Finnish government proposal implements tax rule against reverse hybrid mismatches

By Heikki Vesikansa (Partner and Head of Tax), Jenni Parviainen (Managing Associate), and Stefan Stellato (Senior Associate), Hannes Snellman Attorneys Ltd., Helsinki

On 28 October, the Finnish government issued its proposal (204/2021) to implement the reverse hybrid mismatch rule of the EU’s Anti-Tax Avoidance Directive (ATAD, EU 2016/1164, as amended by Directive 2017/952). The reverse hybrid mismatch rule will apply as of 1 January 2022, as required by the ATAD. 

 Background

The ATAD has required EU member states to apply a broad range of anti-hybrid rules, for example against hybrid financial instruments and hybrid residency arrangements, as of 1 January 2020. However, there is one anti-hybrid rule that member states are required to apply only as of 1 January 2022 – the reverse hybrid mismatch rule.

The Finnish government has now issued its proposal to implement the rule. The government intends to implement the rule by amending the Act on the Taxation of Certain Cross-Border Hybrid Mismatch Arrangements as well as the Income Tax Act.

Reverse hybrid mismatch

A reverse hybrid entity is an entity that for tax purposes is considered transparent in its jurisdiction of incorporation or establishment, but non-transparent in the jurisdiction of the partner/investor. If neither the jurisdiction of the entity nor the jurisdiction of the partner taxes the income, the characterization mismatch may cause double non-taxation.

Such reverse hybrid mismatch can arise only if the Finnish entity is treated as tax transparent for Finnish tax purposes (flow-through taxation). Finnish tax law treats general and limited partnerships, among others, as tax transparent. This means that taxable income is calculated at the partnership level, but taxation occurs at the partner level.

Key proposals

The proposed reverse hybrid mismatch rule is based on Article 9a of the ATAD. In broad terms, the Article requires member states to neutralize the mismatch by regarding the reverse hybrid entity as a resident of that member state and taxing its income to the extent that that income is not otherwise taxed under the laws of the member state or any other jurisdiction.

The proposed rule covers Finnish partnerships (and other entities subject to flow-through taxation), which have a Finnish non-tax resident partner that is a legal person or a legal arrangement, i.e., not a natural person. The partner must be entitled, directly or indirectly, to at least 50% of the partnership’s capital, votes, or profits. Any interest held by related parties is considered towards the 50% threshold. Different from other hybrid mismatch rules, it does not seem possible to apply the reverse hybrid mismatch rule if the threshold is not met, even if the arrangement would have been structured to benefit from the mismatch (so-called structured arrangement).

The proposed rule applies only if the partner’s state of residence does not tax the income from the Finnish partnership for the reason that it considers the partnership as a separate taxpayer. In other words, the double non-taxation must be a result of a mismatch in the characterization of the Finnish partnership. Therefore, the rule does not apply if double non-taxation is caused by the partner’s tax-exempt status or if Finland already taxes the income on another basis, for example, because the partnership has a permanent establishment in Finland.

Exemption for certain alternative investment funds

The proposal includes an exemption for Finnish partnerships that are regulated as alternative investment funds (AIF), provided that the AIF is widely held and has a diversified securities portfolio. The proposal is quite vague on this point because it leaves the definition of “widely held” and “diversified” to be assessed on a case-by-case basis.

It is important to note that the exemption does not cover all AIFs, because AIFs may not necessarily be widely held or have diversified securities portfolios. In addition, real estate is generally not classified as a “security”.

Next steps

The government expects the proposal to raise only minor tax revenue. Based on information included in the proposal, fewer than 200 Finnish partnerships had at least one partner that was not a private individual in the year 2019.

Once the Finnish Parliament has enacted the proposal into law, Finland will have fully implemented the ATAD.

—Heikki Vesikansa is Partner and Head of Tax, Jenni Parviainen is Managing Associate, and Stefan Stellato is Senior Associate at Hannes Snellman Attorneys Ltd., Helsinki.