal presumption (''juris et d:jure') 90 ~ toneeds to focus speClfically on abusive transactions through a case by c ' ut

t 91 Th M b - - ase assessmen . ~s, em er States have to analyze every single case on the basi . -facts a?d Clrcumsta~ces.92In the Rimbaud case, the ECJ held that a ener:t

fItS

sumptIOn of tax aVOIdance is insufficient to justify a tax measure th~t . f' pre­fundamental freedoms.93 III nnges

As can be se~n from c~se Iaw: the ECJ applies a very strict concept of tax avoid­ance, acc?rdmg to whlch natIOnal anti-avoidance rules must be specificall tgeted agamst wholly artifici~l arrangements which do not reflect economic r~aI~r­and the sole purpose of WhICh is to circumvent tax Iaw 94 In add't' . . tyt l' . I IOn, restnctIveax measures app led by Member States to prevent abusive tax ractices m

comply with the principle ofproportionality.95 p ust

~aseJ on t~e fot~going, it seems that the ECJ is not willing to accept a justificationase. o~ t . e c alm th~t the use of certain types of financiaI instruments can be

~buslve III Itself. In thls respect, cross-border transactions with hybrid financ' 1I~struments cannot be considered per se illegaI or wholly artificial.96 This is ::_cIsely the re~son why g.eneraI anti-avoidance rules (GAARs) do not provilfe acomprehenslve mechamsm to counter the use of hybrl'd m' t hd 1 Isma c es arrange-ments an to so ve st~u~turaI problems ofa tax system,97 which Ied the üECD and~heI~~ro~eanCommlssIOn to propose specific changes in domestic Iaws in ordero III t e tax treatment of financiaI instrument, in one jurisdiction t~ the tax

8990

9192

93

94

95

9697

M. Hilling, Intertax 2013, p. 297, FN 49.

A. P. Dourado, "Aggressive Tax Planning in EU Law in the Light ofBEPS' Th EC R d .on Aggresslve Tax Planning and BEPS Actions 2 and 6", Intertax 2015, '45 e ecommen atlOnJudgment m Lankhorst-Hohorst GmbH, C-324/00, EU:C:2002:749, ara

P":'7 .

M. Lenz, SWltch-Over Rules and EU Law in' C Mass / p. '" ,tional Group Financingand Taxes (Vienna: LÍnd~, 2012)r;r2~5,StorcklB. Sturzhnger (eds.) Interna-

~CJ;/f October 2010, Case C-72/09, Rimbaud [201OJ, para. 34. See T. O'Shea "EC}'s R' b d R Img o sters Mut~al Assistance View", Ta.x Notes International201O, pp. 648-652 Im au u -

i·07::~~;~~.EroslOn and Profit Shifting and Interest Expenditure, Sul/etin for Int~rnationalTaxation

Ebru Tiyar, Tax Treatment of Intra-Group Interest in th EU' .zlinger (eds.) International Group Financing and Taxes (Vi:nna: ~~~~ ~:~~ner~~6Storck/B. Stür-J. Bundgaard, European Taxation 2013 p.593 FN 45' L d B EC i: '. p. .V. R. Almendral, Tax Avoidance th' , , : e roe, ax Revlew, p. 311, FN 8.Standard, in: I. Richelle/W. S'chó~/E \~alanced AllocatlOn ofTaxing Powers and the Arm's Lenght

Union (Berlin/Heidelberg: Springer Verl:~:r;~I~~~\1~ocatmgTaxmg Powers within the European

Tomazela Santos

tre:atn1erllin another jurisdiction (linking rules). Unquestionably, a GAAR may beused to recharacterize a financiaI instrument based on a teleologicaI interpretationof its economic substance, regardless of its legal formo However, it does not pro­vide a comprehensive response to cases of double non-taxation arising fromcross-border tax arbitrage,98 whose legal gaps should be covered by the Iegislator.99

In contrast, one may argue that anti-hybrid rules target only artificial hybrid ar­rangements, whose purpose is exploiting mismatches in the characterization of fi­nanciaI instruments in different jurisdictions in order to obtain double non-taxa­tion. This is because anti-hybrid rules only tax the dividends received by the parentcompany to the extent that the remuneration derived from the hybrid financiaI in­strument is deductible at the leveI of the subsidiary. Consequent1y, it would Iead tothe conclusion that the domestic tax measures only adversely affect cross-bordertransactions that intentionally pursued and achieved double non-taxation throughdeduction and non-inclusion schemes. This argument is not convincing, becausethe mismatch in tax outcome does not constitute an abusive tax practice if the hy­brid financiaI instrument provides an arm's Iength remuneration and satisfies agenuine financiaI need of the borrower. lOO Clear evidence to support the statementabove stems from the fact that, even after the 2014 amendment of the Parent-Sub­sidiary Directive, the hybrid financiaI instrument is not re-characterized for taxpurposes. Instead, oniy the tax treatment of the amount received by tHe parentcompany is adjusted with respect to the portion of the mismatch in the tax out­come.101 Another important point to be mentioned is that, when the parent com­pany decides to finance the subsidiary through hybrid financiaI instruments, it nei­ther takes an improper advantage of the fundamental freedoms nor deliberately cir­cumvents domestic Iaw. In addition, it should be kept in mind that taxpayers maychoose financiaI instruments with hybrid features for a variety of non-tax rea­sons. 102 From the corporate financing standpoint, the combination of equity anddebt characteristics in a financiaI instrument may be driven by severaI economic,financiaI, commercial, and legal reasons,103 which bear no relation to tax reductionstrategies. In general, it can be affirmed that the development of hybrid financinghas been motivated primarily by the opportunity to combine the qualities of bothequity and debt instrument, rather than for exploiting cross-border tax arbitrage. 104

98 C. Marchgraber, European Taxation 2014, p. 133, FN 14.99 A. P. Dourado, Intertax 2015, p. 48, FN 90.100 L. de Broe, Some observations on the 2007 communication from the Commission: The application of

anti-abuse measures in the area of direct taxation within the EU and in relation to third countries, ECTax Review 2008, p. 146.

101 R. de Boer/O. Marres, BEPS Action 2: Neutralizing the Effects on Hybrid Mismatch Arrangements,Intertax 2015, p. 24.

102 E. Eberhartinger/M. Six, Taxation ofCross-Border Hybrid Finance: A Legal Analysis, Intertax 2009, p. 4.103 E. F. Brigham/M. C. Ehrhardt, Financiai Management: Tlteory & Practice. 12th Edition (Mason,

Thomson/Souther-Western, 2008), pp. 742-766.104 M. Helminen, The International Tax Lmv Concept ofDividend, pp. 164-164.

178 Dziurdí/Marchgraber (Eds), Non-Discrimination in European and Tax Treaty Law Dziurdí/Marchgraber (Eds), Non-Discrimination in European and Tax Treaty Law 179

Tomazela Santos--------------------------------

In view of the existence of non-tax reasons for the use ofhybrid financiaI instru­ments, domestic laws should at least allow taxpayers the opportunity to Rrove thattax avoidance was not the primary or dominant reason for the structuredadopted. Indeed, as the ECJ already held that protection of tax revenues cannotserve as a possible ground of justification for limiting fundamental rights underthe EU law,I08 it seems necessary to assess, based on the facts and circumstances ofeach case, whether the use of the hybrid financiaI instruments can be consideredan artificial tax-driven transaction.

