Irish anti-hybrid rules and legislation

ATAD II, which was approved by EU Member States on 29 May 2017, required the introduction of anti-hybrid rules with effect from 1 January 2020 and the applicable Irish legislation was included in Finance Act 2019. The legislation came into effect for payments made, or arising, on or after 1 January 2020. With the recent release of the first tranche of Irish Revenue's guidance notes on Irish anti-hybrid legislation, it is timely to consider further how these rules may impact typical Irish alternative investment structures.

As noted previously, the anti-hybrid rules are extremely complex particularly when applied to multi-tiered, multi-jurisdictional structures that are typical in the alternatives industry. In our view, the consultative approach taken by the Irish authorities both during the legislative and Revenue guidance process has resulted in the development of balanced legislation and guidance which we have explored further below. Notwithstanding this approach, the complexity of the rules should not be underestimated.

Overview of Irish anti-hybrid rules

The Irish anti-hybrid rules are designed to apply to arrangements made between associated enterprises. Parties can be associated if shareholding, voting rights or profit distribution thresholds are met (typically a 25% relationship applies here but it is increased to 50% in certain circumstances), if the entities are consolidated for accounting purposes, or if one entity has "significant influence in the management of the other". That final concept is defined to cover circumstances where an entity has the right to participate in the "financial and operating policy decisions of that entity" by virtue of board, or an equivalent governing body, representation.

The main thrust of the rules are aimed at preventing companies from benefiting from differences in the tax treatment of payments made under hybrid financial instruments and on payments by or to hybrid entities. Hybrid financial instruments are broadly those which are treated as debt in one jurisdiction but equity in another (e.g. Profit Participating Notes or loans which are viewed as debt in Ireland but often viewed as equity in other jurisdictions such as the US), while a hybrid entity is typically viewed as opaque in one jurisdiction but transparent in another (e.g. a US check-the-box election which can give certain entities such as an ICAV or S.110 company a specific US tax designation). This tax system arbitrage can result in companies qualifying for tax relief on payments in one jurisdiction without being taxed on the other side in the hands of the recipient in their local jurisdiction (so-called Deduction No Inclusion or 'DNI' situations) or in qualifying for tax relief in more than one jurisdiction on the same payment (Double Deduction or 'DD' situations). The new rules will deny deductions for such payments or, in certain circumstances, will subject them to tax in Ireland, but only to the extent that the DNI or DD outcomes are caused by hybridity.

The anti-hybrid rules can also apply to transactions between parties that are unconnected if the transaction is a 'structured arrangement'. That term covers transactions that give rise to a mismatch outcome where (a) the mismatch outcome is priced into the terms of the arrangement or (b) the arrangement was designed to give rise to a mismatch outcome. The anti-hybrid rules will apply only to taxpayers who share in the value of a tax benefit arising from a structured arrangement.

Another important area covered by the rules relates to imported mismatches. This provision seeks to target deductible payments from Ireland which directly or indirectly fund hybrid mismatches outside of Ireland. Finally, areas such as disregarded permanent establishment, tax residency mismatch outcomes and withholding tax mismatch outcomes are contained in the Irish anti-hybrid rules but such areas are not typically prevalent concerns for Irish alternative investment structures.

Positive Irish measures

Ireland has adopted a practical approach in the transposition of the ATAD II rules into Irish legislation. The overarching aim of capturing hybrid mismatch outcomes and meeting the minimum standard of ATAD II has been achieved in a manner which allows taxpayers to apply (and Irish Revenue to police) the rules in a sensible manner. We have set out some of the key provisions which are helpful from an alternatives industry perspective.

Associated enterprise definition

The definition of associated enterprises is in line with the minimum standard of ATAD II and will clearly capture investors in certain fund structures, although helpfully debt relationships are not explicitly included within the definition. "Acting together" provisions will need to be considered for certain partnership structures where the aforementioned 25%/50% shareholding, voting or profit distribution rights are held by investors.

Inclusion and payee definition

Another very important concept is that of "inclusion" because provided the payment is included in the recipient location, no deductibility restrictions apply. The typical alternative investment structures include an abundance of vehicles of both an opaque and transparent tax nature (such as US LLCs, LPs and UK LLPs). As a result, the search for a "payee" or recipient of the payment, and the subsequent test for inclusion, can be quite unwieldy and create a significant administrative burden.

The Irish definition of "inclusion" covers not just payments that are subject to tax in the overseas jurisdiction, but also payments to exempt foreign entities such as pension funds, Government bodies etc. Furthermore, payments to entities that are located in a jurisdiction that does not impose tax are treated as included, provided that the profits or gains are treated as arising or accruing to that entity. A CFC-type charge (including GILTI and PFIC) imposed under the laws of another territory will also be treated as included. Ireland has helpfully included a broad definition of payee to cater for situations where Ireland may view the initial "payee" as opaque but there is inclusion for a so called "participator" behind that initial payee. A participator is also viewed as a payee under Irish legislation. This can, in certain cases (e.g. a payment to a US LLC), result in scenarios where there are multiple payees in the structure. Helpfully, the recently published guidance states that where multiple payees can be identified in a structure, the test for ‘inclusion’ will be satisfied where the payment is included by at least one payee.

Dual inclusion concepts

Similarly, the concept of dual inclusion is a very important concept for alternative investment structures. In situations where a payment by a hybrid entity or a double deduction scenario arises, no restriction applies as long as the payment can be offset against "dual inclusion income". This is income which is subject to tax in both Ireland and the jurisdiction where the mismatch situation arises. Many structures have US flow through tax treatment, due to multi-tiered check the box elections, which can result in significant double deduction outcomes. In many cases, those deductions are not at asset owning entity level, but at mid-tier levels which can create complexity in identifying the corresponding dual included income in certain cases. Ireland has introduced a jurisdictional, as opposed to entity by entity, test for dual inclusion purposes.

Accordingly, provided there is economic inclusion in Ireland (regardless of whether the expense deduction is in a different Irish entity to the Irish entity where the income is dual included) Ireland will view that income as "included" for dual inclusion purposes. Further, payments into Ireland from within the same US check the box group can be treated as included by the US. However, this is subject to an anti-avoidance rule which can still take effect where in substance there is a hybrid mismatch. There are a number of helpful examples set out in the Revenue Guidance that demonstrate in detail where this situation can arise.

Imported mismatch rules

As noted above, imported mismatch provisions cover deductible payments from Ireland which directly or indirectly fund hybrid mismatches outside of Ireland. It is clear that this rule has the ability to be very broad in scope particularly for alternative investment structures. Irish legislation prescribed that these rules do not apply where payments are made to other EU Member States which is a very positive development. For payments to non-EU territories, similar to the UK rules, the legislation affords the opportunity to place reliance on anti-hybrid rules in another territory which are aligned with the OECD BEPS Action 2 recommendations in certain cases. The charging section is also prefaced by "reasonable to consider" language which is helpful in the context of multi-tiered investment structures.

We are here to help you

The Irish anti-hybrid legislation is live and many clients have completed their impact assessments. While drafted in a sensible manner, the rules are extremely complex and do still bite on many occasions. This has resulted in a number of clients being caught by these rules. Consequently, if you haven't already done so, we would strongly recommend that an impact assessment of your Irish structures is completed as soon as possible.

We expect to see further guidance issued by the Irish Revenue with respect to the anti-hybrid rules in the coming months. We are actively involved in that dialogue so please feel free to feedback any specific comments or fact patterns to us. As always, we are happy to discuss the above in further detail and please feel free to reach out to the PwC Ireland Alternative Investments Tax team for our assistance.