Treasury has released for consultation exposure draft legislation to introduce new rules to neutralise the effects of hybrid mismatch arrangements, in accordance with Action Item 2 of the OECD/G20 Base Erosion and Profit Shifting Project. Multinational groups with cross-border arrangements (or proposing to enter into such arrangements) should consider the impact of these rules, which are likely to commence in the second half of 2018 with no grandfathering of existing arrangements. Consultant Larry Magid, Partner Martin Fry and Senior Associate Jay Prasad report.
How does it affect you?
- New rules will neutralise the effects of hybrid mismatch arrangements by either disallowing a deduction or including an amount in the assessable income of an Australian taxpayer that is a party to an arrangement producing a 'hybrid mismatch' (certain integrity measures could apply even if the taxpayer is not a party to the arrangement).
- Generally, the hybrid mismatch rules should not apply to ordinary cross-border arrangements between unrelated and independent parties that do not attempt to design their arrangements to produce a hybrid mismatch.
- Multinational groups are the primary focus of the new rules, and so multinational groups will need to consider whether the new rules might impact upon any existing or proposed cross-border arrangements between related parties, particularly financing type arrangements or transactions involving hybrid entities.
- However, in addition to the five categories of hybrid mismatch arrangements targeting multinational groups, Australian taxpayers will need to consider the new rules that eliminate imputation benefits or dividend exemptions (as applicable) in circumstances where the entity paying the equity distribution is entitled to a deduction in a foreign jurisdiction in respect of the distribution.
- Submissions on the exposure draft legislation are due on 22 December 2017.
On 24 November 2017, Treasury released exposure draft legislation containing two key measures.
First, introducing a new Division 832 into the Income Tax Assessment Act 1997 containing rules to neutralise the effects of hybrid mismatch arrangements. Hybrid mismatch arrangements subject to the rules are neutralised by either the denial of an allowable deduction in Australia, or the inclusion of an amount into the assessable income of the Australian taxpayer. Adjustments are allowed in circumstances where there is a subsequent reversal of a mismatch previously neutralised. These rules are discussed further below.
The second measure would modify Australia's existing domestic law to limit the exemption for non-portfolio distributions or the imputation benefits for Australian shareholders on franked distributions, in circumstances where a foreign tax deduction is claimed for the distribution that is the subject of the exemption or imputation benefit.
The new hybrid mismatch rules were foreshadowed by the Government some time ago. In October 2015, the OECD published a report titled 'Neutralising the Effects of Hybrid Mismatch Arrangements, Action 2–2015 Final' that contained recommendations for member countries on the design of domestic rules that would neutralise the tax effects of hybrid mismatch arrangements. In the 2015 Budget, the Government requested the Board of Taxation to consult on the implementation of the rules developed by the OECD. The Board recommended that Australia should adopt those rules with some minor modifications.
In the 2016 Budget, the Government announced that it would accept the recommendations made by the OECD having regard to the Board of Taxation's report. Finally, in the 2017 Budget, the Government announced that it would also introduce new rules eliminating mismatches relating to Additional Tier 1 regulatory capital.
A summary of the circumstances in which the hybrid mismatch rules could apply is set out below. The rules contained in the exposure draft legislation are very complex and require close analysis of the particulars of the arrangement being tested. Therefore, the summary below is intended to be an overview of those rules leaving out much of the laborious detail that would need to be considered when applying the rules in practice.
Generally, the rules described below do not apply unless they involve a 'related person' (25 per cent common ownership interest) or members of the same 'control group' (consolidated for accounting purposes or have 50 per cent common ownership interest) or where the taxpayer is a party to a 'structured arrangement' (where the parties expect the arrangement would produce a mismatch or price their arrangement based on that expectation).
The term 'deduction/non-inclusion' referred to below means, broadly, an arrangement under which there is a deductible payment in Australia (or a foreign jurisdiction) that is greater than the corresponding amount subject to tax in the other jurisdiction (or in Australia).
Arrangement: a payment made under a debt interest, equity interest or derivative financial arrangement (or a reciprocal purchase arrangement or securities lending arrangement over one of them) where there is a 'deduction/non-inclusion' mismatch because of differences in the treatment of the interest or arrangement between countries. Alternatively, if a substitution payment is made after the transfer of the debt interest, equity interest or derivative financial arrangement that gives rise to a 'deduction/non-inclusion' mismatch.
Example: a debt instrument under the laws of Australia is treated as an equity instrument under the laws of a foreign jurisdiction meaning that interest payments on the debt instrument are allowable deductions in Australia but returns on the equity instrument are subject to a participation exemption in the foreign jurisdiction (eg a redeemable preference share).
Neutralised as follows: if the payment is made by an Australian taxpayer, a deduction for the payment would be disallowed, or, if the payment is made to an Australian taxpayer, an amount would be included in the assessable income of the Australian taxpayer.
Hybrid payer mismatch
Arrangement: a payment made by a 'hybrid payer' that gives rise to a 'deduction/non-inclusion' mismatch. A hybrid payer is an entity whose income and profits are recognised for the tax laws of one country but not another country. A mismatch that would otherwise be considered to arise from such arrangements is reduced to the extent of amounts that are subject to tax both in Australia and in a foreign country. The CFC regime is switched-off for the purposes of determining whether an entity is a hybrid payer.
