28 February, 2020
This Bulletin outlines the key Australian income tax developments in the last few months affecting your business, including a focus on the proposed amendments to the hybrid mismatch rules in exposure draft legislation released by the Government on 13 December 2019.
Top 5 developments in tax this month you need to know
| Relevant area | At a glance |
| Taxpayer Alert TA 2020/1 Non-arm’s length arrangements and schemes connected with intangible assets |
The Taxpayer Alert outlines the Australian Taxation Office's (ATO) concerns with arrangements that:
In very broad terms, the arrangements involve significant Australian DEMPE activities but with the resultant intangible assets generated by these activities being owned offshore. The ATO considers that these arrangements do not appropriately remunerate Australian entities for functions performed, assets used and risks assumed in connection with intangible assets. Also, they may involve the migration of Australian intangible assets and associated rights to international related parties on non-arm’s length terms or in a manner intended to avoid tax in Australia. In addition, there are concerns that these arrangements may fail to properly comply with the provisions for capital gains tax (CGT), capital allowances, transfer pricing, general anti-avoidance and diverted profits tax.
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| Compliance approach to corporate tax residency |
The ATO has extended the transitional compliance approach period in Practical Compliance Guideline PCG 2018/9 for companies that are taking active and timely steps to change their governance arrangements until 30 June 2021 (for taxpayers with a 30 June year-end). By way of background, in November 2016, the decision of Bywater Investments Limited v Commissioner of Taxation [2016] HCA 45 was handed down by the High Court, which considered the central management and control (CMAC) residency test in the context of foreign incorporated entities. Under this test, a foreign incorporated entity is an Australian resident if it carries on business in Australia and has its CMAC in Australia. Following the decision, in March 2017, the ATO released a new draft ruling and practical guidance and withdrew Taxation Ruling TR 2004/15, which outlined the Commissioner's previous view on the CMAC residency test. In essence, the ATO now takes the view that it is sufficient for this test to be satisfied if a foreign incorporated company carries on business and its CMAC is in Australia, as in this situation, the entity will also carry on business in Australia. PCG 2018/9 provides practical compliance guidelines for applying the Commissioner's view on CMAC and provides for a transitional period during which the ATO will not seek to disturb a foreign incorporated company's status as a non-resident if certain conditions are satisfied. |
| Burton – foreign income tax offset |
The High Court has refused the taxpayer’s application for special leave to appeal from the decision of the Full Federal Court in Burton v Federal Commissioner of Taxation [2019] FCAFC 141. The Full Court had held that the taxpayer was not entitled to a full foreign income tax offset (FITO) for US tax paid on discounted capital gains on the sale of investments, as only half the capital gains had been included in his assessable income. As a result of this decision, taxpayers can only claim the FITO to the extent that the capital gain is assessable in Australia (rather than the full amount assessed in a foreign jurisdiction). |
| Global entities definition; merging super funds bill introduced to the House of Representatives |
The Treasury Laws Amendment (2020 Measures No 1) Bill 2020 was introduced into the House of Representatives on 12 February 2020. The bill expands the definition of significant global entity and makes permanent what are the current temporary concessions for merging superannuation funds. |
| CGT changes for foreign residents with indirect interests |
On 12 December 2019 the Government passed an amendment to strengthen the foreign resident CGT regime. As part of this, foreign resident taxpayers that have indirect interests in entities that hold interests in Australian real property assets in a disaggregated manner will now need to apply the principal asset test (PAT) on an associative inclusive basis. The reforms apply from 9 May 2017 and taxpayers are required to review any tax returns lodged from that date to determine if they have correctly complied with the PAT, and seek amendments if needed. If an amendment is required and a taxpayer actively seeks to amend assessments within a reasonable timeframe after the law change, no tax shortfall penalties will be applied and any interest accrued will be remitted to the base interest rate. |
What you need to know
- The Government has released draft legislation to implement its 2019-20 Budget announcement to make a number of technical amendments to the hybrid mismatch rules in Division 832 of the Income Tax Assessment Act 1997 (Cth).
- The exposure draft legislation, once enacted, is generally intended to apply for income years starting on or after 1 January 2019 (ie, the general hybrid mismatch rules start time), although some of the proposed amendments are proposed to apply from income years starting on or after 2 April 2019 (ie, budget date).
