The ATO recently issued Law Companion Ruling LCR 2021/1 (LCR), which finalises guidance on particular aspects of the targeted integrity rules contained in the hybrid mismatch rules (subdiv 832-J of the Income Tax assessment Act 1997). The final LCR confirms the ATO's view contained in the prior draft and revised draft (LCR 2019/D1) released in 2019 and 2020 respectively and further clarifies some of the enacted amendments to the targeted integrity rule introduced by the Treasury Laws Amendment (2020 Measures No 2) Act 2020. These amendments apply to assessments for income years starting from 2 April 2019. However, the LCR applies retrospectively from 1 January 2019 (including the amendment for state and municipal taxes to be taken into account in working out the rate of foreign income tax).
Hybrid mismatch rules
The hybrid mismatch rules were introduced to deter the use of certain hybrid arrangements that exploit differences in the tax treatment of an arrangement and/or entity under the income tax laws of two or more countries. This is achieved by neutralising the effect of the hybrid mismatches that arise where there is a double non-taxation benefit where a cross-border dealing results in a:
- deduction/non-inclusion (D/NI) mismatch (broadly, a deduction being received for a payment in one country, where the corresponding income is not assessable income in another country), or
- Deduction/deduction (DD) mismatch (broadly, a deduction entitlement arising in two countries for the same payment).
Targeted integrity rules
The targeted integrity rules in subdiv 832-J specifically apply to offshore multinationals. They seek to prevent multinational groups from circumventing the hybrid mismatch rules by routing investment or financing into Australia using interposed entities. For example, a foreign entity incorporated in a low or no tax jurisdiction is interposed as a lender between a foreign parent and an Australian borrower.
Under subdiv 832-J, the targeted integrity rules specifically apply to deny a deduction for the payment of interest (within the meaning of s128A(1AB)) or an amount under a derivative financial arrangement (as defined in s230-350(1)) made by an entity (the paying entity) under a scheme to a foreign entity (the interposed foreign entity) where all the following conditions are satisfied:
- the paying entity, the interposed foreign entity and another foreign entity (the ultimate parent entity) are in the same “Division 832 control group”;
- the ultimate parent entity is not controlled by any other entity (other than an entity that is not a member of the Division 832 control group);
- disregarding section 832-725 (the operative provision of these integrity measures), an entity would otherwise be entitled to a deduction in an income year in respect of the payment;
- the payment is not subject to Australian income tax;
- the payment is either:
- subject to foreign income tax in one or more foreign countries with the highest rate of tax not exceeding 10%, or
- not subject to foreign income tax; and
- it is reasonable to conclude (having regard to certain matters) that the entity, or one of the entities that entered into the scheme, did so for a principal purpose of enabling:
- a deduction to be obtained in respect of the payment, and
- foreign income tax to be imposed on the payment at a rate of 10% or less.
There are certain exceptions to the operation of the targeted integrity rule where a deduction for the payment will not be denied under the integrity measures in certain circumstances. This includes:
- circumstances where:
- it is reasonable to conclude that the payment is taken into account under the CFC rules (i.e. Part X of the ITAA 1936) and
- the sum of the attribution percentages of each attributable taxpayer in relation to the interposed foreign entity is at least 100%.
- circumstances where:
- the interest or derivative payment is taken into account under a foreign CFC regime that has substantially the same effect as Australia’s CFC rules contained in Part X
- there is a wholly-owned group or
- there is an attributable taxpayer with an attribution interest of 100%.
However, the outcome under a foreign CFC regime will not be treated as having substantially the same effect as Part X where the amount included is reduced or offset by an amount of a kind not allowable under Part X. For example, if a foreign law allows any types of offsets, including losses from other entities, the foreign law would not be considered to have substantially the same effect as Part X.