Following ECJ case law, it is possible to state that anti-abuse tax measures must bebased on an objective criterion verifiable by a third party109 and grant to the tax­payer the opportunity to provide evidence of any business ar economic justifica­tion for the transaction carried out, without being subject to undue administra­tive constraints. 110 This implies that the taxpayer must have the right to demon­strate that, in the particular case, the use of the hybrid instrument is not whollyartificial, reflecting the economic reality.lll

To summarize, the prevention of tax abuse does not constitute a general groundof justification for national anti-hybrid rules for the following reasons:

Redeemable Preferred shares usually • priority in the receipt of fixed orPreferred have priority in receipt of cumulative dividendsShares dividends, whether fixed • priority on the return of capital

or minimum, and prior- • no dilution in corporate controlity in the right to claim • reduction of debt : equity ratiothe repayment of capital • absence of voting rightsupon liquidation.

Convertible A convertible bond (or a • delayed dilution of commonbonds or convertible debenture) is stock and earnings per sharedebentures a specific type of bond • lower coupon rate in comparison

that grants to the holder with straight bondsthe right to receive cou- • limited interest payment untilpon payments and to the conversionconvert the bond intoshares of common stockin a future date.

. may be chosen to achieve an optimal uuan<:i;1]structure, by V1rtue of the following advantages: ability to raise capital fundo .co t [fi' t d" mg m as -e IClen manner, accommo atmg to mvestors' needs' 1OS facility to bal h

. I d" ,ancet ec.aplta structure an achleve a hlgher efficiency with respect to equity and d bttIOS; potential to improvethe company's liquidity and its financialleverage e t.ra-

. b . ra lOS'~apaclty .to o t~m ~ better classification in the companies' balance sheet anellmprove ItS credIt ratmg, preventing the increase of the risk ofdefault among th

106 Th th ' o erones: us:. e parent company may have genuine business reasons to opt for aspeclfic hybnd mstru~ent, which implies that the mere existence of a binary di­chotomy between eqUlty and debt in corporate law and private civillaw107 is notenough to assess whether or not the mismatch in tax outcome derives from an t'fi . I b' 1 I ar 1-ICla or a uSlve ega transaction. In the table below, it is possible to find non-taxreasons for the use of the most common financial instruments:

PossibIe non-tax reasons for using hybrid financiaI instrumentsFinanciaI Ins- Definition PossibIe non-tax reasons

trument

PerpetuaI Perpetualloans consist of • interest rates are low for longer-Loans loans that either lack a term debtdefinitive maturity date • investors may have a steady andor specify that maturity predictable source of incomewill not occur for a pro- • it may offer periodic interest ratelonged time (typically increases (e.g. 1 % at the end oflonger than 50 years). each 10 years)

Profit Partici- A loan whose interest • the remuneration is contingentpating payments are dependent upon the results of the debtorLoans on the profits of the • participation in losses is contrac-debtor. tually excluded

• simple and cost-efficient struc-ture (it does not require analysesand prospectuses);

• high degree of financial flexibility(it may include conversion right,subordination, super maturity)

105 E. GaBo, Drawing the BorderIine .between Debt and Equity in Tax Treaty Law (Hybrid Finance) in:C: Massoner/A. Storck!B. Sturzlmger (eds.) International Group Financing and Taxes (Vienna'Lmde, 2012), pp. 467-468. .

106 E. GaBo in: C. Massoner/A. Storck!B. Stürzlinger (eds.) International Group Financing and Taxespp.467-468. '

107 W. Schéin et ~l., Debt and Equity in Domestic and 1nternational Tax Law _ A Comparative PolicyAna!ysls, Brztlsh Tax Review 2014, p. 148.

108 Judgment in Verkooijen, C-35/98, EU:C:2000:294.109 Judgments in Test Claimants in the Thill Cap Group Litigation, C-524/04, EU:C:2007:161; SIAT,

C-318110, EU:C:2012:415.110 A. P. Dourado, Intertax 2015, p. 45, FN 90.111 Dennis Weber, "European Union - Abuse of Law in European Tax Law: An Overview and Some Re­

cent Trends in the Direct and lndirect Tax Case Law ofthe EC] - Part 2", European Taxation2013, p.316; M. HiIling, Intertax 2013, p. 297, FN 49.

180 Dziurdí/Marchgraber (Eds), Non-Discrimination in European and Tax Treaty LawDziurdílMarchgraber (Eds), Non-Discrimination in European and Tax Treaty Law 181

. [fi' are on an objective criterion but h'msu ICIent. i~adequate to determine whether the transacti~n in w Ichrepresents, eIther I~ whole or in part, a purely artificial arrannot .reflect economlC reality. gement does

(2) NatIOnal anti-hybrid mIes do not grant t th t~rovid~ evidenc~ of the underlying econom~cr:as~~Pt~~r'~~~fi~~p~rtunitytotIOn, wIthout bemg sub)'ect to undue admI'n' t t' ) . t e transac-

(3) N' 1 . IS ra Ive constramtsatI~na antI~hy.bridmIes do not target only abusive situation~, as th

hybnd financIaI mstmments cannot be considered artificial in itself. e Use of

In conclusion, nationallegislation which is not s ecificall .purely ~rtificiaI tax planning may not be regardelas jUstif~:~~~~:do~~a;dresspreventmg tax avoidance. As a result the need t . )ec Ive of

d d . . ,oprevent tax aVOldance can t bregar e as a )ustIfication for countering hybrid mI's t h no e

'th d' ma C es arrangements i rWI stan mg ECJ case Iaw since the ant' h b'd 1 n me

, 1- Y n m es are not s 11 l' dwholly artificial arrangements. However in exce t' l' o e y app Ie to

'd ' P lOna CIrcumstances the ECJmay conSI er the prevention of tax abuse to be a valid r ..'..concrete case, provided that the facts and' t g ound of)ustIficatIon m aartificiality in the transaction performed b~I~~~~;~:;.attest to the existence of

V. The Need to Counteract Hybrid Arrangements:a New Ground of Justification?

~~:,r~;~ot~;~:~~ou.t ~his paper, natio~al r~Ies that are applicable to every situa-

the subjective inte~i~:°o;~~~Ut~~;~;~~~~~:~~~~~~~i~e~:dt~~oco~~::~~~~:et~~purposes of combatmg tax avoidance strategies 112 Altho h th ~ b

Ph;i:eCI~phle rigf~t .to comba~ .artificiaI tax planning'stmcture~~mai~y ~:e~ro~~~;e o laIr cOmpetItIOn and co t 'bT

provision that is applicable t rpora ebresponsI 1 Ity, a specific anti-abuse

fi o every cross- order transaction invol' h b .dmanciaI instmments that generate deducfbI vmg y n

general to justify restrictions on the funda~en~a~xfr:~dsoesseems to be excessivelyms.

