Written by Jason Barnes, Sylvester Urban and Jack Anderson.
The Australian Taxation Office (“ATO”) has set out its final guidance as to the ATO’s assessment of the relative levels of tax compliance risk associated with the imported hybrid mismatch rule (“IHMR”) in Practical Compliance Guideline 2021/5 (“PCG”).
In summary, the PCG sets out:
- the ATO’s approach to the assessment of risk in connection with the IHMR, including the ATO’s approach to reviewing whether a taxpayer has undertaken reasonable enquiries in relation to the rules for non-structured arrangements; and
- the level of supporting information the ATO requires to demonstrate compliance with the IHMR.
Our previous alert in relation to the draft version of the PCG (“Draft PCG”) (including background to the IHMR) can be found here.
The PCG applies both prospectively and retrospectively. It is important that potentially affected businesses assess which of the risk zones they fall into and document their reasoning.
Key observations on the changes
The changes that have been made between the Draft PCG and the PCG are welcome, as at least on its face the PCG provides some concessions to taxpayers, tempers the heavily prescriptive requirements set out in the Draft PCG and clarifies some aspects of the Draft PCG. In particular, taxpayers now have greater flexibility in terms of the way in which they can demonstrate they have taken reasonable care to satisfy their income tax obligations relating to the IHMR.
Nonetheless, the ATO’s expectations of what information will be required by taxpayers and from whom remain, for multinational taxpayers, difficult to comply with and will require significant input from Australian and overseas tax managers.
For many multinational taxpayers, identifying imported mismatches is complex and time-consuming, and complying with the ATO’s recommended approach in the context of what is feasible from a business perspective is challenging. We have practical experience in this regard (including in analysing whether foreign countries have hybrid mismatch rules corresponding to Division 832), so please contact us if you would like to discuss.
Greater flexibility in the methods of demonstrating “reasonable care”
In the Draft PCG, the ATO outlined that a taxpayer would have demonstrated “reasonable care” to comply with its hybrid mismatch obligations for non-structured arrangements only if the taxpayer adopted either the top-down or bottom-up approach.
The top-down and bottom-up methods are largely unchanged from the Draft PCG. However, in response to submissions, the PCG:
- provides, in establishing that they have taken reasonable care, that taxpayers can now choose the approach that is most appropriate for their circumstances, which can include a combination of the top-down and bottom-up approach;
- provides that for taxpayers to be considered to have followed the ATO’s recommended approach, they are not required to follow the steps in the order set out in the top-down or bottom-up approach, as long as the outcome of their enquiries provides sufficient evidence to demonstrate compliance with the IHMR; and
- makes clearer that the detailed list of information set out in the Appendix to the PCG is not an exhaustive list of the information that the Commissioner considers may be relevant to demonstrating that the taxpayer has taken “reasonable care”, and should instead be treated as a general guide.
Despite these concessions, the overarching theme of the PCG is still that taxpayers must be able to satisfy themselves, on a reasonable basis, that they are entitled to a deduction before that deduction is claimed.
Updates to the risk assessment framework
In response to submissions that the risk assessment framework was complicated and created a high compliance burden, the ATO have made significant changes to simplify this framework, including:
- allowing taxpayers who fall within the white (no self-assessment of risk necessary), green (low risk) and blue (low-moderate risk) zones in an income year to be classified in those zones for the following two income years, subject to the taxpayer annually reviewing the circumstances of their Division 832 control group and being of the view that they have not materially changed;
- broader and more objective materiality thresholds including:
- taxpayers now fall within the green zone (previously the blue zone) where payments made to members of its Division 832 control group are less than $2 million;
- taxpayers now fall within the blue zone (previously the yellow zone) where they have evidence demonstrating that at least 90% of the total payments that were made to members of the taxpayer’s Division 832 control group under non-structured arrangements do not give rise to an imported hybrid mismatch (e.g. because a payment made by an interposed entity gives rise to a deduction in a foreign jurisdiction that has corresponding hybrid mismatch rules); and
- taxpayers now fall within the updated yellow (moderate risk) zone where it has applied a global policy (which is wholly consistent with the OECD Action Item 2 Report) for managing the risk associated with imported hybrid mismatches to determine the amount of deductions disallowed under the IHMR, and the turnover of the Australian economic group is less than $250 million;
- if a taxpayer can demonstrate that they are complying with their obligations under the IHMR but, in applying the IHMR, adopts a position contrary to ATO advice, they will be classified in the amber (high risk) zone; and
- the 3 red zones have been merged into 2 separate red (very high risk) zones.
