Last week the New Zealand government issued a discussion document proposing that the Organization for Economic Co-operation and Development (OECD)’s recommendations contained in the Base Erosion Profit Shifting (BEPS) plan for combating hybrid mismatches be adopted.

A hybrid mismatch arises when the tax treatment of an entity or an instrument, such as convertible notes, differs between two countries.

Historically, the mismatch between the countries has been exploited to result in ‘double non-taxation’.

This can occur in one of three ways:

1. Deduction no inclusion (D/NI): a payment is tax deductible in one country, but not treated as assessable income in the other country.

2. Double deduction (D/D): a payment that achieves two tax deductions.

3. Indirect deduction no inclusion (indirect D/NI): a payment is tax deductible in one country and assessable income in the other country, however, the assessable income is offset by a deduction achieved through the use of a hybrid mismatch arrangement.

The OECD proposes that the best way to address the issue is for countries to synchronize their rules, with the aim of eliminating all tax benefits currently available through these arrangements.

From a New Zealand income tax perspective one such example of a frequently used hybrid mismatch having been achieved in recent years is through the use of convertible notes issued by a New Zealand subsidiary to an Australian parent of the subsidiary.

Under New Zealand income tax legislation the notes are treated as part debt/part equity, yet under Australian income tax legislation, the notes are treated as 100% equity.

This results in a deduction for interest to the New Zealand entity, with the issue of shares to the Australian parent entity, as is often the practice to compensate for the interest obligation, not assessable income under Australian law.

In addition to hybrid financial arrangements such as the above, hybrid entities can achieve hybrid mismatch arrangements such as where a payment is disregarded by a receiving entity.

An example of this might be a United States parent which is the sole shareholder of a New Zealand subsidiary. By way of a ‘check the box’ election, the New Zealand subsidiary is disregarded for United States income tax purposes. Payments made by the New Zealand subsidiary to the United States parent are tax deductible in New Zealand, however, not assessable income in the United States to the parent entity.

The above example achieves a D/NI outcome.

The discussion paper notes that three options exist to address the issue of hybrid mismatch arrangements:

1. Adopt the OECD proposals.

2. Do not adopt the OECD proposals.

3. Implement New Zealand-centric rules to target hybrid mismatch arrangements which result in double non-taxation outcomes from a New Zealand income tax perspective.

The discussion paper considers a range of factors including the position that other OECD countries are taking, including notably that the Australian government has made a commitment to implement the OECD Action Plan.

New Zealand recognizes that whilst the country’s anti-avoidance rule goes some way towards counteracting the tax implications of hybrid mismatch arrangements,  this is only effective within the jurisdiction of New Zealand, thus not achieving what the OECD plan sets out to achieve.

In addition, New Zealand recognizes the risk of lost tax revenue to the country should other OECD countries adopt the BEPS Action Plan and New Zealand does not. This may occur through other countries becoming more aggressive in pursuing tax revenue than New Zealand.

Whilst the New Zealand government is considering the idea of tailor-made rules to counteract hybrid mismatch arrangements, its current proposal is that the benefits of adopting the OECD Action Plan on hybrid mismatches is the best path to take.

Should New Zealand take this approach there will be some minor adjustments to the OECD plan to enable the rules to effectively integrate into the New Zealand tax landscape – including domestic, and international rules.