Senate

Treasury Laws Amendment (Tax Integrity and Other Measures No. 2) Bill 2018

Revised Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Scott Morrison MP)
This memorandum takes account of amendments made by the House of Representatives to the bill as introduced.

Chapter 2 - OECD hybrid mismatch rules: Branch mismatch arrangements

Outline of chapter

2.1 Part 2 of Schedule 1 to this Bill amends the ITAA 1936 to implement part of the OECD hybrid mismatch rules by limiting the scope of the exemption for foreign branch income and preventing a deduction from arising for payments made by an Australian branch of a foreign bank to its head office in some circumstances.

2.2 All references in this chapter are to the ITAA 1936 unless otherwise stated.

Context of amendments

2.3 In the 2017-18 MYEFO, the Government announced an extension of the OECD hybrid mismatch rules to implement the recommendations in the OECD Branch Mismatch Arrangements Report.

2.4 The amendments in Schedule 1 to this Bill also implement Recommendations 1 and 3 of the OECD Branch Mismatch Arrangements Report.

Recommendation 1 of the OECD Branch Mismatch Arrangements Report

2.5 Recommendation 1 of the OECD Branch Mismatch Arrangements Report is as follows:


Jurisdictions that provide an exemption for branch income should consider limiting the scope and operation of this exemption so that the effect of deemed payments, or payments that are disregarded, excluded or exempt from taxation under the laws of the branch jurisdiction, are properly taken into account under the laws of the residence jurisdiction.

2.6 However, paragraph 35 of the OECD Branch Mismatch Arrangements Report notes that:


Recommendation 1.1 is based on the assumption that the intention of the residence jurisdiction in granting an exemption for branch income is to relieve that income from double taxation, so that income that is not, in fact, subject to net taxation in the branch jurisdiction should not benefit from this exemption. Recommendation 1 should not, however, be interpreted as requiring countries to make any change to deliberate policy decisions they have made, including in respect of the territorial scope of their tax regime. Accordingly, this recommendation only calls for jurisdictions to consider modifying the scope and operation of their branch exemption to neutralise branch mismatches and does not set out any limitations on the amount of the adjustment, or the mechanism for making that adjustment, provided any adjustment is consistent with a jurisdiction's tax treaty obligations, and tax policy settings in that jurisdiction.

2.7 Under section 23AH, certain foreign branch income derived by an Australian resident company in carrying on a business through a foreign PE (a foreign branch) is non-assessable non-exempt income in certain circumstances.

2.8 Therefore, to implement Recommendation 1 of the OECD Branch Mismatch Arrangements Report, section 23AH is being modified to limit the scope of the exemption for foreign branch income.

Recommendation 3 of the OECD Branch Mismatch Arrangements Report

2.9 Recommendation 3 of the OECD Report on Neutralising the Effects of Branch Mismatch Arrangements is as follows:


The jurisdiction that recognises a deemed branch payment (the payer jurisdiction) should deny that deduction to the extent that it gives rise to a branch mismatch.

A deemed branch payment is a deemed payment between the branch and the head office or between two branches of the same taxpayer that gives rise to a deduction/non-inclusion outcome as a result of the fact that such payment is disregarded under the laws of the jurisdiction that is treated as receiving the payment (the payee jurisdiction).

A deemed branch payment shall give rise to a branch mismatch only to the extent the payer jurisdiction allows the deduction to be set off against an amount that is not dual inclusion income.

2.10 Deductions for deemed payments by a branch to its parent are generally not a feature of the Australian income tax law. However, an exception applies for Australian branches of foreign banks (Part IIIB). In this regard, under Part IIIB, an Australian branch of a foreign bank is treated as a separate taxpayer.

2.11 As a result, foreign bank notional payments of interest by a Australian branch to the foreign bank are taken to have been incurred by the Australian branch, paid by the Australian branch to the foreign bank, and derived by the foreign bank in respect of the notional borrowing (section 160ZZZA).

2.12 In addition, notional derivative transactions entered into by the Australian branch to the foreign bank are recognised (section 160ZZZE).

2.13 The same treatment applies to Australian branches of foreign financial entities (section 160ZZZK).

2.14 Therefore, to implement Recommendation 3 of the OECD Branch Mismatch Arrangements Report, Part IIIB is being modified to prevent a deduction from arising for payments made by an Australian branch of a foreign bank to the foreign bank in some circumstances.

