Exposure draft legislation (draft law) was released with amendments to clarify aspects of the hybrid mismatch rules and improve their operation to provide greater certainty for taxpayers and assist them with compliance, on 13 December 2019. The majority of the proposed changes will retrospectively apply to income years commencing on or after 1 January 2019 with potential impact for inbound investments into Australia.
Australia’s hybrid mismatch rules, which commenced for income years starting on or after 1 January 2019, aim to prevent entities liable to taxation in Australia from being able to avoid taxation, or obtain double taxation benefits, by exploiting differences between the tax treatment of entities and instruments across different jurisdictions. They neutralise the effects of hybrid mismatches so that unfair tax advantages do not accrue for multinational enterprise (MNE) groups as compared to domestic groups.
The hybrid mismatch rules broadly operate where a payment gives rise to an Australian deduction which is not matched by inclusion in a foreign income tax base (deduction/non-inclusion mismatch) or where a payment gives rise to an Australian deduction but also gives rise to a foreign income tax deduction (deduction/deduction mismatch). A targeted integrity rule also applies to prevent the hybrid mismatch rules from being circumvented by MNEs using interposed conduit type vehicles to invest in Australia (as an alternative to investing into Australia either directly or by using hybrid entities).
Several different arrangements are captured by the regime. These include a reverse hybrid mismatch where a deductible payment is made from Australia and both the payment recipient’s jurisdiction and the jurisdiction of the investor treat the payment as being allocated to the other jurisdiction, resulting in the payment received not being assessed in any jurisdiction. Another arrangement is a deducting hybrid mismatch where two jurisdictions permit a deduction in relation to the same payment, which is taken into account in calculating the taxpayer’s net income in both jurisdictions.
Specifically, the draft amendments to the law:
- confirm that the hybrid mismatch rules apply to multiple entry consolidated groups (MEC groups) in the same way as consolidated groups;
- establish that for the purpose of applying the hybrid mismatch rules, the definition of “foreign income tax” does not include foreign, municipal or state taxes;
- outline the operation of the hybrid mismatch rules for trusts;
- clarify the operation of the dual inclusion income on-payment rule;
- ensure that the integrity rule applies to arrangements designed to circumvent the operation of the hybrid mismatch rules, and in certain circumstances, where other hybrid mismatch provisions have applied;
- allow franking benefits on distributions made on Additional Tier 1 capital instruments, where they give rise to an entitlement to a foreign income tax deduction and the ATO is notified that the foreign income tax deduction will not be claimed.
The amendments are proposed to apply retrospectively to income years commencing on or after 1 January 2019, with the exception of the change to the integrity rule, which is proposed to apply to income years commencing on or after 2 April 2019.
Changes in Detail
The draft law contains amendments that ensure that the hybrid mismatch rules apply to members of MEC groups in the same way that they apply to members of consolidated groups. Therefore, for the purposes of working out whether a reverse hybrid mismatch arises, an entity is not a transparent entity in Australia if, so far as is relevant, the entity is a member of a consolidated group or a MEC group.
Similarly, for the purposes of working out whether a deducting hybrid mismatch arises, an entity can be a deducting hybrid in relation to a payment if, among other things, the entity is a member of a consolidated group or a MEC group.
Consequential amendments have also been made to the notes in the hybrid mismatch rules so that they make appropriate references to subsidiary members of MEC groups to provide clarity to them when their positions may have been uncertain.
The explanatory memorandum (EM) refers to concerns in relation to foreign municipal taxes and State taxes currently being taken into account in determining whether a payment is subject to foreign income tax and giving rise to a deduction/non-inclusion mismatch or a deduction/deduction mismatch. This is because considering the taxation consequences for such payments at multiple levels of government in foreign jurisdictions, for the purposes of determining whether a hybrid mismatch arises, creates an unreasonable compliance burden. Therefore, there is an amendment clarifying that for the purposes of applying the hybrid mismatch rules, foreign income tax does not include foreign municipal or State taxes.
The amendment however also potentially makes it easier for taxpayers to fail the principal purpose test, which triggers the application of the integrity rule. This test denies deductions for related party interest and derivative payments made by an entity that has entered into or carried out any part of a financing scheme the purpose of which is to obtain a low tax outcome by enabling foreign income tax to either not apply or be applied at a rate not exceeding 10 per cent. Paragraph 1.24 of the EM specifically states foreign municipal or State taxes will still be taken into account in determining the principal purpose of the scheme under which a payment is made, included enabling the imposition of foreign income tax at a rate of 10 per cent or less. Whilst the amendment purports to reduce the compliance borne by taxpayers, it may somewhat paradoxically increase the burden to prove that it is not reasonable to conclude that the requisite principal purpose exists.
