On December 10, 2019, the German Ministry of Finance published draft law which is intended to implement Article 9 and 9b of the Anti Tax Avoidance Directive ("ATAD II"). This Draft ATAD Implementation Act ("Draft AIA") therefore includes, inter alia, anti-hybrid provisions to cover hybrid mismatches.

ATAD II with respect to hybrid mismatches

Art. 9 para. 2 ATAD II applies to the deduction/no inclusion of so-called hybrid instruments like hybrid bonds or participation rights - where payments on hybrid instruments are deductible in the state of the payor (deduction) but the state of the recipient does not qualify the payment as taxable income (no inclusion).

In this context, ATAD II recommends as a primary measure (response) to deny the deduction at the level of the payor, as a secondary measure (defensive rule) to tax the payment at the level of the recipient.

Currently under German law, "only" a defensive rule applies which states that 95% of any dividends received are only exempt from corporate income tax as far as the payment did not decrease the taxable income of the payor.

Deduction/No inclusion ("D/NI") - Securities Lending and Repos

According to the Draft AIA, expenses on the use of capital are not deductible if the corresponding profits are not subject to a tax which is comparable to German taxation. In such cases, the deduction is denied at the level of the payor (primary measure by way of denial of deduction). According to the explanatory notes to the Draft AIA, this will also apply to mismatches arising from cross-border compensation payments made in securities lending transactions or repo transactions.

Furthermore, the new rules also apply to "hybrid transfers", i.e., to transactions in which the profit of capital assets is attributable to more than one person participating in the transaction.

The explanatory notes to the Draft AIA include the example of a cross-border repo transaction in which, under German law, the respective underlying is attributed to the German seller and, therefore, the payments under the repo were treated as (deductible) interest payments, whereas under the law of the state of the purchaser, the underlying is attributed to the purchaser and therefore, the respective payments (dividends as well as profit from the re-purchase) are tax-exempt. In such case, the new law would, if enacted as proposed, deny the deduction of such payments in Germany at the level of the seller.

The new rules would also apply in cases of cross-border securities lending transactions, where, in Germany, the underlying security is attributed to the German borrower but, in the foreign state, the underlying security is attributed to the foreign lender. In such cases, where a manufactured dividend payment would be deductible in Germany and tax-exempt (as a dividend) in the foreign state, the Draft AIA would deny the deduction of such payment in Germany.

Correspondingly, the Draft AIA disallows the exemption of dividend payments at the level of the German recipient if the foreign payor is entitled to a deduction of the respective payment.

There is an exception from the deduction disallowance where the expenses correspond to profits of the same taxpayer and these profits are subject to tax in Germany as well as in the other state (because here the double deduction is avoiding potential double taxation). 

Implementation of further hybrid mismatch provisions

The Draft AIA also applies to some other hybrid mismatch scenarios, in particular:

• to another D/NI scenario - where "reverse hybrid entities" are treated as transparent in their state of residency but are treated as opaque (and taxable entities) in the residency state of their shareholders.
• to double deduction scenarios - where expenses of the same taxpayer are deductible in two different states.
• to imported hybrid mismatch scenarios.

However, payments without a hybrid mismatch that benefit from a low taxation or no taxation at the level of the recipient under the general tax regime of the state of the recipient should not be affected by the Draft AIA.

Last but not least the Draft AIA also contains a new, and unfortunately pretty aggressive version of the long outdated German CFC-rules which, however, shall be dealt with in a separate blog entry.

What happens next?

 The Draft AIA was released on December 10, 2019 for public consultation. As a next step, the German government needs to adopt the Draft AIA and to introduce it into the legislative process. Even though the legislative process will only be completed in the course of the year 2020, most of the measures, including the new anti-hybrid rule, shall be applicable retroactively from January 1, 2020.