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    The Tax Lawyer

    The Tax Lawyer: Winter 2021

    Section 267A and the Taxation of Hybrid Mismatches Under the Code

    Shay Moyal

    Feb 25, 2021

    43 min read

    Businesses International Business Pillar 2

    Summary

    • Hybrid mismatches arise because of differences in the tax rules of different countries. Such mismatches have allowed multinationals to minimize their tax liabilities.
    • The issue has prompted discussions among tax legislators and scholars regarding how they should be addressed.
    • The article analyzes recent U.S. legislation and international law around hybrid mismatches.
    • The article argues that a BEAT-like minimum tax approach to these hybrid mismatches would better prevent double nontaxation, de minimis taxation, and overtaxation.
    • This approach may reduce the complexity of the current law.
    Section 267A and the Taxation of Hybrid Mismatches Under the Code
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    Abstract

    Hybrid mismatches arise because of differences in the tax rules of different countries. Such mismatches have allowed multinationals to minimize their tax liabilities. As tools for minimizing tax liability, hybrid mismatches have troubled tax legislators and tax scholars in many countries and have evoked intriguing intellectual discussions concerning both the legitimacy of using such tools and how countries should address the use of such tools. Indeed, the problem of hybrid mismatches encompasses many complex issues, including the differences between the legal and economic situations of taxpayers, corporate and individual taxpayers, international tax and international law, distinctions among different types of income, and more. These considerations are taken into account to address the conflict between the freedom of jurisdictions to tax their subjects as they wish and their efforts to prevent base erosion and tax competition to ensure their ability to redistribute wealth in their societies.

    Recently enacted rules regarding hybrid mismatches in the U.S. were designed to disallow deductions from payments of interest, royalties, and dividends by or from foreign related parties if such related parties are not already taxed, or exempt, for these payments. The legislative intent, the structure of these rules, and their similarities to proposals offered as part of the Base Erosion and Profit Shifting project undertaken by the Organisation for Economic Co-operation and Development suggest that such rules have become customary international law. Thus, this Article seeks to analyze and improve the current law through the application of international tax principles and recent international tax trends and argues that a BEAT-like minimum tax approach to these hybrid mismatches would better prevent double nontaxation, de minimis taxation, and overtaxation. In addition, such an approach may reduce the complexity of the current law.

    I. Introduction

    Differences in the laws of different jurisdictions generally do not create any issues unless the laws conflict. This conclusion follows from the basic premise that a jurisdiction—a legal system created under some type of social contract—is free to create its own laws. International law, however, limits, to some extent, a jurisdiction’s freedom to create its own laws in order to promote a common international goal. Similarly, in tax law, every jurisdiction has the right to tax its domestic and foreign subjects to which it provides benefits. Differences in the tax laws of two or more jurisdictions may create situations in which taxpayers are provided with tax benefits, known as hybrid mismatches, that erode the base of one or more of those jurisdictions. International tax law seeks to limit the freedom of jurisdictions to structure their tax systems to promote the common goal of preventing tax competition and preserving each jurisdiction’s ability to redistribute wealth in its society.

    This Article analyzes whether the new rules regarding hybrid payments enacted as part of the Tax Cuts and Jobs Act of 2017 (TCJA)—section 245A(e), which applies to dividend income, and section 267A, which applies to interest and royalties income—achieve the common goals of international tax by providing an appropriate balance between normative international tax principles. More specifically, this Article analyzes whether and when the Benefits principle, under which a jurisdiction should be allocated taxation rights based on the benefits it provides to a taxpayer, and the Single Tax principle, under which income should be subject to a minimum level of taxation, are satisfied. These two principles conflict in situations of hybrid mismatches because the ability of a jurisdiction to tax as it wishes may conflict with this minimum tax threshold.

    Part II of the Article describes the special characteristics of the tax mismatch phenomenon and the concerns and motives of jurisdictions to prevent taxpayers from taking advantage of such mismatches. Building on the explanation of hybrid mismatches provided in Part II, Part III provides a normative background by asking the preliminary question of whether sections 245A and 267A (the “hybrid sections”) are properly viewed as addressing an international tax law issue or a domestic tax law issue. The normative discussion will determine whether these sections should pursue international tax principles or domestic tax principles. Part III then describes the long-term debate concerning tax arbitrage and whether unilateral tax measures taken by jurisdictions to prevent tax arbitrage should be viewed as a form of customary international law. Assuming that the hybrid sections are a form of customary international law, this Article considers the application of the Benefits and Single Tax principles and offers factors to analyze and to possibly improve these sections. These factors distinguish between different types of taxpayers and different types of income to determine the sets of benefits that the source jurisdiction provides and how basic tax axioms can shape a minimum threshold of tax under the Single Tax principle to deal with tax arbitrage.

    Part IV applies these factors to the new hybrid sections and to the proposals offered as part of Action 2 of the Base Erosion and Profit Shifting (BEPS) project recently undertaken by the Organisation for Economic Co-operation and Development (OECD). The legislative history to the relatively straightforward new hybrid rules supports my preliminary assumptions that these sections are properly viewed as a form of international tax law. The new hybrid sections and the proposals of BEPS Action 2 are consistent with the matching method, the idea that a jurisdiction should change its tax laws in the case of hybrid mismatches based on the tax rules of the foreign jurisdiction. Part IV will then illuminate the advantages and disadvantages of the matching method based on these factors, as well as the resulting complexity. Finally, Part IV considers alternatives to the matching method, such as the recharacterization method and the effective-minimum-tax rate method. The latter method may better apply the normative factors discussed in Part III than the matching method and is coherent with other existing sections of the Code that address base erosion. This Article seeks to improve the current approach adopted by the U.S. to deal with the hybrid mismatch phenomenon.

    II. Normative Analysis of Hybrid Entities

    A. What Are Hybrid Entities and Hybrid Transactions?

    Hybrid mismatches, which include hybrid entities and hybrid transactions, result from differences in the applicable tax rules by two or more jurisdictions involving the same entity or transaction, respectively. The mismatch of tax rules can result from a variety of differences, such as the tax classification of an entity or the tax treatment of specific types of income and deductions. The problem arises when mismatches are (ab)used by taxpayers who engage in cross-border transactions.

    Hybrid mismatches and the topic of tax arbitrage more generally have been extensively discussed over the last two decades by international tax scholars and policy makers. The problem posed by hybrid mismatches was first raised by the Committee of Fiscal Affairs (the Committee) of the OECD when considering the application of the OECD model convention to pass-through entities, such as partnerships, and the difficulties that result when the residence and source states apply different articles of the convention on the basis of differences in their domestic law. The Committee’s report from 1999 proposed changes to the OECD model convention to prevent double nontaxation. Unilateral and multilateral remedies followed in the footsteps of the OECD model convention. The BEPS project represented a renewed international effort to address hybrid mismatches and resulted in a number of proposals that the U.S. did not adopt. Nevertheless, in 2017, the U.S. unilaterally enacted sections 245A(e) and 267A to address the conceptual chal-lenges raised by tax policy makers concerning hybrid mismatches. Before considering these provisions in detail, we must first understand, or at least analyze, why hybrid mismatches were a subject of concern to many countries and tax institutions around the globe, why they have been subject to criticism, and why they have been perceived as abusive.

