House of Representatives

Treasury Laws Amendment (2020 Measures No. 2) Bill 2020

Explanatory Memorandum

(Circulated by authority of the Minister for Housing and Assistant Treasurer the Hon Michael Sukkar MP)

Chapter 1 - Hybrid mismatch rules

Outline of chapter

1.1 Schedule 1 to the Bill amends the hybrid mismatch rules in the ITAA 1997 to:

·
clarify the operation of the hybrid mismatch rules for trusts and partnerships;
·
clarify the circumstances in which an entity is a deducting hybrid;
·
clarify the operation of the dual inclusion income rule;
·
clarify the operation of provisions that refer to corresponding foreign hybrid mismatch rules;
·
clarify that, for the purpose of applying the hybrid mismatch rules, foreign income tax generally does not include foreign municipal or State taxes;
·
clarify that the hybrid mismatch rules apply to MEC groups in the same way as they apply to consolidated groups;
·
ensure that the hybrid mismatch integrity rule can apply appropriately to financing arrangements that have been designed to circumvent the operation of the hybrid mismatch rules; and
·
where distributions made on Additional Tier 1 capital instruments give rise to a foreign income tax deduction:

-
allow franking benefits on those distributions; and
-
include an amount equal to the amount of the deduction in the assessable income of the entity that makes the distribution.

1.2 All references in this Chapter are to provisions in the ITAA 1997 unless otherwise stated.

Context of amendments

1.3 The hybrid mismatch rules are designed to prevent entities that are liable to income tax in Australia from being able to avoid income taxation, or obtain double taxation benefits, by exploiting differences between the tax treatment of entities and instruments across different countries.

1.4 The types of hybrid mismatch arrangements are:

·
deduction/non-inclusion mismatches, which occur when a deduction is provided for a payment in one country, but the corresponding income is not included as assessable income in the recipient country; and
·
deduction/deduction mismatches, which occur when an entity receives a deduction in two countries for the same payment.

1.5 A mismatch is covered by the hybrid mismatch rules if it is:

·
a hybrid financial instrument mismatch;
·
a hybrid payer mismatch;
·
a reverse hybrid mismatch;
·
a branch hybrid mismatch;
·
a deducting hybrid mismatch; or
·
an imported hybrid mismatch.

1.6 The principal objective of the hybrid mismatch rules is to neutralise the effects of the hybrid mismatches so that unfair tax advantages do not accrue for multinational groups as compared to domestic groups.

1.7 A targeted integrity rule applies to prevent the effect of the hybrid mismatch rules to neutralise double non-taxation outcomes from being compromised by multinational groups using interposed conduit type vehicles to invest in Australia (as an alternative to investing into Australia using hybrid instruments or entities or investing into Australia directly).

1.8 The hybrid mismatch rules were introduced in 2018 and apply to income years starting on or after 1 January 2019.

1.9 These amendments will clarify aspects of the hybrid mismatch rules and improve their operation. The amendments address concerns raised by both the Australian Taxation Office and industry stakeholders following the commencement of the hybrid mismatch rules and will provide greater certainty to affected taxpayers.

Summary of new law

1.10 Schedule 1 to the Bill amends the hybrid mismatch rules to:

·
clarify the operation of the hybrid mismatch rules for trusts and partnerships;
·
clarify the circumstances in which an entity is a deducting hybrid;
·
clarify the operation of the dual inclusion income rule;
·
clarify the operation of provisions that refer to corresponding foreign hybrid mismatch rules;
·
clarify that, for the purpose of applying the hybrid mismatch rules, foreign income tax generally does not include foreign municipal or State taxes;
·
clarify that the hybrid mismatch rules apply to MEC groups in the same way as they apply to consolidated groups;
·
ensure that the hybrid mismatch integrity rule can apply appropriately to financing arrangements that have been designed to circumvent the operation of the hybrid mismatch rules; and
·
where distributions made on Additional Tier 1 capital instruments give rise to a foreign income tax deduction:

-
allow franking benefits on those distributions; and
-
include an amount equal to the amount of the deduction in the assessable income of the entity that makes the distribution.

Comparison of key features of new law and current law

New law Current law
For the purpose of applying the hybrid mismatch rules, trusts and partnerships will be recognised as entities that can:

·
make and receive payments;
·
hold, acquire or dispose of assets; and
·
enter into schemes.

If an entity is a trust or a partnership, a reference in the hybrid mismatch rules to an amount being included in assessable income, or being allowable (or not allowable) as a deduction to an entity, will be taken to be a reference to an amount that is taken into account in determining:

·
for a trust - the net income of the trust;
·
for a partnership - the net income or partnership loss of the partnership.

No equivalent.

An entity will be a deducting hybrid if:

·
the entity is a liable entity in one deducting country (but not in both deducting countries);
·
the entity is a liable entity and satisfies the residency test in both deducting countries; or
·
the entity is a member of a consolidated group or MEC group.

An entity is a deducting hybrid if:

·
the entity is a liable entity in at least one deducting country; or
·
the entity is a member of a consolidated group.

Dual inclusion income can be applied to reduce the neutralising amount for a hybrid payer mismatch or a deducting hybrid mismatch.

If an entity is a corporate tax entity, the amount of dual inclusion income is reduced by the amount of any Australian foreign income tax offsets in respect of that income.

Two or more entities will be members of a dual inclusion income group in a country for the purposes of applying the hybrid mismatch rules if, in that country, there is either one or more liable entities (but no other liable entities) in respect of the income or profits of each of the relevant entities.

For the purpose of applying the dual inclusion income on-payment rule, an on-payment amount will be taken to be subject to Australian income tax or foreign income tax if it is reasonable to conclude that the funding income or profits have been subject to Australian income tax or foreign income tax in the country in which the dual inclusion income group exists (including as a result of a previous application of the rule).

Dual inclusion income can be applied to reduce the neutralising amount for a hybrid payer mismatch or a deducting hybrid mismatch.

The amount of dual inclusion income is reduced by the amount of any Australian foreign income tax offsets in respect of that income.

Two or more entities are members of a dual inclusion income group in a country for the purposes of applying the hybrid mismatch rules only if there is a single liable entity in respect of the income or profits of the relevant entities.

