Australia s revised exposure draft on hybrid mismatch tax rules: A detailed review

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1 19 March 2018 Global Tax Alert Australia s revised exposure draft on hybrid mismatch tax rules: A detailed review EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Executive summary On 7 March 2018, Australia s Treasurer released a revised Exposure Draft Treasury Laws Amendment (OECD Hybrid Mismatch Rules) Bill 2018 (the RED) for public consultation. The RED will implement the Organisation for Economic Co-operation and Development (OECD) October 2015 Report on Base Erosion and Profit Shifting (BEPS) Action 2 Countering the effects of Hybrid Mismatch Arrangements. Submissions in relation to the RED are due by 4 April The RED contains two important measures announced but not included in the first exposure draft released on 24 November 2017 (the first ED), namely a branch hybrid mismatch rule and an additional Australian integrity rule which targets financing arrangements. 1 The mechanics and structure of the law have also been refined in the RED, however, the scope and operation of the law largely reflects that embodied in the first ED. The most significant changes contained in the RED are: A branch hybrid mismatch rule which denies deductions for payments which give rise to a branch hybrid mismatch and limits the scope of the tax exemption for foreign branch income where a branch hybrid mismatch arises. It also prevents, in certain circumstances, a deduction from arising for notional payments made by an Australian branch of a foreign bank to its head office.

2 2 Global Tax Alert An additional integrity rule which targets multinational groups using foreign interposed entities that result in an Australian income tax deduction and the imposition of foreign income tax on the related payment at a rate of 10% or less. For a large number of taxpayers, exclusion from the integrity measure will require demonstrating that it is reasonable to conclude the scheme was not designed to produce an in substance hybrid outcome. However, there is little statutory guidance or explanation contained within the explanatory memorandum to assist in ascertaining what is reasonable. Absent further guidance (for example, a detailed Practical Compliance Guideline (PCG) and/or Law Companion Guideline (LCG)) there will be significant uncertainty with respect to existing structures. As highlighted in the November 2017 Global Tax Alert for the first ED: The Australian Taxation Office (ATO) still intends to issue a PCG on the application of Australia s general anti-avoidance rule (Part IVA) to restructures carried out in response to the OECD hybrid mismatch rules. The PCG is expected to be released shortly. Where a debt deduction is disallowed under the hybrid mismatch rules, the RED still does not contain any rules to provide that the calculations of adjusted average debt for thin capitalization purposes should be adjusted. Detailed discussion What has changed? The most significant changes contained in the RED are: A. Branch hybrid mismatch rule: Subdivision 832-F In the Mid-Year Economic and Fiscal Outlook (MYEFO), the Government announced an extension of the hybrid mismatch rules to implement the recommendations in the OECD Branch Mismatch Arrangements Report (the Report). These rules will: An entity is a branch hybrid in relation to a payment if: Residence country applies branch profits exemption A liable entity in respect of its own income or profits (i.e., subject to tax on all or part of its income or profits) A resident of Australia or a foreign country (or its tax base as it relates to foreign tax includes income from worldwide sources) The payment is treated as income derived by the entity in carrying on a business at or through a permanent establishment (PE) in another country As a result of an exemption or other tax concession to which that liable entity is entitled in respect of income derived in carrying on a business at or through the PE, the payment is not subject to Australian income tax (if the liable entity is resident in Australia) or foreign income tax (if the liable entity is resident in a foreign country) Branch country fails to tax payment The branch country also does not treat the payment as being subject to tax in that branch country on the basis that the payment is not derived in carrying on business at or through a PE in that branch country. However, the branch hybrid mismatch rules only apply where both the entity that made the payment and the branch hybrid are members of the same Division 832 control group 2 or the scheme under which the payment is made is classified as a structured arrangement. 3 For completeness, a payment does not give rise to a branch hybrid mismatch if it gave rise to a hybrid financial instrument mismatch, hybrid payer mismatch or a reverse hybrid mismatch. The explanatory memorandum to the RED provides the following example of a branch hybrid mismatch. 1. Deny deductions for a payment that gives rise to a branch hybrid mismatch A payment gives rise to a branch hybrid mismatch if: The payment gives rise to a deduction/non-inclusion mismatch The payment is made directly or indirectly through one or more interposed entities to a branch hybrid The deduction/non-inclusion amount exceeds the amount of the mismatch calculated under certain assumptions