    There are a number of special characteristics of hybrid mismatches. First, hybrid mismatch tax rules concern the tax base of a jurisdiction rather than tax rates. Hybrid mismatches frequently result in base-eroding payments, and the measures that have been taken against them are part of a more general effort to fight base erosion. Interestingly, the anti-hybrid measures considered thus far do not specifically take into consideration whether a certain item of income is taxed at only a de minimis rate, but rather consider whether the item is ultimately taxed at all.

    Second, unilateral, bilateral, and multilateral approaches define mismatches by considering whether the taxation of a transaction by two or more jurisdictions provides an entity with a tax benefit, such as the deferral, deduction, or exemption of income. This definition applies to hybrids and reverse-hybrids alike.

    Third, hybrid mismatches only create a tax benefit for a taxpayer if the parties to a transaction are related (i.e., the parties control or are controlled by a common entity). Generally, the taxpayer and the second party to the transaction are considered related if such party is under the control of the taxpayer or in control of the transferred asset immediately after the transfer from an economic perspective. Otherwise, there is no tax benefit in transferring an asset or making a payment that does not compensate for the cash or other asset that is owned by third-party entities immediately after the transaction. For example, consider a U.S. taxpayer who owns 25% of the shares of a foreign entity that is a resident for tax purposes in a zero percent tax rate jurisdiction. When the U.S. taxpayer pays the foreign related party $100 for the use of its patents, the U.S. taxpayer gains a tax benefit of a full deduction, which results in tax savings of $21—the product of $100 and 21%, the U.S. corporate tax rate. The foreign related party pays zero taxes, but the U.S. taxpayer loses 75% of the economic interest to the unrelated shareholders in the foreign jurisdiction. The total economic loss for the U.S. taxpayer is $54 ($75 minus $21) without taking into account the economic benefit from the use of the patent. However, if the U.S. taxpayer economically owns the foreign entity, then it obtains a tax benefit of $21 and loses none of the economic interest in the transferred cash.

    These characteristics of hybrid mismatches explain the motivation of governments to prevent double nontaxation in connection with transactions between related parties. Curiously, neither the rate of the tax nor whether a taxpayer gained an actual tax benefit from a transaction appears to be a subject of concern. In other words, under certain situations, anti-hybrid measures disregard the potential result of the extent of taxation. Situations in which mismatches result in taxation in both (or more) jurisdictions, but at only de minimis levels, may not trigger anti-hybrid measures. On the flip side, additional tax on hybrid mismatches may be imposed when the tax rate with respect to the relevant transaction is already high. Thus, the measures either assume that hybrid mismatches are wrong per se or that hybrid mismatches have an instrumental value to flag or presume hybrid mismatch misuse to achieve double nontaxation. It is important, therefore, to understand what is abusive about hybrid mismatches.

    B. Are Hybrid Transactions Wrong Per Se? If Not, What Is the Instrumental Value of Preventing Them?

    The next issue is to determine whether hybrid transactions are wrong per se and, if not, to determine the instrumental value in preventing them. To address this issue, we should take a step back and ask whether domestic or international tax principles should be considered when analyzing hybrid mismatches. The answer to this question depends on whether an anti-hybrid transactions rule should be viewed as an international tax or domestic tax provision. Before exploring the differences between international tax and domestic tax provisions, we can acknowledge that hybrid transactions are not wrong per se. For hybrid transactions to be wrong per se, the fact that a transaction is taxed differently in two (or more) jurisdictions, in which one of the jurisdictions disregards either the taxed entity or de facto does not tax or provide any tax benefit, needs to violate some basic norm. Obviously, there is nothing wrong if a transaction is taxed differently in two jurisdictions nor with a jurisdiction effectively exempting or not taxing income, or otherwise providing a tax benefit. The fact that a transaction may be taxed differently by two jurisdictions is not the concern of legislators and the international tax community; the concern is the potential for double nontaxation.

    Whether hybrid mismatches concern international or domestic tax law depends on the basic norm that is violated. Hybrid mismatches concern international tax law if the basic norm that is violated is nontaxation, and possibly the broad interpretation of the Single Tax principle, which concerns minimum tax, as further explained below. Alternatively, hybrid mismatches concern domestic tax law if the basic norm that is violated involves the ability-to-pay principle because horizontal or vertical equity (or both) is violated when compared to a taxpayer that makes the same payment to a related party in the same jurisdiction. The complex conceptual issues with hybrid mismatches lie in a conjunctive test that can be summarized as follows: (1) are hybrid mismatches a matter of international or a domestic tax law; (2) based on the answer to (1), what are the competing normative international or domestic tax principles that hybrid mismatches violate; and (3) what factors should be taken into account in order to determine the proper balance to resolve this international tax issue?

    The first part of the conjunctive test (i.e., whether hybrid mismatches—tax arbitrage—are a matter of international tax law) has been discussed in depth in the international tax scholarship. This part of the test will determine whether international or domestic principles should be applied to analyze hybrid mismatches. States create public international law in three different ways. First, states create public international law when they expressly and voluntary accept laws between themselves in treaties. In international tax, this is reflected in bilateral tax treaties or multilateral efforts, such as BEPS and the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (MLI). There is wide agreement that these treaties are international law. Second, states create international law when a consistent practice of the states is accompanied by opinio juris, the conviction of those states that the consistent practice is required by a legal obligation. This debate in the literature is mainly factual and discusses whether tax jurisdictions practice specific tax rules. Third, states create international law through the existence of general principles of law that are commonly recognized by the major legal systems of the world. If international tax principles are commonly recognized by major legal systems, then tax jurisdictions of the world are legally bound to them when they enact international tax rules.

    Hybrid transactions have been at the center of the long-term debate over whether certain domestic international tax provisions constitute customary international law. This discussion is mostly based on facts that show obligation or non-obligation to obey customary international tax law between countries. Scholars such as Reuven Avi-Yonah and Diane Ring have argued that practices of international taxation do not allow a specific country to deviate from the commonly practiced norms of the international tax regime. Practices such as nondiscrimination (i.e., that nonresidents from a treaty country should not be treated worse than residents), the arm’s length standard, and foreign tax credits demonstrate a customary international law that, in the absence of tax treaty provisions, require tax jurisdictions to create rules according to these norms.

