In Brief: Businesses will need to analyse their tax affairs where there are beneficial tax treatments for payments and other financial arrangements
The Treasury has issued draft legislation implementing the OECD Hybrid Mismatch Rules. A hybrid entity is one that is treated as a taxable entity in one jurisdiction but as transparent in another. A hybrid instrument can be treated as debt in one jurisdiction and equity in another. Both can be structured to minimise tax.
Hybrid mismatches are an exceptionally complex area of tax law, and have been subject to OECD consideration as part of the OECD/G20 Inclusive Framework on BEPS (base erosion and profit shifting). The OECD issued a final report in 2015 on neutralising the effects of Hybrid Mismatch Arrangements.
The legislation may have a significant impact upon businesses arrangements where they have international structures or operations or use cross-border financial instruments
The rules are intended to prevent entities (including multinational corporations) liable to income tax in Australia from being able to structure income taxation, or obtain a double non-taxation benefit, but exploiting differences between the tax treatment of entities and instruments across countries.
Deduction/non-inclusion and deduction/deduction
The key concepts relating to mismatches are:
(a) a deduction/non-inclusion mismatch; and
(b) a deduction/deduction mismatch.
A deduction/non-inclusion mismatch occurs when:
(a) a deduction is allowable to an entity in an income year in respect of a payment; and
(b) the amount of the deduction exceeds the sum of the amounts of the payment that are:
(i) subject to foreign income tax; or
(ii) subject to Australian income tax.
(in other words, the deduction under Australian law is more than the relevant taxable income).
A deduction/deduction mismatch occurs where a payment:
(a) gives rise to a foreign income tax deduction; and
(b) also gives rise to a deduction in Australia (or, in more exotic structures, a deduction in a third Country).
The double deduction (or double non-inclusion) is the "holy grail" of aggressive tax structuring as the income will escape tax in both jurisdictions.
The broad aim of the legislation is to provide that where a hybrid mismatch occurs, an amount equal to the mismatch may not be deducted from Australian taxable income.
What are hybrid financial instrument mismatches?
A financial instrument is a hybrid where:
(a) a payment is made under a debt interest, equity interest or derivative financial arrangement; and
(b) a mismatch is attributable to differences in the treatment of the debt interest, equity interest or due to financial arrangement arising from the terms of the interest or arrangement.
(This rule does not apply if the difference primarily relates to a deferral in recognition of income or profits and the term is less than three years).
A deduction/deduction or deduction/non-inclusion mismatch is a hybrid financial instrument mismatch if:
(a) it is attributable to hybridity in the treatment of a financial instrument; or
(b) an arrangement to transfer a financial instrument; and
(c) the relevant parties are related; or
(d) the mismatch occurs under a structured arrangement.
A scheme is a structured scheme if the payment gives rise to a hybrid mismatch and:
(a) either the hybrid mismatch is priced into the terms of the scheme; or
(b) it is reasonable to conclude that the hybrid mismatch is a design feature of the scheme.
Integrity rules apply where payments could reasonably be regarded as having been converted into a form that is in substitution for a return upon the interest or arrangement.
What are hybrid payer mismatches?
A deduction/deduction or deduction/non-inclusion mismatch is a hybrid payer mismatch if it is made by a hybrid payer and the mismatch would not have arisen or would have been less, had the payment been made by an ungrouped entity.
Parties must be in the same control group or the mismatch must arise under a structured arrangement.
An entity is a hybrid payer if a payment it makes is disregarded for the purposes of the tax of one country (resulting in non-inclusion) but is deductible for the purposes of the tax law of another country.
Reverse hybrid mismatches
An entity is a reverse hybrid if the entity is transparent for the purposes of the tax law of the country in which it is formed, but non-transparent for the purposes of the tax law of the country in which investors in it are subject to tax.
Branch hybrid mismatches
This section applies where there are mismatches between the treatment of an entity and its branch between two countries.
A deduction/non-inclusion or deduction/deduction mismatch is a branch hybrid mismatch if:
(a) it is made directly or indirectly to a branch hybrid; and
(b) the mismatch would not have arisen or would have been less had the resident's country not recognised the permanent establishment.
Due to the way branches are treated in international tax law, a classic double non-inclusion scenario . This is because the entity in the country of origin may not be obliged to include the branch's income in its own taxable income, but the branch's country's laws do not count the branch's income as the branch's, but rather the parent's. .
Deducting hybrid mismatches
The draft legislation provides for a "tie breaking" system to decide which country has the primary response and how neutralising amounts are reduced.
Imported hybrid mismatches
The legislation neutralises imported hybrid mismatches, where one or more entities are interposed between a hybrid mismatch and a country that has hybrid mismatch rules.
This deals with the interposition of an entity in a third country (or similar) in an attempt to evade the originating country's hybrid mismatch rules.
Regulatory AT 1 capital
The legislation will also align Australia's treatment of financial instruments issued for Additional Tier 1 regulatory capital with that of other major OECD partners. Financial institutions such banks and insurers could issue them via a foreign branch where the Australian legislation treated convertible bonds as capital in Australia (therefore eligible for franking credits) even though large equivalent countries such as the UK treated them as debt (and hence interest would be tax deductible).
The franking will be removed for certain foreign entity distribution for issues where the instrument is tax deductible in the branch country.
Greater scrutiny will be applied to hybrid mismatches
Hybrid mismatch rules are among the most complex of international taxation issues. Hybrid mismatches are also fertile ground for minimising and structuring tax.
As noted above, it is highly likely that legislation will be passed, given Australia's involvement with the OECD multi-country working group in respect of BEPS.
This means that businesses will need to analyse their tax affairs in some detail, in particular where they have entered into transactions or financial instruments, or made arrangements with branches or entities in other countries, where there are beneficial tax treatments for payments and other financial arrangements.
Without a solid business case for the arrangement, other than tax treatment, the arrangement will immediately be suspect. Even where there is a business case, it is likely that hybrid mismatch rules will apply, meaning that an entity's tax affairs will become more complex and more costly and they may be liable to further tax.