The potential impact of Australia's imported hybrid mismatch rules

Broadly, a ‘hybrid mismatch’ is an arrangement that exploits differences in the tax treatment of an entity or instrument under laws of two or more tax jurisdictions. A typical example would be a payment that is deductible for tax purposes in the payer’s jurisdiction, but not correspondingly assessable for tax purposes in the payee’s jurisdiction. Australia has in place a sophisticated regime to counteract the tax effect of such arrangements, which is set out in Division 832 of its Income Tax Assessment Act 1997 (ITAA 1997).

Important hybrid mismatch rules

Subdivision 832-H of the ITAA 1997 prescribes specific imported hybrid mismatch rules (the rules) that effectively implement (and arguably go beyond) Recommendation 8 of the Organization for Economic Co-operation and Development's (OECD) Action 2 Report and Recommendation 5 of the OECD’s Branch Mismatch Arrangements Report by seeking to neutralize arrangements that shift the tax effect of an offshore hybrid mismatch into Australia (i.e., 'import' the hybrid mismatch).

The rules broadly operate to disallow deductions for payments where the corresponding income is set-off, directly or indirectly, against a deduction that arises under a hybrid mismatch arrangement in an offshore jurisdiction. The rules apply generally to payments that give rise to an offshore hybrid mismatch (e.g., interest, service payments, rent and royalties) under a ‘structured arrangement’¹ to any payee, or direct or indirect payments to another member of the same accounting consolidated group.² Critically, in determining whether a payment is made indirectly through an interposed entity to an offshore deducting entity, it is not necessary to demonstrate that a payment funds another, or that one occurs after the other – it is sufficient that payments simply exist between each entity. This is one of the key areas where Australia’s implementation of these rules is broader than that of other jurisdictions.

A deduction will not be denied to the extent a hybrid mismatch is neutralized by equivalent provisions of a foreign hybrid mismatch rule. Although this concession is helpful where a payment is made, say, through an EU or UK entity (given that the EU and UK have largely implemented comprehensive hybrid mismatch rules through the EU Anti-Tax Avoidance Directive (ATAD)), complexities and uncertainties arise in the case of some jurisdictions which have limited scope anti-hybrid rules that do not fully implement OECD recommendations (such as the U.S. and Japan).

Australian taxpayers face unavoidable compliance burdens in relation to these rules. Each year, Australian taxpayers must file an International Dealing Schedule (i.e., a schedule that discloses precisely how the rules apply) and evaluate the filing of a Reportable Tax Position (RTP) (i.e., a schedule³ that discloses self-assessed risk in relation to the rules). Non-compliance with these filing requirements can currently result in a penalty of up to AUD 550,000, per obligation.

ATO compliance approach

The Practical Compliance Guideline PCG 2021/5 Imported hybrid mismatch rule – ATO’s compliance approach (the PCG) sets out a practical administration approach to assist taxpayers in complying with these Rules. This practical administration approach applies retroactively from Jan. 1, 2019, requiring Australian taxpayers with an international connection to re-evaluate their arrangements.

The PCG outlines the ATO’s expectations that Australian taxpayers responsibly demonstrate and adequately document steps taken to collect information showing that the imported hybrid mismatch Rules do or do not apply. In order to do so, Australian taxpayers should undertake reasonable enquiries each year with qualified responsible individuals within their multinational group (e.g., the Head of Tax) to obtain sufficient evidence to document their position. An Australian Public Officer signing off on the annual tax return cannot simply rely on the hybrid mismatch analysis done for other jurisdictions.

Through the PCG, the ATO takes a firm stance on the following items:

• Taxpayers should not claim a tax deduction for a payment unless the taxpayer is able to obtain sufficient information to support a conclusion that the deduction is not denied under the rules
• Penalties may result where the taxpayer neglects reasonable care and / or the ATO disagrees with the taxpayer's self-assessment
• Where an arrangement falls outside the defined low-risk zone (i.e., a self-assessed rating within the PCG's risk assessment framework), it is likely that the ATO will conduct some form of engagement and assurance activity to assess the resultant tax outcomes

Carve-out where payment is subject to foreign income tax

Section 832-130 of the ITAA 1997 provides that a DNI mismatch will not arise to the extent that a deduction does not exceed the amount of a payment that is ‘subject to foreign income tax’. This would, for example, preclude the existence of an imported hybrid mismatch.