The operation of the dual inclusion income on-payment rule is uncertain where, for example, payments are made through multiple members of a dual inclusion income group.

Foreign hybrid mismatch rules will be a foreign law that corresponds to:

·
the hybrid financial instrument mismatch rule;
·
the hybrid payer mismatch rule;
·
the reverse hybrid mismatch rule;
·
the deducting hybrid mismatch rule; or
·
the imported hybrid mismatch rule.

As a result, for example, under the hybrid financial instrument mismatch rule, Australia will be required to apply the secondary response unless, in the country in which the foreign income tax deduction arose, the mismatch is covered by:

·
foreign hybrid mismatch rules that correspond to the hybrid financial instrument mismatch rule; or
·
a law that has substantially the same effect as foreign hybrid mismatch rules that correspond to the hybrid financial instrument mismatch rule.

Foreign hybrid mismatch rules are foreign laws that correspond to Australia's hybrid mismatch rules.

There is some uncertainty about when or whether:

·
foreign laws must correspond to Australia's hybrid mismatch rules as a whole (including the hybrid mismatch integrity rule); or
·
foreign laws must correspond to a particular hybrid mismatch that arises under Australia's hybrid mismatch rules.

For the purpose of applying the hybrid mismatch rules, foreign income tax will generally not include foreign municipal taxes and State taxes.

However, for the purposes of applying the hybrid mismatch 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.

There is some uncertainty about whether foreign income tax includes foreign municipal taxes and State taxes.
For the purpose of working out whether a reverse hybrid mismatch arises, an entity that is a member of a MEC group will be treated in the same way as an entity that is a member of a consolidated group. For the purpose of working out whether a reverse hybrid mismatch arises, an entity that is a member of a consolidated group is not treated as a transparent entity in Australia.
The hybrid mismatch integrity rule will be strengthened to ensure that it can apply to financing arrangements that have been designed to circumvent the operation of the hybrid mismatch rules. The hybrid mismatch integrity rule may not apply to some financing arrangements that have been designed to circumvent the operation of the hybrid mismatch rules.
If all or part of a 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 making the distribution.

If all or part of a distribution made on an Additional Tier 1 capital instrument gives rise to a foreign income tax deduction, franking benefits on the distribution are denied.

Detailed explanation of new law

1.11 Schedule 1 to the Bill amends the hybrid mismatch rules to:

·
clarify the operation of the hybrid mismatch rules for trusts and partnerships;
·
clarify the circumstances in which an entity is a deducting hybrid;
·
clarify the operation of the dual inclusion income rule;
·
clarify the operation of provisions that refer to equivalent foreign hybrid mismatch rules;
·
clarify that, for the purpose of applying the hybrid mismatch rules, foreign income tax generally does not include foreign municipal or State taxes;
·
clarify that the hybrid mismatch rules apply to MEC groups in the same way as they apply to consolidated groups;
·
ensure that the hybrid mismatch integrity rule can apply appropriately to financing arrangements that have been designed to circumvent the operation of the hybrid mismatch rules; and
·
where distributions made on Additional Tier 1 capital instruments give rise to a foreign income tax deduction:

-
allow franking benefits on those distributions; and
-
include an amount equal to the amount of the deduction in the assessable income of the entity that makes the distribution.

Operation of the hybrid mismatch rules for trusts and partnerships

1.12 The amendments clarify the operation of the hybrid mismatch rules for trusts and partnerships.

1.13 In this regard, for the purposes of applying the hybrid mismatch rules, it may be necessary to identify an entity and determine whether the entity:

·
makes a payment to, or receives a payment from, another entity;
·
holds, acquires, or disposes of an asset, interest or other property; and
·
enters into or carries out a scheme or a part of a scheme.

1.14 The hybrid mismatch rules then test the consequences that arise from applying the tax laws of different countries to that entity's payments and income or profits.

1.15 Some uncertainty has arisen in applying the hybrid mismatch rules to trusts and partnerships because of, for example:

·
the way that the Australian income tax law applies to these entities; and
·
the way in which these entities are treated under the income tax law of foreign jurisdictions.

Certain provisions in the income tax law disregarded

1.16 A number of provisions in the hybrid mismatch rules refer to an entity making a payment to another entity. Certain provisions in the income tax law are disregarded in determining whether an entity makes or receives a payment. The disregarded provisions are:

·
the single entity rule (subsection 701-1(1)) that applies for the purposes of Australia's tax consolidation regime;
·
Part IIIB of the ITAA 1936 (which contains special rules for Australian branches of foreign banks); and
·
any law of a foreign country that, for the purposes of a foreign tax, treats a different entity as having made a payment, or disregards a payment (such as a foreign law that has a similar effect to the single entity rule under Australia's tax consolidation regime).

[Schedule 1, item 1, subsection 832-30(1)]

1.17 The purpose of subsection 832-30(1) is to establish a uniform basis for recognising payments between entities across all jurisdictions. In some cases, a payment may not have a tax consequence because the payment is disregarded for tax purposes.

1.18 This outcome is consistent with the outcome that currently arise under section 832-30. However, the existing subsection is being repealed and replaced due to the inclusion of special rules for trusts and partnerships.

Trusts and partnerships taken to have done certain things

1.19 For the purpose of applying the hybrid mismatch rules to an entity that is a trust or a partnership, the trust or partnership (instead of a trustee or partner) is taken to:

·
make or receive a payment;
·
hold, acquire or dispose of an asset, interest or other property; and
·
enter into or carry out a scheme or a part of a scheme.

[Schedule 1, item 1, subsection 832-30(2)]

1.20 The fact that the trust or partnership (instead of a trustee or partner) is taken to have done these things must also be taken into account in identifying the income or profits of the trust or partnership. [Schedule 1, item 1, subsection 832-30(3)]

1.21 The objective of these amendments is to clarify the operation of the hybrid mismatch rules for trusts and partnerships. For trusts and partnerships, consistent with the definition of entity in section 960-100 (which defines an entity to include a trust or a partnership), the hybrid mismatch rules make a distinction:

·
for a trust - between the trust and the trustees; and
·
for a partnership - between the partnership and the partners.