The question that arises is whether the combating of hybrid' hsuch, be regarded as a valid overriding reason in the comm:Is~atc es can, as?ur?ose .of justifying a restriction to the fundamental freedom~ I~e:t, for thhe)uStIficatIOn based on the need t ..' s own, t ehas not been yet put forward by aO~~~~:~a~t~~:~~~~r~~me EatCchJeFs arrtha~gementsthe aim h . t 'd" . or IS reasonECJ and ber~ IS o ~rovI e I~SI~ht into the possible challenges to be faced by th~

Y omestIc courts m ItS future judgments on the subject.

112 Judgment in Centros Lld, C-212/97, EU:C:1999:126.

Tomazela Santos

first glance, it may seem that double non-taxation in itself is not contrary tothe fundamental freedoms, because it does not represent an insurmountable ob­stacle to the free movement of goods, services, persons, and capital irrespective ofnatIOnal borders. It might well be argued that double non-taxation does not im­properly affect economic decisions of undertakings or investors, nor prevent thedevelopment of economic activities within the internaI market, as it does not con­stitute a serious impediment for working, investing, establishing, or sellingabroad. 113 Therefore, this would lead to the conclusion that double non-taxationis not contrary to the fundamental freedoms, but rather a political issue thatshould be countered by the harmonization of Member States' tax systems. Conse­quently, Member States could not justify discriminatory or restrictive tax meas­ures on grounds of tackling hybrid mismatches arrangements.

However, a broader analysis of the potential impact of double non-taxation re­veals its capacity to distort conditions of competition on the single market. 1l4 ItaIso stimulates economic agents to invest abroad, rather than in their home coun­tries, thus improperly affecting economic decisions and the optimal allocation ofresources within Europe as a whole. 115 In this scenario, the preservation ofa directlink between deduction and taxation, in a broader cross-country context,unay beaccepted as result of the singIe tax principIe, according to which income frominternational transactions should be subject to tax once (not more, but also notIess than once).116 From a theoreticaI perspective, the singIe tax principIe may bejustified based on efficiency, neutrality, fairness, inter-nation equity, and preven­tion of revenue Ioss.

Strictly speaking, efficient tax mIes are neutral from an economic standpoint, be­cause they neither create economic distortions nor affect the economic judgmentof rational decision-makers. Tax mIes should not distort decisions on the alloca­tion of production factors, unless it is strictly necessary for correcting other formsof inefficiencies, inequalities or externalities that affect the free market. ll7 Extend­ing the efficiency and neutrality to an international context implies that cross­border activities and the decision where to invest should not be distorted by dif­ferences on tax mIes of various countries. 118 In order to achieve this goal, incomederived from cross-border transactions should not be taxed more heavily thandomestic income, as the extra tax burden creates an inefficient incentive to invest

113 B.). M. Terra/P. J. Wattel, European Tax Law, p. 130.114 See section 2 above.115 W. Schon, "Tax Competition in Eurape - General Report", In: W. Schon (Ed.), Tax Competition in

Europe (Amsterdam: IBFD, 2003), pp. 5-8.116 R. S. Avi-Yonah, Intemational Tax as lntemational Law - An Analysis ofthe Intemational Tax Re­

gime (Cambridge Tax Law Series, 2007), pp. 8-10.117 S. Barsch, Taxation ofHybrid Financiai Instrwnents and the Remuneration Derived Therefrom in an

Intemational and Cross-border, pp. 44-45.118 S. Barsch, Taxation ofHybrid Financiai Instruments and lhe Remuneration Derived Therefrom in an

lntemalional and Cross-border, pp. 46.

182 Dziurdz/Marchgraber (Eds), Non-Discrimination in Europ d Tean an ax Treaty Law Dziurdz/Marchgraber (Eds), Non-Discrimination in European and Tax Treaty Law 183

Prevention of Hybrid Mismatches as a Justification?

124 R. S. Avi-Yonah, Commentary (Response to artic1e by H. David Rosenbloom), Michigan Tax LawReview 2000, pp. 168-171.

125 Judgments in Mark Kercklwert and Bernadette Morres, C-513/04, EU:C:2006:713; Jacques Dam-seaux, C-128/08, EU:C:2009:47I.

126 K. Daxkobler/E. Huisman, Levy & Sebbag: The EC) Has Once Again Been Asked To Deliver ItsOpinion on Juridical Double Taxation in the InternaI Market, European Taxation 2013, p. 400.

127 See the following excerpt from the CIBA case: "European Union iaw, in the current state of its devel­opment (...), does not lay down any general criteria for the attribution ofareas ofcompetence betweenthe Member States in relation to the elimination of double taxation within the European Union".Oudgment in CIBA, C-96/08, EU:C:2010:185, paras. 27 et seq).

128 D. Gutmann, How to avoid Double Taxation in the European Union, in: I. Richelle/W. Schõn/E.Traversa (Eds.), Allocating Taxing Powers within the European Union (Berlin/Heidelberg: SpringerVerlag, 2013), pp. 63-72.

seen from the fact that withholding taxes are reduced in the source state based onthe assumption that the corresponding income is subject to tax in the residencestate. The preservation of the matchingprinciple is aIso the primary reason for notentering into tax treaties with tax havens, in which the income is not properlytaxed.124 Based on the single tax principIe and on the good functioning of theinternaI market, it would be possible to extend the matching principIe beyond thetax treaty context in order to establish a direct link between, on the one hand, thedeductibility of the remuneration derived from the hybrid instrument at the leveIof the subsidiary, and, on the other hand, the taxation of the correspondingamount at the leveI of the parent company.

Thus, the preservation of a direct link between deduction and taxation, in abroader cross-country context, may be accepted as result of the single tax princi­pIe. However, if this is the foundation for tackling international tax arbitragethrough the use of anti-hybrid rules, it is necessary to recognize, for the sake ofconsistency, that countries should aIso offer proper solutions for all cases of dou­ble taxation, even outside a tax treaty contexto It implies that double taxationshould no longer be considered to be the simple result of the parallel exercise oftaxing rights by sovereign countries, but rather as a violation of the single taxprincipIe. This interpretation of EU law is highly controversial, becaus~ the EC]has consistently held that the fundamental freedoms do not offer any remedyagainst the problem of double taxation,125 which is a consequence of the parallelexercise of taxing rights and of the Member States' fiscal sovereignty.126

Indeed, in the examination of different cases, the ECJ has always reached the con­clusion that the fundamental freedoms do not prevent double taxation, for whichreason Member States should, as far as is necessary, negotiate double tax treatiesto avoid double taxation in the internaI market. 127 The approach adopted by theEC] is very open to criticism, in view of the fact that double taxation is an obviousobstacle to the functioning of the internaI market, which makes it difficult toaccept that its negative effects for the development of international trade are inline with EU law.128 Despite this, for the sake of consistency, if the EC] decides

Tomazela Santos----,----------------------_.-:-=..:..:.:..:.:.:::..=.:..:::-=.::..:..:..:..::.::.

domestically. Conver~ely, income arising from cross-border transactions sh::no: be taxed less heavily, as the tax saving obtained creates an inefficient incent'to m:,est abroad rather than at home. 119 The deadweight loss associated with lVetaxatI~n or under-taxati0I1 of cross-border income contradicts the idea of se~~~­up a smgle market in the European Community. g

Fr?m another ~n~le, the under-taxation ofcross-border income caused by hybridmls~atches wlthm the Europ~an Union violates both horizontal and verticaleqUlty when compared to the hlgher tax burden imposed on domestic-source .c.ome.

