This article was written by Jason Barnes, Sylvester Urban and Jack Anderson.
The Australian Taxation Office ("ATO") has released a highly anticipated draft practical compliance guideline (PCG 2021/D3) which provides much needed clarity on:
what reasonable enquiries are required to demonstrate compliance with the imported hybrid mismatch rule ("IHMR"); and
- the ATO's approach to risk assessment for the application of the IHMR to taxpayers' circumstances.
The ATO's approach is very rigorous and may be difficult for some multinational corporations to comply with where the Australian entities are not a dominant part of the group.
Once PCG 2021/D3 is finalised, it will apply to imported hybrid mismatches both before and after its issue.
What is the Imported Hybrid Mismatch Rule?
The IHMR is a specific sub-set of the hybrid mismatch rules in Division 832 of the Income Tax Assessment Act 1997 (Cth), which are collectively designed to counter the exploitation of differences between the tax treatment of entities and instruments across different jurisdictions. For further background on the hybrid mismatch rules and the recent amending legislation, please see our alerts here and here.
The IHMR will apply where there is a payment that is an "importing payment" in relation to an "offshore hybrid mismatch".
In broad terms, an "importing payment" is a payment that satisfies the following criteria:
- the payment, or part thereof, gives rise to a deduction or, in some circumstances, a foreign income tax deduction;
- the payment is made directly, or indirectly through one or more interposed entities, to another entity; and
- the other entity (the offshore deducting entity) is the entity that made the payment that gave rise to the offshore hybrid mismatch.
An "offshore hybrid mismatch" generally arises where foreign income is offset against a foreign income tax deduction arising under a hybrid mismatch arrangement involving offshore jurisdictions where foreign hybrid mismatch rules do not apply in relation to the mismatch.
Furthermore, for there to be an imported hybrid mismatch, the importing payment must be made either:
- under a structured arrangement – that is:
- where the hybrid mismatch has been priced into the terms of the scheme; or
- it is reasonable to conclude that the hybrid mismatch is a design feature of the scheme; or
- directly or indirectly through one or more interposed entities to the offshore deducting entity where the payer of the importing payment, the offshore deducting entity and each interposed entity are related for Division 832 purposes (i.e. they are part of a "Division 832 control group").
Obligations under structured arrangements
If a taxpayer makes an importing payment under a structured arrangement, the ATO considers that the taxpayer will have all relevant information necessary (or will be able to obtain that relevant information from the other parties to that structured arrangement) to apply the IHMR, and to correctly disallow deductions.
Where members of the taxpayer's Division 832 control group are also party to the structured arrangement and the taxpayer does not already possess all the relevant information to apply the IHMR, the relevant members of the taxpayer's Division 832 control group are expected to provide the taxpayer with any information necessary to calculate the amounts of the importing payments and importing deductions.
Accordingly, where there is a structured arrangement, there is little scope to argue that the Australian taxpayer did not have the necessary information to determine the amount of the deductions that should be neutralised.
Obligations under non-structured arrangements
Different requirements arise where a taxpayer seeks a deduction for a cross-border payment made to a member of its Division 832 control group where a hybrid mismatch arises under a non-structured arrangement. In this case, the taxpayer must:
- determine whether the cross-border payment results in an offshore hybrid mismatch being directly or indirectly imported into Australia; and
- document their enquiries and obtain relevant information prior to lodgement of the income tax return.
The ATO also expects that the members of the taxpayer's Division 832 control group will provide the taxpayer with full and complete disclosure of all relevant information. If the taxpayer is not able to obtain sufficient information to support a conclusion that the deduction in respect of the payment is not disallowed under the IHMR, then no deduction should be claimed.
The ATO's compliance approach (including for the purposes of applying administrative penalties in the event of non-compliance) will be based on reviewing the extent to which taxpayers have obtained information to establish that the IHMR does not apply, or that they have correctly "neutralised" any imported hybrid mismatch in respect of non-structured arrangements. The ATO will consider that a taxpayer has taken "reasonable care" to comply with their income tax obligations relating to the IHMR for non-structured arrangements where the taxpayer follows one of the ATO's two recommended approaches to making enquiries set out in PCG 2021/D3, being:
- the top-down approach – this approach involves the taxpayer reviewing the Division 832 control group to identify whether the group has any mismatch outcomes and determining whether any identified mismatch outcomes are offshore hybrid mismatches subject to Subdivision 832–H, and are being imported into Australia. If the taxpayer adopts this approach, they will need to:
- obtain the core information necessary to identify and advise of mismatch outcomes from the group's Head of Tax;
- filter information by the local tax manager, including determining whether any of the identified mismatches are covered by a relevant foreign hybrid mismatch rule or whether the payment is not a hybrid mismatch under Australian law;
- quantify the amount of the offshore hybrid mismatch; and
- identify any interposing payments and quantify the imported hybrid mismatch, by obtaining further information on deductible transactions between any members of the Division 832 control group that are necessary to determine whether the taxpayer has made an indirect importing payment, and identifying if any of the interposed entities are resident in a jurisdiction that has corresponding hybrid mismatch rules.
