Addressing Malta’s Anti-Hybrid Rules – A Technical Overview

In response to global efforts to combat tax avoidance strategies, Malta has enacted legislation to address hybrid mismatches, ensuring conformity with international standards. This is the second part of the Directive transposed in Maltese legislation which seeks to counteract tax advantages arising from hybrid mismatches. Hybrid mismatches exploit differences in tax treatment of financial instruments or entities across jurisdictions to achieve tax advantages. Malta’s anti-hybrid rules are designed to neutralise these advantages, promoting tax fairness and preventing erosion of the tax base. Such rules came into effect in Malta from 1^st January 2020, with the exception of rules regarding reverse hybrid mismatches, which applied from 1^st January 2022.

Understanding Hybrid Mismatches

Hybrid Mismatches arise when the legal characterization or treatment of financial instruments or entities differ across jurisdictions. Such disparity allows entities to exploit the differences and gain a tax advantage. Malta’s anti-hybrid rules primarily target arrangements involving hybrid instruments, entities and permanent establishments and these rules also apply for both inbound and outbound payments and transactions, aimed at preventing instances where a payment is deducted in one jurisdiction without the corresponding income being taxed in the other jurisdiction involved. Common examples of hybrid mismatches include the following:

1. Hybrid financial instruments mismatches; were two jurisdictions classify the same financial instrument differently. A typical example is when a financial instrument is treated as debt in one jurisdiction, allowing interest deductions, while treated as equity in another, resulting in exempt dividend income.
2. Hybrid entities mismatches; were entities that are treated as transparent for tax purposes in one jurisdiction and as non-transparent in another jurisdiction. Such difference in treatment can lead to situations where the income derived by the hybrid entities will be deemed as exempt in both jurisdictions.

Hence the primary objective of the hybrid mismatch rules is to neutralize the tax effects of hybrid mismatches that may arise from the above elements and ensure that income is not subject to double non-taxation or double deduction and that if a hybrid mismatch occurs, the appropriate corrective mechanism is applied.

Mismatch Outcomes

Hybrid mismatches will typically lead to mismatch outcomes taking the form of either a double deduction or a deduction without inclusion. A double deduction occurs when a deduction of a payment, expense or loss is claimed in both the jurisdiction where the payment has its source and where the losses are incurred. Subsequently a deduction non-inclusion occurs where a deduction of a payment is claimed in any jurisdiction in which they payment is made, without a corresponding inclusion for tax purposes in the payee jurisdiction. Similarly, a deduction non-inclusion may incur when a deduction is taken for deemed payment between the head office and a permanent establishment in any jurisdiction without a corresponding inclusion for tax purposes of that deemed payment in the payee jurisdiction.

Corrective Mechanisms

Whenever a hybrid mismatch results in a mismatch outcome, the regulations provide that a corrective mechanism would need to be applied to negate such mismatch outcome. Corrective mechanisms comprise of a primary rule and a secondary where the secondary rule is triggered only to the extent that the primary rule is not applicable. The primary rule and the secondary rule differ depending on whether the mismatch outcome results in a double deduction or a deduction without inclusion.

In the case where we have a double deduction:

• The primary rule requires that the deduction needs to be denied in Malta if Malta is the investor jurisdiction; and
• The secondary rule provides that the deduction be denied in Malta if Malta is the payer jurisdiction.

Where a hybrid mismatch results in a deduction non-inclusion:

• The primary rule requires that the deduction is denied in Malta if Malta is the payer jurisdiction; and
• The secondary rule requires that Malta should include within its taxable income the income that gives rise to the deduction non-inclusion but only to the extent that Malta is the payee jurisdiction and the deduction non-inclusion results from either an arrangement involving a payment under a financial instrument or a payment made by a hybrid entity where such payment is disregarded by Maltese Law.

Reverse Hybrid Rules

Reverse hybrid rules have been implemented to address tax avoidance strategies associated with hybrid mismatches involving hybrid entities. These rules aim to prevent situations where an entity is treated as fiscally transparent for tax purposes in one jurisdiction while being considered as fiscally non-transparent in another jurisdiction at the level of the investors. In the Maltese context, reverse rules attribute income earned by a reverse hybrid entity to its owners or members for tax purposes. This means that if a Maltese taxpayer owns a reverse hybrid entity, the income of that entity will be taxed in Malta regardless of where the income is generated. Therefore, the corrective mechanism applied for reverse hybrid mismatches operates in such a way that transforms the reverse hybrid entity’s classification from a transparent entity to a fiscally opaque entity.

Implications for Businesses in Malta

The adoption of anti-hybrid rules in Malta carries a significant impact for businesses which are engaged in cross-border transactions and tax planning activities. To comply with these rules, requires a thorough understanding of the instruments and entities which may give rise to a mismatch outcome. This might involve the re-evaluation of the entity’s financing arrangements to ensure compliance with the Directive. Furthermore, businesses may need to reassess their intercompany transactions and policies to align with the objectives of the anti-hybrid rules and avoid unintended tax consequences. In addition to this, anti-hybrid rules can impact the overall tax planning strategies of businesses, requiring them to adopt more transparent and less complex tax structures. The benefit for businesses is that this shift towards a greater transparency may have a positive implication on the company’s reputation as it signals a commitment to ethical tax practices. Ultimately, while navigating these complexities can present challenges, businesses that proactively address these implications stand to mitigate risks and maintain a competitive advantage.