Summary of new law

2.15 Part 2 of Schedule 1 to this Bill also amends the ITAA 1936 to:

·
limit the scope of the exemption for foreign branch income; and
·
prevent a deduction from arising for payments made by an Australian branch of a foreign bank to its head office in some circumstances.

Comparison of key features of new law and current law

New law Current law
Foreign branch income that is branch hybrid mismatch income derived by the Australian resident company will be assessable income. Foreign branch income derived by an Australian resident company in carrying on a business through a foreign PE (a foreign branch) is non-assessable non-exempt income in certain circumstances.
An Australian branch of a foreign bank cannot deduct notional payments of interest made to the foreign bank or an amount paid in respect of a notional derivative transaction for an income year unless the payment gives rise to dual inclusion income in that income year.

A deduction may be allowed for the amount in a later income year in which the Australian branch derives dual inclusion income.

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 recognised for income tax purposes.

Detailed explanation of new law

Limit the scope of the branch exemption

2.16 Consistent with Recommendation 1 of the OECD Branch Mismatch Arrangements Report, section 23AH is being modified to limit the scope of the exemption for foreign branch income.

2.17 Foreign income derived by an Australian resident company that is carrying on business at or through a PE in a foreign country is generally non-assessable non-exempt income of the company (subsection 23AH(2)).

2.18 The amendments ensure that subsection 23AH(2) does not apply to foreign income that would otherwise give rise to a branch hybrid mismatch. [Schedule 1, items 2 and 3, paragraph 23AH(1)(d) and subsection 23AH(4A)]

2.19 A company has branch hybrid mismatch income if it derives foreign income that, for the purposes of the OECD hybrid mismatch rules in Division 832 of the ITAA 1997, is a payment received by the company that (apart from subsection 23AH(4A)) would give rise to a branch hybrid mismatch. The amount of branch hybrid mismatch income is equal to the amount of the foreign income to the extent that it does not exceed the amount of the branch hybrid mismatch. [Schedule 1, item 4, subsection 23AH(14C)]

2.20 For the purposes of section 23AH, a reference to a PE in the branch hybrid mismatch rules in Division 832 of the ITAA 1997 is taken to have the same meaning as in subsection 23AH(15). [Schedule 1, item 4, subsection 23AH(14D)]

Example 2.1 : Branch profits exemption denied Aus Co carries on a business through a branch in Country B. Australia has an international tax agreement with Country B.Aus Co would be eligible for an exemption under section 23AH (ignoring subsection 23AH(4A)) for the foreign branch profits.Under Country B's domestic tax law, non-residents of Country B are only taxable in Country B if they earn income that is effectively connected with a trade or business in Country B.Country B does not consider Aus Co to have sufficient operations in Country B to generate any income that is effectively connected with a trade or business in Country B.Subject to either of the scope requirements in subsections 832-500(3) or (4) of the ITAA 1997 being met, the income treated by Aus Co as foreign income derived at or through the PE in Country B would otherwise give rise to a branch hybrid mismatch under subsection 832-505(1) of the ITAA 1997.As a result, the income will be branch hybrid mismatch income for Aus Co under subsection 23AH(4A).

Deemed branch payment rule

2.21 Consistent with Recommendation 3 of the OECD Branch Mismatch Arrangements Report, Part IIIB is being modified to prevent a deduction from arising for payments made by an Australian branch of a foreign bank to the foreign bank in some circumstances.

2.22 The modification applies if:

·
either:

-
an amount of interest (a notional payment) in respect of a notional borrowing is taken under section 160ZZZA to be incurred or paid by an Australian branch to a foreign bank; or
-
an amount (also a notional payment) is taken under section 160ZZZE to be an amount paid by an Australian branch to a foreign bank in respect of a notional derivative transaction;

·
the amount would (apart from section 160ZZZL) give rise to an Australian income tax deduction for the Australian branch for an income year; and
·
the amount of the Australian income tax deduction exceeds the amount worked out under subsection 160ZZZL(3).

[Schedule 1, item 6, subsection 160ZZZL(1)]

2.23 The amount worked out under subsection 160ZZZL(3) is the sum of:

·
the amount of the notional payment that is subject to foreign income tax;
·
so much (if any) of the notional payment that it is reasonable to conclude is effectively funding non-deductible third party expenses; and
·
the amount (if any) of income or profits of the Australian branch that is both:

-
subject to Australian income tax for the purposes of subsection 832-680(1) of the ITAA 1997 in the relevant income year; and
-
subject to foreign income tax for the purposes of subsection 832-680(1) of the ITAA 1997 in the foreign country in which the foreign bank is resident.