- the bottom-up approach – this approach involves the taxpayer reviewing the cross-border payments made by the taxpayer to members of the Division 832 control group to determine if these payments are directly or indirectly importing any offshore hybrid mismatches. If the taxpayer adopts this approach, they will need to undertake the following steps:
- identify all potential importing payments made to non-resident members of the taxpayer's Division 832 control group (direct tested entities);
- request the person(s) responsible for the taxation affairs for the applicable jurisdiction or entity to provide information necessary to identify mismatch outcomes for the direct tested entities (including whether an amount of a hybrid mismatch is fully offset by dual inclusion income in a relevant foreign country);
- identify potential interposed payments made by direct tested entities (that do not reside in a jurisdiction that has foreign hybrid mismatch rules) to other non-resident members of the Division 832 control group (indirect tested entities) that result in a foreign income tax deduction but do not result in a deduction/non-inclusion mismatch; and
- identify and follow payments by repeating the above steps for each indirect tested entity.
Under either approach, the taxpayer must make and document formal requests for information to the responsible individuals or suitably qualified representatives responsible for and within the relevant Division 832 control group, such as the group's Head of Tax and/or the persons responsible for taxation in jurisdictions where the related party transactions have occurred.
However, "reasonable care" will not be considered to have been taken in respect of non-structured arrangements where:
- there is information known, or that should have been known, by the taxpayer or their agent, and the failure to consider that information results in a tax shortfall; or
- a member of a taxpayer's Division 832 control group has deliberately withheld information from the taxpayer or deliberately provided the taxpayer with false or misleading information.
Where either of these scenarios apply, the ATO will determine whether a penalty applies on a case by case basis.
The draft PCG also states that a taxpayer cannot uncritically rely on the existence of hybrid mismatch analysis done in a foreign country. Rather, it must obtain a copy of that analysis and satisfy itself that the analysis can be relied upon in determining whether the IHMR applies.
The draft PCG also sets out a detailed list of the information the Commissioner considers should be obtained to demonstrate that the taxpayer has taken "reasonable care" in adopting the top-down or bottom-up approach and which may be requested by the ATO when assessing risk during engagement or assurance activity.
Risk assessment framework
The ATO has also outlined a risk assessment framework in relation to the IHMR. Where a taxpayer falls outside a low risk zone (that is, yellow zone or higher) in relation to its related party arrangements, the ATO is more likely to conduct some engagement and assurance activity to further test the taxation outcomes of the taxpayer's arrangements to ensure no inappropriate tax outcomes are achieved.
The risk assessment framework is made up of the following eight risk zones. There are also certain interactions and hierarchies between the risk zones.
- White zone – no self-assessment is required as the ATO is already satisfied that imported hybrid mismatch issues are low risk for the taxpayer (e.g. because the taxpayer is subject to a pre-lodgement compliance review and the application of the IHMR has been reviewed and assessed with a "low risk" rating).
- Green zone – the taxpayer has undertaken enquiries under the ATO's recommended approach and no offshore hybrid mismatches were identified or have already been neutralised, or the taxpayer did not claim any deductions in relation to payments made to offshore members of the group because they have insufficient information to determine the application of the IHMR.
- Blue zone – the total otherwise deductible payments that the taxpayer made to any members of their group under non-structured arrangements are less than $2 million.
- Yellow zone – the taxpayer has undertaken enquiries using the ATO's recommended approach and has evidence to demonstrate that:
- at least 90% of the total payments to group members under non-structured arrangements that are otherwise deductible do not give rise to an imported hybrid mismatch; and
- for the remaining 10% or less of payments, the maximum possible importing deduction that could be disallowed is less than 2% of the taxpayer's assessable income.
- Amber zone – the taxpayer has undertaken enquiries using the ATO's recommended approach and based on the information received the taxpayer has not disallowed deductions under the IHMR in respect of one or more offshore hybrid mismatches because the taxpayer does not consider that an importing payment has been made directly or indirectly to the offshore deducting entity.
- Red zone 1 – the taxpayer has made a payment that is an importing payment under a structured arrangement and the taxpayer does not have evidence to demonstrate that the offshore hybrid mismatch under all the structured arrangements to which the taxpayer is a party have been neutralised.
- Red zone 2 – the taxpayer has treated the deducted payment as not being an importing payment under a structured arrangement only because the taxpayer takes a position that the payment is treated as not made directly or indirectly through one or more interposed entities.
- Red zone 3 – where the taxpayer has made a deductible payment to a member of the taxpayer's Division 832 control group and the taxpayer does not fit into any other risk zone (including where the taxpayer has received insufficient information to determine if the IHMR applies).
Importantly, the ATO states that it is concerned about views being adopted that a payment is not made indirectly through one or more interposed entities despite payments existing between the entities involved in the relevant sense. Some of the risk zones above reflect this concern.
The ATO may require taxpayers who are required to complete a Reportable Tax Position Schedule to provide adequate evidence to support their self-assessment. If this information is not provided, and the ATO disagrees with the taxpayer's self-assessment, the ATO may undertake further engagement and assurance activity.
What should businesses do now?
- accelerate their reviews of the application of the IHMR to their arrangements to meet the ATO's expectations; and
- review past work to ensure that they have satisfied the rigorous requirements set out by the ATO.
The draft PCG is to apply both prospectively and retrospectively. It is important that potentially affected businesses immediately start assessing which of the risk zones they fall into and document their reasoning.
The ATO has invited comments on the draft PCG until 21 May 2021.