Hybrid mismatch rules: proposed changes before Parliament

19 May 2020

In brief

On 13 May 2020, proposed amendments to the Australian hybrid mismatch rules were introduced into Parliament. The measures include a range of refinements reflecting consultation in relation to Exposure Draft law released on 13 December 2019. 

The majority of the proposed amendments are retrospective and likely to be viewed as beneficial to taxpayers as they clarify interpretative uncertainties and should reduce the compliance burden for a range of taxpayers. However, some of the proposed measures may cause difficulties for taxpayers.   

In detail

The Australian hybrid mismatch rules were released in draft form in late 2017, enacted in August 2018, and took effect for tax periods commencing on or after 1 January 2019. Australian income tax returns impacted for the first time by the hybrid mismatch rules are those due to be lodged in the next few months for the income year ended 31 December 2019.

It continues to be our experience that many taxpayers are finding it challenging to interpret and apply this complex and novel legislation. A key element of difficulty is the requirement under the hybrid mismatch rules to make judgements 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 law and the flow of payments through the group structure which arise from deductions in Australia. Another common difficulty is the broad scope of the imported mismatch rules which can impact any related-party cross border payments that are deductible for Australian income tax purposes. For example, this rule can affect deductions for the cost of goods sold as well as interest, royalties and management fees.

The Treasury Laws Amendment (2020 Measures No. 2) Bill 2020, which was introduced into Parliament on 13 May 2020, includes a range of amendments to the hybrid mismatch rules. Although we expect that the Bill is likely to be passed into law without any further changes, it is unclear as to when it will be passed by Parliament and accordingly, affected taxpayers should monitor progress of the proposed amendments.

The proposed amendments are broad-reaching and highly technical. However, we have summarised below the key elements of the proposed amendments.

Trusts and partnerships 

The proposed amendments clarify the operation of aspects of the hybrid mismatch rules for trusts and partnerships that have been creating many practical difficulties. These clarifications include:

• “Flow-through” trusts will not be viewed as a “liable entity” (i.e. a taxpayer) for Australian tax purposes. This should limit and simplify the application of the deducting hybrid (i.e. double deduction) rule for many trusts with cross-border investments or foreign investors. The deducting hybrid rule will continue to apply where the trust is viewed as a liable entity in the foreign country (e.g. New Zealand or in some cases the United States (US)). 

• Foreign sourced income earned through a trust or partnership will be considered “subject to Australian tax” for the purposes of calculating dual inclusion income (DII) even if that amount is not included in the Australian taxable income of a partner or beneficiary. This is a welcome change for Australian funds that have a mix of Australian and foreign investors and invest in offshore assets.  

These changes are proposed to apply to income years commencing on or after 1 January 2019.

New hybrid requirement for Deduction/Deduction mismatches 

The proposed amendments narrow the operation of the deducting hybrid mismatch rule applicable to deduction/deduction mismatches, which occur when an entity receives a deduction in two countries for the same payment.  The new definition excludes entities that are a “liable entity” in both deducting countries (provided they are not a dual resident taxpayer or a member of an Australian income tax consolidated group). In practice, the key impact of this change include:

• Some entities operating through a foreign branch may no longer be considered a deducting hybrid.  However, where the entity with the branch is part of an Australian or foreign tax group the outcome may not change.  

• Individuals and certain trusts (including superannuation funds) should no longer be considered deducting hybrids where they are regarded as the taxpayer in both deducting countries. 

These changes are proposed to apply to income years commencing on or after 1 January 2019. 

Changes to when Australia’s “secondary response” is required 

In broad terms, the secondary response rules are intended to allocate taxation rights in circumstances where the hybrid mismatch rules of two or more countries may operate to neutralise the same hybrid mismatch outcome. Broadly, this is based on whether a foreign country has “foreign hybrid mismatch rules”, or another law that has “substantially the same effect” as foreigh hybrid mismatch rules. There has been some uncertainty in relation to the operation of these rules that can affect direct and imported mismatches and whether an Australian response (i.e. denial of deduction or income inclusion) is required.  Under the proposed amendments:

• It is made clear that the foreign law only needs to correspond to a particular type of hybrid mismatch (not all of the Australian rules).

• For the secondary response to not be required in relation to Australian and offshore hybrid mismatches, it is not sufficient that the foreign country has foreign hybrid mismatch rules or a law that has substantially the same effect as foreign hybrid mismatch rules.  It will be necessary that the particular mismatch is “covered by” the relevant foreign laws.  According to the Explanatory Memorandum, for example, a mismatch relating to service fees would not be “covered” by a foreign hybrid mismatch rule that applies only to interest and royalties.  Importantly, the Explanatory Memorandum also makes it clear that it is not necessary to determine whether the foreign jurisdiction has actually applied the foreign hybrid mismatch rules to neutralise the mismatch.  

• In the context of “indirect importations” under the imported hybrid mismatch rules, the Australian secondary response will not be required if there is a foreign income tax deduction in any country that has a law corresponding to any of the particular types of mismatches in the Australian hybrid mismatch rules.   

