Australia’s hybrid mismatch rules and their departures from the OECD’S recommendations
On 5 October 2015, the Organisation for Economic Cooperation and Development (OECD) released its first report detailing its recommendations for tackling Action Item 2 of its Base Erosion and Profit Shifting (BEPS) Action Plan, on neutralising the effects of hybrid mismatch arrangements.
Australia, along with a number of other countries, has since adopted hybrid mismatch rules, with Australia’s hybrid mismatch rules taking effect for income years starting on or after 1 January 2019. However, Australia’s hybrid mismatch rules contain various departures from the OECD’s recommendations.
The other countries that have introduced the hybrid mismatch rules include the United Kingdom, New Zealand, Germany, Japan, Mexico, Netherlands, Norway and South Africa. More states plan to introduce hybrid mismatch rules from 1 January 2020.
Australia’s hybrid mismatch rules
Australia’s hybrid mismatch rules aim 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 the OECD’s recommendations. The hybrid mismatch rules broadly operate to deny deductions in Australia for a broad range of payments including rents, royalties, interest and fees for services, and deal with six categories: hybrid financial arrangements; hybrid payers; reverse hybrids; branch hybrids; deducting hybrids; and imported mismatches.
When Australia’s hybrid mismatch rules were drafted, there was a fear that they would be subverted by refinancing through a low or tax-free jurisdiction, e.g. where a parent company equity financed a company in a low-tax jurisdiction which subsequently debt financed an Australian entity. This would not give rise to a hybrid mismatch as such, therefore a financing integrity measure was developed to deal with this issue.
Targeted integrity rule
The most notable departure from the OECD’s recommendations in Australia’s hybrid mismatch rules is the targeted integrity rule. This rule is designed to prevent multinational groups from entering into structures to circumvent them, which effectively requires lending into Australia to be taxed somewhere in the world at a minimum rate in excess of 10%. The targeted integrity rule arguably represents a departure from the general deduction/non-inclusion rule, which does not require that the foreign tax be payable in a particular country.
The targeted integrity rule also targets payments of interest (or a payment of a similar character) under a scheme that do not include a hybrid mismatch per se, but include arrangements which have a similar effect, where:
- An equivalent deduction/non-inclusion (DNI) mismatch arises through the use of one or more interposed foreign entities in the same “control group” which invest into Australia; and
- The principal purpose of the arrangement is to enable an Australian income tax deduction and foreign income tax to be imposed on the receipt at a rate of 10% or less.
If the targeted integrity rule is triggered, the Australian deduction will be disallowed unless the parent entity’s jurisdiction has a tax rate equal to or lower than the tax rate in the recipient’s country, and no hybrid mismatch would otherwise have arisen. The targeted integrity rule also has the potential to impose additional Australian tax on interest and derivative payments to foreign interposed zero or low rate (FIZLR) entities, irrespective of whether the arrangement involves a hybrid element. It therefore impacts lending into Australia from tax havens that have a less than 10% tax rate or do not impose tax, i.e. the Cayman Islands, as well as lending from jurisdictions (e.g. Singapore) which do not tax foreign income that is not remitted onshore.
Principal purpose and foreign Controlled Foreign Company exemption
In order for the targeted integrity rule to apply, it must be reasonable to conclude that the entities who entered into or carried out the scheme or any part of the scheme did so for a principal purpose, or for more than one principal purpose that includes a purpose, of:
- Enabling an Australian income tax deduction to be obtained in relation to the payment; and
- Enabling foreign income tax to be imposed on the payment at a rate of 10% or less, or enabling foreign income tax not to be imposed on the payment
The targeted integrity rule will not apply if it is reasonable to conclude that:
- The payment is taken into account under the Australian controlled foreign company (CFC) rules or the law of a foreign country that has ‘substantially the same effect’ as the Australian CFC rules; or
- Assuming that the payment had been made directly to the ultimate parent entity, the payment would be:
- Subject to foreign income tax at a rate that is the same as, or less than, the foreign country rate or not be subject to foreign income tax; and
- The payment would not give rise to a hybrid mismatch.
Deducting hybrid mismatch rule
Australia’s specific deducting hybrid mismatch rule also departs from the OECD recommendations, specifically 6.2 and 6.4, which make it clear that the hybrid mismatch rules are aimed at double deduction situations arising from payments that result in deductions for two distinct entities, e.g. a deduction for the payer, and an investor in the payer or a related person. The Australian deducting hybrid rules however, are extended to include a single taxpayer claiming deductions in two countries for the same expense.
For example, an individual who is a tax resident of Australia undertakes a short-term employment in a foreign country or has an investment property in a foreign country. Such a situation would generally not be considered to constitute a hybrid mismatch and would not be caught by the OECD’s recommendations, but would have the potential of being caught by the Australian deducting hybrid mismatch rules, resulting in the denial of deductions for expenses incurred in producing foreign income. This will generally be a problem where the taxpayer is making a current year loss on the foreign income i.e. expenses exceed income in the current year. However, there is a mechanism that results in the non-deductibility being reversed if the investment is making a profit in both Australia and the foreign country (dual inclusion income). This, in effect, results in the Australian deducting hybrid rules being an anti-negative gearing provision for foreign income.
Proposed changes and ATO guidance
In its 2019-20 Federal Budget, the Australian Government announced further changes aimed at making technical amendments to the hybrid mismatch rules to clarify their operation, including: stipulating how they apply to multiple entry consolidated (MEC) groups and trusts, limiting the meaning of foreign tax, and specifying that the integrity rule can apply where other provisions have applied. If enacted, these amendments are expected to apply on or after 1 January 2019, with the exception of the amendments to the integrity rule, which will apply to income years commencing on or after 2 April 2019.
Draft law has yet to be released, but in the interim the Australian Taxation Office (ATO) has released guidance to assist taxpayers in assessing how the rules may apply:
- Draft taxation determination TD 2019/D12 which states that the USA's global intangible low taxed income rules do not correspond to Australia’s assessing provisions in the CFC regime;
- Draft Law Companion Ruling (LCR) 2019/D1 regarding particular aspects of Australia’s low tax lender rule;
- Finalised LCR 2019/3 on the phrases “structured arrangement” and “party to the structured arrangement”;
- Finalised Practical Compliance Guideline (PCG) 2019/6 with the ATO’s approach for taxpayers to assess their risk of the hybrid mismatch rules applying to their circumstances; and
- Finalised PCG 2018/7, which outlines straightforward low risk restructuring where they will not seek to apply tax avoidance provisions.
Taxpayers with international dealings should perform a high-level review of their structure and transactions to identify the possible application of the hybrid mismatch rules to a group that has some foreign assets, income or entities in their structure. Taxpayers that have previously not had to consider the targeted integrity rule in relation to financing arrangements because they triggered one of the specific hybrid mismatch rules, but without full denial of deductions, should also consider if it applies.