Australian draft law provides clarity on hybrid mismatch rules
On 13 December 2019, exposure draft legislation (draft law) was released with amendments to clarify aspects of the hybrid mismatch rules and improve their operation, to provide greater certainty for taxpayers and assist them with compliance. The amendments are proposed to apply retrospectively to income years commencing on or after 1 January 2019, with the exception of the change to the integrity rule, which is proposed to apply to income years commencing on or after 2 April 2019.
Multiple Entry Consolidated (MEC) groups
The draft law contains amendments that ensure that the hybrid mismatch rules apply to members of MEC groups in the same way that they apply to members of consolidated groups. Therefore, for the purposes of working out whether a reverse hybrid mismatch arises, an entity is not a transparent entity in Australia if, so far as is relevant, the entity is a member of a consolidated group or a MEC group. Similarly, for the purposes of working out whether a deducting hybrid mismatch arises, an entity can be a deducting hybrid in relation to a payment if, among other things, the entity is a member of a consolidated group or a MEC group.
The explanatory memorandum (EM) refers to concerns in relation to foreign municipal taxes and State taxes currently being taken into account in determining whether a payment is subject to foreign income tax and giving rise to a deduction/non-inclusion mismatch or a deduction/deduction mismatch. This is because considering the taxation consequences for such payments at multiple levels of government in foreign jurisdictions creates an unreasonable compliance burden.
Therefore, the amendment clarifies that for the purposes of applying the hybrid mismatch rules, foreign income tax does not include foreign municipal or State taxes. Notably, this amendment will also potentially make it harder for taxpayers to pass the principal purpose test in the integrity rule. This test, if failed, denies deductions for related party interest and derivative payments where, among other requirements, the applicable foreign income tax interest rate on the payment does not exceed 10%.
Trusts and partnerships
The amendments attempt to clarify the operation of the hybrid mismatch rules for trusts and partnerships to account for the fact that despite the fact that trusts and partnerships are not “legal entities”, the Australian tax law still generally treats them as “entities.” The amendments propose to ensure that the activities of the trustees and partners (the legal entities) are deemed to be the activities of the trusts and partnerships. This includes whether they have made or received a payment; hold, acquire or dispose of an asset, interest or other property; and enter into or carry out a scheme or a part of a scheme.
The draft law also confirms that the deducting hybrid mismatch provision should apply to a trustee and not the trust itself where the trust is not treated as a flow-through entity for Australian tax purposes. This includes public trading trusts and superannuation funds.
Dual inclusion income
Dual inclusion income arises where the same amount is assessable in two countries, and applies to reduce the amount of deductions denied by the hybrid mismatch rules. Additionally the “on-payment” rule allows for payments made between entities that are grouped for tax purposes in their country of residence to be treated as if they were assessable, if it is reasonable to conclude that such payments are funded from an amount of income of the payer that is assessable for tax purposes in their country of residence. However, there have been concerns relating to the interaction between dual inclusion income and the “on payment” rule where, for example, a payment is made through multiple members of a dual inclusion income group.
Amendments in the draft law clarify therefore that an on-payment amount will be taken to be subject to Australian income tax or foreign income tax if it is reasonable to conclude that the funding income or profits have been subject to Australian income tax or foreign income tax in the country in which the dual inclusion income group exists. This amendment appears to be a concession to ensure that on-payment of dual inclusion income through corporate groups is appropriately recognised and captured by the dual inclusion income rules.
The integrity rule is a unilateral measure Australia incorporated into its hybrid mismatch rules as a notable departure from the Organisation for Economic Co-operation and Development’s recommendations. The Integrity rule seeks to prevent offshore MNEs from effectively replicating a hybrid mismatch outcome by routing financing into Australia through an interposed entity in a no or low-tax (that is, 10% or less) jurisdiction. However, it does not currently apply to (some, not all) arrangements that are already subject to one of the other hybrid mismatch rules where the effect of those rules is offset by either dual inclusion income, or because Australia is a secondary response country in relation to the hybrid mismatch.
It is therefore still currently possible to obtain an effective replication of a deduction/non-inclusion outcome by the interposition of a foreign entity located in a no or low-tax jurisdiction. Under such circumstances, even though the deduction has been sheltered by dual inclusion income, the arrangement provides the replication of a deduction/non-inclusion of income outcome. The integrity rule does not currently apply to neutralise the replicated deduction/non-inclusion outcome. To address these concerns, the integrity rule is being modified so that it can apply to a payment even if it gives rise to a deducting hybrid mismatch. However, the general hybrid mismatch rules will continue to take precedence over the integrity rule to the extent the deduction is already denied under the deducting hybrid mismatch rules.
“Tier 1 capital” is the primary funding source of a bank and consists of shareholders' equity and retained earnings. Currently, if all or part of a distribution made on an Additional Tier 1 (AT1) capital instrument gives rise to a foreign income tax deduction, franking benefits on the distribution are denied.
An amendment has been proposed so that if all or part of a distribution made on an AT1 capital instrument gives rise to a foreign income tax deduction, franking benefits will be allowed if an authorised deposit-taking institution or insurance company notifies the ATO that it or any other entity will not claim the foreign income tax deduction.
This concessionary amendment is proposed to only apply to financial institutions with AT1 capital requirements, but could potentially be extended to other taxpayers.
Australian MNEs and their subsidiaries (inbound and outbound) and hybrid entities should begin to closely review their structures and collate evidence to support related party financing deductions for income years commencing on or after 1 January 2019. Trust and partnership investment vehicles should note that they are no longer immune from the hybrid mismatch rules following the clarification that they are subject to the regime.
MNE groups with related party finance that have utilised financing from low-taxed entities and branches should expect reduced compliance following the amendment that excludes state taxes from the definition of “foreign income tax”, but note that arrangements with effective tax rates greater than 10% will still be within scope.
The amendment to the dual inclusion income will require Australian MNEs with potential hybrid mismatch neutralising amounts to assess all of their sources of funding before relying on the on-payment rule, especially inbound service companies that benefit from inter-entity charges and are hybrid entities.