Of relevance for U.S.-headquartered taxpayers is TD 2022/9, covered in a recent tax insight from RSM Australia, which effectively provides that being subject to the U.S. GILTI rules will not constitute being “subject to foreign income tax” for the purposes of the rules. This means that any taxes paid pursuant to GILTI will be disregarded for purposes of determining the existence and quantum of a hybrid mismatch, including imported hybrid mismatches. This determination increases the risk of economic double taxation.

Practical illustration

The following example is adapted from the PCG and is intended to illustrate the practical operation of the rules:

• AusCo, an Australian corporation, owns 100% of USCo, a U.S. corporation, which owns 100% of XCo, a corporation of Country X. All three companies are members of the same accounting consolidated group.
• The companies are tax resident in Australia, the U.S. and Country X, respectively.
• The functional currency of each entity is the U.S. Dollar (USD).
• XCo grants USCo a license for the use of XCo’s intellectual property (IP). AusCo will not use XCo’s IP.
• USCo borrows money from external financiers, of which loans the funds to AusCo on back-to-back terms to finance capital investment by AusCo.
• During the current tax year:
  • AusCo will make a deductible $2M USD interest payment to USCo. The interest income will be taxable to USCo;
  • USCo will make a deductible $2M USD interest payment to external financiers; and
  • USCo will make a deductible $4M USD royalty payment to XCo. However, XCo.'s royalty income is not subject to tax in Country X, as USCo is treated as a disregarded entity under Country X’s tax rules. The royalty income will be subject to tax in the U.S. pursuant to the GILTI regime.

The chain of payments will be treated under Australia’s imported hybrid mismatch rules as an indirect payment by AusCo to XCo. Thus, AusCo will be denied a deduction for the $2M USD interest payment to USCo. The entire $2M USD deduction could well be denied, notwithstanding that the royalty income received by XCo was subject to tax in the U.S. pursuant to the GILTI rules.

Implications to U.S. multinationals

Hybrid mismatches can negatively impact an organization’s global effective tax rate (ETR) and ultimately lead to economic double taxation. Generally, when deductions are disallowed from a foreign tax perspective, but allowed when calculating tested income for U.S. GILTI, this often results in a foreign tax credit (FTC) limitation from a U.S. tax perspective. A FTC limitation is not necessarily a bad result due to the carryover rules. However, there is no carryover for 951A taxes. While a U.S. multinational will not pay residual U.S. tax in these situations, the foreign subsidiary bears the cost (i.e., higher taxable income due to disallowed deductions), thereby increasing the ETR.

U.S. multinationals with Australian subsidiaries should also reevaluate historical hybrid mismatch positions taken in light of this recent guidance. Taxpayers should specifically determine whether they have been relying on the notion that GILTI constituted being subject to foreign income tax (i.e., serving as the basis for allowing a specified deduction).

¹ The term ‘structured arrangement’ is defined by section 832-210 of the ITAA 1997 to cover any arrangement whereunder the hybrid mismatch is priced into the terms of the scheme under which the payment is made, or it is reasonable to conclude that the hybrid mismatch is a design feature thereof.

² The rules also capture payments made to an entity in which the payer has a total participation interest of 50% or more (or vice versa), as well as where a third entity holds a total participation interest of 50% or more in both the payer and payee.

³ The RTP schedule must be completed by all public companies, and foreign-owned companies with total business income of AUD $250m for the relevant tax year, or total business income of at least AUD $25m where the company is part of a public of foreign owned economic group with total business income of AUD $250m or more in the relevant tax year.