Hybrid mismatches

What it means

Hybrid mismatches arise when two countries treat the same payment, instrument or entity differently. For example, one country treats a financial instrument as a loan and the interest as deductible, while the other treats it as equity and the payment as an exempt dividend. The result is a deduction with no taxation on the other side.

Another type arises with entities that one country treats as a separate company and the other as transparent, attributing their income to the partners, or with a permanent establishment that each country views differently. The same expense can then be deducted twice in two countries.

The rules against hybrid mismatches were introduced by the ATAD directive and its extension ATAD 2. The principle is simple: if an expense would be taxed nowhere or deducted twice, one of the countries denies the deduction or taxes the income so the outcome matches the ordinary situation.

How it works in practice

An ordinary Slovak company without foreign ties is not affected. The rules matter for groups with companies in several countries, especially where the structure includes entities such as a US LLC, a partnership or foreign funds, and for companies with hybrid financial instruments such as profit-participating loans.

For such clients we review payments of interest, royalties and services within the group: how the recipient’s country treats them and whether they are actually taxed there. This often requires information from foreign colleagues or advisers, which must be obtained before the return is filed.

The rules are closely linked with transfer pricing, CFC rules and the global minimum tax. When restructuring a group it is best to assess them all together, since changing one structure can create a mismatch elsewhere.

What to watch out for

The most common mistake is not knowing how the other country treats a payment. A Slovak company deducts interest in good faith, and only in an audit does it emerge that the recipient abroad is a transparent entity and the payment was taxed nowhere. The adjustment is then made retroactively with interest.

The second risk is the complexity of the rules. They cover several types of mismatch, exceptions and interactions, and applying them correctly takes expert assessment. For any non-standard structure it is worth having a written analysis that will stand up in an audit.