Guidance on specific issues
The LCR clarifies the ATO's view on the following specific issues:
Identifying the ultimate parent entity of a Division 832 control group
The targeted integrity rule requires the identification of at least three separate entities who are all members of the same Division 832 control group: the paying entity (the entity making the payment), an interposed foreign entity, and another foreign entity who is the ultimate parent entity of the Division 832 group. The ATO states that where entities are members of the same Division 832 control group because they have been grouped for accounting consolidation purposes, that same control criterion should be relevant to identifying the ultimate parent entity. Conversely, if the entities are in the same control group as a result of participation interests one might have in the other, the participation interest control criterion should be relevant to identifying the ultimate parent entity;
When the single entity rule is relevant in applying Division 832
The targeted integrity rules were amended (to remove the reference to the ‘paying entity’) to clarify that the entity which is entitled to a deduction in respect of a payment does not have to be the entity making the payment. This avoids confusion relating to the entitlement to the deduction where the paying entity is a subsidiary member of a tax consolidated group. Under the single entity rule (which treats subsidiaries as part of the head company of a tax consolidated group), where a subsidiary makes a payment (as the paying entity) to the foreign entity (i.e. the interposed foreign entity), the head company is treated as making the payment and the head company is the entity entitled to claim the deduction for the payment. In other words, the head company becomes the paying entity, and it will be the subject of the targeted integrity measures. Accordingly, the amendment only clarifies the Commissioner’s previous view on the operation of the law, and ensures the targeted integrity rules will apply in these circumstances.
Later income year adjustments and residual operation of the targeted integrity rule
The targeted integrity rule does not apply where a payment gives rise to a hybrid financial instrument mismatch, a hybrid payer mismatch, a reverse hybrid mismatch, a branch hybrid mismatch or an imported hybrid mismatch. This is on the basis that one of the other subdivisions in Division 832 (applicable to the mismatch) has already applied to the payment. In the event a deduction was denied under the integrity measures, and subsequently denied under a separate specific hybrid mismatch, this would give rise to a double denial of the relevant deduction.
However, under the more specific hybrid mismatch provisions, a deduction that had previously been denied may subsequently become deductible where the amount becomes subject to foreign income tax in a later year. For example, where a deduction has been disallowed in respect of a payment giving rise to a hybrid financial instrument mismatch, that amount may become deductible (on the basis that the amount has been subject to foreign income tax in a period corresponding to that later income year).
The latest amendments ensure that a later year deduction will not be allowed (in a later income tax year) where a deduction has been disallowed in an earlier income year, if (in certain circumstances) the targeted integrity rule would have denied a deduction in respect of that payment in the earlier year. In effect, the amount that would otherwise become deductible will be denied under the targeted integrity measures.
There are also circumstances where the targeted integrity rule will have residual application to payments subject to the deducting hybrid mismatch rule (i.e. double deductions). Under the deducting hybrid mismatch, there may be circumstances where a deduction for some of the payment is treated as non deductible, with the remaining balance being deductible in the year in which the payment is made. Where the arrangement involving the payment also satisfies the targeted integrity rules, the balance of the payment that would otherwise be treated as deductible in the year in which the payment is made, will be treated as non deductible through the operation (referred to as the residual operation) of the targeted integrity rules. For example, if a payment of $100 gives rise to a deducting hybrid mismatch, such that $60 is disallowed, a deduction for the remaining $40 of the payment (i.e. the mismatch amount not ‘neutralised) will be disallowed under the targeted integrity rule. Also, no deduction will be allowed in the later income year for a payment that gave rise to a deducting hybrid mismatch in the current year, resulting in no deduction ever being allowed for the payment.
In other words, where the operation of any of the specific hybrid mismatch rules operates to treat some or all of the payment as non deductible, and those non deductible amounts could be deductible in a later income year, the targeted integrity rules operate to deny the availability of the later deduction, as well as denying a deduction in the year in which the payment is made where some of that payment would otherwise have been deductible under the other hybrid mismatch rules.
How to determine if the foreign income tax applied to a payment is 10% or less
The targeted integrity rule also requires that the payments of interest, or an amount under a derivative financial arrangement, be either not subject to foreign income tax, or the highest rate of foreign income tax applied to the payment is 10% or less. An amount is subject to foreign income tax where an amount is subject to foreign income tax because the amount is included in the foreign country’s tax base.
- The LCR clarifies the following in determining the foreign income tax:
- where two countries both tax the whole payment, it is the higher rate of tax that is applied to the whole of the payment that is determinative rather than ascertaining a cumulative effect for these purposes.
- In the ATO's view, the targeted integrity rule requires the whole of the payment to be subject to foreign income tax at a rate of greater than 10%, to fall outside the provisions (i.e. condition in paragraph 832-725(1)(g)). (Alternatively, the rule will not apply if the payment is subject to Australian income tax.)