Trusts and Partnerships
Uncertainty has arisen in applying the hybrid mismatch rules to trusts and partnerships because of the way in which these entities are treated under the income tax laws of different foreign jurisdictions including Australia.
The amendments attempt to clarify the operation of the hybrid mismatch rules for trusts and partnerships to account for the fact that despite the fact that trusts and partnerships are not “legal entities”, the Australian tax law still generally treats them as “entities.” The amendments propose to ensure that the activities of the trustees and partners (the legal entities) are deemed to be the activities of the trusts and partnerships. This includes whether they have made or received a payment; hold, acquire or dispose of an asset, interest or other property; and enter into or carry out a scheme or a part of a scheme.
The draft law also confirms that the deducting hybrid mismatch provision should apply to a trustee and not the trust itself where the trust is not treated as a flow-through entity for Australian tax purposes. This includes public trading trusts and superannuation funds.
In relation to public trading trusts, the Australian tax law treats them as if they are companies for tax purposes, therefore to promote consistency, amendments are proposed to be made to the legal tax provisions on public trading trusts to clarify that the hybrid mismatch rules will also apply to them as though they were companies.
Dual Inclusion Income
Dual inclusion income arises where the same amount is assessable in two countries and applies to reduce the number of deductions denied by the hybrid mismatch rules. Additionally, the “on-payment” rule allows for payments made between entities that are grouped for tax purposes in their country of residence to be treated as if they were assessable if it is reasonable to conclude that such payments are funded from an amount of income of the payer that is assessable for tax purposes in their country of residence.
There have been concerns however relating to the interaction between dual inclusion income and the “on payment” rule where, for example, a payment is made through multiple members of a dual inclusion income group.
Amendments in the draft law clarify therefore that an on payment amount will be taken to be subject to Australian income tax or foreign income tax if it is reasonable to conclude that the funding income or profits have been subject to Australian income tax or foreign income tax in the country in which the dual inclusion income group exists. This amendment appears to be a concession to ensure that on payment of dual inclusion income through corporate groups is appropriately recognised and captured by the dual inclusion income rules.
The integrity rule is a unilateral measure Australia incorporated into its hybrid mismatch rules (and notable departure from the Organisation for Economic Co-operation and Development’s recommendations) that seeks to prevent offshore MNEs from effectively replicating a hybrid mismatch outcome by routing financing into Australia through an interposed entity in a no or low tax (that is, 10% or less) jurisdiction. It does not, however, apply to (some, not all) arrangements that are already subject to one of the other hybrid mismatch rules where the effect of those rules are offset by either dual inclusion income or because Australia is a secondary response country in relation to the hybrid mismatch.
It is therefore still possible to obtain an effective replication of a deduction/non-inclusion outcome by the interposition of a foreign entity located in a no or low tax jurisdiction. Under such circumstances, even though the deduction has been sheltered by dual inclusion income, the arrangement provides the replication of a deduction/non-inclusion of income outcome. The integrity rule does not currently apply to neutralize the replicated deduction/non-inclusion outcome.
To address these concerns, the integrity rule is being modified so that it can apply to a payment even if it gives rise to a deducting hybrid mismatch. However, the general hybrid mismatch rules will continue to take precedence over the integrity rule to the extent the deduction is already denied under the deducting hybrid mismatch rules.
“Tier 1 capital” is the primary funding source of the bank and consists of shareholders' equity and retained earnings. Currently, if all or part of a distribution made on an Additional Tier 1 (AT1) capital instrument gives rise to a foreign income tax deduction, franking benefits on the distribution are denied. An amendment has been proposed so that if all or part of a distribution made on an AT1 capital instrument gives rise to a foreign income tax deduction, franking benefits will be allowed if an authorised deposit-taking institution or insurance company notifies the ATO that it or any other entity will not claim the foreign income tax deduction.
This concessionary amendment is proposed to only apply to financial institutions with AT1 capital requirements but could potentially be extended to other taxpayers. On 16 December 2019, the ATO released a statement on the proposed amendments in which it confirmed that it would release further information in due course to assist issuers of AT1 capital instruments and their investors after consulting with key stakeholders.
Australian MNEs and their subsidiaries (inbound and outbound) and hybrid entities should begin to closely review their structures and collate evidence to support related party financing deductions for income years commencing on or after 1 January 2019. Trust and partnership investment vehicles should note that they are no longer immune from the hybrid mismatch rules following the clarification that they are subject to the regime.
MNE groups with related party finance that have utilised financing from low taxed entities and branches should expect reduced compliance following the amendment that excludes state taxes from the definition of “foreign income tax” but note that arrangements with effective tax rates greater than 10% will still be within scope.
The amendment to the dual inclusion income will require Australian MNEs with potential hybrid mismatch neutralizing amounts to assess all of their sources of funding before relying on the on payment rule, especially inbound service companies that benefit from inter-entity charges and are hybrid entities.