12ÜThus, the av~idance of double taxation and double non-taxation is ess~~~

tIal for t.he preservatlOn of fairness and equality in the tax system, since the taxbu~~en lmposed. o~ each :axpayer has to be determined in accordance with theablltttto-pay pr~nclple,121 lrrespective of the origin of the corresponding income(forelgn-source mcome or domestic-source income).

Deviation~ from th~ sin~le tax principIe caused by hybrid mismatches also distortt~e allocatlOn of taxl~g nghts between jurisdictions and affect inter-nation equit ,glven t~e fact that nelther the residence state nor the source state will impose t~~n the m~ome g~nerated.by :he hybrid financiaI instrumento The development ofl~ter-natlo~ equlty can slgmficantly contribute to achieving fairness in interna­tlOnal taxatlOn, but its usefulness as a tax policy goal has been largely underval­ued, perh~ps ~ecause ~olicy-makers and tax scholars believe it depends greatly onthe coordmatlOn of dlrect tax systems within the EU 122 As J: • t .. . . lar as In er-natlOnequlty IS conc.erned, taxing rights and tax base have to be equitably allocated~mong the resld~nce state. and the source state. 123 However, by means of financiaIm~trumen:s WhlCh combme debt and equity features, it is possible to avoid thefalr a.llocatlOn of taxes between the countries concerned, regardless of the benefitsp:ovlded by e~ch country for the generation of the income (public goods and ser­VICes, economlC and legal framework).

In lig~t o~ the foregoing, :he anti-hybrid rules introduced in the Parent-Subsidi­~ry Dl~eCtIve n:ay be consldered a mechanism to achieve the principle 01matching~n the mternatlO~al tax field beyond the scope of tax treaties. It is well know thatmcome tax treatIes are generally based on the matching principle, which can be

119 R: S. Avi-Yonah, International Tax as International Law - An Analysis oifthe International Tax Re­gIme, p. 9.

120 R. S. Avi-Yonah, International Tax as International Law - An Analysis oifthe International Tax Re­glme,p.IO.

121 IS, tBãrScth, Talxatdio'CI ofHybrid Financiai Instruments and the Remuneration Derived ThereFrom in ann erna zona an ross-border, p. 56. :I'

122 K. Brooks, Chapter 15 - Inter-Nation Equity: The Development of an Important but Undera re'ated InternatlOnaI Tax Policy Objective, in: J. G. Head/R. Krever (Eds.), Tax Reform in the 21~rCe~::tury )- A Volume /ti Memory ofRichard Musgrave (Alphen aan den Rijn' Kluwer Lan Inte t' I2009 , pp. 489-493. . rna lOna,

123 S. Bãrsch, Taxation ofHybrid financiai Instruments and the Remlmeration Derived Th ,r; .Internatzonal and Cross-border, pp. 57-61. ereJrom /ti an

184 Dziurdz/Marchgraber (Eds), Non-Discrimination in European and Tax Treaty Law DziurdUMarchgraber (Eds), Non-Discrimination in European and Tax Treaty Law 185

tax principIe and the inter-nation equity are able to justify l1<tlIOn:l1ruI~s agains.t dou~Ie non-taxation, then it is necessary to folIow the

same approac~m cas~s mvolvmg double taxation. It is true that, from a practicaIstand,r0mt, thIS soIutIOn seems to be very difficult to implement, due to the factthat, m the absence of tax.harmonization, EU Iaw does not provide any criter'

d . h li IOnto etermme t e a ocation of taxing rights among Member States, which .essentiaI to verify, in a cross-border context, which Member State did not com IISwi.th EU Iaw in a case that ended up in double taxation. 129 As double taxat~~anses from the cumulative exercise of taxing rights by two different MembStates, it is not possible to blame a single country for this outcome.I3O Howev er. . e~

Just as It was necessary to amend the Parent-Subsidiary Directive, there is aIso aneed to further develop rules to tackle double taxation at the EU leveI. 13l MorespecificalIy, it is necessary, at the very Ieast, to create rules to prevent double taxa­tion derived from hybrid financiaI instruments,which may occur if a cross-bor­der payment is classified as dividend at the leveI of the subsidiary and as interestat the leveI of the parent company.132

Furthermore, the ECJ has consistent1y held that Member States are not requiredto take into account possible negative effects derived from peculiarities of thedomestic law of another Member State, for the purposes of applying their owntax legislation.

133More precisely, in the Krankenheim Ruhesitz am Wannsee case

(~-157/ü7), the ECJ held that Member States are not obliged to design their na­tIOnal tax Iaw based on the rules in force in other Member States, only to ensurethat, in alI circumstances, any disparities arising from the interaction between~he two juridical s~stems are eliminated. 134 Based on a similar line of reasoning,m the Keller Holdzng case (C-4711ü4),135 the ECJ decided that a Member Statecould not apply a discriminatory tax treatment on dividends received by theparent company, merely because the profits earned by a foreign subsidiary, outof which the dividends were distributed, were not taxed in that other MemberState.

136This implies that a discriminatory tax measure cannot be justified based

on the tax treatment applicable in another Member State, which makes it diffi­cult to accept as justification the need to safeguard the symmetry betweendeduction and taxation in a cross-border context.

129 F. A. García Prats, Revisiting "Schumacker": Source, Residence, Citizenship in the EC) Case Law onDirect Taxation, in: I. Richelle/W. Schon/E. Traversa (Eds.), A/locating Taxing Powers within the Eu­ropean Union (Berlin/Heidelberg: Springer Verlag, 2013) pp. 22-25.

130 M. Lang, Chapter 2 -. Double Taxation and EC Law, in: R. S. Avi-Yonah, J. R. Hines Jr.lM. Lang(Eds.), COI~paratlve Fiscal Federalzsm (Alphen aan den Rijn: Kluwer Law International, 2007), p.17.

131 F. A. Gar~laPrats, In: Isabelle RIChelle/Wolfgang Schon/Edoardo Traversa (Eds.), A/locating TaxingPowers wlth/ll the European Union, pp. 22-25.

132 C. Marchgraber, European Taxation 2014, p. 42, FN 14.133 O. Thommes/A. Linn, Intertax 2014, pp. 31, FN 39.134 Judgment in Krankenheim Ruhesitz am Wannsee, C-157/07, EU:C:2008:588, paras. 49-50.135 Judgment in Keller Holding, C-471/04, EU:C:2006:143, para. 43.136 O. Thommes/A. Linn, Intertax 2014, pp. 31.