    On the other side of the debate, several prominent tax scholars such as David Rosenbloom, Julie Roin, and Mitchell Kane argue that there is no international tax regime and that the use of hybrid mismatches to achieve double nontaxation is legitimate tax planning. Rosenbloom cites tax arbitrage (the term Rosenbloom uses to describe hybrid mismatches), and transactions that are otherwise designed to take advantage of differences between national tax systems to achieve double nontaxation, as proof. According to Rosenbloom, international tax arbitrage is the natural response of taxpayers to the normal differences that occur between any two tax systems, and countries such as the U.S. have limited interest in preventing tax arbitrage, whether through treaties or otherwise. According to Rosenbloom, tax arbitrage does not represent a problem or at least no adequate explanation for why it is a problem has yet been given. Moreover, Rosenbloom argues that, even if it were a problem, there is likely no solution available in the current and any possible future state of the world.

    Avi-Yonah, a well-known enthusiastic advocate of the idea that international tax is customary international law, commented on Rosenbloom’s arguments, arguing that the existence of tax arbitrage is factually insignificant as compared to the commonalities of tax laws in the world that adopt international tax principles. Avi-Yonah further argues that tax arbitrage violates the Single Tax principle of international tax.

    Two decades have passed since this debate took place and much has changed. Bilateral and multilateral efforts have enhanced the scope of international law that is aimed to prevent hybrid mismatches. Recent unilateral legislation, such as section 267A, has pushed the debate (quite decisively, as discussed in Parts III and IV below) toward the understanding that these provisions are meant to conform with current international tax law, which is motivated by international tax principles, and, therefore, constitute customary international law. We can understand, therefore, that hybrid mismatch rules, including section 267A, are international law that should thus be analyzed using normative international tax principles.

    Avi-Yonah has noted that hybrid mismatches violate the single-tax norm of international tax because hybrid mismatches generally result in double nontaxation; thus, he has rightfully argued that they should be prevented. Nevertheless, international tax also recognizes the Benefits principle under which the source jurisdiction is free to tax and, to some extent, not tax the related party. The conflict between these basic principles must be considered and balanced.

    The remaining discussion assumes that hybrid mismatch rules that are enacted unilaterally constitute customary international law and, thus, take into account international tax objectives. The conclusions reached may differ materially if hybrid mismatches are considered as a domestic tax issue.

    III. The Benefits and Single Tax Principles and Their Respective Weights

    To analyze any international tax rule, including section 267A, an understanding of the normative principles of international tax is necessary. There are five normative principles in international tax: Benefits, Single Tax, Efficiency (or Neutrality), Nondiscrimination, and Transparency. While each of these principles can be associated with hybrid mismatches in one way or another, the Benefits and Single Tax principles are the most relevant to this discussion. As explained further below, hybrid mismatches violate the Single Tax principle because hybrid mismatches generally result in nontaxation. On the other hand, the Benefits principle allocates taxation rights, including the right to tax at a de minimis rate or, to some extent, not at all, to the jurisdiction that provides benefits to the taxpayer. This Part further explains these principles and proposes a number of factors to resolve the conflict between these principles and to consider in an analysis of section 267A.

    A. The Benefits Principle

    Under the Benefits principle, a taxpayer should be taxed by the jurisdiction providing benefits, even if the taxes it pays to such jurisdiction are de minimis. In essence, measuring benefits in the residence jurisdiction is almost impossible because taxes are subject to coercive powers under the social contract. On the other hand, in the source jurisdiction, the relationship with a taxpayer is essentially a commercial contract, in which the jurisdiction, as offeror, offers to a foreign taxpayer the use of its resources to produce income, and the taxpayer, as offeree, pays fees to that jurisdiction for the use of those resources. In this situation, the benefits can be measured by the fees paid to the source jurisdiction, similar to any other commercial contract between a jurisdiction and an individual. Residence and source rules measure the benefits that a jurisdiction provides and thereby allocate the taxation rights between these jurisdictions. Without taking into account the Single Tax principle, either the source or residence jurisdiction has the prerogative not to tax, tax at a de minimis rate, or otherwise provide tax benefits.

    B. The Broad Interpretation of the Single Tax Principle

    The Single Tax principle establishes that a taxpayer should be taxed on an item of cross-border income exactly once. The Single Tax principle is justified on both equity and efficiency grounds. From an equity perspective, taxing cross-border transactions differently (either under- or overtaxation) from domestic transactions violates both horizontal and vertical equity when compared to the taxation of taxpayers in the same residence jurisdiction. From an efficiency perspective, if a cross-border transaction is taxed more heavily than domestic income, the added tax burden creates an inefficient incentive to invest domestically.

    Nevertheless, recent multilateral efforts demonstrate that a broader application of the Single Tax principle has become more accepted in the international community. Under this broader interpretation, the Single Tax principle serves not only as a coordination instrument—one that takes into account very low or zero tax rates—but as a mechanism to ensure that taxpayers are subject to a minimum level of tax by the residence jurisdiction (in the manner similar to the recent BEAT provision) because of the prevalence of tax planning practices, such as the “Stateless Income” phenomenon, patent boxes, and the shifting of intellectual property to jurisdictions providing significant tax benefits.

    Recent proposals, such as those in BEPS Action 2, demonstrate a genuine shift from the narrow interpretation previously used to this broader interpretation. The recent digital services minimum tax that has been adopted in a number of countries and that imposes a minimum tax on taxpayers that conduct digital business in a specific jurisdiction is further evidence of this shift. Digital minimum taxes are not the only proposals that apply the broader interpretation of the Single Tax principle. In 2020, the OECD is set to issue a final report designed to provide consensus-based, long-term solutions to address some of the inadequacies in the anti-base-erosion framework it published in 2015. The Pillar Two Anti-Base-Erosion measure is a global intangible low-taxed income (GILTI)-like “income inclusion” minimum tax on foreign profits. The Pillar Two proposal is some yet-to-be-specified tax on outbound payments not subject to significant tax by the residence jurisdiction. Pillar Two rules would also provide jurisdictions with a right to “tax back” when other jurisdictions have not exercised their primary taxing rights or the payment is otherwise subject to low levels of effective taxation.

    Not only are many tax jurisdictions and policy-making institutions around the globe, such as the OECD and the United Nations, moving in the direction of a minimum tax approach, many tax jurisdictions, including the U.S. through its enactment of the BEAT and GILTI, have implicitly adopted the broader interpretation from a better and more coherent normative perspective. If the primary objective of the Single Tax principle is to prevent a race to the bottom with respect to tax rates and to restrain tax competition through either (1) locating profits in tax havens or (2) using hybrid transactions or entities to prevent particular profits from appearing to have been earned anywhere, then the Single Tax principle must be interpreted broadly. In addition, the broad interpretation—one that imposes a minimum effective tax rate—recognizes the fact each taxpayer receives at least some minimal level of benefits as a resident of a jurisdiction. Even corporate taxpayers receive benefits from their residence jurisdictions in the form of corporate laws, market regulations, and brand protections. If residency is based on the place of effective management and control, even greater benefits are provided.

