This article was written by Sylvester Urban and Dean Paganis.
On 25 August 2020, legislation to amend Australia's hybrid mismatch rules (Treasury Laws Amendment (2020 Measures No. 2) Bill 2020) (Amending Legislation) passed both Houses of Parliament and now awaits Royal Assent.
As discussed in our earlier alert, Australia maintains complex tax rules in Division 832 of the Income Tax Assessment Act 1997 (Cth) to counter hybrid mismatch arrangements. The rules counter the exploitation of the difference in the characterisation of a financial instrument or an entity under the laws of two or more countries.
The Amending Legislation contains a range of welcome clarifications. Notably, the changes seek to ensure that the uncertainties associated with the impact of foreign laws do not unduly interfere with Additional Tier 1 capital issuances. Also welcome is the narrowing of the deducting hybrid rule to exclude certain types of branch arrangements.
Other rules have been strengthened. For example, the tax shelter integrity rule will now have a residual application in certain circumstances.
Most of the amendments are to have retrospective effect.
Additional Tier 1 capital
The market for regulatory capital remains strong. There have been a number of Australian issuers who have accessed offshore markets in the last few months for regulatory capital issuances.
The Amending Legislation prevents imputation benefits being denied on a distribution on Additional Tier 1 capital where the distribution gives rise to a foreign income tax deduction. Instead, an amount is included in the issuer's assessable income.
This is particularly relevant where the issuance funds (to any extent) the operations of a foreign branch. This will be a relief for issuers of Additional Tier 1 capital who would otherwise have found it difficult to obtain a class ruling from the Australian Taxation Office to confirm imputation benefits will be available, although the possibility of additional assessable income is to be reckoned with.
Given the market in Additional Tier 1 capital is overwhelmingly franked and there is as yet no sign of the development of an unfranked market in such instruments, the change is welcome in removing this concern for issuers.
Deducting hybrid rule
The deducting hybrid rule has been narrowed. Most significantly, the Amending Legislation effectively excludes taxpayers with certain branch arrangements from having to consider the deducting hybrid rule in relation to payments made by the branch.
This change is particularly welcome because the primary response provisions of the deducting hybrid rule do not require the payment to have been made to a related person or under a structured arrangement (which are key limitations seen in the other rules).
The tax shelter integrity rule will have residual application. For example, later year deductions will now be disallowed if, broadly:
- a deduction would have been denied in an earlier income year under the integrity rule, but the deduction was actually denied under the hybrid financial instrument mismatch rule; and
- the application of the hybrid financial instrument mismatch rule was offset by later year foreign income tax.
Separately, under the current rules, the tax shelter integrity rule will be "switched off" if there is a deduction/deduction outcome to which the deducting hybrid rules would prima facie apply. The Amending Legislation requires that the deducting hybrid rule actually neutralises the mismatch before the integrity rule is switched off (recognising that the deducting hybrid rule does not apply to all deduction/deduction mismatches, for example where there is dual inclusion income).
Dual inclusion income
The Amending Legislation expands the concept of dual inclusion income (DII) (which can offset the deducting hybrid and hybrid payer rules) in the following ways.
A foreign income tax offset (FITO) will not reduce DII for most trusts and partnerships. This is a welcome change because it reduces the compliance costs for flow through entities, which may have otherwise had to make enquiries of their beneficiaries or partners to determine how a FITO was applied. However, the FITO will continue to reduce the DII of companies.
Clarifications are also made to the DII on-payment rule to ensure that:
- DII can be traced through multiple entities in a consolidated group; and
- certain entities (e.g. certain types of foreign partnerships) are not excluded from the DII rule.
Foreign hybrid mismatch rules play an important role in limiting Australia's response under Division 832. The Amending Legislation clarifies that:
- a foreign law will be a "foreign hybrid mismatch rule" where it corresponds to the specific type of Australian hybrid mismatch rule being examined (e.g. the hybrid financial instrument mismatch rule); and
- the foreign law need not correspond to Australia's hybrid mismatch rules as a whole.
This change resolves significant uncertainty, as the tax shelter integrity rule is an unusual feature of Australia's implementation of the OECD rules.
Separately, foreign municipal and state taxes will be excluded from the concept of "foreign income tax". However, these taxes will continue to be recognised in determining whether a payment has been subject to foreign tax at a rate of 10% or less.
Trusts, partnerships and MEC groups
The Amending Legislation clarifies that trusts and partnerships are relevant "entities" that need to be examined to determine if the hybrid mismatch rules apply. Partnerships and trusts will be expressly recognised as entities that can make and receive payments, hold, acquire or dispose of assets, enter into schemes and have assessable income/deductions in their own right.
A further amendment seeks to tidy up references to "consolidated groups" in Division 832 to include MEC groups.