Tomazela Santos

.the EU treaty framework, the functioning of the internaI market is ~is-

d When the taxpayer suffers double taxation or enjoys double non-taxatlOntorte ... .. . hdue to disparities or mconslstencres caused by dlvergmg tax systems, glv~n t er t that competitive conditions and overalI tax burden are affected dependmg onIaC .. d ) 137 A' th'the character of the transactIOn (domestIc or cross-bor er . gamst IS argu-

t one may say that the fundamental freedoms only prevent Member Statesmen, ., .f imposing a worse tax treatment on cross-border transactIOns m compansonror:rely domestic transactions, without impeding the concession of a favorable

to p I' . h h' . M bt treatment to a cross-border transaction. In me Wlt t IS reasomng, em er~~tes should not restrict the funda~ental freedom~by hi~deringeconomi~play-

in entering other Member States market or leavmg thelr Member States mar-ers . d' h fuk t because these obstacles against cross-border transactIOns Istort t e nc-ti~~ing of the internaI market. 138 It foliow~ that double non-taxa:ion obtained ineross-border transactions would not constltute an obstacle to the mternal market.However, the author disagrees with this idea, because if taxpayers earn h~gher

fter-tax returns investing abroad than on domestic investments earning a hlghera . . h I tt 139 Abefore-tax return, they WllI prefer the former mvestment over t e a er. s aresult, investments wilI be allocated away from their most productive use, thusharming the single market. This incentive may aIso result in an over-~u~plyofcapital for cross-border investments and an under-supply for domestI~ mvest­ments. 140

Notwithstanding the arguments above, one may argue that focusing on double­taxation or double non-taxation diverts attention away from the real problem,which is the relative tax burden at various relevant margins, regardless of thenumber of different times that the same income is taxed under the tax system ofdifferent countries. It is possible to claim that what realIy matters in a cross-bor­der context is the final tax burden charged at a certain margin, irrespective of thenumber of taxes that are effectively charged, since any taxpayer wiU probably pre­fer to be taxed twice at a 10 % rate each time than once at a 35 % rate. Thus, theideal solution would be to focus on the overalI effective tax burden at the margin,rather than on the number of times that the cross-border income is taxed. 141

Whilst the importance of the effective tax burden at the margin has to beacknowledged, the truth is that the prevention of double non-taxation generatedby deduction and non-inclusion schemes focuses on a concrete problem that cov­ers the former, because if neither the residence state nor the source state taxes the

137 S. Barsch, Taxation ofHybrid Financiai Instruments and the Renwneration Derived Therefrom in anIntemational and Cross-border, p. 65. .

138 S. Barsch, Taxation ofHybrid Financiai Instruments and the Remuneration Derived Therefrom /Il anIntemational and Cross-border, p. 64.

139 R. S. Avi-Yonah, Michigan Tax Law Review 2000, p. 171, FN 124.140 R. S. Avi-Yonah, Michigan Tax Law Review 2000, p. 171, FN 124. . .141 D. Shaviro, Fixing U.S. Intemational Taxation (New York: Oxford Umvensty Press, 2014), pp. 4-7.

186 Dziurdí/Marchgraber (Eds), Non-Discrimination in European and Tax Treaty law Dziurdí/Marchgraber (Eds), Non-Discrimination in European and Tax Treaty law 187

143144145

Prevention of Hybrid Mismatches as a Justification?

income deríved from thehybríd financiaI instrument, then the margínal rate oftax on that íncome is zero, which is necessarily lower than the rate of tax on thresidence state, thus creating an íncentíve to ínvest in the source country ín orde;to take advantage of the hybrid mísmatch. 142

On the assumption that double non-taxation obtaíned through hybríd ínstru­ments should be combatted by EU law due to íts negative effects for the ínternalmarket, the íssue that aríses is that antí-hybríd rules are not entírely successful intackling hybrid mísmatches arrangements because of their límíted scope. Indeed,the national tax measures adopted by Member States, based on the amendment ofParent-Subsídiary Dírective, do not cover alI opportunítíes for hybrid mis­matches, because the oblígation to tax is only applícable wíthin íts materíal andterritorial scope, which compríse profits dístributed by an EU subsídiary to íts EUparent company. In addítion, outsíde the scope of the Parent-Subsídíary Dírec­tíve, recalcítrant companies may stíll structure transactions with hybríd financiaIinstruments between an EU and a non-EU company,143 ín order benefit fromexemptíons granted by domestic law or tax treaties, mainly by Member States thatdesire to attract foreign investors.

Another type ofhybrid mismatch not covered by the Parent-Subsídiary Directiveinvolves the notional interest deductíon províded for by the domestic law of cer­tain countríes, especialIy Belgium. 144 Strictly speaking, Article 4.1 (a) of the Par­ent-Subsídiary Dírectíve does not cover the notional interest deduction, becausethe dividend dístributed is not deductible at the leveI of the subsídíary. However,from an economic perspective, the notional ínterest deduction ensures a similareffect, as it alIows the subsidiary to deduct the amount corresponding to its riskcapital from the tax base of the corporate íncome taxo Although ít does not pro­duce a mismatch ín tax outcomes in the sense contemplated by the Parent-Sub­s~diary Dírective and Action 2 of BEPS Action Plan, the same reasoníng that jus­tifies tax measures against hybrid financiaI instruments also requires a compre­hensive approach to the matter, ín order to prevent injustices. Otherwise, notonly taxpayers may exploít new loopholes in tax legíslation, but Member States aswelI may attempt to provide an attractive alternative to foreígn investors.145

Moreover, the Parent-Subsídiary Directíve does not provide for a proper solutionfor the cases in which Member States rely on the indirect credit method to avoiddouble taxation. A fulI tax credit of the corporate income tax paid by the subsidi­ary, along with the deduction of the amount distributed to the parent company,

142 R. S. Avi-Yonah, "No Country is an Island: Is a Radical Rethinking of International TaxationNeeded?", Univeristy ofMichigan Public Law Research Paper No. 380 (2014), p. 6.L. de Broe, EC Tax Review 2014, p. 311, FN 8.Article 205 of the Belgian Income Tax Code.It is not objective of this paper to analyze whether the notional interest deduction may constitute aform ofState aid.

Tomazela Santos

would aIso lead to double non-taxation. 146 As regards the credit method, Article4(1)(b) of the Parent-Subsidiary Directive states that the parent. company mu~t

deduct from the amount of tax due the fraction of the corporate mcome tax paIdby its subsidiary and any lower-tier subsidiary on the pro~ts distributed. Thewording of the provísíon does not clarify whether the deductlOn of the rem~ner­

ation derived from the hybrid instrument reduces the amount of the tax credIto Inorder to avoid increasing disparities between the exemption and the creditmethod, which are not fulIy equivalent remedies,147 the European Commissionshould have explícitly addressed the issue.

In addition, ít ís commonly stated in the líterature that, from an economic per­spective, ít may be very difficult to dístinguish.between non-taxation .and t~xatí~nat a very low rate. 148 Consequently, anti-hybnd rules may create a dlstortive blastowards investments that benefit from mismatches in tax rates, as a substantialdifference between the tax rates may lead to an economic result similar to doublenon-taxation.149 Strictly speakíng, the anti-hybrid rules only apply where the pay­ment is deducted at the leveI of the subsidiary, which means, on the other hand,that the parent company should refrain from taxing the profit distribution wherethe payment is not deductible at the leveI of the subsidiary, even if the leveI of taxactualIy paid ís signíficantly low. In the author's opínion, since the Parent-%Subsid­iary Directive alIows both the exemption method and the indirect credit method,the nationallaws of the Member States can provide for a switch-over to the indi­rect credit method when the leveI of taxation ín the subsidiary state is excessivelylow. In this case, the country of the parent company will comply with the provi­sion of Article 4 of the Parent-Subsidiary Directive, thereby achieving the goal ofpreventing double taxation.