    The narrow interpretation of the Single Tax principle is appropriate if it serves merely as a coordination mechanism, allocating taxation rights between jurisdictions. This objective would be accomplished even if the taxing jurisdiction imposes tax at a de minimis rate. But, as explained above, recent anti-base-erosion efforts are evidence that the now accepted broader interpretation of the Single Tax principle is superior in order to prevent a race to the bottom and to restrain tax competition. This broader interpretation will be used to analyze sections 267A and 245A(e).

    C. Balancing the Benefits and Single Tax Principles with Respect to Hybrid Mismatches

    The freedom to provide tax benefits that result in no taxation or taxation below the minimum tax threshold under the Benefits principle conflicts with the broader interpretation of the Single Tax principle. Conflicts between principles can be addressed through the use of rules. The rules should be based on factors that distinguish among certain relevant facts and should be coherent with other existing rules. In addition, in addressing the conflict between the Benefits principle and the broad interpretation of the Single Tax principle, the rules must be based on factors that concern not only international tax but also domestic tax features to the extent they promote international tax objectives. The conflict between the Benefits and the Single Tax principles arises when the source jurisdiction that provides the benefits to the related party chooses not to tax, or to tax at a lower rate under the commercial contract. The residence jurisdiction of the taxpayer considers the related party to be economically part of the taxpayer, or at least sufficiently related to gain from the tax benefit of the transaction. The benefits that are provided to the related party are deemed, or at least partly deemed, to be provided to the taxpayer.

    While there are a number of important factors, such as the complexity or the type of law in which the rule is embedded (i.e., unilateral, bilateral, or multilateral), this Article focuses on two main factors that will assist in establishing appropriate anti-hybrid rules: (1) the effective tax rate under the Single Tax principle and (2) the sets of benefits that the source jurisdiction provides under the Benefits principle.

    1. Effective Tax Rate

    It is important to examine the effective tax rate to which the related taxpayers are subject in both the source and residence jurisdictions as compared to the minimum level of tax that is set in the residence jurisdiction. If the effective tax rate is similar to the minimum level of tax set by the residence jurisdiction and the taxpayer in the residence jurisdiction benefits from the hybrid mismatch transaction with the related party, the Single Tax principle should be deemed satisfied; hybrid mismatches in such a situation should generally not be viewed as violating the Single Tax principle. A comparison of the effective tax rate with the minimum level of tax set by the residence jurisdiction must recognize that an item of income subject to tax at the full rate in the related party’s jurisdiction may be offset by a corresponding deduction generated by a payment to another related party in a third jurisdiction that does not tax the payment as income or may be provided with other significant tax benefits. Similarly, such a comparison must recognize whether the jurisdiction of the related party applies a rule similar to that of section 267A or a defensive rule, requiring the deductible payment to be included in income or denying the duplicate deduction depending on the nature of the mismatch in order to avoid overtaxation. Only by taking such considerations into account can the Single Tax principle be coherently applied.

    a. The Effective Tax Rate Applied to a Transaction Versus the Effective Tax Rate Applied to the Taxpayer. Although it is possible to analyze the benefits of every transaction that involves hybrid mismatches, the minimum tax rate should not be examined at the transactional level but rather at the taxpayer level. First, from a practical perspective, it is extremely complicated and may impose a significant burden on an entity to determine the effective tax rate for each transaction. Such a determination would presumably require that all features, including credits and losses, of the income tax system be considered. Second, from a normative perspective, as explained before, hybrid mismatches are not wrong per se, but they do affect the overall tax position of a taxpayer. The proper level of analysis, therefore, should consider how hybrid transactions affect the effective tax rate of a taxpayer who engages in such transactions. In addition, the idea that income has a locatable source seems to not be economically coherent and, per Schanz-Haig-Simons, international tax is properly based on the geographic location (i.e., the residence) of an individual.

    b. Which Jurisdiction Should Determine the Minimum Tax Rate? There are two jurisdictions to which the effective tax rate can be compared: the jurisdiction where the income is sourced and the jurisdiction where the taxpayer is resident. If the concern of the international tax of hybrid mismatches lies in minimizing the tax liability and eroding the tax base of a jurisdiction, then the comparable effective tax rate should be determined in that jurisdiction. In other words, the effective tax rate should be compared to the minimum level of tax in the residence jurisdiction of the taxpayer who engages in a transaction with a related party. In addition, as explained above, under the Benefits principle, a taxpayer should be taxed in the place it receives benefits. Measuring benefits in the residence jurisdiction is almost impossible because of coercive powers under the social contract. In the source jurisdiction, benefits can be much more easily measured by the fees paid to the source jurisdiction, similar to any other commercial contract between a jurisdiction and an individual. If the jurisdiction that provides the tax benefits, generally the source jurisdiction, does not provide any significant benefits to a taxpayer, the taxes should be allocated to the residence jurisdiction. If, for example, specific practices of a jurisdiction are to provide a very minimal set of benefits, such as mere place of incorporation or patent boxes, or the practices violate other international tax principles, such as Transparency or the Single Tax, then allocating taxation rights to such jurisdiction, regardless of whether this jurisdiction taxed the income, undermines the Benefits principle, as the allocation rights should be allocated to the jurisdiction that provides the benefits.

    c. How to Determine the Effective Minimum Tax Rate? As previously discussed, the minimum effective tax rate should be compared to the minimum level of tax in the residence jurisdiction of the taxpayer. Under the social contract (it can be in a democratic form or other ways of determining rules), the residence jurisdiction sets a minimum level of tax on taxpayers that are involved in hybrid mismatches. A determination of the minimum level of tax must take into consideration other taxes on that income, such as controlled foreign corporation or GILTI style taxes.

