20 February, 2018
This Bulletin outlines the key Australian income tax developments in the last month affecting your business, including the Federal Government's Exposure Draft legislation aimed at addressing hybrid mismatches.
Top 5 developments in tax this month you need to know
What you need to know
The Federal Government has released Exposure Draft legislation of the Treasury Laws Amendment (OECD Hybrid Mismatch Rules) Bill 2017 (Cth) (the Rules). The Rules are based on recommendations set out in the 2015 OECD BEPS Action 2 Report.
Broadly, hybrid mismatches arise as a result of differences in the characterisation of an entity or instrument under the laws of two or more tax jurisdictions to obtain a tax benefit – such as a deduction in two or more jurisdictions for the same payment or a deduction in one jurisdiction and no income recognition in another jurisdiction.
The Rules would apply to some hybrid mismatch arrangements to prevent these tax benefits arising.
Overview of the legislation
The Rules, if passed, will insert a new Division 832 into the Income Tax Assessment Act 1997 (Cth) (ITAA97).
Which transactions are covered?
The Rules provide that a hybrid mismatch will arise where a transaction occurs which results in a payment:
being treated as deductible in more than one jurisdiction (deduction/deduction mismatch); or
being treated as deductible in one jurisdiction and non-assessable in another jurisdiction (deduction/non-inclusion mismatch).
Many types of payments could be hybrid mismatches under the Rules, including royalties, rent, interest and service payments.
The Rules do not include a broad prohibition against all hybrid mismatch arrangements. Rather, the Rules will only apply to a mismatch if it falls within one of five categories. While the criteria relevant to each category are technical and detailed, each category can be summarised broadly as follows:
Hybrid financial instruments mismatch
This is the classic hybrid instrument which creates a deduction/non-inclusion mismatch attributable to the terms of a financial instrument (or an arrangement to transfer the same), causing the financial instrument to receive different tax characterisation as between jurisdictions. For example, payments under redeemable preference shares (treated as debt, and deductible, in Australia) might be treated as non-assessable distributions (under an equity interest) in a foreign jurisdiction. Financial instruments or arrangements with a term of three years or less are excluded.
In this situation, a deduction for the payment by an Australian payer would be disallowed, or, if the payment is made to an Australian taxpayer, an amount would be included in the assessable income of the taxpayer.
The Rules also deal with timing mismatches arising from hybrid arrangements. If, for example, the foreign jurisdiction did not have a participation exemption for dividends paid on redeemable preference shares, the dividends would be taxable in the foreign jurisdiction but may be taxable in a later year than the year of deduction (eg, the dividends are taxable on receipt while deductible on an accruals basis). Here, the Australian deduction would be deferred until the payment of dividends.
Hybrid payer mismatch
This includes the basic hybrid entity structure under which a deduction/non-inclusion mismatch is created through the use of a "hybrid payer". An entity is a hybrid payer when a payment it makes is disregarded by one jurisdiction and deductible in another. For example, an Australian company could make a payment to its parent company in a foreign jurisdiction. The foreign jurisdiction could disregard the Australian entity and disregard the payment whereas Australia may treat the payment as deductible. As such, the payment would not be assessed in the foreign jurisdiction and the Australian company would receive a deduction.
In this situation, a deduction for the payment by an Australian payer would be disallowed, or, if the payment is made to an Australian taxpayer but is not otherwise recognised, an amount would be included in the assessable income of the Australian taxpayer.
Reverse hybrid mismatch
This category includes a deduction/non-inclusion mismatches attributable to a "reverse hybrid". Broadly, an entity is a reverse hybrid if it is treated as transparent in the jurisdiction where it is formed (ie its investors are liable in respect of income/profits) but non-transparent in the jurisdiction where its investors sit (ie the foreign entity is liable, not the investors). An example would include a tax deductible payment made by an Australian company to a foreign general partnership (in country A) where the partners are located in a third foreign jurisdiction (country B) and the partnership is tax transparent in country A but is treated as a taxable entity in the partners' jurisdiction country B. The payment to the partnership is not taxable in country A (as it is treated as foreign source income from country A's perspective derived by non-residents of country A). It is also not taxable in country B as it is treated being derived by a separate taxable entity located in country A.
In this situation, as the payment is made by an Australian taxpayer, a deduction for the payment would be disallowed.
Deducting hybrid mismatch
This category includes a deduction/deduction mismatches attributable to a "deducting hybrid". An entity is a deducting hybrid if a payment it makes is deductible in two jurisdictions. Technically, this would include all foreign companies incurring deductible expenses in connection with a branch in Australia where the foreign jurisdiction taxes the company on its worldwide income (ie, it does not have an exemption regime for branch profits).
In this situation, if the payment is made by an Australian taxpayer, a deduction for the payment would prima facie be disallowed. However, the amount disallowed is reduced where the branch derives income which is assessable in both Australia and the foreign country.