- Further, where a country has a headline corporate tax rate (consisting of multiple government level impositions) of more than 10%, but tax imposed on the actual interest or derivative payment is at a rate of 10% or less, the payment would fall within the targeted integrity rule (subject to the other qualifying factors also being satisfied).
- Generally, income or profits are subject to foreign income tax if foreign income tax is payable under the law of the foreign country because the amount is included in that country’s tax base. However, it is acknowledged that amounts would not be regarded as subject to foreign income tax if a foreign law does not impose tax on the type of payment or subjects the type of payment to tax at a rate of 0%. Similarly, where a payment is made to an entity in a country that does not impose an income tax, the payment cannot be regarded as having been subject to income tax in that country.
- Where a payment is subject to foreign income tax, determining whether the rate of tax applied to the whole payment is 10% or less requires consideration of the specific facts surrounding the actual payment including the tax rate that would be applied to the income (net of deductions for expenses) rather than an effective tax rate.
- In the ATO's view, where a country allows a deduction for tax paid (or some other concession), that deduction (or concession) reduces the tax rate that would apply to an entity's profits for the purposes of applying the “10% or less” threshold test. The Commissioner considers that such deductions (or concessions) need to be taken into account in considering the tax rate applied to the whole payment (e.g. this may include where a subsequent tax refund is received).
- In addition, foreign income taxes levied on the payment at the national, state and municipal levels, will all be relevant in working out the rate of foreign income tax the payment is subject to in a particular country for the purposes of the targeted integrity rule. In this regard it will be the cumulative total consisting of the income taxes applied, within the one country, to the payment at each level (national, state and municipal) that will be used to determine an aggregate foreign country rate.
- A payment which is only subject to foreign income tax if remitted to the foreign country will only be regarded as being subject to foreign tax at a particular rate if it is in fact remitted.
- If an entity has negotiated a tax holiday or concessional tax rate based on its particular activities or status, this would also impact on whether tax is payable and would therefore be relevant in determining the foreign tax rate applicable for the purposes of the targeted integrity rule.
The principal purpose test
The draft LCR provides limited guidance on how the ATO will interpret the principal purpose test. The Commissioner has indicated these words would be interpreted in the context of Section 177DA of Part IVA.
Extension of the targeted integrity rule to payments of interest under back-to-back arrangements
The recent amendments extend the targeted integrity rule to payments made under back-to-back loan arrangements.
- These occur where there is:
- An interest payment to an entity;
- That entity, or a ‘further entity’ (that does not directly receive an interest payment) makes an interest payment to a foreign entity; and
- The interest payments are made under a back-to-back loan or economically equivalent and intended to have a similar effect.
A back-to-back loan or economic equivalent exists where the recipient of the payment has an effective obligation to pass on substantially all of the amount to another entity under another loan or similar arrangement. This obligation may be expressed or implied by the surrounding circumstances, including the relationship between the entities.
The Commissioner discusses how this type of determination would be made, requiring tracing and a commercial nexus between the payments of interest. The substance of the payment made by the interposed entity needs to be tested. In essence the Australian tax consequences of the payment made by the interposed entity or any further entity must be tested in the context of the original payment. It is also expected that the terms of each loan will be substantially the same, but it is not essential for the terms to be identical. Timing is also important, however it is not a requirement for issue dates to be identical.
Where an arrangement is a back-to-back loan or economic equivalent, the targeted integrity rule applies (in a hypothetical sense) as if the original interest payment is made directly to the foreign entity that is the final recipient of the interest payment under the back-to-back loan (i.e. the integrity rule can look through multiple Australian entities). This hypothetical sense is deemed to be the actual state of affairs and any actual consequences are ignored in applying the integrity rule.
Therefore the tax outcomes (i.e. whether the payment is subject to foreign income tax at a rate of 10% or less), are based on the payment being made to the foreign entity (as the final recipient of the interest payment) and are treated as the real tax outcomes (rather than those resulting from the payment to the original recipient).
For example, if AusCo1 (the original paying entity) makes an interest payment to AusCo2 (another entity) who in turn makes an interest payment to Foreign Co under a back-to-back loan, and the payment satisfies the requirements of the targeted integrity rules, AusCo1 is treated as making the interest payment directly to Foreign Co (and not to AusCo2) under the back to back arrangements.