    2. How to Determine the Sets of Benefits in the Source Jurisdiction

    a. Types of Taxpayers. While there is no reason to distinguish among the types of taxpayers to which a jurisdiction should apply anti-abuse rules from an equity perspective, jurisdictions can choose, for efficiency reasons, to make distinctions based on certain types of income that do not require jurisdictions to provide a substantial set of benefits. Corporations and multinationals entities (MNE) commonly earn active income and individuals mostly earn passive income in foreign jurisdictions. The source jurisdiction provides substantial benefits to corporations that carry on business in its jurisdiction, such as security, regulation, and the maintenance of markets. In contrast, the benefits provided by the residence jurisdiction are generally more limited in the form of a place of incorporation or a place for management and control. The benefits individual taxpayers, and possibly partners in a partnership, receive from their residence jurisdiction are much more visible than those received by corporate taxpayers from their residence jurisdiction. Individuals are provided with political rights, legal systems, security, education, and much more. Of course, that fact does not mean a foreign jurisdiction in which a taxpayer keeps property and uses it to earn passive income does not provide any benefits and should not be granted any taxation rights. But this is an example of how to determine whether the source jurisdiction provides a substantial set of benefits that will cause a significant violation of the Benefits principle. Nevertheless, especially in the U.S. and under the check-the-box rules, multinationals can form subsidiaries that can easily be fiscally transparent for tax purposes. Despite the above-mentioned differences, it might be normatively better to distinguish entities that engage in business in the source jurisdiction, which can be done by distinguishing among the various types of income.

    b. Types of Income. Similar to the explanation above regarding types of taxpayers, there is no normative reason to distinguish between different types of income from a single-tax perspective. Nevertheless, in order to resolve the conflict between the Single Tax principle and the Benefits principle while minimizing administrative reporting and enforcement costs, any rules adopted to prevent hybrid mismatches should be limited to specific types of income, specifically active income in the source jurisdiction and passive income in the residence jurisdiction. As explained above, the set of benefits given to a taxpayer in the source jurisdiction is often not as substantial in connection with passive income as compared with active income. In addition, passive types of income are highly mobile, and for that reason abusive transactions often involve passive income. The weak nexus between taxpayers and source jurisdictions with respect to passive income can be seen in the source rules for passive income. For example, the source rule for interest income is the residence of the payor. The place of incorporation of a lender has little relationship to the set of benefits provided by the source jurisdiction.

    We can conclude that hybrid mismatch rules are international law that need to balance the conflict between the Single Tax principle, based on its broad interpretation, and the Benefits principle. The balance should take into account the effective tax rate and the benefits that a jurisdiction provides to the taxpayer. The next Part will apply the ideas discussed above as part of an analysis of section 267A.

    IV. Section 267A, BEPS Action 2, and the Matching Income Method

    Prior to the enactment of section 267A and the adoption of anti-base-erosion measures in the U.S., violations of the Single Tax principle generally led countries to adopt measures bilaterally, through double tax treaties, as well as multilaterally. These measures will, as explained below, eventually constitute the basis for the U.S. anti-hybrid mismatch rules.

    A. The Precedent: BEPS Action 2

    One of the two parts in BEPS Action 2 was designed to be adopted unilaterally by countries. It sets forth at least four factors that characterize hybrid mismatches: (1) a disparity in the characterization of an entity by two or more jurisdictions; (2) payment by or from a transparent entity; (3) the fact that the parties to the transaction are related, share interests, or are part of a consolidated group; and (4) at least one of the following three tax advantage outcomes.

    • Deduction/No Inclusion (D/NI): Payments that give rise to a deduction under the rules of one country and are not included as taxable income for the recipient in another.
    • Double Deduction (DD): Payments that give rise to two deductions for the same payment.
    • Indirect Deduction/No Inclusion (Indirect D/NI): Payments that are deductible under the rules of the payer country when the income is taxable to the payee but offset by a deduction under a hybrid mismatch arrangement.

    Action 2’s response to all targeted hybrid mismatches is to deny a deduction to the payer to the extent that the payment is not included in the taxable income of the recipient in the counterparty jurisdiction. If this primary rule is not applied, then the counterparty jurisdiction can generally apply a defensive rule, requiring the deductible payment to be included in income or denying the duplicate deduction depending on the nature of the mismatch. The policy behind this rule was clearly meant to apply the Single Tax principle; it meant to prevent “more than one country applying the rule to the same arrangement and also avoids double taxation.” In addition, Action 2 recognizes the importance of efficiency, by setting a rule that will “ensure that the rules are effective and to minimize compliance and administration costs for taxpayers and tax administrations.” The end goal, without a doubt, was to create customary international law by setting out “a common set of design principles and defined terms intended to ensure consistency in the application of the rules.”

    This so-called matching method, under which the tax treatment in one jurisdiction matches that in the other jurisdiction, was adopted in the recent TCJA through the enactment of sections 267A and 245A(e). This adoption suggests that the intent of Congress was to adopt coherent multilateral measures by the U.S. that constitute customary international law.

    B. Adoption of BEPS Action 2—Section 267A Explained

    1. Legislative History

    Unlike other base-erosion provisions, the original intent of the hybrid arrangements was rather clear. The legislative history of section 267A notes that section 267A is intended to be “consistent with many of the approaches to the same or similar problems” addressed in, among other sources, Action 2 of BEPS. The report by the Senate Finance Committee explains that section 267A is intended to be “consistent with many of the approaches to the same or similar problems [regarding hybrid arrangements] taken in the Code, the OECD base erosion and profit shifting project (“BEPS”), bilateral income tax treaties, and provisions or rules of other countries.” In addition, as the report further explains, “[t]he Committee believes that hybrid arrangements exploit differences in the tax treatment of a transaction or entity under the laws of two or more tax jurisdictions to achieve double non-taxation . . . .” The report provides evidence of Congress’s intent to adopt section 267A as customary international law. As explained in Part III above, the OECD’s intent was to apply the Single Tax principle globally, and the U.S. joined in that effort. Even if it did not officially adopt any of the BEPS Actions or sign the MLI, this has been U.S.’s customary international practice for a long time.

    2. The Hybrid Rules Mechanism Explained

    Section 267A joined a family of U.S. anti-hybrid rules in the Code and tax treaties. As explained below, section 267A applies to interest and royalty payments but it has to be read together with section 245A(e), which applies to dividends. Under section 245A(e), dividend-received deductions are disallowed in the case of “hybrid dividends” for which the payor is allowed a deduction or other tax benefit. The Dual Consolidated Loss (DCL) rules complement sections 267A and 245A(e) by preventing a consolidated group from claiming the same loss to offset U.S. income of a U.S. corporation and foreign income of a foreign corporation. The DCL rules are an example of the DD situation described in BEPS Action 2.

    A “hybrid entity,” from the U.S. perspective, is an entity that is fiscally transparent for U.S. tax purposes but opaque for foreign tax purposes generally, such as a U.S. LLC that is treated as a corporation in other countries. A “reverse-hybrid entity” from the U.S. perspective, on the other hand, is an entity that is a separate taxpayer or “opaque” for U.S. tax purposes but fiscally transparent for non-U.S. tax purposes, such as a foreign partnership that elects to be treated as a corporation for U.S. tax purposes under the “check-the-box” regulations.