[Schedule 1, item 6, subsection 160ZZZL(3)]

2.24 If the notional payment is in respect of a notional borrowing and it is reasonable to conclude that the notional borrowing is effectively funded by actual borrowings of the foreign bank, then the expenses in respect of the actual borrowings are non-deductible third party expenses to the extent (if any) that those expenses do not give rise to foreign income tax deductions. [Schedule 1, item 6, subsection 160ZZZL(4)]

2.25 If the notional payment is in respect of a notional derivative transaction and it is reasonable to conclude that the foreign bank has hedged or managed all or part of its risk in respect of the notional derivative transaction by entering into actual transactions, then the expenses in respect of the actual transactions are non-deductible third party expenses to the extent (if any) that those expenses do not give rise to foreign income tax deductions. [Schedule 1, item 6, subsection 160ZZZL(5)]

2.26 If the modification applies, then so much of the Australian income tax deduction as equals the excess worked out under paragraph 160ZZZL(1)(c) is not allowable as a deduction in the income year. [Schedule 1, item 6, subsection 160ZZZL(2)]

2.27 However, as a safe harbour, for the purposes of paragraph 160ZZZL(1)(c), a deduction is not taken to exceed the amount worked out under subsection 160ZZZL(3) if the foreign bank adopts a recognised transfer pricing methodology in allocating expenditure and income between itself and all of it branches. [Schedule 1, item 6, subsection 160ZZZL(6)]

2.28 If subsection 160ZZZL(2) applies to deny a deduction for an amount for an income year, the amount may be deductible in a later income year (the adjustment year) in which the Australian branch derives dual inclusion income. That is, the Australian branch may be able to deduct an amount in the adjustment year if an amount of income or profits of the Australian branch is both:

·
subject to Australian income tax for the purposes of subsection 832-680(1) of the ITAA 1997 in the adjustment year; and
·
subject to foreign income tax for the purposes of that subsection in the foreign country in which the foreign bank is resident.

[Schedule 1, item 6, subsection 160ZZZN(1)]

2.29 In these circumstances, the Australian branch can deduct in an adjustment year an amount equal to so much of income or profits that satisfies paragraph 160ZZZL(1)(c) to the extent that it does not exceed the amount that was not allowable. [Schedule 1, item 6, subsection 160ZZZN(2)]

2.30 For the purposes of a later application of section 160ZZZN, an amount of a deduction that was not allowable under subsection 160ZZZL(2) is reduced by the amount deducted under subsection 160ZZZN(2). This is to ensure that a deduction for the amount is allowed only once. [Schedule 1, item 6, subsection 160ZZZN(3)]

2.31 In addition, to ensure that dual inclusion income is applied only once:

·
for the purposes of paragraphs 160ZZZL(3)(c) and 160ZZZN(1)(c), an amount of income or profits is disregarded if the amount is dual inclusion income that has been applied by a provision of Division 832 of the ITAA 1997; and
·
for the purposes of Division 832, an amount of dual inclusion income is not available to be applied by a provision of that Division if it has been taken into account under paragraph 160ZZZL(3)(c) or subsection 160ZZZN(2).

[Schedule 1, item 6, section 160ZZZP]

2.32 The following terms that are used in sections 160ZZZL, 160ZZZN and 160ZZZP have the same meaning as in Division 832 of the ITAA 1997:

·
dual inclusion income;
·
foreign income tax deduction;
·
subject to Australian income tax; and
·
subject to foreign income tax.

[Schedule 1, item 6, section 160ZZZR]

2.33 Currently, a bank can elect not to apply Part IIIB in the calculation of its taxable income for an income year if, in addition to some other requirements, an international tax agreement applies in relation to the bank (subsection 160ZZVB). To ensure that the hybrid mismatch rules for foreign bank branches operating in Australia do not have different consequences depending on whether the country in which the foreign bank's head office resides has an international tax agreement with Australia, the election to opt out of Part IIIB is being extended to foreign bank's resident in non-international tax agreement countries. [Schedule 1, item 5, subsection 160ZZVB(2)]

Application and transitional provisions

2.34 The amendments to limit the scope of the exemption for foreign branch income and prevent a deduction from arising for payments made by an Australian branch of a foreign bank to its head office in some circumstances will apply to assessments for income years starting on or after 1 January 2019. [Schedule 1, item 14]


View full documentView full documentBack to top