3 Global Tax Alert 3 Aus Co makes a deductible payment to the foreign branch (Foreign Branch) of a group member, Parent Co. Country B has a complete exemption for foreign branch profits. In Country C, Parent Co is recognized as having a PE but the payment is regarded as having been paid to Parent Co in its own right, instead of being allocated to the Foreign Branch. The payment is therefore not subject to foreign income tax in either Country B or Country C. Consequently the branch mismatch rule will operate to deny a deduction for Aus Co. 2. Limit the scope of the tax exemption for foreign branch income under section 23AH of the Income Tax Assessment Act 1936 (ITAA36) where a branch hybrid mismatch arises The section 23AH exemption will no longer apply where a company derives foreign income that is: (a) A payment received by the company (b) Such payment gives rise to a branch hybrid mismatch This amendment captures scenarios where the Australian company is the recipient of the payment (i.e., the noninclusion component of the mismatch). There is also an anti-overlap provision that captures very specific circumstance where two Australian companies within a Division 832 control group are party to the branch hybrid mismatch. That is, one receives the non-inclusion component and the other the deduction component of the mismatch. In this circumstance, the payer will not be denied a deduction because the recipient will include the payment in its assessable income since the Section 23AH exemption will be denied. 3. Prevent in certain circumstances a deduction from arising for notional payments made by an Australian branch of a foreign bank to its head office Under current law, an Australian branch of a foreign bank can deduct notional payments of interest made to the foreign bank. In addition, notional derivative transactions entered into by the Australian branch to the foreign bank are recognized for income tax purposes. Under proposed Section 160ZZZL of the ITAA36, an Australian income tax deduction will be denied for the amount of the notional payment (i.e., interest or a payment in relation to a derivative transaction) which exceeds the sum of the following amounts: The amount of the notional payment that is subject to foreign income tax So much of the amount of the notional payment as it is reasonable to conclude is effectively funding nondeductible third party expenses (e.g., borrowings or actual hedging transactions of the foreign bank) The amount of income or profits of the Australian branch that is both subject to Australian and foreign income tax (in the jurisdiction in which the foreign bank is resident) B. Integrity rule: Subdivision 832-J As also announced during the MYEFO, the Government has introduced a targeted integrity rule which was not contained in the OECD recommendations. This rule is intended to prevent multinational groups from being able to enter into intra-group financing arrangements designed to circumvent the hybrid mismatch rules. Importantly, however, the rule is not limited to circumstances where a group restructures out of an arrangement that would otherwise attract the hybrid mismatch rules. That is, it is not necessary for a hybrid structure to be present or contemplated in order for the integrity rule to apply. The rule targets multinational groups using foreign interposed entities that result in an Australian income tax deduction and the imposition of foreign income tax on the related payment at a rate of 10% or less. The Government s concern from an integrity perspective is that such structures could be used to effectively replicate a deduction/noninclusion outcome. Broadly, this measure will operate to disallow an Australian income tax deduction of an entity (the paying entity) for a payment of interest (or a payment of a similar character) to a foreign entity (the interposed foreign entity) where the following conditions are met: The paying entity, interposed foreign entity and the ultimate parent entity are in the same Division 832 control group. The interposed foreign entity and the ultimate parent entity are not residents of the same foreign country. The foreign income tax rate of the country of residence of the interposed foreign entity is 10% or less. This rate excludes the impact of net operating losses in the foreign country and tax credits arising in the foreign country from Australian interest withholding taxes.