    From an international tax perspective, hybrid mismatches involving hybrid and reverse-hybrid entities should not be allowed if, under the broader interpretation of the Single Tax principle, they result in de minimis taxation because existing international tax rules are indifferent as to where the entity is taxed. Sections 267A and 245A(e) are not limited to specific types of taxpayers, unlike other base-erosion provisions such as the BEAT. Nevertheless, because the Benefits principle allocates the taxation rights to the jurisdiction providing benefits, it generally makes sense to allocate taxation rights for passive types of income to the residence jurisdiction. Consequently, sections 267A and 245A(e) focus on passive types of income—interest and royalties under section 267A and dividends under section 245A(e).

    BEPS Action 2 applies the Single Tax principle to all types of base-eroding payments: “The meaning deductible and deduction is the same as used in the other recommendations in the report and generally covers items of current expenditure such as service payments, rents, royalties, interest and other amounts that may be set-off directly against ordinary income.” Thus, sections 267A and 245A(e) are more limited in scope than BEPS Action 2, but this deviation may represent a more appropriate resolution of the conflict between the Benefits and Single Tax principles. As explained above, passive types of income are more mobile than active income, making payments of passive income the most commonly used form of base-erosion payments. From a single-tax perspective, however, there is neither a normative nor a practical justification to treat different types of income differently. All types of income should be taxed once at a tax rate comparable to that in the residence jurisdiction. Any difference in treatment should depend on how much of the benefits a jurisdiction provides slips away to other jurisdictions and is not taxed or, in other words, whether the source and residence rules fail to reflect the benefits that are provided by the jurisdiction.

    Under section 267A, deductions are disallowed if a certain “disqualified related party amount” paid or accrued to a related party was made pursuant to a hybrid transaction or made by or to a hybrid entity. A disqualified related party amount is any interest or royalty paid or accrued to a related party to the extent that (1) the amount is not included in the income of the related party under the local tax laws of the country of which the related party is a resident for tax purposes or where the related party is otherwise subject to tax or (2) the related party is allowed a deduction with respect to the payment under local tax law. In addition, section 267A applies to payments to related parties made to, or by, a hybrid entity. For this purpose, the term “hybrid entity“ means any

    entity which is either—(1) treated as fiscally transparent for purposes of [U.S. federal income tax] but not so treated for purposes of the tax law of the foreign country of which the entity is resident for tax purposes or is subject to tax, or (2) treated as fiscally transparent for purposes of such tax law but not so treated for purposes of [U.S. federal income tax].

    For purposes of the disqualified related party amount, a related party is defined by reference to section 954(d)(3), which requires 50% common ownership or control.

    The legislative text of section 267A could be read to exclude reverse-hybrids from the definition of a hybrid entity because the statute defines a hybrid entity as an entity treated as being fiscally transparent in the country in which such entity is tax resident or otherwise subject to tax. Invariably, a reverse-hybrid entity is neither subject to tax nor a tax resident under the laws of a jurisdiction in which it is treated as fiscally transparent. Section 267A does not include a definition of fiscal transparency, nor is there a specific cross-reference to any other provisions of the Code to provide further clarity. Currently, the regulations provide a definition of “fiscally transparent” for the purposes of claiming treaty benefits. Under this provision, an entity is fiscally transparent with respect to an item of income if, under the laws of its jurisdiction, its interest holder is required to separately take into account the item of income on a current basis with the same source and character as if the interest holder had realized the income directly from the originating source. Notably, in determining whether an entity is fiscally transparent with respect to an item of income in the entity’s jurisdiction, it is irrelevant that, under the laws of the entity’s jurisdiction, the entity is permitted to exclude the item from gross income or that the entity is required to include the item in gross income but is entitled to a deduction for distributions to its interest holders.

    Although section 267A technically can be read as excluding reverse-hybrid mismatches, it includes all the four factors of its precedent, BEPS Action 2, which applies to reverse-hybrids. First, section 267A requires a disparity in the characterization of an entity by two or more jurisdictions, which involves a transparent entity. Second, it requires a payment involving a transparent entity. Third, it sets a 50% rule for related parties. Fourth, such payment produces a D/NI.

    Along with the specific statutory language, section 267A also grants the Treasury Department broad authority to promulgate regulations to apply the section in other situations, including “certain conduit arrangements” involving a hybrid transaction or a hybrid entity, branches, and “certain structured transactions.” The scope of the regulatory authority also includes the authority to address the “overly broad or under-inclusive application of this provision.” While the general focus for the exercise of this regulatory authority is to address situations that involve the D/NI outcome, the preamble of the proposed regulations makes clear, citing the legislative history of the provision, that “the policy of section 267A is not to address all situations that give rise to no-inclusion outcomes, but to only address a subset of such situations where they arise due to hybrid arrangements,” and that where non-inclusion arises due to other features of the international tax system, other rules (such as withholding taxes, tax treaties, or new statutes) are better suited to address these concerns.

    3. Normative Analysis of the Matching Method

    The U.S. and BEPS chose to address the tax arbitrage issue through the use of the matching method, under which a jurisdiction adjusts its tax rules to the other jurisdiction’s tax rules. Matching is the underlying idea of the value added tax (VAT), which disallows a deduction (in a subtraction method VAT) or a credit (in a credit method VAT) unless it can be shown that the payor paid its VAT liability on the supply of goods and services with respect to the income. This idea can be applied to income tax, and is also not unrelated to international tax. Generally, the disallowance of a deduction is equivalent to taxing income at the marginal or corporate tax rate of the country whose base is eroded.

    The adoption of the matching method has several interesting features. First, the matching method requires looking at other jurisdiction’s tax laws and prevents any potential double nontaxation by imposing tax if the result in the other jurisdiction does not require an income inclusion. While non-inclusion of income can be easily determined in many cases, there are various instances in which such a determination adds complexity and requires transparency and information exchange in order to properly monitor the taxpayers involved.

    Second, the matching method considers the income of a taxpayer rather than the taxpayer’s ability to pay. A taxpayer may be taxed at a high effective tax rate in a specific jurisdiction even though the income from a particular transaction was not subject to tax.

    Third, matching may result in an additional layer of tax, or even double (over) taxation. For example, consider a corporation X that makes a deductible interest payment to a wholly owned foreign subsidiary Y that is resident in a jurisdiction in which the interest payment is not included in income. The tax rate is 21% in the domestic jurisdiction and 15% in the foreign jurisdiction. If the foreign subsidiary had included this interest in income, the effective tax rate would have been reduced by 6% (21% deduction less 15% income). Note, however, that the disallowance of the deduction results in an additional tax layer of 6% as the related party is effectively treated as a domestic corporation for purposes of calculating the tax rates. The less control the taxpayer has over the related party, the less the taxpayer will benefit economically from the transaction because part of the payment will go to unrelated parties. The burden of disallowing a deduction on the entire payment is heavier in such cases, although the economic benefit outcome is minimized, especially if the domestic entity does not control the cash or other asset that was transferred.

