Further to the OECD’s Base Erosion and Profit Shifting (BEPS) project, an action item was identified in relation to hybrid mismatches.
What are hybrid mismatches?
Hybrid mismatches are essentially arrangements where the taxation treatment differs across jurisdictions. Common misconceptions about hybrids include that they relate solely to related party transactions or are solely focused on structures. This is not the case under the new law which go significantly further and look through certain domestic laws when determining domestic tax treatment.
The amendments, first announced in the 2016-17 Federal budget are long and complex. In essence, the hybrid mismatch rules apply by preventing entities that are liable to income tax in Australia from being able to avoid income taxation, or obtain a double non-taxation benefit, by exploiting differences between the tax treatment of entities and instruments across different countries.
When do they occur?
Broadly, a hybrid mismatch will arise if an entity enters a scheme that gives rise to a payment and the payment gives rise to:
- A deduction / non-inclusion mismatch –where a deduction is claimed in Australia and this exceeds the amount subject to tax in a foreign jurisdiction or Australia;
- A deduction / deduction mismatch – where the payment generates a deduction in Australia and in a foreign jurisdiction.
A mismatch is widely defined and will include financial instruments, branch mismatches and payer mismatches amongst other things. A simple example of a hybrid mismatch would be where interest is paid by an Australian entity to company overseas in a jurisdiction that does not tax foreign sourced income.
How do these rules apply?
The hybrid mismatch rules apply in relation to a payment whether or not the scheme has been or is entered into or carried out in Australia or outside. Until now, in determining the Australian tax consequences of a transaction, the Australian entity only needed to have reference it its activities and tax status, whereas under the new rules it needs to be aware of the tax profile of its counter-party.
Importantly, a number of the provisions in the hybrid mismatch rules refer to an entity making a payment. Making a payment is to be worked out disregarding a variety of provisions including the single entity rule that applies for the purposes of Australia’s tax consolidation regime. As such, this could result in a payment between two members of a tax consolidated group giving rise to a hybrid mismatch issue subject to elections made by a foreign parent in its domestic jurisdiction (eg US check the box elections).
The rules can also include an amount in the assessable income of an entity. If this arises then the amount that is included in assessable income will be reduced to the extent (if any) necessary to ensure that the total amount included in the entity’s assessable income in relation to the payment does not exceed the amount of the payment. In other words, the amount of income included is capped to the amount of the deduction claimed.
The new provisions will also provide a targeted integrity rule to prevent the effect of the hybrid mismatch rules being compromised. The integrity rules could apply to intra-group financing arrangements involving routing of funds through foreign interposed entities which result in an Australian tax deduction for interest and the imposition of foreign income tax on the payment at a rate of 10% or less.
When will they come into effect?
The OECD hybrid mismatch rules will have general application for income years starting on or after 1 January 2020, however, may apply in certain circumstances for income years starting on or after 1 January 2019. Whilst there is some time before the new hybrid laws become active, review of existing structures and cross border arrangements should be undertaken as a priority to identify and address any hybrid arrangements.
Should you have any questions regarding these changes, please contact your ESV engagement partner on 02 9283 1666.