What you need to do
- The hybrid mismatch rules are broad in their potential application and very complex. If taxpayers consider that the proposed amendments could affect the application of the hybrid mismatch rules to their arrangements they would be well advised to consult with their tax advisors.
Spotlight on new exposure draft to amend the hybrid mismatch rules
On 13 December 2019, the Government released exposure draft legislation to amend the hybrid mismatch rules. The proposed amendments implement changes announced in the 2019 Federal Budget.
Outlined below is an overview of the proposed amendments in the exposure draft legislation.
MEC groups
The exposure draft clarifies that the hybrid mismatch rules will apply to Multiple Entry Consolidated (MEC) groups in the same way as consolidated groups. For example, for the purpose of working out whether a reverse hybrid mismatch arises, an entity will not be considered a transparent entity (ie, flow-through) in Australia if, so far as is relevant, the entity is a member of a consolidated group or a MEC group. This would be relevant where, for instance, the Australian entity would be the reverse hybrid entity in a reverse hybrid mismatch arrangement.
Under the current rules, for example, an eligible tier-one company (ET-1) of a MEC group that is not the provisional head company could technically be a reverse hybrid entity where (as might commonly be the case) the ET-1 is opaque in the parent's jurisdiction as, in this scenario, the ET-1 company is not a liable entity in Australia. The rules already contain provisions to deal with subsidiary members of consolidated groups in this scenario (and effectively not treat these as reverse hybrids) and these amendments will give the same treatment to subsidiary members of MEC groups.
Also, for the purpose 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 MEC group (currently, the rules omit the reference to MEC groups).
Essentially, this amendment rectifies a technical defect in the existing rules by now aligning the treatment of consolidated groups and MEC groups.
Foreign income tax
A critical concept in the hybrid mismatch rules is whether an amount is subject to foreign income tax. According to the explanatory memorandum to the exposure draft (the EM), concerns had been raised regarding the uncertainty about whether foreign income tax includes "foreign municipal taxes" and "State taxes". The amendments address this issue by clarifying that for the purposes of applying the hybrid mismatch rules, foreign income tax does not include "municipal tax" or "State taxes".
This change is expected to be particularly significant in applying the "targeted integrity rule" (which, broadly, can apply to disallow interest and like deductions for payments made to related entities in jurisdictions with a tax rate of less than 10%), as foreign State and municipal taxes will not be able to be taken into account in determining whether the 10% tax rate threshold is met.
Trusts and partnerships
According to the EM, some uncertainty has arisen in applying the hybrid mismatch rules to trusts and partnerships because of:
- the way that Australian income tax law applies to these entities; and
- the way in which these entities are treated under the income tax law of foreign jurisdictions.
The objective of the amendments is to clarify the operation of the hybrid mismatch rules for trusts and partnerships by recognising a trust or partnership (instead of a trustee or the partners) as the entity that does specified things, having regard to the fact that some foreign laws may recognise payments between non-legal entities as giving rise to tax consequences. The amendments seek to redress this uncertainty by:
- Having the trust or partnership be taken to: make or receive 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, rather than the trustee or partner. Also, the above things taken to be undertaken by the trust or partnership must also be taken into account in identifying the income or profits of the trust or partnership, as applicable.
- Clarifying that a reference in the hybrid mismatch rules to an amount being included as assessable income of an entity, or not allowable, as a deduction to an entity, is taken to be a reference to an amount that is taken into account in the net income calculation.
The amendments do not affect whether or not an entity or amount is subject to tax. So, for example, an item of income or profits derived by a trust or partnership will still only be subject to Australian tax if it is subject to Australian tax in the hands of the beneficiaries or partners.
Dual inclusion income
Dual inclusion income is (broadly) income that is taxed in two countries. This type of income may be applied to reduce the neutralising amount for a hybrid payer mismatch (which, broadly, deals with situations where a deduction is allowed in the paying country but income is not recognised in the recipient country due to tax grouping of the payer and recipient) or a deducting hybrid mismatch (which, broadly, deals with situations where deductions are allowed in multiple jurisdictions for the same payment).