Another problem is that the anti-hybrid rule based on the Parent-SubsídiaryDirective may affect legal transactions that were not originalIy íntended to be cov­ered. As already mentioned, Article 4.1 (a) of the Parent-Subsidiary Directivestates that the Member State of the parent company must "refrain fram taxingsuch prafits ta the extent that such prafits are nat deductible by the subsidiary".150Thus, this legal provision may be rendered applícable where the country of thesubsidiary denies, based on its national thin capitalizatíon rules, the deduction ofa payment characterized as interest under íts domestic law. In this situatíon, thereare two possible outcomes, without any reasonable justification for the unequal

146 C. Marchgraber, European Taxation 2014, p. 136, FN 14.147 B. j. M. Terra/P. j. Wallel, European Tax Law, pp. 312-313.148 R. de Boer in: R. de Boer/M. Nouwen (eds.), The European Union's Struggle with Mismatches and

Agressive Tax Plmming, p. 68.149 R. de Boer in: R. de Boer/M. Nouwen (eds.), The European Union's Struggle with Mismatches and

Agressive Tax Planning, p. 68.150 Council Directive 2011196/EU of30 November 2011 (recast), amended by: Council Directive 2013/

13/EU of 13 May 2013 and Council Directive 2014/86/EU of8 july 2014.

188 Dziurdí/Marchgraber (Eds), Non-Discrimination in European and Tax Treaty Law Dziurdí/Marchgraber (Eds), Non-Discrimination in European and Tax Treaty Law 189

154155156157158159

Prevention of Hybrid Mismatches as a Justification?~~:":":':::":":":-::":":":'::L.:.::..~~~~"::':":':::'::"":::'::"":::",:":::,::,,::,:,,:,::::::,,:::,,:::,:,,,:,:,- _

tax treatment. On the one hand, if the country of the parent company character_izes the payment as interest, the amount may be taxed based on its domestic law,under the Interest and Royalty Directive. On the other hand, if the country of theparent company characterizes the payment as profit distribution, within the con­text of the Parent-Subsidiary Directive, the corresponding amount must not betaxed to the extent that the corresponding payment was not deducted at the leveIof the subsidiary. Therefore, the European Commission did not properIy addressthis type of mismatch, stemming from the classification of the income for thepurposes of applying both directives. If it were acknowledged that the neutraliza_tion of hybrid mismatches arrangements and their effects (double non-taxationor double taxation) is a goal to be pursued by the European Union, it would beconsistent to adopt a more comprehensive approach, instead of just focusing onparticular types of tax planning strategies.

Finally, it is worth mentioning that, in order to circumvent the application ofanti-hybrid rules, tax planning structures may be adopted to avoid either the sub­stantial participation of 10 % or other requirements for the application of the Par­ent-Subsidiary Directive, especially when domestic law or tax treaties grant anykind of relief to portfolio dividends. To this end, dividend washing or dividendstripping transactions, which entail a temporary transfer of the title to the sharesjust before the distribution of dividends,I51 may now be used in the oppositedirection to get around domestic anti-hybrid rules. This may open room for theuse of investment funds, collective investment vehicles, usufruct agreements, to­tal return swap, among other tax planning strategies, for the purpose of fallingoutside the scope of the Parent-Subsidiary Directive and of the anti-hybrid rule.

VI. Proportionality test

The principIe of proportionality initially appeared within the EU framework as ageneral principIe of law, but has been assimilated by the ECJ in the course of in­terpretation and application ofCommunity law. 152 The analysis of the principIe ofproportionality is of fundamental importance because restrictive tax measuresare often rejected by the ECJ not on the absence of a legitimate ground of justifi­cation, but on the disproportionality of their restrictive effects. 153 According toECJ case law, national tax measures which are liable to make less attractive the ex­ercise of fundamental freedoms guaranteed by EU law may nevertheless beallowed in special circumstances, provided that: (i) they pursue an objective in thepublic interest; (ii) they are appropriate to attaining that objective; (iii) they do

151 K. Daxkobler/E. Pamperl, Chapter 12 - Austria, in: G. Maisto (ed.), Taxation oflntercompany Divi­dends under Tax Treaties and EU LalV (Amsterdam: IBFD, 2012), p. 307.

152 A. Zalasinski, Proportionality of Anti-Avoidance and Anti-Abuse Measures in the ECrs Direct TaxCase Law, Intertax 2007, p. 310.

153 B. J. M. Terra/P. J. Wattel, European Tax LalV, p. 45.

Santos

beyond what is necessary to attain the objective pursued. 154 Thus, on theno

t~ption that a restriction to fundamental freedoms may be justifie~ based o~

assU

ounds examined above, the question arises as to whether the natlO~al antl­th~g.rd rules are in accordance with the principIe of proportionality. In thls paper,~~sr:mpossible to reach a definitive conclusion on the fulfillm~ntof the pr~por­I. nality test, since it depends on the analysis of the actual wordmg ~f the ~ntl-httl~d I introduced by each Member State. 155 For this reason, thls sectlOn wI11bn ruoeme controversial aspects of anti-hybrid rules which may eventually becover s . l'tytaken into consideration by the ECJ in its analysis of proportlOna I .

ro riate: The national tax measure must be adequate, app:opriate,. capable,App 't Pble cor the production of the effects intended by the natlOnalleglslator. Itor SUl a l' b" dope

st clearIy contribute for the attainment of the purpose, o !ectlve, an s~

:~ired b the Member State with the text of the law. 156 On .thls matter: an~l-hy­brid rule: introduced by Member States will probably ac.hle~e the obJectl:e ~favoiding double non-taxation generated by hybrid finanCIaI mstruments .wlth.mthe scope of the Parent-Subsidia1J' Dir~ct~ve, although other f~rms ofhybnd mls­matches are technically still posslble wIthm the European Umon.

Necessary: From a theoretical perspective, the national tax measure should be theleast restrictive among available alternatives to the fund~m~ntal freedoms or to theaffected rights granted by EU law.157 Apart from contnbutmg to the gddual pro­motion of its purpose, the domestic tax rule introduced by the Member State m~stbe the least restrictive among all other tax measures available and equally effectlveto attain the objective pursued by the legislator. 158 However, the ECJ does not ~l­wa s recognize that the Member State has the obligation to choose the least restnc­tiv; means,159 as can be inferred from the Alpine Investments ~ase (C-384/93),where it held that "the fact that one Member Stat~ impose less ~tnct rule.s than an­other Member State does not mean that the latter s rules are dlsproportlOn.ate ~n.dhence incompatible with Community law".16ü From a theore.tical per.spectlve, It ISonly possible to agree with the ECJ decision if the two optlOn~ avaI1able a.re notequally effective to attain the objective pursued, even ,tho~g~ thls may be dlffic~tto evaluate in some circumstances. Thus, in the author s opmlOn, am.o~g aHlequa yeffective tax measures, Member States should choose the least restnc~l:e m~ans

of preventing double non-taxation obtained under the Pare~t-Subsl?la~Dlrec­tive. This criterion, which is usually disregarded by the ECJ m practlce, would

B. J. M. Terra/P. J. Wattel, European Tax LalV, pp. 44-45.N. Strelnikova, Master Thesis, p. 32, FN 38.A. Zalasinski, Intertax 2007, p. 312, FN 152.A. Zalasinski, Intertax 2007, p. 312, FN 152.B J M Terra/P J Wattel, European Tax LalV, p. 44. . ( Ic'. HJI 'Pana~i, D~uble Taxation, Tax Treatíes, Treaty Shopping and the European Conllmmlty A­phen aan den Rijn: Kluwer Law International, 2007), p. 206.

