Legislation containing amendments to the Australian hybrid mismatch rules, including a range of new refinements, has passed both Houses of Parliament. Most of the changes have retrospective effect from 1 January 2019 and are designed to reduce the compliance burden for a range of taxpayers, however not all of them will be welcomed.
On 17 June 2020, Treasury Laws Amendment (2020 Measures No. 2) Bill 2020 (the Bill) passed the Senate containing amendments to the Australian hybrid mismatch rules in the Income Tax Assessment Act 1997 (ITAA 1997). The legislation includes a range of previously unannounced refinements reflecting feedback during the consultation process on the exposure draft law released on 13 December 2019.
Schedule 1 to the Bill amends the hybrid mismatch rules to:
- clarify the operation of the hybrid mismatch rules for trusts and partnerships;
- reduce the number of circumstances in which an entity is a deducting hybrid;
- expand the operation of the dual inclusion income rule for non-corporates and clarify the on-payment rule;
- clarify the operation of provisions that refer to corresponding foreign hybrid mismatch rules;
- clarify that, for the purpose of applying the hybrid mismatch rules, foreign income tax generally does not include foreign municipal or State taxes;
- confirm that the hybrid mismatch rules apply to MEC groups in the same way as they apply to consolidated groups;
- ensure that the hybrid mismatch integrity rule can apply appropriately to financing arrangements that have been designed to circumvent the operation of the hybrid mismatch rules; and
- where distributions made on Additional Tier 1 capital instruments give rise to a foreign income tax deduction:
- allow franking benefits on those distributions; and
- include an amount equal to the amount of the deduction in the assessable income of the entity that makes the distribution.
Trusts and partnerships
The Bill includes amendments that clarify that trusts and partnerships, as opposed to trustee or partners, are the relevant ‘entities’ that need to be examined to determine if the hybrid mismatch rules apply. As trusts and partnerships are not legal entities at general law, they cannot be said to receive or make payments or hold assets etc. These amendments clarify that the assets held or payments made or received by the trustee or partners are treated as being held, made or received by the ‘trust’ or ‘partnership’ for the purposes of the Hybrid Mismatch rules. The EM specifically notes in relation to trusts this only applies to ‘flow through entities’ for tax purposes such as Division 6 trusts and Australian Managed Investment Trusts (AMITs) and distinguishes these from Division 295 superannuation funds and Division 6C public trading trusts, where the trustees are the taxed entities.
However, this amendment does not apply to all the foreign hybrid rules applying to trusts. For example, The trustee and beneficiaries will both continue to be treated as ‘liable entities’ for the purposes of determining whether the income is “subject to Australian tax” or “subject to Foreign tax”
This change is to apply retrospectively from income years commencing on or after 1 January 2019.
Deducting hybrid rule
Prior to these changes the deducting hybrid rules could apply to a number of situations where the likelihood of the arrangement giving rise to a double tax benefit was minimal. For example, it could have applied to an individual who has an investment property in a foreign country. Before these changes an entity was a deducting hybrid if it is a liable entity in at least one deducting country; or the entity is a member of a consolidated group. The Bill includes an amendment to narrow the scope of the deducting hybrid rule to entities that are either liable entities in one country but not the other, dual resident liable entities or members of a consolidated group or MEC group.
Ordinary inbound and outbound branch structures as well as individuals, small business entities and trusts, which may have previously been ordinarily treated as ‘deducting hybrids’, will no longer need to consider the complex hybrid mismatch rules.
This change is to apply retrospectively from income years commencing on or after 1 January 2019.
Dual inclusion income
The Bill contains three amendments to expand the concept of dual inclusion income (DII). DII applies where income is taxed in more than one jurisdiction and can result in a reduction of the amount of the deductions denied by the hybrid mismatch rules.Two of the amendments relate to the on-payments rule, which provides an increase in the amount of income or profits of an entity that is subject to Australian income tax or foreign income tax. Firstly, it will now be applied on an iterative ‘reasonable to conclude’ basis for determining whether an amount of funding income or profits has been subject to tax. Secondly, only groups that are headed by a transparent vehicle will be able to access the on-payments rule.
There is also a third amendment clarifying that the foreign income tax offset (FITO) reduction rules will only apply to corporate tax entities and not trusts and partnerships which currently find it impracticable to comply with given FITO entitlements sit with ultimate beneficiaries and partners.
These changes are all to apply retrospectively from income years commencing on or after 1 January 2019.