1.22 The hybrid mismatch rules operate on the basis that the test entity can be:

·
for a trust - the trust (instead of the trustee); or
·
for a partnership - the partnership (instead of the partners).

1.23 For example, the test entity to which the hybrid payer rules in Subdivision 832-D apply in respect of a payment made by a trustee is the trust (rather than the trustee).

1.24 Therefore, as neither trusts nor partnerships are legal persons, for the purpose of applying the hybrid mismatch rules, the trust or partnership (instead of a trustee or partner) is treated as the entity that does the specified things.

Identifying income and profits of entities

1.25 A number of provisions in the hybrid mismatch rules refer to income and profits of an entity. For the purposes of applying the hybrid mismatch rules, things recognised in accordance with subsection 832-30(1) or (2) as being done by an entity are to be taken into account in identifying the income or profits of the entity. [Schedule 1, item 1, subsection 832-30(3)]

Assessable income and deductions of trusts and partnerships

1.26 Under the income tax law that generally applies to trusts, the trustee must work out the net income of the trust. The net income of the trust is, broadly, the total assessable income of the trust calculated as if the trustee were a taxpayer in respect of that income and an Australian resident, less allowable deductions (with some exceptions).

1.27 Broadly, any beneficiaries who are presently entitled to a share of the income of the trust are taxable on the corresponding proportion of the net income of the trust. The trustee is generally taxed on the balance of net income - broadly:

·
the net income which is not assessed to beneficiaries on the basis of present entitlement; or
·
the share of net income attributable to a beneficiary who is under a legal disability.

1.28 A similar outcome arises for attribution managed investment trusts and their members (noting that the mechanism is different).

1.29 For a trust that is a public trading trust, the net income of the trust is worked out on a similar basis. However, the trustee of the trust is liable to tax on that net income.

1.30 Under the income tax law that applies to partnerships, the net income or partnership loss of the partnership must be worked out. The net income of the partnership is, broadly, the assessable income of the partnership calculated as if the partnership were a taxpayer and an Australian resident, less allowable deductions (with some exceptions). A partnership loss arises if, broadly, the allowable deductions exceed the amount of the assessable income of the partnership.

1.31 Therefore, if the hybrid mismatch rules operate to include an amount in the assessable income of an entity, or make an amount allowable (or not allowable) as a deduction to an entity, the amount is taken to be included, allowable or not allowable (as the case requires) in determining:

·
for an entity that is a trust (including a trust that is a public trading trust or an attribution managed investment trust, but not a trust that is a superannuation entity) - the net income of the entity; or
·
for a partnership - the partnership's net income or partnership loss.

[Schedule 1, item 1, subsection 832-30(4)]

1.32 The definition of net income is being extended so that:

·
for a public trading trust, net income has the same meaning as in section 102M of the ITAA 1936; and
·
for an attribution managed investment trust, net income means the trust's assessable income reduced by all deductions of the trust (see section 276-265).

[Schedule 1, items 39 and 40, definition of 'net income' in subsection 995-1(1)]

Section 832-30 does not affect the interpretation of other provisions

1.33 Section 832-30 modifies the way that the hybrid mismatch rules apply to trusts and partnerships in the sense that it treats the trust or partnership (instead of a trustee or partner) as doing certain things and clarifies the operation of provisions in the hybrid mismatch rules that refer to amounts being included in assessable income or amounts being deductible.

1.34 However, section 832-30 does not affect whether tax or foreign income tax is imposed on an entity. [Schedule 1, item 1, subsection 832-30(5)]

1.35 In addition, the modifications made by section 832-30 only affect the operation of the hybrid mismatch rules. They do not limit, by implication, any other provision in the income tax law. [Schedule 1, item 1, subsection 832-30(6)]

Trustees and beneficiaries may be liable entities

1.36 A number of provisions in the hybrid mismatch rules refer to an entity that is a liable entity. Generally, an entity is a liable entity in Australia if income tax is imposed on the entity in respect of all or part of its profits, or in respect of all or part of the profits of another entity (section 832-325). An entity may be a liable entity for a country even if it has no actual liability to pay income tax.

1.37 A trust that is taxed under Division 6 of Part III of the ITAA 1936 is taxed as a flow-through entity. In these circumstances:

·
the trustee of the trust (in its capacity as trustee) is a liable entity in Australia in respect of the income or profits of the trust because it is liable to tax on the net income of the trust in some circumstances; and
·
each beneficiary of the trust is also a liable entity in Australia in respect of the income or profits of the trust because they are liable to tax on the net income of the trust in some circumstances.

Example 1.1: NZUT is a unit trust that is resident in New Zealand. Benny and Anne are each unit holders. The trustee of NZUT is Constance.NZUT is subject to Division 6 of Part III of the ITAA 1936 for Australian income tax purposes. It is treated as a company for New Zealand income tax purposes.Constance, as trustee of the NZUT makes a payment to Benny. The payment:

·
is not considered to be a distribution from the trust for the purposes of Division 6; and
·
is not income of the trust to which Benny is presently entitled.

However, the payment is deductible against the income or profits of the NZUT for New Zealand income tax purposes.Subsection 832-30(2) provides that the NZUT is taken to have made the payment which was actually made by Constance as trustee.Section 832-320 provides that NZUT (the test entity) will be a hybrid payer if:

·
NZUT is a liable entity in the deducting country (New Zealand) in respect of its own income or profits and not also a liable entity in New Zealand in respect of Benny's income or profits; and
·
NZUT or another entity is a liable entity in Australia in respect of NZUT's income or profits and that entity is also liable in Australia in respect of income of profits of Benny.

Under subparagraph 832-325(1)(b)(i), NZUT is a liable entity in New Zealand because New Zealand imposes tax on the NZUT in respect of all of its income or profits.Under paragraph 832-325(2)(a), Benny, Anne and Constance (in her capacity as trustee) are all liable entities in Australia.

·
Benny and Anne are liable entities because, as unit holders, tax would be imposed on them in respect of part of the income or profits of NZUT.
·
Constance is also a liable entity because, if NZUT had net income attributable to Australian sources but no income to which any beneficiary was presently entitled, Constance (in her capacity as trustee) would be liable to taxation under section 99A of the ITAA 1936.