    De facto, the adoption of the matching method treats hybrid mismatches as wrong per se. Presumably, this approach is intended to flag or presume such base-erosion practices and to shift the right to tax back to the U.S. This presumption is efficient in the sense that it can minimize controversies, conserve resources from the tax authorities, reduce filing burdens on taxpayers, and increase certainty for taxpayers. However, this presumption may result in overtaxation in violation of the Single Tax principle in some cases and often involve unwary, uninformed taxpayers or taxpayers who must engage in these transactions due to nontax legal reasons.

    Lastly, the matching method and section 267A do not address the important issue that a jurisdiction can provide significant tax benefits, or tax at a de minimis rate, and escape the application of these hybrid rules. This issue connects to the point that the broad interpretation of the Single Tax principle is justified normatively, if the purpose is to prevent base erosion—the objective of section 267A as clearly stated in the legislative history, because base erosion may be prevented by ensuring a level of tax that is more than de minimis. These overtaxation situations can be addressed in part through the broad authority given to the Treasury Department to issue regulations. As a policy matter, action may be justified if, in the majority of the cases, section 267A prevents additional cases of double nontaxation, unless there are other ways to prevent double nontaxation while minimizing the overtax effects.

    C. Possible Alternatives to the Matching Method to Prevent Hybrid Mismatches and Their Respective Benefits in a Nutshell

    The problems with the matching method described above can be avoided through the adoption of alternative methods that address the hybrid mismatch problem. Clearly, each of the methods described below needs to be further developed to be applicable in more complex situations, but the following discussion provides the general idea behind them.

    The first alternative method, very similar to the matching method, is to include the non-included income of the source jurisdiction as if the income was taxable, or as if the taxpayer was an opaque entity under the rules of the foreign jurisdiction. For example, using the facts of the last example in Part IV.B.3, if the interest payment was exempt or treated as a dividend eligible for a 100% dividend-received deduction and the tax rate in the source jurisdiction is 10%, $10 will be included in the transferor income (the product of 10% and $100 payment) that will offset a part of the deduction that is given to the transferor. The same result could be obtained by disallowing a portion of the deduction. Unlike the matching method, this method takes into account the tax treatment, and not only the tax rate, of the foreign jurisdiction. This alternative also eliminates absurd cases where in both jurisdictions the result would be less than full taxation of the related party.

    This alternative method applies on a residence taxation basis to a taxpayer if the taxpayer retains control the related party. Hence, this rule applies capital export neutrality that the scholarship connects to the Efficiency principle because it means having a neutral policy toward a resident’s choice between domestic and foreign investments that provide the same pretax rates of return. This method, similar to the matching method, de facto treats any transaction that involves hybrid mismatches as wrong per se or constitutes a presumption to detect base-erosion practices and shifts the respective taxation right back to the U.S. Although this method avoids the problem of overtaxation, it does not avoid the other disadvantages of the matching method. Moreover, its complexity would make it very difficult for taxpayers to implement. Applying the tax rates and the tax laws applicable to the foreign jurisdiction would raise issues of how to interpret the tax laws of the other jurisdiction, which will generally impose a significant burden on tax authorities and taxpayers and may produce arbitrary results.

    Another alternative method, the recharacterization approach, does not focus on the tax consequences (i.e., whether the payment is taxed or taxed at a minimum rate) but on the tax characterization disparity between jurisdictions. The recharacterization approach requires that the source jurisdiction recharacterize a reverse-hybrid entity as a taxable entity instead of a pass-through entity. For example, assume that ACo, which is organized in state A, owns BSub, which is organized in state B and is treated as a transparent entity under the laws of B, and that BSub is paid interest by CSub, which is organized in state C. Under the recharacterization approach, the transparency treatment in state B (where the reverse hybrid is organized) should be replaced by treating the entity as opaque. This would ensure that the interest payments received are included in the ordinary income in state B.

    The recharacterization approach would prevent the problem of overtaxation discussed above because it ensures that the income is taxed per the source rules at the rate of the source jurisdiction. This approach also avoids the complexities in applying the other methods because it avoids the complexity of applying the tax laws of the other jurisdiction. This approach, however, violates the Nondiscrimination principle because it provides for a different tax treatment for nonresidents. In addition, like the matching method, this approach applies the narrow interpretation of the Single Tax principle. Lastly, jurisdictions will be discouraged from adopting this rule because it concerns other countries’ base erosion and not necessarily their own. The method is unlikely to succeed under any game theory because the utility of every participant player is indirect and depends on the cooperation of the other players.

    A third alternative, and one that applies the broad interpretation of the Single Tax principle, requires the establishment of an effective minimum tax. This approach targets taxpayers who engage in hybrid mismatches and calculates a minimum tax, such as an improved BEAT, set by the residence jurisdiction. The main advantage of this approach is that it takes into account the entire income of a taxpayer for the year. In addition, double taxation is avoided as this approach merely requires that taxpayers pay tax at a specified effective minimum tax rate.

    The effective-minimum-tax alternative has a few disadvantages. First, it may not resolve the horizontal and vertical equity issues under the ability-to-pay principle between taxpayers that engage in hybrid mismatches and taxpayers that operate domestically. The recharacterization approach may apply the ability-to-pay principle better, as it applies the same tax treatment applicable to taxpayers that generate domestic income. Second, the effective-minimum-tax approach might be more complex to adopt and may impose a burden on taxpayers to implement.

    These disadvantages, however, could be minimized if the effective-minimum- tax alternative were adopted. Sections 267A and 245A(e) were enacted along with other base-erosion measures, such as the BEAT and GILTI that applied a semi-territorial regime. The BEAT sets an effective minimum tax for relatively large multinational corporations with a base-erosion percentage of at least three percent of its total deductions. The tax is equal to 10% (from 2019 until 2025 and increasing to 12.5% after 2025) of the taxpayer’s “modified taxable income” minus a portion of some tax credits. The tax computed under the BEAT is then compared to the taxpayer’s regular tax liability. If the BEAT liability is higher, the taxpayer pays the additional tax computed under the BEAT. As such, the BEAT prevents taxpayers from eroding the U.S. tax base by claiming a deduction in the U.S. on payments to related parties. Congress provided several justifications for enacting the BEAT. First, the BEAT is meant to compensate for the failure of the transfer pricing rules. Second, even if the pricing of the transfer was set to reflect the benefits and risks between the parties to the transaction, the BEAT is meant to reflect the benefits that were provided by a jurisdiction to a taxpayer and compensate for the failure of the source rules to do so. And third, the BEAT is meant to apply the Single Tax principle.