160 Jud ment in Alpine Investments, C-384/93, EU:C:1995:126, para. 51. .161 U. ~chreiber, Intemational Company Taxatíon (Berlin/Heidelberg: Spnnger Verlag, 2013), p. 103.162 A. Zalasinski, Intertax 2007, p. 312, FN 152.

190 Dziurdz/Marchgraber (Eds), Non-Discrimination in European and Tax Treaty Law DziurdUMarchgraber (Eds), Non-Discrimination in European and Tax Treaty Law 191

Prevention of Hybrid Mismatches as a Justification? -le~d .to the discussion 9f al~ernative solutions for tackling hybrid mismateheswlthm the European Umon, m particular through the harmonization of domesflaws and the introduction of the Common Consolidated Corporate Tax Ba~~(CCCTB). Unfortunately, this long debate requires a specific analysis that cannotbe aeco~modat~dwithin the limits of this papeL Despite this, it is important toemphaslze that, morder to comply with the proportionality test, the domestic anti­hybrid rule should grant to the taxpayer the opportunity to provide evidence ofgenuine economic reasons that justify the use ofhybrid financial instruments. 163 Asthe parent company already has the onus ofproving that the payment was non-de­ductible at the leveI of the subsidiary in order to qualify for the exemption orcredi.t, 1~4 the aeeeptance of evidence connected with the business reasons for usinghybnd mstruments does not overly increase the existing administrative burden.165

Proportionality in the narrower sense: The tax measure adopted by the MemberState should confine itself to the minimum required to achieve its objectives andnot go beyond what is necessary for attain that purpose. 166

Against this background, the problem is that anti-hybrid rules go beyond what isneeessary to attain the objeetive of avoiding double non-taxation. Considering theexistence of differences in statutory tax rates among EU Member States, anti-hy­brid rules may create overkill or underkill effects that negatively affect cross-bor­der transactions. For example, the overkill effect may oceur where the payment isdeducted at the leveI of the subsidiary at a 15 % rate, whereas the correspondingamount is taxed at the leveI of the parent company at a 35 % rate. In contrast, theunderkill effect may occur where the payment is deducted at the leveI of the sub­sidiary at a 35 % rate, whereas the corresponding amount is taxed at the leveI of theparent company at a 15 % rate. 167 In the judgment in the Schempp case, the ECJ didnot attaeh weight to the tax rate applicable to the ineome against which the ex­pense was deducted, in comparison to the tax rate eharged on the income by theMember State of the beneficiary of sueh payment. Indeed, the ECJ decided that thedisallowanee of the deduction of expenses derived from cross-border alimonypayments in one Member State does not contravene EU law if the amount re­eeived by the beneficiary of the payment is not taxed in another Member State, re­gardless of any differences between the tax rates applicable. 168 This implies thatthese differenees in statutory tax rates are considered by the ECJ to an ineseapableeonsequenee of the sovereignty of the Member States in the field ofdirect taxation.However, it gives rise to praetical implieations, as the exemption method and the

163 N. Strelnikova, Master Thesis, p. 32, FN 38.164 O. Thõmmes/A. Linn, Intertax 2014, p. 34, FN 39.165 N. Strelnikova, Master Thesis, p. 32, FN 38.166 A. Zalasiriski, Intertax 2007, p. 312, FN 152.167 R. de Boer in: R. de Boer/M. Nouwen (eds.), The European Union's Struggle with Mismatches and

Agressive Tax Planning, pp. 67-68.168 )udgment in Schempp case, C-403/03, EU:C:2005:446.

Tomazela Santos-. direct credit method will seldom lead to the same result. 169 Several factors may1ll d' . .have an influence on the final result, such as tax rates, maximum.cre It, tl~l~g ~s-

cts carry-forward of tax credits, per-country or overalllimitatlOn, multl-tler m-pe , -o h ..direct credit, administrative burden, among other things. 11 T e econOI~llc lmpactmay be aggravated if the profits are earned by a sub-subsidiary resident m anotherMember State. 171 Although the differences between the exemption method a~d.the. direct credit already existed prior to the amendment of the Parent-Subsldlary~irective, it must be acknowledged that taxpayers will still be able to exploit: withhybrid financiaI instruments, the tax policy chosen by t~e Member States l~ theimplementation of the directive. This may repres~nta senous o.b~tade to antl-hy­brid rules in light of the proportionality test, mamly because, lf It were assumedthat the EC} is right in its daim that EU law does not require the prevention ofdouble taxation in the first place, then it would be difficult to oblige a MemberState to adopt the credit method in a certain detailed manneL

172

In addition, it should be noted that Artide 4(1) of the Interest and Royalty Directiveallows the source Member State to exdude certain payments fram its material scope,especially hybrid financiaI instruments that fall between equity and debt: 17~ In thiscase, the interest expense is deductible from the taxable prafit of the Subsldlary, butthe source state keeps the right to impose the withholding income tax on tqe remit­tance. The application of this provision simultaneously with the new rule introducedin the Parent-Subsidiary Directive may end up in juridical double taxation, due tothe levy of the withholding income tax on the payment made by the subsidiary andthe taxation of the amount received at the leveI of the parent company.174 Even if theparent company grants a tax credit on the withholding income tax charged in ~ecountry of the subsidiary, the sum ofthe withholding income tax and the underlymgtax paid by subsidiary may exceed the amount of corporate income tax due in thecountry of the parent company. In this scenario, the tax credit granted to the parentcompany may be limited, because Member States that rely on the credit method donot carry their capital export neutrality principIe to the point of refunding the for­eign tax credit. 175 It follows that the concomitant application ofboth rules may causean overkill effect, thereby infringing the principIe of proportionality.

Moreover, the anti-hybrid rule introduced in the Parent-Subsidiary Directivelinked the tax treatment applicable to the profit distribution to the deduction ornot of the corresponding amount at the leveI of the first-tier subsidiary. Thus, it

169 B.). M. Terra/P.). Wattel, European Tax Law, pp. 312-313.170 For more information, see: W. Loukota, The Credit Method and Community Law, in: M. Lang/ ).

SChllCh/C. Staringer (eds.) Tax Treaty Law and EC Law (Vienna: Linde, 2007), pp. 125-149.171 C. Marchgraber, European Taxatio/12014, p. 136-138, FN 14.172 B.). M. Terra/P.). Wattel, European Tax Law, p. 131.173 D. Hristov, The Interest and Royalty Directive in: M. Lang/P. Pistone/J. Schuch/C. Staringer (eds.)

