In response to recommendations by the Organisation for Economic Co-operation and Development (‘OECD’) in Action 2 of it's Base Erosion and Profit Shifting (‘BEPS’) initiative in 2015, Australia has now enacted a new hybrid mismatch regime that generally applies to income years commencing on or after 1 January 2019. The rules apply broadly to all Australian outbound and inbound groups – and is not confined to ‘significant global entities’ as with some recent measures.
These rules are very complex in their application and can adversely impact a range of Australian groups – principally by denying deductions – including in situations where circumstances exist that they are completely unaware of. This is particularly evident in the case of ‘imported mismatches’, which are discussed in further detail below.
Additionally, Australia has gone beyond the OECD BEPS recommendations by also introducing a specific financing integrity measure which, broadly stated, effectively requires lending into Australia to be taxed at a minimum rate in excess of 10%.
Nevertheless, despite this complexity, all multinational groups will need to undertake some work to ascertain whether or not the hybrid mismatch regime applies to them – not least because they are specifically required to disclose the outcome of this self-assessment in their International Dealings Schedule.
What is a hybrid mismatch?
A hybrid mismatch will typically arise where taxpayers exploit differences in the tax treatment of an entity or instrument under the laws of two or more tax jurisdictions to defer or reduce the overall cost of income tax.
This most commonly will be in the form of:
- a deduction in two jurisdictions for the same payment (a deduction/deduction (“DD”) mismatch); or
- a deduction in one jurisdiction for a payment, which is not assessed as income in the recipient jurisdiction (a deduction/non-inclusion (“DNI”) mismatch).
What is Australia’s hybrid mismatch regime designed to do?
Australia’s hybrid mismatch regime is designed to counteract hybrid mismatch arrangements for Australian taxpayers by either including additional amounts in the taxpayer’s assessable income or denying tax deductions.
When will Australia’s hybrid mismatch regime apply?
Australia’s hybrid mismatch regime will generally only apply to taxpayers who have entered into:
- Arrangements with entities that are related or arrangements with members of the same control group.
- entities are related if one owns 25% or more in the other entity or they share a common owner with a 25% or more interest (on an associate inclusive basis).
- entities are in the same control group if they are consolidated for accounting purposes, own 50% or more of the other entity or have a common owner with a 50% or more interest; or
- A structured arrangement – a structured arrangement is an arrangement where:
- the hybrid mismatch has been priced into the terms of the scheme; or
- it is a design feature of the scheme (regardless of whether the parties are related).
Notably, the ATO has set out an expansive view of when a ‘structured arrangements’ may exist which potentially impacted groups will need to be aware of.
Types of hybrid mismatch captured by the regime
If a taxpayer has entered into an arrangement that satisfies either of the above, then consideration must be given as to whether the arrangement is one of the following types of hybrid mismatch (in order of priority) as summarised below.
1. Hybrid financial instrument mismatch
A hybrid financial instrument mismatch exploits differences in the tax treatment of:
- a financial interest (e.g. a debt interest, an equity interest or a derivative financial arrangement); or
- an arrangement to transfer a financial instrument (e.g. a repurchase or a securities lending arrangement).
An example of when this type of mismatch may arise is when Australia allows a deduction for distributions paid on a redeemable preference share that is debt for Australian tax purposes, but the recipient jurisdiction treats the distribution as non-assessable under a dividend participation exemption.
A hybrid financial instrument mismatch is classified as a DNI mismatch which, depending on the circumstances, is neutralised by Australia’s hybrid mismatch regime by either denying a deduction to the Australian taxpayer or including an amount in the Australian taxpayer’s assessable income.
There is however an exception for hybrid financial instrument mismatches where the difference in treatment relates to deferral in the recognition of assessable income for a period of 3 years or less.
2. Hybrid payer mismatch
A hybrid payer mismatch arrangement exploits differences in the tax treatment of the payer.
An example of when this type of mismatch may occur is where payment is made by an Australian subsidiary to a U.S. parent where a “check the box” election has been lodged to treat the Australian subsidiary as a disregarded entity for U.S. tax purposes. In this instance, a deduction would arise to the Australian subsidiary, but an amount would not be included in the U.S. parent’s assessable income.