    The BEAT and the hybrid rules share similar features and a similar objective—to apply the Single Tax principle. First, both seek to prevent taxpayers from lowering their U.S. tax liabilities by making payments to foreign related parties. Payments made to related parties by a “25-percent owner” are subject to the BEAT, regardless of whether the payments were included in the related party’s income. Similarly, payments made to related parties, of which the taxpayer constructively owns more than 50% of the voting shares or value and that are not included in the related party’s income, are disallowed as a deduction under sections 267A and 245A(e). Second, sections 267A and 245A(e) apply to dividends, royalties, and interest, whereas the BEAT applies to other suspected base-eroding deductions, thus providing a more comprehensive defense of the U.S. tax base as well.

    Congress obviously decided to apply different standards to base-erosion payments under the BEAT than under sections 267A and 245A(e). Why it decided to do so is not clear from either a normative perspective or the legislative history. Had the BEAT approach been adopted to address the hybrid mismatch problem, the payments would have been subject to an effective minimum tax comparable to that of the residence jurisdiction. Given the normative superiority of the effective-minimum-tax method over the matching method, the congressional decision to apply the new hybrid rules and not the BEAT to hybrid transactions is questionable, despite the fact that the matching method might be less burdensome than the minimum tax method from an administrative perspective. Thus, given the introduction of an effective-minimum-tax method under the BEAT with respect to certain types of base-erosion payments, the adoption of the matching method does not provide any clear advantages over the effective-minimum-tax method with respect to hybrid mismatch payments.

    Moreover, the matching method, which is applied under the hybrid rules, applies to specific types of payments rather than the overall income of a taxpayer. Thus, the matching method applies the narrow interpretation of the Single Tax principle and may cause overtaxation. The legislative intent, as described above, shows that Congress enacted this rule as a base-erosion measure. The minimum effective tax rate is, thus, a preferable method to be applied under the Code and would be more coherent with the legislative intent and international tax trends.

    A final important note regarding the legislative intent behind the hybrid rules concerns the debate over tax arbitrage and customary international law. The rules under sections 267A and 245A(e) applicable to hybrid mismatches depend on whether the taxpayer is taxed abroad, even if the taxpayer is taxed under the BEAT in the U.S. The fact that the U.S. provides this special standard as well as the adoption of BEPS Action 2, and the fact that the legislative history shows that Congress intended that this section be analyzed under international law principles, suggests that these sections are customary international law. As such, regulations or court holdings that concern these hybrid sections should be analyzed under international tax principles.

    V. Conclusion

    The main takeaway of this Article is that two recent trends should shape the way we think about hybrid transactions: (1) the “constructive dialogue” among the U.S., the OECD, and the U.N. on how to apply international tax principles and (2) the shift from the narrow interpretation of the Single Tax principle to the broad one. The first trend includes the recognition, as part of the international tax debate over base erosion in general and hybrid transactions in particular, that such unilateral laws are customary international law. The newly enacted anti-hybrid laws found in section 267A and 245A(e) are yet another chapter in the “constructive dialogue” among the U.S., the OECD, and the U.N. on how to apply international tax principles and, in particular, the Single Tax principle. The hybrid laws perfectly illustrate this dialogue. At first, the second part of BEPS Action 2, which discusses application to treaties, followed the method set earlier by the U.S. in Article 1(6) of the 2006 U.S. Model Convention, with some minor variations. Article 1(6) of the 2016 U.S. Model Convention is almost identical to the new Article 1(2) of the 2017 OECD Model Convention and Article 3(1) of the MLI. This dialogue demonstrates the intent of participants in international taxation to view international tax law as customary international law. As international tax law, sections 267A and 245A(e) should be analyzed through the lens of international tax principles and, in particular, the Single Tax principle.

    The second trend, as evidenced by the enactment of the BEAT, GILTI, and digital services minimum taxes and by the adoption of Pillar Two of BEPS, is the shift, by both the U.S. and other countries that participated and adopted these measures, from the narrow interpretation of the Single Tax principle to the broad one. International tax scholars understand that to effectively prevent base erosion and tax competition, international tax law must adopt the broad interpretation of the Single Tax principle to include a minimum tax threshold.

    These two trends, in addition to Congress’s intent to prevent base erosion by enacting the hybrid laws, support the proposal that the current matching method adopted to address the hybrid mismatch problem by the U.S should be replaced with the effective-minimum-tax method. The effective-minimum-tax method provides the optimal balance between the Benefits and the Single Tax principles. First, it takes into account the total effective tax rate of the taxpayer in the residence jurisdiction, which is a better proxy for the taxpayer’s wealth and the benefits provided by the jurisdiction rather than taking into account specific transactions. It will also eliminate the risk of taxing the taxpayer on a hybrid transaction more heavily than if the transaction were not a hybrid. Second, the taxpayers and tax authorities will avoid the complexity and the burden of interpreting the tax laws of a foreign jurisdiction. Further, taxpayers that are subject to the BEAT will not have additional administrative burdens. Although the technical aspects of the BEAT and the way that it works are far from perfect, the use of a similar method to address the hybrid mismatch problem offers a better solution.

    It might be better to focus on passive payments, that is, types of income that are highly mobile and reflect minor benefits, as the current hybrid laws do. Although from the Single Tax principle perspective, it does not matter what type of income is used to achieve a minimum tax threshold, disallowing all types of income, some of which reflect a clear nexus between the taxpayer to the jurisdiction, is a violation of the Benefits principle.

    What is next? The Treasury Department has broad authority to issue regulations to minimize the disadvantages of the current method. To prevent overtaxation, the Treasury can generally exempt those situations that “the Secretary determines do not present a risk of eroding the Federal tax base,” as well as specific transactions in which the related party is taxed or considered a resident of another jurisdiction. From the de minimis taxation perspective, the regulations treat cases in which the recipient of the payment is taxed under its tax law at a preferential rate on the income resulting from such payment, or the payment amount is partially excludable, exempt, deductible, or offset by a credit such that the tax benefit offsets 90% or more of the payment, the payment is treated as not being included in income at all. This safe harbor prevents the case of de minimis income inclusion.

    As explained above, however, the matching method measures one transaction rather than the effective tax rate for a whole year despite the fact that hybrid mismatches are not wrong per se. Second, the safe harbor tax rate that is used is that of the source jurisdiction. Because the benefits provided in the source jurisdiction to the related party (and indirectly to the transferor) for interest, royalties, dividends, and similar types of income are not substantial, they do not justify the allocation of taxation rights. Therefore, the safe harbor tax rate that should be used is that of the residence jurisdiction. In an optimistic sense, the extraordinarily broad authority given to the Treasury Department includes an anti-avoidance standard if the principal purpose of a transaction or entity is the avoidance of sections 245A(e) and 267A. These anti-avoidance rules in the final regulations should adopt the ideas explained in this Article.

    I would like to thank Reuven Avi-Yonah, Leopoldo Parada, Omri Marian, Eduard Fox, Bill Lyons, David Cameron, and Elizabeth Dengler for their helpful comments.

      Author