Consequently, as section 832-320 is satisfied, NZUT is a hybrid payer.However, the payment will give rise to a hybrid payer mismatch under subsection 832-305(1) only if:

·
the payment satisfies the other conditions to meet the hybrid requirement;
·
the payment gives rise to a deduction/non-inclusion mismatch; and
·
the payment is made under the relevant scope requirements.

1.38 A trust that is an attribution managed investment trust taxed under Division 276 is also taxed as a flow-through entity. Therefore:

·
the trustee of the attribution managed investment trust (in its capacity as trustee) is a liable entity in Australia in respect of the income or profits of the trust; and
·
each member of the attribution managed investment trust who is attributed a share of the income of the trust is also a liable entity in Australia in respect of the income or profits of the trust.

1.39 A trust that is a public trading trust taxed under Division 6C of Part III of the ITAA 1936 is not taxed as a flow-through entity - that is, only the trustee of the public trading trust (in its capacity as trustee) is liable to pay income tax in respect of the income or profits of the trust. However, as public trading trusts are effectively taxed like companies, for the purposes of applying the hybrid mismatch rules, a public trading trust (including a public trading trust that has made a choice to be the head company of a consolidated group) is taken to be a liable entity in Australia. [Schedule 1, item 15, subparagraph 832-325(1)(a)(ii)]

1.40 Similarly, for the purposes of applying the hybrid mismatch rules, an entity will be a liable entity in a foreign country if the law of a foreign country imposes income tax on the income or profits of the entity in a way that corresponds to the way that foreign income tax is imposed under the law of that country on the income or profits of a company (regardless of whether the foreign income tax is actually imposed on that entity or another entity). [Schedule 1, item 15, subparagraph 832-325(1)(b)(ii)]

1.41 In this regard, a company is universally recognised as an incorporated legal person that is an entity which is treated as opaque for tax purposes.

1.42 A trust that is a superannuation entity taxed under Division 295 is also not taxed as a flow-through entity - that is, only the trustee of the superannuation entity (in its capacity as trustee) is liable to pay income tax in respect of the income or profits of the trust. However, for the purposes of applying the hybrid mismatch rules, a trust that is a superannuation entity is taken to be a liable entity in Australia. [Schedule 1, item 15, subparagraph 832-325(1)(a)(iii)]

1.43 Subsection 832-325(2) specifies when an entity is a liable entity in respect of another entity's (the test entity's) income or profits. A modification is being made so that an entity is not a liable entity in respect of the income or profits of a test entity as a result of the operation of subparagraph 832-325(1)(a)(ii), (a)(iii) or (b)(ii). This reflects the company-like taxation treatment of the test entity in these circumstances. [Schedule 1, item 20, subsection 832-325(2A)]

Division 832 control group

1.44 For the purposes of applying some of the hybrid mismatch rules it is necessary to work out whether two or more entities are in the same Division 832 control group. Generally, this is worked out by considering whether an entity has, broadly, a controlling interest in another entity.

1.45 The amendments clarify that, if a trust is in a Division 832 control group (because of the operation of subsection 832-205(1)), then the trustee of the trust is taken to be in the same Division 832 control group. [Schedule 1, item 12, subsection 832-205(1A)]

Consequential amendments

1.46 In addition, as a consequence of the amendments in section 832-30 to clarify the operation of the hybrid mismatch rules for entities that are trusts and partnerships, minor amendments are made to, for example, notes that refer to an entity's payments, income or profits. [Schedule 1, items 5, 6, 14, 16, 17, 19 and 21, section 832-125, notes after subsection 832-320(1), subsection 832-325(1), subsection 832-325(2) and subsection 832-410(1)]

The deducting hybrid mismatch rule

1.47 A payment or other amount gives rise to a deducting hybrid mismatch if there is a deducting hybrid in relation to the payment or other amount.

1.48 Unlike other hybrid mismatch rules, where Australia is the primary response country, there is no requirement that the payment is made between members of a Division 832 control group or that the payment is made under a structured arrangement. Consequently, the deducting hybrid mismatch rule can, in some circumstances, result in inappropriate outcomes arising where the likelihood of a payment giving rise to double tax benefits for the entity is minimal.

1.49 To address this concern, the circumstances in which an entity is a deducting hybrid are being modified. That is, in addition to the requirements that, broadly, the payment gives rise to a deduction/deduction mismatch and that the entity makes the payment, an entity will be a deducting hybrid if:

·
the entity is a liable entity in one deducting country (but not both);
·
in both deducting countries, the entity:

-
is a liable entity; and
-
satisfies the hybrid mismatch residency test (in subsection 832-555(9)); or

·
the entity is a member of a consolidated group or MEC group.

[Schedule 1, item 25, paragraph 832-550(c)]

1.50 As a result, the scope of the deducting hybrid payment mismatch rule will be narrowed with the effect that individuals and certain small business entities and trusts will generally not be a deducting hybrid.

1.51 However, a trust that is not a liable entity in Australia but is a liable entity in another deducting country will be a deducting hybrid. Similarly, a public trading trust or a trust that is a superannuation entity may be a deducting hybrid if they are not a liable entity in another deducting country.

Dual inclusion income

1.52 Dual inclusion income is income or profits that is taxed in two countries (section 832-680). Dual inclusion income can be applied to reduce the neutralising amount for a hybrid payer mismatch or a deducting hybrid mismatch (sections 832-330 and 832-560). It can also give rise to a later year adjustment for a hybrid payer mismatch or a deducting hybrid mismatch (sections 832-335 and 832-565).

1.53 An amount of income or profits is taken to be taxed in Australia if it is subject to Australian income tax. However, for the purposes of applying the dual inclusion income rule, in determining whether an amount of income or profits is taken to be subject to Australian income tax, subsection 832-125(2) (which is about when an amount that is included in the assessable income of a trust or partnership is subject to Australian income tax) is disregarded, but only to the extent that it applies in relation to assessable income from a foreign source. [Schedule 1, items 30 and 31, subsection 832-680(1A) and paragraph 832-680(2)(a)]

1.54 As a result, foreign source income of an Australian trust or partnership which flows through to a foreign resident beneficiary or partner will be taken to be subject to Australian income tax for the purposes of applying the dual inclusion income rule.

