On 24 November 2017 draft law was released in Australia to implement the OECD hybrid mismatch rules to prevent multinational groups from exploiting tax differences across jurisdictions. The government also announced that it will also develop a targeted integrity rule and implement the OECD’s branch mismatch rules (BEPs action item 2) for dealings between a head office and a foreign branch. Submissions are due on 22 December 2017. Australian taxpayers with cross-border transactions should begin considering the potential impact of the hybrid mismatch rules.
What are the hybrid mismatch rules?
A ‘hybrid mismatch’ arises if double non-taxation results from the exploitation of differences in the tax treatment of an entity or financial instrument under the laws of two or more countries. Double non-taxation occurs if a deductible payment is not included in a tax base (non-inclusion mismatch), or if a payment gives rise to two deductions (deduction mismatch).
If a mismatch arises, it will be ‘neutralised by disallowing a deduction, or including an amount in assessable income i.e. where cross-border arrangements give rise to payments (including, for example, interest, royalties, rent, dividends) that:
- Are deductible under the tax rules of the payer and not included in the income of the recipient (deduction/no inclusion or ‘deduction or non-inclusion outcome’), or
- Give rise to duplicate deductions from the same expenditure (double deduction). If arrangements give rise to a deduction or non-inclusion or double deduction outcome, the hybrid mismatch rules operate to eliminate the mismatch by, for example, denying a deduction or an income exemption (including franking credits). The rules mechanically allocate the taxation right in relation to a mismatch and the purpose of the arrangement does not affect the outcome.
In the 2016/17 Budget, the Government announced it would implement the OECD hybrid mismatch rules developed by Action Item 2 of the OECD Base Erosion Profit Shifting Action Plan taking into account recommendations by the Board of Taxation. The rules were intended to apply to all payments made on or after the later of 1 January 2018 or six months after the relevant law is enacted. In the 2017/18 Federal Budget that the rules would also apply to regulatory capital of banks and financial institutions. The OECD released a draft report in relation to branch mismatch arrangements in August 2016 which was finalised in July 2017. The United Kingdom has introduced hybrid mismatch rules, with effect from 1 July 2017, largely based on the OECD recommendations and New Zealand announced plans for OECD style hybrid mismatch rules from 1 July 2018. 28 EU member states plan to introduce hybrid mismatch rules from 1 January 2020.
New hybrid mismatch rules draft legislation
On 24 November 2017 the Government released for consultation exposure draft legislation (draft law) to implement the OECD hybrid mismatch rules to prevent multinational groups from exploiting tax differences across jurisdictions. The Treasurer also announced that the Government will develop a targeted integrity rule, and implement the OECD’s branch mismatch rules (BEPS Action Item 2) for dealings between a head office and a foreign branch. The draft law closely follows this on neutralising the effects of hybrid mismatch arrangements, but allows for some departures that are specific to Australia.
The draft law will insert a new Div 832 of the ITAA 1997 which will contain the core concepts in relation to hybrid mismatches. Broadly, the hybrid mismatch rules will apply to related parties, members of a Division 832 control group and structured arrangements. In addition, the draft law includes imported hybrid mismatch rules which, in essence, seek to reduce or eliminate tax deductions for payments made by an Australian company which directly or indirectly fund a hybrid mismatch outcome in any country that has not adopted OECD hybrid mismatch rules. These rules can operate to deny deductions in Australia for a broad range of payments including rents, royalties, interest and fees for services. Imputation benefits will be denied if a foreign income tax deduction is available in respect of a distribution. A transitional rule will be available for regulatory capital of an authorised deposit-taking institution that was issued before 9 May 2017.
Examples from the explanatory memorandum
Hybrid financial instrument mismatch
The Explanatory Memorandum (EM) to the draft law contains an example (1.5) of when a payment will give rise to a hybrid financial instrument mismatch. An Australian company issues redeemable preference shares (RPS) to a foreign company. In Australia the RPS is deductible but the foreign country has a participation exemption in relation to the dividends. A deduction or non-inclusion mismatch that is attributable to the terms of the debt interest. Therefore, s832-105 disallows the deduction that the Australian company would otherwise have claimed. Interestingly this problem only arises because Division 974 (itself an integrity measure) reclassifies a dividend or RPS as a deductible interest.
Hybrid payer mismatch
The EM to the draft law contains an example (1.7) of when a payment will give rise to a hybrid payer mismatch. An Australian company makes a deductible payment to its foreign parent for the provision of services. The foreign country treats the Australian company as a ‘disregarded company’ and deem the profits of the Australian company as being derived by the foreign parent. The Australian company is a ‘hybrid payer’ because the payment is a deduction in Australia and disregarded in the foreign country.
Reverse hybrid mismatch
The EM to the draft law contains an example (1.9) of when a payment will give rise to a reverse hybrid mismatch.
An Australian company makes a deductible payment to a group member RHP which is a partnership owned by Investor Co and which resides in a country that regards Investor Co as the liable entity in respect the payment. The overseas country however regards RHP as a separate liable entity and does not subject the payment to tax. RHP is a reverse hybrid and the deductible payment is disallowed for the Australian company.
Commencement date and problems in practical application?
Timing will be tight given the wide range of complexities involved. The amendments will apply to payments made on or after the day that is 6 months after the Bill receives Royal Assent. The 6-month delay in application from Royal Assent however a fair position to enable MNCs to understand their position and unwind it. BDO are of the belief that the OECD is not trying to raise tax in Australia but merely eliminate global asymmetries. However, as Parliament has concluded for 2018 the legislation cannot be introduced until it reconvenes on 5 February 2018 at the earliest so a likely start date will be in late 2018. There will be no grandfathering of existing arrangements.
Whilst consistent with the OECD’s principles, BDO also believe the hybrid mismatch rules contain the unusual concept that Australia’s taxing rights are now going to require the taxpayer and the revenue authorities to ponder the tax profile in other jurisdictions without consideration of which legislation has created the flaw. The hybrid mismatch rules have appropriately addressed idiosyncrasies of Australian tax law, such as the single entity rule, however if all OECD jurisdictions introduce legislation along the same lines then there will be the question of who gets to go first? You have a mismatch, but who gets the taxing right? Perhaps, we have to ponder whose laws created the mismatch in the first place and hence gets the opportunity via the hybrid mismatch rules to fix it, otherwise, Australia will opportunistically collect revenue that rightly belongs to other countries—presumably not what the OECD was intending. These and other issues will no doubt be raised in submissions due to Treasury by 22 December 2017.
All Australian taxpayers with cross-border transactions should consider the potential impact of the hybrid mismatch rules sooner rather than later. Identifying hybrid mismatches, particularly under the imported hybrid mismatch rule, is not simple and taxpayers affected by the branch mismatch rule may have even less time to prepare. In addition, restructuring will require careful consideration of legal, accounting, treasury and foreign tax issues. BDO can assist with:
- Reviewing application of the hybrid mismatch rules to structures and unwinding them
- Analysis of the implications of the proposed changes including stamp duties on refinancing, the impact on tax consolidation and taxation of financial arrangements and foreign currency rules (TOFA 2) and developing strategies
- Obtaining Foreign Investment Review Board approval for affected organisations.