Foreign hybrid mismatch rules
Prior to these changes it was not clear what was meant by “foreign hybrid mismatch rules”. In some cases, were an arrangement is subject to foreign hybrid mismatch rules, the effect on the Australian Hybrid mismatch rules can be modified. For example, if a hybrid financial instrument results in a deduction in Australia and no income inclusion in the foreign jurisdiction, the primary response is deduction denial. The secondary response only applies if the foreign jurisdiction does not have corresponding hybrid mismatch rules with substantially the same effect whereby an amount equal to the amount of the hybrid financial instrument mismatch is included in the entity’s assessable income.
When considering whether a foreign law has equivalent hybrid mismatch rules, it was not clear whether the foreign law is compared to Division 832 as a whole or compared to the provisions of a particular hybrid mismatch. The Bill contains an amendment that clarifies that a foreign law need only correspond to the specific type of hybrid mismatch rule in order to discharge the need for the hybrid mismatch rule to operate.
The change will apply to assessments made for income years starting on or after 1 July 2020.
State Taxes and the Definition of foreign income tax
For the purposes of applying the hybrid mismatch rules, foreign income tax is payable under a foreign law in respect of a payment, or an amount is deductible in working out a tax base under a foreign law dealing with foreign income tax. The EM notes the unreasonable compliance burden on affected taxpayers to take into account foreign municipal taxes and state taxes in determining whether a payment is subject to foreign income tax and gives rise to a deduction/non-inclusion mismatch or a deduction/deduction mismatch. Accordingly, the definition of foreign income tax, for the purposes of the hybrid mismatch rules only, will exclude municipal taxes and, in the case of a federal foreign country, state taxes. Although this is described as a compliance saving measure, it has the potential of disadvantaging some taxpayers where the relevant foreign country has a high rate on state of municipal income taxes.
This change will apply retrospectively from income years commencing on or after 1 January 2019.
A minor amendment has been made to treat multiple entry consolidated (MEC) groups in the same way as consolidated groups for the purposes of the hybrid mismatch rules, which will provide clarity to MEC groups whose positions may have been uncertain when applying the deducting hybrid mismatch rule. This change will apply retrospectively from income years commencing on or after 1 January 2019.
Targeted integrity rule
Australia’s hybrid mismatch rules include a targeted integrity rule that affects financing structures, whereby a foreign entity in a low (10% or less tax rate) or no tax jurisdiction is interposed as a lender between a foreign parent and an Australian borrower. It does not apply to a payment if one of the other hybrid mismatch rules has already applied to the same payment. The Bill contains an amendment that extends the integrity rule so that is applies to certain payments that are subject to the deducting hybrid or hybrid financial instrument mismatch rules as well as to payments by subsidiaries of tax consolidated groups. The EM says this change is in accordance with the original intent of the hybrid mismatch rules and takes effect for income years beginning on or after 2 April 2019.
Hybrid regulatory capital
Changes made to the franking rules as part of the hybrid mismatch measures broadly operate to deny imputation benefits on distributions where all or part of the distribution gives rise to a foreign income tax deduction. These arrangements typically affect additional Tier 1 (AT1) capital issued by ADIs and insurance companies where the AT1 is attributable to a foreign branch. The EM cites an issue with this rule applying to the whole of a distribution where a comparatively small amount of the distribution gives rise a foreign income tax deduction. Therefore, under the amendments, if all or part of the distribution made on an AT1 capital instrument gives rise to a foreign income tax deduction, franking benefits will be allowed on the distribution and an amount equal to the amount of the foreign income tax deduction will be included in the assessable income of the entity. The amendment will apply to distributions made on or after 1 January 2019.
Most taxpayers will be satisfied with the changes as they clarify interpretative issues and reduce the compliance burden of the hybrid mismatch rules. Taxpayers with trust and partnership investment vehicles will be pleased with the clarification of how trusts and partnerships are treated under the hybrid mismatch rules and taxpayers with outbound investment structures will welcome the relaxation of the deducting hybrid and DII rules.
Other taxpayers may be adversely affected by some of the changes and will need to review their arrangements following the amendments. Such taxpayers include service entity subsidiaries deriving internal recharges that still need to comply with the DII rules and inbound hybrid entities with related party financing expenses that will face additional scrutiny as the targeted integrity rule now has residual application.
Inbound hybrid entity structures, including groups with low tax related party financing structures should continue to be mindful of the ATO’s focus on the application of the hybrid mismatch rules on group structures. Taxpayers with a 31 December year-end that will lodge their annual tax returns in the next few months in particular should determine if they need to make disclosures, including those relating to restructuring designed to remove the existence of offshore hybrid mismatches.
Please contact your local BDO adviser for further information regarding these issues.