1.55 To avoid doubt, to the extent that a provision in section 832-680 has the effect that an amount is treated as if it were subject to Australian income tax or subject to foreign income tax, then that effect extends to another provision of the income tax law that refers to an amount that is (as the case requires):

·
subject to Australian income tax for the purposes of subsection 832-680(1); or
·
subject to foreign income tax for the purposes of subsection 832-680(1).

[Schedule 1, item 37, subsection 832-680(9)]

1.56 Examples of other provisions that refer to these amounts include paragraph 832-330(2)(b), subparagraph 832-335(1)(b)(ii), paragraph 160ZZZL(3)(c) of the ITAA 1936 and paragraph 160ZZZN(1)(c) of the ITAA 1936.

Clarifying the operation of the Australian foreign income tax offset adjustment

1.57 Currently, an amount of income or profits that is subject to Australian income tax is treated as if it were not subject to Australian income tax (or is subject to Australian income tax to a lesser extent) if an amount of foreign income tax paid in respect of the income or profits counts towards an Australian foreign income tax offset (subsection 832-680(2)). This reduces the extent to which an amount of income or profits can be regarded as dual inclusion income.

1.58 In practical terms, it is very difficult for trusts and partnerships that are taxed as flow-through vehicles to apply subsection 832-680(2) because the trust or partnership does not know the tax details of the underlying investors or partners who receive the benefit of the foreign income tax offset.

1.59 In this regard, the OECD Action 2: 2015 Final Report (at paragraph 126) states that:


Double tax relief, such as a domestic dividend exemption granted by the payer jurisdiction or a foreign tax credit granted by the payee jurisdiction should not prevent an item from being treated as dual inclusion income where the effect of such relief is simply to avoid subjecting that item to an additional layer of taxation in either jurisdiction.

1.60 Subsection 832-680(2) represents a departure from this position and was introduced to address integrity concerns that could otherwise arise for companies.

1.61 Therefore, to improve the operation of the dual inclusion income rule and reduce compliance costs, the amendments ensure that the reduction to dual inclusion income to reflect an Australian foreign income tax offset applies only to corporate tax entities. [Schedule 1, item 32, paragraph 832-680(2)(a)]

1.62 A corporate tax entity is defined in section 960-115 to mean an entity that is:

·
a company;
·
a corporate limited partnership; or
·
a public trading trust.

The dual inclusion income on-payment rule

1.63 Currently, the dual inclusion income on-payment rule (subsections 832-680(4), (5) and (6)) applies if, broadly:

·
a payment which forms income or profits of the payee (the on-payment amount) is made within a dual inclusion income group; and
·
the payment can be traced or reasonably linked to an amount of income or profits of the payer (the funding income or profits) that have a tax outcome which results in the income or profits being subject to Australian income tax or subject to foreign income tax (as the case may be).

1.64 Concerns have been raised that the operation of the dual inclusion income on-payment rule is uncertain where, for example, a payment is made through multiple members of a dual inclusion income group.

1.65 One of the requirements for the dual inclusion income on-payment rule to apply is that the funding income or profits must be subject to Australian income tax or subject to foreign income tax (paragraph 832-680(4)(d)). The amendments modify this test so that the test is satisfied if it is reasonable to conclude that the funding income or profits must be subject to Australian income tax or subject to foreign income tax (including as a result of a previous application of paragraph 832-680(4)(d)). [Schedule 1, items 34 and 35, paragraph 832-680(4)(d) and subsection 832-680(4A)]

1.66 Example 1.2 illustrates the iterative operation of the dual inclusion income on-payment rule under subsection 832-680(4) following the amendments. Under this example, the on-payment rule is applied to a bottom-up series of payments within a dual inclusion income group. However, in appropriate circumstances, the on-payment rule can equally be applied to a top-down series of payments within a dual inclusion income group.

Example 1.2

Example 1.2

Aus Head Co, Aus Sub 1 and Aus Sub 2 are all members of a tax consolidated group in Australia (and therefore the same dual inclusion income group in Australia).Aus Head Co (a deducting hybrid) borrowed an amount from an external bank and makes interest payments to the external bank. The interest payments give rise to deduction/deduction mismatches.The funds borrowed by Aus Head Co from the external bank were on-lent (via Aus Sub 1) to Aus Sub 2. As a result:

·
Aus Sub 2 makes interest payments to Aus Sub 1; and
·
Aus Sub 1 makes interest payments to Aus Head Co.

Aus Sub 2 receives external income which is subject to Australian income tax. However:

·
Aus Head Co does not receive any income other than the interest payments from Aus Sub 1; and
·
Aus Sub 1 does not receive any income other than the interest payments from Aus Sub 2.

The interest payments made between Aus Sub 2, Aus Sub 1 and Aus Head Co are disregarded for Australian income tax purposes (because of the operation of the consolidation single entity rule in subsection 701-1(1)).However, the interest payments made by Aus Sub 1 to Aus Head Co are subject to foreign income tax in Country B.Disregarding the dual inclusion income on-payment rule, the interest payments made by Aus Sub 1 to Aus Head Co are not dual inclusion income. This is because, although these interest payments are subject to foreign income tax in Country B, they are disregarded for Australian income tax purposes.However, the interest payments made by Aus Sub 1 to Aus Head Co may be treated as if they were subject to Australian income tax under subsection 832-680(4).In this regard:

·
subsection 832-680(4) can first be applied to the interest payments made by Aus Sub 2 to Aus Sub 1; and
·
subsection 832-680(4) can next be applied to interest payments made by Aus Sub 1 to Aus Head Co.

If the interest payments made by Aus Sub 2 to Aus Sub 1 satisfy subsection 832-680(4), the interest income received by Aus Sub 1 from Aus Sub 2 is taken to be subject to Australian income tax. Subsection 832-680(4) can then be applied to the interest payments made by Aus Sub 1 to Aus Head Co.The interest payments made by Aus Sub 1 to Aus Head Co will ultimately be taken to be subject to Australian income tax if it is reasonable to conclude that:

·
the interest payments made by Aus Sub 2 to Aus Sub 1 were funded by external income received by Aus Sub 2 which is subject to Australian income tax (under the first application of subsection 832-680(4)); and
·
the interest payments made by Aus Sub 1 to Aus Head Co were funded by interest income received by Aus Sub 1 from Aus Sub 2 (under the second application of subsection 832-680(4)).