I/1troduction to European Tax Law 0/1 Direct Taxatio/1, 3rd edition (Vienna: Linde, 2013), p. 185.174 Nataliya Strelnikova, Master Thesis, p. 33, FN 38.175 B.). M. Terra/P.). Wattel, European Tax Law, p. 314.

192 DzillrdUMarchgraber (Eds), Non-Discrimination in Ellropean and Tax Treaty Law Dziurdz/Marchgraber (Eds), Non-Discrimination in European and Tax Treaty Law 193

Prevention of Hybrid Mismatches as a Justification?--_--:..:-::..~~~--:.:.::..:..:.:.::..:..:...:..:.:.;::..::...:::..::...:~::::.:~~~~----------

lead to the discussion of alternative soIutions for tackling hybrid mismatchwithin the European UnioÍ1, in particular through the harmonization of domest~SIaws and the introduction of the Common Consolidated Corporate Tax Ba;~(CCCTB), Unfortunately, thislong debate requires a specific analysis that cannotbe accommodated within the limits of this papeL Despite this, it is important toemphasize that, in order to comply with the proportionality test, the domestic anti­hybrid mIe should grant to the taxpayer the opportunity to provide evidence ofgenuine economic reasons that justify the use ofhybrid financial instmments, 163 Asthe parent company already has the onus ofproving that the payment was non-de­ductible at the leveI of the subsidiary in order to qualify for the exemption orcredi,t, 1~4 the acceptance of evidence,connected with the business reasons for usinghybnd mstmments does not overly mcrease the existing administrative burden. 165

Proportionality in the narrower sense: The tax measure adopted by the MemberState should confine itself to the minimum required to achieve its objectives andnot go beyond what is necessary for attain that purpose, 166

Against this background, the problem is that anti-hybrid rules go beyond what isnecessary to attain the objective ofavoiding double non-taxation. Considering theex~stenceof differences in s:atutory tax rates among EU Member States, anti-hy­bnd mIes may create overkill or underkill effects that negatively affect cross-bor­der transactions. For example, the overkill effect may occur where the payment isdeducted at the leveI of the subsidiary at a 15 % rate, whereas the correspondingamount is taxed at the leveI of the parent company at a 35 % rate, In contrast, theunderkill effect may occur where the payment is deducted at the leveI of the sub­sidiary at a 35 % rate, whereas the corresponding amount is taxed at the leveI of theparent company at a 15 % rate, 167 In the judgment in the Schempp case, the ECJ didnot attach weight to the tax rate applicable to the income against which the ex­pense was deducted, in comparison to the tax rate charged on the income by theMember State of the beneficiary ofsuch payment. Indeed, the ECJ decided that thedisallowance of the deduction of expenses derived from cross-border alimonypayments in one Member State does not contravene EU law if the amount re­ceived by the beneficiary of the payment is not taxed in another Member State, re­gardless of any differences between the tax rates applicable,168 This implies thatthese differences in statutory tax rates are considered by the ECJ to an inescapableconsequence of the sovereignty of the Member States in the field ofdirect taxation.However, it gives rise to practical implications, as the exemption method and the

163 N. Strelnikova, Master Thesis, p. 32, FN 38.164 O. Thommes/A. Linn, Intertax 2014, p. 34, FN 39.165 N. Strelnikova, J'vlaster Thesis, p. 32, FN 38.166 A. Zalasinski, Intertax 2007, p. 312, FN 152.

167 R. de Boer in: R. de Boer/M. Nouwen (eds.), The European Union's Struggle with Mismatches andAgressive Tax Planning, pp. 67-68.

168 Judgment in Schempp case, C-403/03, EU:C:2005:446.

Tomazela Santos

indirect credit method will seldom Iead to the same result. 169 SeveraI factors mayhave an influence on the final result, such as tax rates, maximum credit, timing as­pects, carry-forward of tax credits, per-country or overallljmitation, muI:i-:ier in­direct credit, administrative burden, among other things. 1/O The economlC lmpactmay be aggravated if the profits are earned by a sub-subsidiary resident in anotherMember State,171 Although the differences between the exemption method and theindirect credit already existed prior to the amendment of the Parent-SubsidiaryDirective, it must be acknowledged that taxpayers will still be able to exploit, withhybrid financiaI instmments, the tax policy chosen by the Member States in theimplementation of the directive. This may represent a serious obstacle to anti-hy­brid mIes in light of the proportionality test, mainly because, if it were assumedthat the ECJ is right in its claim that EU Iaw does not require the prevention ofdouble taxation in the first place, then it would be difficult to oblige a MemberState to adopt the credit method in a certain detailed manner,172

In addition, it should be noted that Article 4(1) of the Interest and Royalty Directiveallows the source Member State to exclude certain payments from its material scope,especially hybrid financiaI instruments that fall between equity and debt. 173 In thiscase, the interest expense is deductible from the taxable profit of the subsidiary, butthe source state keeps the right to impose the withholding income tax on the femit­tance. The application of this provision simultaneously with the new rule introducedin the Parent-Subsidiary Directive may end up in juridicaI double taxation, due tothe Ievy of the withholding income tax on the payment made by the subsidiary andthe taxation of the amount received at the leveI of the parent company.174 Even if theparent company grants a tax credit on the withholding income tax charged in thecountry of the subsidiary, the sum ofthe withholding income tax and the underlyingtax paid by subsidiary may exceed the amount of corporate income tax due in thecountry of the parent company. In this scenario, the tax credit granted to the parentcompany may be limited, because Member States that rely on the credit method donot carry their capital export neutrality principIe to the point of refunding the for­eign tax credit. 175 It follows that the concomitant application ofboth rules may causean overkill effect, thereby infringing the principIe ofproportionality.

Moreover, the anti-hybrid mIe introduced in the Parent-Subsidiary Directivelinked the tax treatment applicable to the profit distribution to the deduction ornot of the corresponding amount at the leveI of the first-tier subsidiary. Thus, it

169 B. J. M. Terra/P. J. Wattel, European Tax Law, pp. 312-313.170 For more information, see: W. Loukota, The Credit Method and Community Law, in: M. Lang/ 1.

Schuch/C. Staringer (eds.) Tax Treaty Law and EC Law (Vienna: Linde, 2007), pp. 125-149.171 C. Marchgraber, European Taxation 2014, p. 136-138, FN 14.172 B. J. M. Terra/P. J. Wattel, European Tax Law, p. 131.173 D. Hristov, The lnterest and Royalty Directive in: M. Lang/P. Pistone/J. Schuch/C. Staringer (eds.)

Introduction to European Tax Law on Direct Taxation, 3rd edition (Vienna: Linde, 2013), p. 185.174 Nataliya Strelnikova, Master Thesis, p. 33, FN 38.175 B. 1. M. Terra/P. J. Wattel, European Tax LalV, p. 314.

192 Dziurdz/Marchgraber (Eds), Non-Discrimination in European and Tax Treaty LawDziurdz/Marchgraber (Eds), Non-Discrimination in European and Tax Treaty Law 193