4 4 Global Tax Alert An amount will be excluded from the integrity rule if it is reasonable to conclude: The amount of the payment will be included in assessable income of an entity under the controlled foreign company (CFC) provisions or included under a corresponding provision of a law of a foreign country in working out the tax base of an entity; or If it is assumed the payment has been made directly to the ultimate parent entity, the payment would be subject to foreign income tax at a rate the same as or less than the interposed entity rate and does not give rise to a hybrid financial instrument mismatch, a hybrid payer mismatch or a reverse hybrid mismatch; or The scheme was not designed to produce an Australian income tax deduction and foreign income tax is imposed at a rate of 10% or less. In relation to the third exclusion, whether a scheme has been designed to produce the Australian and foreign income tax outcomes must be determined with reference to all the facts and circumstances that exist in connection with the scheme, including the scheme s terms. Limited examples are included in the explanatory memorandum for the RED of factors that may be relevant to making the above determination. For example: Whether the interposed foreign entity undertakes a group financing or treasury function or otherwise has substantial economic activity When the interposed foreign entity was established relative to the deductions taken in Australia Sources where the interposed foreign entity obtained its funding (e.g., external versus internal) For a large number of taxpayers, exclusion from the integrity measure will require demonstrating that it is reasonable to conclude the scheme was not designed to produce an in substance hybrid outcome. However, there is little statutory guidance or explanation contained within the explanatory memorandum to assist in ascertaining what is reasonable. Absent further guidance (for example a detailed PCG and/ or LCG), there will be significant uncertainty with respect to existing structures. C. Foreign exchange and Taxation of Financial Arrangements (TOFA) To the extent a gain or loss represents a currency exchange rate effect, it will in very broad terms be treated as a separate gain or loss and the hybrid mismatch rules will not apply to it. Further, the amount of a Division 230 TOFA gain or loss will be adjusted where the hybrid mismatch rules have the effect of adjusting the amount of that gain or loss. Currency exchange rate effects not covered by Division 230 (e.g., Division 775) are now dealt with via the definitions of Australian deduction and foreign income tax deductions (used in the calculation of deduction/non-inclusion mismatch amounts). To the extent a deduction is solely attributable to a currency exchange rate effect (as defined in Division 775), it is excluded from contributing to the deduction component of a deduction/non-inclusion mismatch. These are welcome clarifications, albeit they will create an additional compliance burden given the need to separate out the currency effect from otherwise deductible payments. D. Dual inclusion income (DII) The definition of DII is now included in a separate sub-division (832-I) in the RED. Broadly, DII is income or profits that are taxed in two countries and can be applied to reduce the neutralizing amount for the hybrid payer mismatch and the deducting hybrid mismatch. In the first ED, amounts were specifically excluded from constituting DII if they entitled an entity to a credit in a foreign country. This exclusion would have created a significant tax burden for taxpayers who were paying the appropriate amount of Australian tax on amounts in certain circumstances by denying deductions where there was no hybrid mismatch actually occurring. In the RED, the definition of DII has been amended to remove this exclusion. Amounts of income or profits that carry with them a credit in a foreign country will not be excluded from DII. This is a very positive change for inbound investors to Australia.

5 Global Tax Alert 5 Next steps and start date Broadly, the law will likely be applied to Australian income tax deductions which are claimed six months after the date of Royal Assent of the legislation. That said, the RED is not clear on this and this six month period may be shortened if Royal assent is delayed. Importantly, consistent with the first ED, there is no grandfathering of existing arrangements. As the RED is open for consultation until 4 April 2018, the earliest a Bill can be introduced into Parliament will be during the winter Parliamentary sittings which commence on 8 May Given the Government s legislative timetable, a start date of 1 January 2019 appears likely and we understand is being targeted by Treasury. However, the start date will ultimately depend on the timing of the passage of the bill through Parliament. EY continues to be actively involved in the consultation process and is preparing a submission. Implications Multinational groups should consider the application of the hybrid mismatch and integrity rules to their existing structures and work to implement a strategy for unwinding any impacted hybrid structures and structures attracting the operation of the integrity rule. In this regard, matters that may require deeper analysis include legal matters, Foreign Investment Review Board considerations, tax issues including foreign currency tax implications, stamp duty and accounting issues. These issues may involve significant lead times if tax, legal and accounting are not aligned. Endnotes 1. See EY Global Tax Alert, Australia releases draft anti-hybrids law, dated 28 November Two or more entities are in the same Division 832 control group if any of the following apply: (a) Each of the entities is a member of a single consolidated accounting group; (b) One of the entities holds a total participation interest of 50% or more in each of the other entities; or (c) A third entity holds a total participation interest of 50% or more in each of the entities. 3. A scheme under which a payment is made is a structured arrangement if the payment gives rise to a hybrid mismatch and either the hybrid mismatch is priced into the terms of the scheme or it is reasonable to conclude that the hybrid mismatch is a design feature of the scheme.

6 6 Global Tax Alert For additional information with respect to this Alert, please contact the following: Ernst & Young (Australia), Sydney Sean Monahan Stephen Chubb Lachlan Cobon Ernst & Young (Australia), Melbourne Brendan Dardis Peter Janetzki Ernst & Young (Australia), Perth Andrew Nelson David S Browne david.browne@au.ey.com Ernst & Young LLP, Australian Tax Desk, New York David Burns david.burns1@ey.com

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