Introduction and overview
The Australian Treasurer, The Hon Scott Morrison MP, on Friday 24 November 2017, released exposure draft legislation to prevent entities that are liable to Australian income tax from avoiding income taxation or obtaining a double non-taxation benefit, by utilising differences between the tax treatment of entities and instruments across different countries i.e. hybrid mismatch rules.
The most prevalent types of hybrid mismatch arrangements are those that give rise to firstly, a deduction/non-inclusion mismatch (e.g. redeemable preference shares that are treated as debt in Australia and equity in a foreign jurisdiction) and secondly, a double deduction mismatch (where a deduction is available in two or more countries for the same payment). In these circumstances, under the rules the hybrid mismatch may be neutralised by firstly, disallowing a deduction or secondly, including an amount in assessable income.
The hybrid mismatch rules are based on the recommendations of the 2015 Organisation for Economic Co-operation and Development (OECD) Report, Neutralising the Effects of Hybrid Mismatch Arrangements, and also the recommendations of the Australian Board of Taxation, including its Consultation Paper of November 2015, Implementation of the OECD Anti-hybrid Rules.
The Australian Government had previously indicated that it would implement the recommendations of the 2015 OECD report and this exposure draft legislation will now be open for consultation and submissions up until Friday 22 December 2017.
The release of the Australian hybrid mismatch rules is part of a growing global trend which has been preceded by the United Kingdom enacting similar laws which commenced effect on 1 January 2017 and the European Union's commitment to similar rules by 1 January 2020. It is also expected that other countries, including New Zealand, will adopt similar rules in the foreseeable future.
Australian hybrid mismatch rules
The hybrid mismatch rules are principally contained in the proposed new Division 832 (Sections 832-1 to 832-1020) of the Income Tax Assessment Act 1997 (the 1997 Act) and will generally apply to payments made on or after the day that is six months following the legislation receiving royal assent.
Broadly, a hybrid mismatch will arise if firstly, an entity enters into a scheme that gives rise to a payment and secondly, the payment gives rise to either a deduction/non-inclusion mismatch (Section 832-920) or a deduction/deduction mismatch (Section 832-925).
The new rules will apply to payments between related entities (i.e. 25% or more common ownership or the same 'control group') or parties to a structured arrangement (i.e. where the pricing of the instrument is based on the hybrid mismatch).
Application of the hybrid mismatch rules
The new rules will principally apply to five types of arrangements, which are as follows:
- a hybrid financial instrument mismatch;
- a hybrid payer mismatch;
- reverse hybrid mismatch;
- a deducting hybrid mismatch; or
- an imported hybrid mismatch.
In neutralising a particular mismatch, generally a deduction will be disallowed or an amount included in the assessable income.
There is potentially an extremely wide range of arrangements that could fall within the hybrid mismatch rules. Provided below is a brief overview of likely affected arrangements.
Hybrid Financial Instrument Mismatch
A payment will give rise to a hybrid financial instrument mismatch (among other circumstances) where arrangements are treated as debt, equity or derivative contracts in different jurisdictions. For example, redeemable preference shares are treated as debt interests in Australia (and returns/dividends are deductible as they accrue) but can be treated as equity interests in other jurisdictions. Thus redeemable preference shares issued by an Australian company to a non-resident related party resident a country that has a participation exemption would result in a deduction/non-inclusion mismatch.
Hybrid Payer Mismatch
Example 1.7 of the Explanatory Memorandum notes that a hybrid payer mismatch may occur in the context of intra group payments for the provision of services. For example, where an Australian company (Aus Co) makes a deductible payment to its parent (Parent Co) for the provision of services, and Parent Co's country of residence treats Aus Co as a disregarded entity (and the profits of Aus Co are treated as being directly derived by Parent Co), Aus Co is a 'hybrid payer'.