Imported hybrid mismatch
This category includes mismatches which arise where a payment would have resulted in an Australian tax deduction for an entity in relation to an "offshore hybrid mismatch". Such mismatches can arise where the hybrid outcome is achieved using payments from Australia to a hybrid structure in a foreign country. For example, an Australian company may make a borrowing from foreign company A under a traditional loan where foreign company A has itself borrowed from foreign company B under a hybrid financial instrument of the type described in (1). In this scenario:
- interest on the loan paid by the Australian company to foreign company A would be deductible in Australia;
- foreign company A would be taxable on the interest received but would also receive a deduction for the payments to foreign company B, resulting in nil tax paid to jurisdiction A; and
- foreign company B treats the payments received from foreign company A as not taxable, resulting in nil tax paid to jurisdiction B.
As a result, there is a net deduction overall in Australia (and the hybrid is, in effect, hidden outside Australia). In this situation, if the foreign entity (foreign company A) is in a jurisdiction which does not have hybrid mismatch rules, and the payments received are set-off against a deduction arising under a hybrid mismatch arrangement in another jurisdiction (with foreign company B), the Rules would operate to deny the deduction for the Australian company.
Generally, other types of hybrid arrangements should not be affected.
Who do the Rules apply to?
The Rules will apply to payments between members of the same "Division 832 control group" or parties to a "structured arrangement". Additionally, in relation to hybrid financial instrument mismatches, the Rules will apply to payments between "related entities" (25% common ownership).
Entities will be members of the same Division 832 control group if they are part of the same tax consolidated group or have at least 50% common ownership. In relation to tax consolidated groups, the 'single entity' rule will be disregarded under the Rules, for the purposes of determining whether an entity makes a payment to another entity, or for determining the amount of income or profits of an entity.
An arrangement will be a structured arrangement if the hybrid mismatch is priced into its terms and if it is reasonable to conclude that the scheme has been designed to produce a hybrid mismatch.
In most circumstances, the Rules will apply where Australia is the 'primary response country'. Australia will be the primary response country where a hybrid mismatch can be neutralised by denying a deduction in Australia. Where another country has hybrid mismatch rules and is the primary response country, the rules of that country will apply. In circumstances involving a deducting hybrid mismatch, a separate test is applied in determining which country's rules apply.
The Rules will apply regardless of whether the scheme is entered into or carried out in or outside of Australia. Unlike the recently enacted DPT or MAAL, the Rules do not have a de minimus or materiality threshold.
Consequential amendments
The Rules also include an amendment which will deny imputation benefits on franked distributions in circumstances where the distribution is made by an Australian company which was entitled to a foreign income tax deduction in respect of all or part of the distribution.
The Government has also indicated that it will legislate a "targeted integrity rule". This will apply in circumstances where multi-national groups who invest into Australia seek to evade the Rules.
What happens next?
The consultation period ended on 22 December 2017. The Rules are expected to be introduced into Parliament in the 2018 Parliamentary sittings.
The Rules, if passed, will commence six months after the date of Royal Assent. This will likely be sometime in the latter half of 2018. The Rules do not provide for any grandfathering of existing arrangements.
Ashurst comments
The Rules contain an extraordinarily complex array of preconditions, exceptions and definitions that run to over 40 pages in the draft legislation. Given the compressed timetable to potential commencement, Australian taxpayers with cross-border transactions will need to move quickly to understand and consider the potential impact of the Rules.
As the application of the Rules depends on tax effects occurring under foreign law (and in the case of imported mismatches, potentially several tiers removed from Australia), one difficult aspect will be understanding the application of tax laws in other countries. This is important because there is no "avoidance" aspect to the Rules, meaning that arrangements which inadvertently produce a hybrid mismatch could be caught regardless of whether that result was an intended outcome.
Given the breadth of the Rules, taxpayers may not always be aware that they are involved in a structure that will be caught by the Rules. This could occur, for example, in a joint venture, where one of the co-venturers has used a hybrid mismatch arrangement several tiers removed from the joint venture vehicle (in an imported hybrid mismatch scenario). In such circumstances, it is unlikely that the co-venturer would be aware of the other party's tax arrangements but the Rules will nevertheless adversely impact the joint venture's Australian tax profile.
Another particularly problematic aspect is that the application of the Rules is assessed at the time of payment, and it is conceivable that tax treatments could change from the time of set up of an arrangement to the time a payment is made.
However, for the Rules to apply, there must either be an element of structuring to produce the hybrid mismatch or alternatively there must be some element of common ownership between the parties. As such, most Australian taxpayers dealing with unrelated independent third parties should not be materially impacted, and the main impact will be on Australian multinational groups with cross-border arrangements.
For further information, please contact:
Vivian Chang, Partner, Ashurst
vivian.chang@ashurst.com
