This article was written by David Wood, Darren McClafferty, Sylvester Urban and Timothy Garvey.
The Federal Government has released revised exposure draft legislation relating to “hybrid mismatch arrangements”.
Broadly, a hybrid mismatch arrangement exploits the difference in tax treatment between countries of an instrument or entity. This can give rise to:
- a deduction in both countries; or
- a deduction in one country with no corresponding amount assessed in the other country.
Under the proposed rules, hybrid mismatches are neutralised either by disallowing an Australian tax deduction or including an amount in the entity’s Australian assessable income. Branch mismatch arrangements, and routing of arrangements through low tax jurisdictions, are also addressed. Broadly, arrangements with a term of 3 years or less where the mismatch is merely one of timing, are not intended to be covered.
The rules are generally self-executing and do not depend on the Commissioner of Taxation making a determination.
Entities issuing or otherwise dealing in cross-border hybrid instruments should review the proposed rules, and consider whether the profitability of the instruments will be impacted. Multinationals should also give thought to any foreign branch mismatch issues which may arise.
Investors and investment managers may also need to review their global investment strategies in light of the proposed changes.
Background to the reform
The Exposure Draft of the Treasury Laws Amendment (OECD Hybrid Mismatch Rules) Bill 2018 proposes to insert a new Division 832 into the Income Tax Assessment Act 1997 (Cth) (1997 Act) and make other amendments to the Australian tax laws. The Exposure Draft was initially released in November 2017, and has now been redrafted with previously announced amendments relating to, amongst other things:
- the inclusion of branch mismatch rules following the recent OECD report on Neutralising the Effects of Branch Mismatch Arrangements; and
- a targeted integrity rule to prevent inbound investing entities from using interposed conduit type vehicles to circumvent the rules.
The draft legislation is a response to the OECD Action 2 Report (2015), which is part of the broader OECD/G20 Base Erosion and Profit Shifting (BEPS) Project. Various other jurisdictions have taken similar steps following the OECD report, including the United Kingdom, New Zealand and Member States of the European Union. The Australian rules have also been influenced by commentary from the Board of Taxation.
Hybrid mismatch arrangements reduce the global tax base, even though (as the Explanatory Material acknowledges) it may be hard to work out which country has actually suffered the loss. By necessity, the hybrid mismatch rules are complex as they must take into account the existing Australian rules relating to taxation of cross-border financial arrangements (e.g. taxation of financial arrangements (TOFA), foreign currency rules and controlled foreign corporation (CFC) rules), and also address the impact of foreign tax laws.
The development of mismatch rules in other countries gives rise to the risk of double taxation. The Australian rules aim to address this possibility, although the effectiveness of these rules will be best determined through practical application.
Branch mismatch arrangements
Branch mismatches are a specific type of mismatch which occur as a result of the allocation of income and expenditure (under normal allocation rules) between head offices and branches (or between two branches). Such a situation may lead to part of a taxpayer’s net income escaping the tax net, through it not being subject to tax in either jurisdiction. The proposed laws would:
- limit the existing exemption for foreign branch income in section 23AH of the Income Tax Assessment Act 1936 (Cth) (1936 Act); and
- limit the availability of deductions for payments made by an Australian branch of a foreign bank to its head office pursuant to Part IIIB of the 1936 Act.
Cross-border equity distributions
In the 2017-18 Federal Budget, the Government announced that it would introduce measures:
- to prevent distributions on Additional Tier 1 (AT1) regulatory capital from carrying franking credits where the distributions are deductible in a foreign jurisdiction; and
- where the AT1 capital is not wholly used in the offshore operations of the issuer, requiring the franking account of the issuer to be debited as if the distributions were to be franked.
The Exposure Draft legislation includes provisions to:
- deny imputation benefits on Australian corporate distributions if the distribution gives rise to a foreign income tax deduction for the issuer. These provisions have the potential to significantly affect popular deductible/frankable structures including, but not limited to, AT1 instruments issued through an offshore branch; and
- prevent non-portfolio foreign equity distributions from being non-assessable non-exempt income of an Australian corporate recipient under Subdivision 768-A of the 1997 Act, if all or part of the distribution gives rise to a foreign income tax deduction for the issuer.
Importantly, the provisions in the Exposure Draft are not limited to regulatory capital.
An integrity rule seeks to prevent inbound investing entities from using interposed vehicles in no or low tax countries to circumvent the rules.
When will the rules apply?
It is proposed that the rules would generally apply to payments and distributions made on or after the date that is six months after Royal Assent.
Special rules apply in relation to the denial of imputation benefits in respect of AT1 capital instruments issued by certain entities (ADIs or certain insurance companies) before 9 May 2017. The amendments do not apply to distributions made before the first scheduled call date of the instrument that occurs on or after 9 May 2017.
Consultation on the draft legislation is open until 4 April 2018.