The dual inclusion income rules recognise that these mismatches do not necessarily give rise to a tax benefit where both of the relevant countries treat the income against which the payment is deducted as assessable income. Where there is dual inclusion income, it can reduce the amount of the hybrid mismatch liable to be neutralised by the rules (the neutralising amount).
The amendments seek to redress concerns that have been raised about the operation of the dual inclusion income on-payment rule. Under this rule, very broadly, a payment between a member of a tax group (a "dual inclusion income group") to another member of the tax group, and which might ordinarily be disregarded for tax purposes, can be treated as dual inclusion income of the recipient where the payment was funded out of income which is assessable income of the payer.
Broadly, the concern with the existing rule is that it is uncertain whether the on-payment rule applies where, for example, a payment is made through multiple members of a dual inclusion income group. For example, it is uncertain whether the on-payment rule could apply to a payment made by a subsidiary member of a consolidated group to the head company which is traceable to a payment made by another subsidiary member to the first mentioned subsidiary member out of assessable income derived by the second mentioned subsidiary member.
As such, the amendments clarify that an on-payment will be taken to be subject to Australian income tax or foreign income tax (as the case may be) 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 (including as a result of a previous application of the rule) for the purposes of:
- applying the dual inclusion income on-payment rule; and
- neutralising amounts and adjustments for hybrid payer mismatches and deducting hybrid mismatches.
Improvement of the operation of the targeted integrity rule
Further to the above, the targeted integrity rules operate to deny an Australian deduction of an entity for the payment to a foreign entity of interest (or a payment of similar character), or an amount under a derivative financial arrangement, under a scheme, if among other things, the scheme results in foreign tax being imposed on the payment at a rate of 10 per cent or less.
In general, the targeted integrity rule does not apply if the payment gives rise to a hybrid mismatch under one of the other specific hybrid mismatch rules. This is the case even where no deduction is disallowed under the specific hybrid mismatch rule because of the operation of an exclusion.
For instance, consider a situation where an interest payment to a foreign interposed entity in a no tax jurisdiction gives rise to a deducting hybrid mismatch, but the entitlement to a deduction may not be fully neutralised because, for example, the deduction has been sheltered by dual inclusion income. In this circumstance, the amount of the deduction that is not neutralised would not be disallowed by the targeted integrity rule because another hybrid mismatch technically arose, albeit with no deduction disallowance.
The amendments propose to modify the targeted integrity rule so that it can apply to that part of the payment that is not otherwise neutralised by the deducting hybrid mismatch rule.
The proposed amendments also modify other rules which operate to allow deductions previously disallowed under the hybrid mismatch rules where, in effect, the hybrid mismatch is "unwound" in a later income year (eg, under the deducting hybrid mismatch rules where an amount of dual inclusion income is available to be applied by the deducting hybrid in that later income year or under the financial instrument hybrid mismatch rules where income is recognised in a later income year to the year in which the deduction would originally have been allowable). The modifications will have the effect that this later year deduction will not be allowed if a deduction would have been denied in the earlier income year under the integrity rule, on the assumption that the integrity rule applied to the payment in that earlier income year.
Franking benefits on distributions made on Additional Tier 1 capital instruments issued in Australia
Currently, the hybrid mismatch rules in combination with the franking rules deny franking benefits on a distribution if all or part of the distribution gives rise to a foreign income tax deduction.
The proposed amendments ensure that the franking benefits on distributions on Additional Tier 1 capital instruments from ADIs, general insurance companies or life insurance companies made in respect of non-share equity interests will be available if the taxpayer notifies the Commissioner that it will not claim a foreign income tax deduction for the distribution.
Comment
In general, the exposure draft legislation seeks to rectify technical defects in the hybrid mismatch rules, although there are some amendments of a more substantive nature which might well pull taxpayers into the scope of the rules. The exclusion of foreign State and municipal taxes as relevant foreign taxes could be particularly significant in this regard.
Given the complexity of the rules and the raft of new concepts, further amendments and technical guidance from the ATO can be expected in the coming years.
For further information, please contact:
Vivian Chang, Partner, Ashurst
vivian.chang@ashurst.com