Dual inclusion income group

1.67 Currently, a dual inclusion income group can be formed only if there is only one liable entity in respect of the income or profits of the group members. As a result, investments held by a transparent holding vehicle with multiple investors typically would not be able to form a dual inclusion income group.

1.68 A modification is being made to the definition of dual inclusion income group so that two or more entities (the member entities) are members of a dual inclusion income group in a country for the purposes of applying the hybrid mismatch rules if, in that country:

·
the same entity or entities are liable entities in respect of the income or profits of each of the member entities; and
·
no other entity is a liable entity in respect of the income or profits of each of any of member entities.

[Schedule 1, item 36, subsection 832-680(6)]

Example 1.3 :

Example 1.3

P1, P2 and P3 are companies that are residents of Country X and that collectively have a wholly owned partnership interest in a limited partnership (XLP).XLP, which is also formed in Country X, has a wholly owned Australian subsidiary (Aus Co) that is treated as a disregarded entity - that is, for Country X purposes, Aus Co is treated as part of XLP and not as a separate liable entity.For Country X tax purposes, P1, P2 and P3 are each:

·
liable entities in respect of their own income or profits and part of the income and profits of both XLP and Aus Co; and
·
not liable entities in respect of each other's income or profits.

Aus Co derives income of $100 in an income year. This income is subject to Australian income tax in the hands of Aus Co. This same income will be subject to foreign income tax in Country X in the hands of P1, P2 and P3 based on their respective partnership interests in XLP.For Country X tax purposes, P1, P2 and P3 are the liable entities in respect of each of Aus Co and XLP. Apart from P1, P2 and P3, there are no other liable entities in respect of Aus Co and XLP's income or profits. Therefore, Aus Co and XLP will be members of a dual inclusion income group in Country X.P1, P2 and P3 will not be members of this dual inclusion income group in Country X as they are not liable entities in respect of each other's income or profits.For the same reason, XLP will also not be in a dual inclusion income group in Country X with any of P1, P2 or P3.

Foreign hybrid mismatch rules

1.69 A number of provisions in the hybrid mismatch rules refer to equivalent foreign hybrid mismatch rules.

1.70 Concerns have been raised that the definition of foreign hybrid mismatch rules in subsection 995-1(1) requires the foreign law to correspond to, or have substantially the same effect as, Division 832. Therefore, when benchmarking a foreign law, it is uncertain whether the foreign law is benchmarked against Division 832 as a whole or whether there is scope to benchmark the foreign law against, for example, the provisions of a particular hybrid mismatch.

1.71 To address this concern, the definition of foreign hybrid mismatch rules in subsection 995-1(1) is being amended so that it refers to a foreign law corresponding to any of the following Subdivisions:

·
Subdivision 832-C (the hybrid financial instrument mismatch rule);
·
Subdivision 832-D (the hybrid payer mismatch rule);
·
Subdivision 832-E (the reverse hybrid mismatch rule);
·
Subdivision 832-F (the reverse hybrid mismatch rule);
·
Subdivision 832-G (the deducting hybrid mismatch rule); or
·
Subdivision 832-H (the imported hybrid mismatch rule).

[Schedule 1, item 50, definition of 'foreign hybrid mismatch rules' in subsection 995-1(1)]

1.72 In addition, the amendments clarify the operation of provisions that have regard to the operation of equivalent foreign hybrid mismatch rules.

1.73 Therefore, under the hybrid financial instrument mismatch rule, Australia is required to apply the secondary response unless, in the country in which the foreign income tax deduction arose, the mismatch is covered by:

·
foreign hybrid mismatch rules that correspond to the hybrid financial instrument mismatch rule; or
·
a law that has substantially the same effect as foreign hybrid mismatch rules that correspond to the hybrid financial instrument mismatch rule.

[Schedule 1, item 42, subsection 832-185(2)]

1.74 In addition, a hybrid financial instruments mismatch will not be an offshore hybrid mismatch if it is covered by:

·
foreign hybrid mismatch rules that correspond to the hybrid financial instrument mismatch rule; or
·
a law that has substantially the same effect as foreign hybrid mismatch rules that correspond to the hybrid financial instrument mismatch rule.

[Schedule 1, item 43, paragraph 832-195(1)(c)]

1.75 Under the hybrid payer mismatch rule, Australia will be required to apply the secondary response unless, in the country in which the foreign income tax deduction arose, the mismatch is covered by:

·
foreign hybrid mismatch rules that correspond to the hybrid payer mismatch rule; or
·
a law that has substantially the same effect as foreign hybrid mismatch rules that correspond to the hybrid payer mismatch rule.

[Schedule 1, item 44, subsection 832-290(2)]

1.76 In addition, a hybrid payer mismatch will not be an offshore hybrid mismatch if it is covered by:

·
foreign hybrid mismatch rules that correspond to the hybrid payer mismatch rule; or
·
a law that has substantially the same effect as foreign hybrid mismatch rules that correspond to the hybrid payer mismatch rule.

[Schedule 1, item 45, paragraph 832-300(1)(c)]

1.77 Under the reverse hybrid mismatch rule, a reverse hybrid mismatch will be an offshore hybrid mismatch if:

·
the deduction component of the mismatch is a foreign income tax deduction; and
·
the country in which the foreign income tax deduction arose has foreign hybrid mismatch rules that correspond to the reverse hybrid mismatch rule.

[Schedule 1, item 46, subsection 832-390(1)]

1.78 Under the branch hybrid mismatch rule, a branch hybrid mismatch will be an offshore hybrid mismatch if:

·
the deduction component of the mismatch is a foreign income tax deduction;
·
the country in which the foreign income tax deduction arose has foreign hybrid mismatch rules that correspond to the branch hybrid mismatch rule; and
·
subsection 23AH(4A) of the ITAA 1036 does not apply in relation to the branch hybrid mismatch.