The changes are proposed to apply to income years commencing on or after 1 July 2020. However, it should be noted that the Explanatory Memorandum explains that the proposed amendments “are intended to clarify the operation of the existing law but apply prospectively because they have not been previously announced”. 

Dual inclusion income 

DII is an important concept because it can reduce the amount of a hybrid payer or deducting hybrid mismatch that would otherwise lead to an increase in Australian taxable income.   

The proposed amendments include a number of simplifications to the DII rules including:

• Under the current law, DII is reduced where foreign income tax paid in respect of an assessable amount counts toward a foreign income tax offset.  This was a departure from the OECD’s recommendations in relation to DII.  Under the proposed amendments, this departure will be limited to corporate tax entities. 

• Under the current law, super funds with an Australian tax rate of 15 per cent were faced with the prospect of a denial of deductions in relation to certain foreign investments as well as requiring complex calculations in respect of each investment creating a significant compliance burden. Similarly, many widely held trusts find it difficult to comply with the existing rule because of a need to understand the tax profile of all of the trust’s investors.  The proposed amendments should reduce a significant amount of uncertainty and complexity for super funds and trusts that invest into foreign jurisdictions through partnership or other tax transparent structures, where the income and deductions from the investment are subject to tax in Australia and a foreign country.  

• The concept of dual inclusion income group (DIIG) will be expanded.  The DIIG rule allows entities to effectively “share” amounts of DII.   The existing definition requires that there is only a single “liable entity” in respect of the profits of all members of the DIIG.  The proposed amendments will relax this requirement which should allow certain partnerships and their wholly-owned entities to be included in a DIIG.  In addition, the proposed amendment seems to be intended to ensure members of an Australian tax consolidated group are members of a DIIG. Furthermore, under the proposed amendments, the circumstances where a foreign tax consolidation or fiscal unity may qualify as a DIIG have been expanded but the operation of foreign laws will continue to be a critical element of this test.  

• The DII on-payment rule will be expanded. The DII on-payment rule provides an increase in the amount of income or profits of an entity that is considered subject to Australian income tax or foreign income tax.  Under the proposed amendments, the test will be satisfied if it is reasonable to conclude that the funding income or profits must be subject to Australian or foreign taxes. This is intended to ensure the on-payments rule can apply to a series of payments within a DIIG. 

These changes are proposed to apply to income years commencing on or after 1 January 2019. 

Definition of foreign income tax

There has been some uncertainty about whether foreign income tax includes foreign municipal and State taxes.  Under the proposed amendments:

• For the purpose of applying the hybrid mismatch rules, foreign income tax will generally not include foreign municipal taxes and State taxes. This will alleviate concerns that it is necessary to consider the taxation consequences for a payment at multiple levels of government in a foreign jurisdiction (e.g. 50 states of the US) for the purpose of determining, for example, whether a hybrid mismatch arises. It is acknowledged in the Explanatory Memorandum that this would place an unreasonable compliance burden on taxpayers.

• For the purposes of applying the unilateral low tax lender “integrity” rule, foreign municipal taxes and State taxes will be recognised for determining whether a payment has been subject to foreign tax at a rate of 10 per cent or less.

These changes are proposed to apply to income years commencing on or after 1 January 2019. 

Low tax lender rule

Australia’s hybrid mismatch rules include a low tax lender rule which is designed to prevent the use of interposed conduit type entities that effectively pay no (or “low”) tax to fund investments in Australia.

The low tax lender rule does not apply if, among other things, the payment gives rise to a hybrid mismatch under one of the particular hybrid mismatch rules, notwithstanding the deduction may not be neutralised because, for example, Australia is the secondary response country or the deduction has been sheltered by DII.  Similarly, the low tax lender rule does not apply to timing mismatches under the hybrid financial instrument mismatch rule.  Under the proposed amendments the integrity rule will be extended to apply to certain payments that are subject to the deducting hybrid or hybrid financial instrument mismatch rules. 

The proposed amendment also extends the operation of the low tax lender rule to payments by subsidiaries of tax consolidated groups in accordance with the original intent of the rules.

These changes are proposed to apply to income years commencing on or after 2 April 2019 (income years commencing after the date of announcement). 

Additional Tier 1 capital

Under the proposed amendments, if all or part of the distribution made on an Additional Tier 1 capital instrument gives rise to a foreign income tax deduction, franking benefits will be allowed on the distribution.  However, an amount equal to the amount of the foreign income tax deduction will be included in the assessable income of the entity.

The takeaway

Overall, the proposed changes should be welcomed by taxpayers as they clarify interpretative issues and should reduce the compliance burden for a range of taxpayers.  However, not all of the changes are beneficial and many apply retrospectively from 1 January 2019.   

These proposed changes should be of immediate interest to taxpayers with a 31 December year end because annual tax returns for the year ended 31 December 2019 are due to be lodged in the next few months. The tax return requires extensive disclosure in relation to the potential operation of the hybrid mismatch rules including restructuring designed to remove hybridity and the existence of offshore hybrid mismatches.  Another common practical difficulty is the broad scope of the imported mismatch rules which can impact any related-party cross border payments that are deductible for Australian income tax purposes including, for example, cost of goods sold as well as interest, royalties and management fees.