Example: An entity that is recognised under Australia's tax laws makes a deductible payment to its parent company in a foreign jurisdiction that disregards the payment and instead treats the profits of the Australian entity as being derived by the parent directly.
Neutralised as follows: if the payment that gives rise to the mismatch is recognised as an Australian deduction, the deduction for the payment would be disallowed, or, if the payment that gives rise to the mismatch is made to an Australian entity but is not recognised, an amount would be included in the assessable income of the Australian taxpayer.
Reverse hybrid mismatch
Arrangement: a payment made to an entity that is a 'reverse hybrid' that gives rise to a 'deduction/non-inclusion' mismatch. An entity is a reverse hybrid if it is transparent in the country in which it is formed but not in the country in which its investors are liable to tax. In contrast to testing whether an entity is a 'hybrid payer' (see above), the CFC regime is not switched off for these purposes.
The foreign hybrid rules contained in Division 830, which broadly apply to align the tax treatment of certain foreign hybrids for Australian tax purposes to their treatment under the foreign laws in which they are established, would limit the circumstances in which reverse hybrid mismatches might arise in an Australian outbound context.
Example: a payment is made to an Australian general partnership that is transparent for Australian tax purposes but a taxable entity for the purposes of a foreign jurisdiction in which the partners are located where the payment is not subject to tax. If the payment were made directly to the partners, the payment would be subject to tax in the foreign jurisdiction. The Australian general partnership is a reverse hybrid in this example.
Neutralised as follows: if the payment is made by an Australian taxpayer, a deduction for the payment would be disallowed.
Deducting hybrid mismatch
Arrangement: a payment that an entity makes, called a 'deducting hybrid', is deductible in two different countries provided the entity is not a resident of a foreign jurisdiction that has foreign hybrid mismatch rules. However, there is no mismatch if a deduction is set-off against income included under both Australian tax law and the tax laws of the foreign jurisdiction.
Example: a foreign company borrows money from an Australian bank through its Australian permanent establishment. The profits of the permanent establishment would be worked out having regard to a deduction for the interest incurred on the borrowing, and if the foreign jurisdiction taxes the company on its worldwide income the amount would also be deductible for the purposes of working out the company's tax position.
Neutralised as follows: if the payment is made by an Australian taxpayer, a deduction for the payment would be disallowed subject to any reduction to the amount disallowed on account of income returned in both Australia and the foreign jurisdiction.
Imported hybrid mismatch
This is an integrity provision designed to prevent taxpayers from artificially shifting a hybrid mismatch under one of the arrangements described above from Australia to a jurisdiction that does not contain anti-hybrid rules. Specifically, the rule applies if a payment, called an 'importing payment', is made directly, or indirectly through interposed entities, and the income from the payment is set-off against a deduction arising under a hybrid mismatch arrangement in another jurisdiction. In these circumstances, the rules neutralise the effect of the mismatch that is 'imported' into Australia by disallowing a deduction made by an Australian taxpayer.
As noted in the Board of Taxation's report, the imported hybrid mismatch rule will require taxpayers to consider the tax treatment of payments to other entities with whom they do not directly transact, and for that reason will impose a significant compliance burden for taxpayers.
Much of the complexity contained in the exposure draft relates to the preconditions, exceptions and definitions that need to be considered to determine whether an arrangement is of a kind that produces a hybrid mismatch. Once determined, the operative effect of the rules is relatively simple; to the extent there is a mismatch, either a deduction is disallowed or an amount is included in assessable income.
What these rules also require is an understanding of how a payment made or received by a counterparty under a qualifying arrangement would be treated for tax purposes in a foreign jurisdiction. This assumes that parties to an arrangement would be able and willing to readily share tax information, which is clearly not always the case.
However, one of key features for an arrangement to produce a hybrid mismatch is that there must be some element of common ownership between the parties, or alternatively, the parties must have structured their arrangement in a way so as to produce, or take advantage of, a mismatch. In either case, it may not be unreasonable to infer that parties would have some insight into the tax outcomes that their arrangements would produce.
More importantly, the rules would generally not apply to ordinary cross-border arrangements between unrelated and independent parties who do not seek to design their arrangements to produce a mismatch (ie are not parties to a 'structured arrangement'). In contrast, multinational groups should consider the impact of these rules on their existing (or any proposed) cross-border arrangements as common ownership obviates the need for the arrangement to be a structured arrangement.
The rules will commence six months after Royal Assent, which is likely to be sometime in the second half of 2018. There is no grandfathering of existing arrangements (other than for certain regulatory capital; see further below).
In addition to the five identified hybrid mismatch arrangements described above:
- The exposure draft contains rules under which imputation credits will be denied on franked distributions in circumstances where the Australian resident corporate entity paying the dividend is entitled to a deduction in a foreign jurisdiction in respect of the distribution. The provisions are not, by their terms, limited to regulatory capital of Australian banks, but they fulfil the announcement in the 2017-18 Budget to this effect. Special transitional rules apply in this context.
- The exposure draft contains rules under which foreign equity distributions are included in the assessable income in Australia (not treated as non-assessable non-exempt income) in circumstances where the foreign payer is entitled to a deduction in a foreign jurisdiction in respect of the distribution.
An important aspect of these further measures is that they do not require the existence of a control-type relationship between the payer and the recipient of the equity distribution (in relation to the foreign equity distribution the lower 10 per cent ownership interest is relevant).