[Schedule 1, item 47, paragraph 832-465(1)(b)]

1.79 Under the deducting hybrid mismatch rule, Australia will be required to apply the secondary response unless, in the primary response country, the mismatch is covered by:

·
foreign hybrid mismatch rules that correspond to the deducting hybrid mismatch rule; or
·
a law that has substantially the same effect as foreign hybrid mismatch rules that correspond to the deducting hybrid mismatch rule.

[Schedule 1, item 48, paragraph 832-535(2)(b)]

1.80 In addition, a deducting hybrid mismatch will not be an offshore hybrid mismatch if, in any country in which a foreign income tax deduction arose; it is covered by:

·
foreign hybrid mismatch rules that correspond to the deducting hybrid mismatch rule; or
·
a law that has substantially the same effect as foreign hybrid mismatch rules that correspond to the deducting hybrid mismatch rule.

[Schedule 1, item 49, paragraph 832-540(1)(b)]

1.81 A mismatch is covered by foreign hybrid mismatch rules that correspond to the relevant Subdivision in Division 832 if those foreign hybrid mismatch rules can apply to the mismatch. For these purposes, it is not necessary to determine whether the foreign jurisdiction has actually applied the foreign hybrid mismatch rules to neutralise the mismatch.

Example 1.4 :

Example 1.4

Aus Sub and Aus Sub 2 are members of the XYZ Ltd consolidated group. Aus Sub incurs service fees which are paid to Aus Sub 2 in respect of its permanent establishment in Country X.XYZ Ltd is a liable entity in Australia in respect of the income or profits of Aus Sub and Aus Sub 2. Therefore, the requirement in subsection 832-325(3) is met.In Country X, Aus Sub is the liable entity in respect of its own income or profits.Consequently, the service fee paid by Aus Co to Aus Sub 2:

·
is deductible in Country X against the profits of Aus Sub's Country X permanent establishment; and
·
is not subject to Australian income tax because of the single entity rule.

Accordingly, Aus Sub is a hybrid payer and the service fee payment gives rise to a deduction/non-inclusion mismatch.Country X has a law that results in denials of deductions or inclusions in assessable income for hybrid mismatches in respect of payments that give rise to a deduction in one country and non-inclusion of income in the recipient country.However, as this law only applies in respect of payments in the nature of interest and royalties for Country X purposes, it does not cover the payment of service fees from Aus Sub to Aus Sub 2.Consequently, the mismatch is not covered by:

·
foreign hybrid mismatch rules that correspond to the hybrid payer mismatch rules in Subdivision 832-D; or
·
a law that has substantially the same effect as foreign hybrid mismatch rules that correspond to the hybrid payer mismatch rules in Subdivision 832-D.

Therefore, under subsection 832-290(2), Australia is required to apply the secondary response to the hybrid payer mismatch.

Foreign income tax does not include foreign municipal or State taxes

1.82 The hybrid mismatch rules apply to a payment only if:

·
a deductible payment gives rise to double non-taxation because it is not included in a tax base - that is, a deduction/non-inclusion mismatch arises; or
·
a payment gives rise to two deductions - that is, a deduction/deduction mismatch arises.

1.83 At least one of the components of a deduction/non-inclusion mismatch or a deduction/deduction mismatch is determined by reference as to whether an amount is subject to foreign income tax.

1.84 Concerns have been raised that there is some uncertainty about whether foreign income tax includes foreign municipal taxes and State taxes.

1.85 If foreign municipal taxes and State taxes were taken into account in determining whether a payment is subject to foreign income tax and gives rise to a deduction/non-inclusion mismatch or a deduction/deduction mismatch, it would be necessary to consider the taxation consequences for a payment at multiple levels of government in a foreign jurisdiction for the purpose of determining whether a hybrid mismatch arises. This would place an unreasonable compliance burden on affected taxpayers.

1.86 To address these concerns, the amendments clarify that, for the purposes of applying the hybrid mismatch rules, foreign income tax does not include:

·
municipal tax; and
·
in the case of a federal foreign country - a State tax.

[Schedule 1, item 11, subsection 832-130(7)]

1.87 This is relevant for the purposes of determining whether:

·
a foreign income tax deduction arises in relation to an amount - this is a core concept that affects the operation of all of the hybrid mismatch rules and the hybrid mismatch integrity rule;
·
an amount is subject to foreign income tax - this is a core concept that affects the operation of all of the hybrid mismatch rules (other than the imported hybrid mismatch rule) and the hybrid mismatch integrity rule;
·
the extended operation of the hybrid financial instrument mismatch rule in relation to concessional foreign taxes applies;
·
an entity is a liable entity - this is a core concept that affects the operation of all of the hybrid mismatch rules and the hybrid mismatch integrity rule;
·
the hybrid requirement in the branch hybrid mismatch rule is satisfied;
·
an entity is a branch hybrid for the purposes of the branch hybrid mismatch rule;
·
a country is a secondary response country for the purposes of the deducting hybrid mismatch rule;
·
a payment made by an entity is an importing payment in relation to an offshore hybrid mismatch for the purposes of the imported hybrid mismatch rule; and
·
the adjustment to dual inclusion income for an Australian foreign income tax offset applies.

[Schedule 1, items 2 to 4, 7 to 10, 13, 18, 23, 24, 26, 28, 29 and 33, sections 832-110, 832-120, 832-130, 832-235, 832-325, 832-480, 832-485, 832-555, 832-625 and 832-680]

1.88 As a result of these amendments, taxes imposed at the local or State level in a foreign jurisdiction will not have to be taken into account in determining whether a payment gives rise to a deduction/non-inclusion mismatch or a deduction/deduction mismatch.

1.89 However, for the purpose of applying the hybrid mismatch integrity rule, in working out whether foreign income tax has been imposed on the payment in a foreign jurisdiction at a rate of 10 per cent or more, any foreign municipal taxes and State taxes will be taken into account. [Schedule 1, item 38, subsection 832-725(1A)]

1.90 In this regard, the hybrid mismatch integrity rule is intended to apply only if a scheme results in the total foreign income tax being imposed on a payment is at a rate of 10 per cent or less.