Reverse Hybrid Mismatch
Conversely, a 'reverse hybrid' is an entity that is treated as transparent in its jurisdiction of establishment, but treated as a taxable entity by the investor jurisdiction (e.g. a partnership). A deductible payment made to a reverse hybrid can give rise to a mismatch in tax outcomes where that payment is not included in the ordinary income of the partnership in its jurisdiction of establishment or in the jurisdiction of any investor (e.g. a partner).
Deducting Hybrid Mismatch
A deducting hybrid mismatch can for example occur where an entity makes a payment through a cross border structure (e.g. a foreign branch of an Australian company) and a deduction can be claimed for that expenditure both in the foreign jurisdiction and in Australia. The amount of the deducting hybrid mismatch will be modified where there is also a dual inclusion of the income offsetting the deduction.
Imported Hybrid Mismatch
An imported hybrid mismatch occurs where the tax advantage from a hybrid mismatch is shifted to a jurisdiction that has not applied the anti-hybrid rules. For example, where interest payments on a loan are made from Aus Co to an entity (B Co) in another jurisdiction that does not have hybrid-mismatch rules (and does not itself give rise to a hybrid mismatch), which B Co sets off against a hybrid deduction for a payment made to a third entity (C Co).
Further initiatives dealing with imputation benefits and eligibility for non-assessable non-exempt income distributions
Further specific amendments to Australia's existing tax laws (i.e. the 1997 Act) are proposed based on the recommendations of the Australian Board of Taxation.
Firstly, the recipient of a franked distribution will be denied imputation benefits if the Australian corporate payer of the distribution was entitled to a foreign income tax deduction in respect of part or all of the distribution.
Secondly, the Australian corporate recipient of a distribution from a foreign company will not be able to treat the distribution as non-assessable non-exempt income if the foreign company is entitled to a foreign income tax deduction in respect of the distribution. Accordingly, the distribution from the foreign company in these circumstances will be included in the assessable income of the Australian corporate recipient.
Further targeted integrity rule
The Australian Treasurer has warned that the Government will develop a targeted integrity rule to ensure that further planning arrangements cannot be used to circumvent the OECD recommended hybrid mismatch rules. In particular, the proposed integrity rule appears to be targeted at multinational groups utilising financing arrangements through intermediaries based in zero tax countries, which effectively reduces Australian taxable income without the related income streams being subject to foreign tax.
Branch mismatch rules
Similar hybrid mismatch rules will be introduced for dealings within the same legal entity (i.e. branch mismatch rules) to make the treatment of, for example, head office to foreign branch arrangements consistent with the new hybrid mismatch rules. Exposure draft legislation is expected in the coming months to implement this initiative.
Application of the hybrid mismatch rules
The new hybrid mismatch rules are applicable to all relevant payments made from six months after this legislation receives royal assent. Accordingly, there is no grandfathering for existing arrangements and thus all multinationals should promptly ascertain the potential impact of the new rules on both existing and proposed arrangements.
Conclusion and takeaways
- Given the extremely wide range of potential arrangements (entities and instruments) that could fall within the new rules, multinationals should review their cross border transactions, particularly financing arrangements, service arrangements and hybrid entity structures, to evaluate any exposure under the proposed new hybrid mismatch rules.
- As there is no grandfathering of existing hybrid instruments or entities, it is critical that these reviews be undertaken at your earliest convenience.
- The Explanatory Memorandum accompanying the exposure draft legislation provides significant additional guidance, including examples on the practical application of the new rules, and thus serves as an important reference material.
- Notably the ordering rule contained in Section 832-50, which means that if the arrangement is caught by, for example, the hybrid financial instrument mismatch provision, then this arrangement does not need to be tested under the subsequent types of hybrid mismatches in Division 832.
- The introduction of these hybrid mismatch rules, along with the earlier enactment of the Multinational Anti-Avoidance Law and the Diverted Profits Tax, confirms Australia's leading and proactive role in combatting multinational tax avoidance practices.