A hybrid payer mismatch is classified as a DNI mismatch which, depending on the circumstances, is neutralised by either denying a deduction to the Australian taxpayer or including an amount in the Australian taxpayer’s assessable income.
Certain “dual-inclusion income” rules mitigate this denial outcome to the extent this deduction is offset by amounts of assessable income. However, even these rules have elements of complexity to their application.
3. Reverse hybrid mismatch
A reverse hybrid mismatch will arise where a deductible payment is made from Australia and both the payment recipient’s jurisdiction and the jurisdiction of an investor in that recipient treat the payment as being allocated to the other jurisdiction, thus resulting in the payment received not being assessed in any jurisdiction.
An example of a reverse hybrid is a Dutch “CV/BV” arrangement, which have been commonplace in a number of US-parented multinational groups.
A reverse hybrid mismatch is classified as a DNI mismatch which is neutralised by Australia’s hybrid mismatch regime by denying a deduction to the Australian taxpayer.
4. Branch hybrid mismatch
A branch hybrid mismatch will arise where both the ‘residence’ jurisdiction and the ‘branch’ jurisdiction treat a payment as being allocated to the other jurisdiction, resulting in the payment not being assessed in any jurisdiction.
A reverse hybrid mismatch is classified as a DNI mismatch which, is neutralised by Australia’s hybrid mismatch regime by denying a deduction to the Australian taxpayer.
5. Deducting hybrid mismatch
A deducting hybrid mismatch will arise where two jurisdictions permit a deduction in relation to the same payment and the deduction is taken into account in calculating the taxpayer’s net income in both jurisdictions.
US general partnerships formed as the head entity of a US tax consolidation – which may also be part of an Australian tax consolidated group – are a relatively common example of a deducting hybrid, where they have borrowed funds to acquire US subgroups.
A deducting hybrid mismatch is classified as a DD mismatch which, is neutralised by Australia’s hybrid mismatch regime by denying a deduction to the Australian taxpayer.
6. Imported hybrid mismatch
An imported hybrid mismatch will arise when a hybrid mismatch is ‘imported’ into Australia through an importing payment.
An imported hybrid mismatch is an integrity measure that applies when one or more entities are interposed between a hybrid mismatch and a country that has hybrid mismatch rules. This mismatch is neutralised by denying a deduction to the Australian taxpayer.
These provisions give rise to significant practical complexity for Australian inbound groups of global multinationals. Effectively, they require Australian inbound groups.
7. FINANCING Integrity measure
Australia’s hybrid mismatch regime also contains an integrity measure that targets payments of interest (or a payment of a similar character) under a scheme that does not include a hybrid mismatch per se, but includes arrangements which have a similar effect, where:
- an equivalent 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 at a rate of 10% or less.
If this integrity measure is triggered, the Australian deduction will be disallowed unless the parent entity’s jurisdiction has an equal or lower tax rate and no hybrid mismatch would otherwise have arisen.
This integrity measure is designed to prevent multinational groups from entering into structures to circumvent Australia’s hybrid mismatch rules. Subject to these limited exemptions, this rule now effectively requires lending into Australia to be taxed at a minimum rate in excess of 10%. This will impact lending into Australia from tax havens that do not impose tax, as it will impact lending from jurisdictions such as Singapore which do not tax foreign income that is not remitted onshore.
The key points for taxpayers in relation to Australia’s hybrid mismatch regime include:
- The rules are more far-reaching than they appear, there are no grandfathering provisions for existing arrangements and there is no de minimis threshold for their application. In particular, they are not limited to ‘significant global entities’.
- The rules catch a broad range of payments including payments for services, interest, royalties and rents.
- The rules may apply to both payments between related parties and unrelated parties, in certain cases.
- Interest Withholding Tax will generally still apply where a debt deduction has been denied.
- It is important that all taxpayers with international dealings have a detailed understanding of their global structure and the application of foreign income tax laws as they apply to their group. In particular, such taxpayers will need to have undertaken an appropriate degree of self-assessment when completing their tax returns – and will specifically be asked in their International Dealings Schedule whether they are party to any hybrid mismatches. This will include imported hybrid mismatches – which they may well be entirely unaware of.
- It is possible that an Australian entity may pay tax because someone else (generally in a foreign jurisdiction) does not.
For more information
If you have any questions or require further information, please contact your local RSM adviser.