ATO finalises Practical Compliance Guidelines on imported hybrid mismatches

17 December 2021

In brief

On 16 December 2021, the Australian Taxation Office (ATO) finalised Practical Compliance Guideline PCG 2021/5 (PCG) which sets out the the expectations regarding the Commissioner's assessment of risk in connection with the imported hybrid mismatch rules, including the Commissioner's approach to reviewing whether a taxpayer has undertaken reasonable enquiries in relation to the rules for non-structured arrangements. This PCG is relevant to any Australian taxpayer that makes any cross-border related party payments (including interest, royalties, management fees and purchases of raw materials and trading stock).  

There are welcome changes to the PCG based on consultation in relation to the draft issued in April 2021.  However, it is clear that the Commissioner’s expectations on the process and information required by a taxpayer to evidence compliance with the imported hybrid mismatch rule are extensive.  A number of changes to the seven “risk zones” have been made in the final PCG along with clarification of some aspects of the ATO’s expectations.

Reporting obligations for all multinational companies (MNC) with operations in Australia in relation to the hybrid mismatch rules are extensive and are expected to be expanded for the 2022 tax year.  

In detail

Australia’s hybrid mismatch rules took effect for tax periods commencing on or after 1 January 2019.  In our experience, many subsidiaries of foreign multinational corporations continue to find it challenging to interpret and apply this complex and novel legislation which can impact any cross-border related party payments (and in some cases, third party payments) that are otherwise deductible for Australian income tax purposes.  

A key element of difficulty is the imported hybrid mismatch rule which requires Australian taxpayers to make judgments about the operation of foreign tax laws as well as the presumption that the Australian taxpayer has perfect knowledge of the overseas group structure, relevant foreign tax law and the flow of payments through the global group structure. This “tracing” exercise arguably may involve payments that have no direct or commercial link to payments made by the Australian entity and can make it very difficult to apply in practice (the PCG reiterates that extensive tracing is required).  

This tracing rule typically goes further than other countries that have adopted the hybrid mismatch rules designed by the Organisation of Economic Cooperation and Development (OECD) as part of the Base Erosion and Profit Shifting (BEPS) project.

The PCG is designed to explain the ATO assessment of compliance risk associated with the imported hybrid mismatch rule including the level of documentation expected. The PCG does set a high bar in terms of the information and documentation expected to be obtained by all taxpayers in relation to the global operations of a MNC.    

Some of the key changes to the PCG as compared to its predecessor draft are as follows:

• In addition to a “top-down” approach or “bottom-up” approach, it is recognised that a combination of both the top-down and bottom-up approach is acceptable. 
• For taxpayers to be considered to follow the ATO's “recommended approach”, they are not required to follow the steps in the order specified in the PCG, provided the outcome of the enquiries provides sufficient evidence to demonstrate compliance with the imported hybrid mismatch rule.
• Where the ATO’s recommended approach is not followed, the Commissioner will assess whether reasonable care has been taken on a case-by-case basis based on the taxpayer’s circumstances. This may impact the level of penalty in the event of a tax shortfall.
• It is not sufficient for taxpayers to solely rely on the analysis performed for another jurisdiction with imported hybrid mismatch rules.   
• The ATO expects to engage with taxpayers based on their risk zone. For example, taxpayers in the amber (moderate risk) or red (high risk) zones are likely to be reviewed by the ATO.  
• The ATO will consider reducing shortfall penalties and shortfall interest charges for the first 18 months from 16 December 2021 where a taxpayer makes a voluntary disclosure in respect of their arrangements. 

Practical compliance guidelines are not prepared for the primary purpose of expressing the ATO’s view on the way a tax law provision applies. The PCG does not provide guidance in relation to any of the challenging interpretative issues associated with the imported hybrid mismatch rules. For example, an important and potentially contentious issue is what countries may be considered to have corresponding foreign hybrid mismatch rules. This may impact the existence of an offshore hybrid mismatch under the top-down approach as well as the tracing that may be required under the bottom-up approach. In the compendium to the PCG, the Commissioner acknowledges that the ATO is considering what guidance it may provide on the principles to follow in determining whether a country has corresponding hybrid mismatch rules. 

Taxpayers required to file a Reportable Tax Position (RTP) Schedule are required to self-assess and disclose their PCG “risk-zone” (see for example 2022 RTP Category C question 39) and it is expected that the 2022 International Dealings Schedule (IDS) will require more extensive information in relation to the imported hybrid mismatch rules, including details in relation to certain offshore hybrid mismatches. 

The takeaway

Under Australia’s self assessment system, taxpayers must be able to establish that they are entitled to claim deductions for cross-border payments in light of the imported hybrid mismatch rule. The PCG sets a high bar in relation to the Commissioner’s substantiation expectations. 

All taxpayers making cross-border related party payments will need to consider the PCG and decide what work may sensibly be required prior to lodging their Australian tax return.  

Although the ATO requirements set out in the PCG are not required by law, it will be important to consider the consequences of not meeting ATO expectations including the tax return disclosures that may be required, the experience in the event of an ATO review (including requests for information) and the impact on penalties in the event a tax shortfall is later identified.