Importantly, taxpayers will no longer fall within a very high risk zone if they have treated the relevant deducted payment as not being an importing payment under a structured arrangement because they take a position that the payment is treated as not made directly or indirectly through one or more interposed entities as a result of the operation of paragraph 832-625(3)(b). Paragraph 832-625(3)(b) provides that a payment will not be regarded as having been made indirectly through one or more interposed entities to an offshore deducting entity where a payment made by an interposed entity gives rise to a foreign income tax deduction in a country that has foreign hybrid mismatch rules.
Therefore, at least in respect of structured arrangements, this is a significant concession having regard to the broad scope of the IHMR, particularly where payments are made indirectly through one or more interposed entities to the offshore deducting entity.
However, importing payments made under a structured arrangement where the taxpayer does not have evidence to demonstrate that the offshore hybrid mismatch has not been neutralised are still classified as very high risk.
Due to the broader materiality thresholds introduced by the PCG, there is an increased possibility that a taxpayer finds that they satisfy the requirements for multiple risk zones. In that case, they must self-assess themselves as being within the highest risk zone that they satisfy.
Additionally, the ATO has provided an indication of the likely consequences for taxpayers of being in certain risk zone categories. In particular, where the taxpayer is within:
- the white zone, the ATO will not conduct a review other than to confirm ongoing consistency with the agreed/determined approach;
- the green zone, the ATO will not perform a review other than to confirm that the taxpayer has satisfied the necessary criteria to fall within the green zone;
- the blue zone, the ATO will undertake a limited review to confirm that the taxpayer’s arrangements are low to moderate risk;
- the yellow zone, the ATO may apply compliance resources to review the taxpayer’s compliance methodologies and outcomes;
- the amber zone, the ATO is likely to apply compliance resources to review the taxpayer’s compliance methodologies and outcomes and resolve any areas of difference;
- red zone 1, the ATO will, as a matter of priority, commence reviews of the taxpayer’s compliance methodologies and outcomes, with matters likely to proceed directly to audit; and
- red zone 2 for two or more years, the ATO will, as a matter of priority, likely commence reviews of the taxpayer’s compliance methodologies and outcomes
Finally, taxpayers may wish to undertake a self-assessment for prior years for their own compliance purposes. If such a review reveals a potential breach of the IHMR, taxpayers will be able to take advantage of a potential reduction in the shortfall penalties and shortfall interest charges offered by the ATO where they voluntarily disclose such a breach before June 2023.
Reliance on corresponding hybrid mismatch rules in other countries
The PCG confirms the position set out in the Draft PCG that there will only be an importing payment where each deductible payment made by an interposed entity gives rise to a deduction in a foreign jurisdiction that does not have corresponding hybrid mismatch rules.
Although the PCG does not provide express guidance on what countries are regarded as having “foreign hybrid mismatch rules” (the applicable term defined in Australia’s legislation), it is encouraging that the ATO has indicated in the Compendium to the PCG that it is considering what guidance could be provided on the principles that should be followed in identifying whether a country’s foreign hybrid mismatch rules sufficiently correspond to Australia’s. If guidance could be provided by the ATO which readily enables taxpayers to identify whether a country has foreign hybrid mismatch rules, it could significantly reduce the compliance burden for taxpayers as payments by interposed entities resident in particular jurisdictions will not need to be further traced when determining whether a deductible payment gives rise to an imported hybrid mismatch.
The ATO has reiterated its view that a payment will have been made indirectly to an offshore deducting entity if the taxpayer makes a deductible payment to a member of its Division 832 control group and payments have been made by each interposed entity to an offshore deducting entity or to another interposed entity. The ATO’s view expressed in the PCG is that it will be sufficient for the purposes of the IHMR that payments exist between each interposed entity, and it is not necessary to demonstrate that each payment in a series of payments funds the next payment, or is made after the previous payment.
Accordingly, the PCG confirms the broad scope of the IHMR and, in addition to our observations above, reinforces why further guidance on identifying whether a country’s foreign hybrid mismatch rules sufficiently correspond to Australia’s will be so important in applying the IHMR and in undertaking the ATO’s recommended approach.