Operation of the hybrid mismatch rules for MEC groups

1.91 Under the consolidation regime (Part 3-90), an Australian owned corporate group can be treated as a single entity for income tax purposes by forming a consolidated group (consisting of the Australian head company and its wholly owned subsidiaries).

1.92 A foreign owned corporate group that has Australian resident members (and two or more first tier Australian subsidiaries) can also be treated as a single entity for income tax purposes by forming a MEC group (consisting of the Australian entities in the group). One of the first tier Australian subsidiaries of the group (an eligible tier-1 company) is taken to be the head company of the group.

1.93 The amendments ensure that the hybrid mismatch rules apply to members of MEC groups in the same way that they apply to members of consolidated groups.

1.94 Therefore, for the purpose of working out whether a reverse hybrid mismatch arises, an entity is not a transparent entity in Australia if, so far as is relevant, the entity is a member of a consolidated group or a MEC group. [Schedule 1, item 22, subparagraph 832-410(2)(b)(ii)]

1.95 Similarly, for the purpose of working out whether a deducting hybrid mismatch arises, an entity can be a deducting hybrid in relation to a payment if, among other things, the entity is a member of a consolidated group or a MEC group. [Schedule 1, item 25, subparagraph 832-550(c)(iii)]

1.96 A consequential amendment is made to a note to section 832-325 (which specifies when an entity is a liable entity) so that it appropriately refers to a subsidiary member of a consolidated groups or MEC group. [Schedule 1, item 17, note 2 after subsection 832-325(1)]

The hybrid mismatch integrity rule

1.97 The targeted hybrid mismatch integrity rule operates to disallow an Australian income tax deduction of an entity for a payment of interest (or a payment of a similar character), or an amount under a derivative financial arrangement, under a scheme to a foreign entity if, among other things, the scheme results in foreign income tax being imposed on the payment at a rate of 10 per cent or less.

1.98 The integrity rule does not apply if, among other things, the payment gives rise to a hybrid mismatch under one of the specific hybrid mismatch rules.

1.99 The amendments ensure that the hybrid mismatch integrity rule can apply appropriately to financing arrangements that have been designed to circumvent the operation of the hybrid mismatch rules.

Both the deducting hybrid mismatch rule and the integrity rule can apply to a payment

1.100 The integrity rule does not apply to financing arrangements that, for example, give rise to both:

·
a deduction/deduction outcome that gives rise to a deducting hybrid mismatch; and
·
an effective replication of a deduction/non-inclusion outcome by the interposition of a foreign entity located in a no or low tax jurisdiction.

1.101 The deduction/deduction outcome may trigger the deducting hybrid mismatch rule. However, the entitlement to a deduction may not be neutralised because, for example, Australia is the secondary response country or the deduction has been sheltered by dual inclusion income.

1.102 In these circumstances, the integrity rule does not apply to neutralise the replicated deduction/non-inclusion outcome even though the entitlement to a deduction has survived.

1.103 Therefore, to address these concerns, the integrity rule is being modified so that it can apply to a payment even if the payment gives rise to a deducting hybrid mismatch. [Schedule 1, item 58, subsection 832-725(6)]

1.104 However, the hybrid financial instrument mismatch will continue to take precedence over the integrity rule. Therefore, the integrity rule will not apply to deny a deduction for a payment to the extent that the deduction is denied under subsection 830-530(2) because the payment gives rise to a deducting hybrid mismatch. [Schedule 1, item 59, subsection 832-725(7)]

1.105 Minor technical amendments are also being made to the integrity rule to:

·
update the guide material for the integrity rule; and
·
clarify that the entity that may be entitled to a deduction in respect of a payment (but for the operation of the integrity rule) may not be the paying entity.

[Schedule 1, items 54 to 57, section 832-720, paragraph 832-725(1)(e) and subsection 832-725(3)]

1.106 Generally, if a deduction for a payment is denied under the deducting hybrid mismatch rule in an income year, a deduction may be allowed for the payment in a later income year if an amount of dual inclusion income that has been subject to Australian income tax or foreign income tax or is available to be applied by the deducting hybrid in that later income year (section 832-565).

1.107 To protect the integrity of the hybrid mismatch rules, this later year deduction will not be allowed if a deduction would have been denied in the earlier income year under the integrity rule (on the assumption that the integrity rule applied to the payment in that earlier income year). [Schedule 1, item 53, subsection 832-565(2A)]

1.108 This reflects the outcome that would arise if the integrity rule (rather than the deducting hybrid mismatch rule) had applied in the earlier income year. That is, if the integrity rule applies to deny a deduction for a payment in an income year, a deduction is not allowed in a later income year where there is an amount of dual inclusion income in that later income year.

Example 1.5 In the 2020-21 income year, Aus Co:

·
makes an interest payment of $10,000 to Interposed Foreign Co; and
·
derives an amount dual inclusion income of $2,000 - that is, an amount that is less than the interest payment.

Interposed Foreign Co is a resident of a foreign country that has a corporate tax rate of 8 per cent. Both Aus Co and Interposed Foreign Co are members of the Global Co corporate group.The interest payment made by Aus Co to Interposed Foreign Co gives rise to a deducting hybrid mismatch under section 832-545.Australia is identified as the primary response country with respect to the deducting hybrid mismatch under section 832-555.As the deducting hybrid mismatch rule takes priority over the integrity rule, that rule operates in the first instance to deny a deduction for the interest payment under section 832-530 in the 2020-21 income year.However, dual inclusion income derived by Aus Co ($2,000) is available to reduce the neutralising amount of $10,000. Therefore, only $8,000 of the deduction is disallowed under the deducting hybrid mismatch rule. As a result, a remaining part of the deduction for the interest payment ($2,000) is still available.Subsection 832-725(7) allows the integrity rule to apply to the interest payment to deny that part of the deduction for the interest payment that was not denied under the deducting hybrid mismatch rule.As the conditions for applying the integrity rule in subsection 832-725(1) are satisfied in relation to the interest payment (and none of the exceptions in subsections 832-725(4) to (6) apply), subsection 832-725(3) will apply to deny the remaining part of the deduction ($2,000) for the interest payment.In the 2022-23 income year, Aus Co identifies an additional amount of dual inclusion income ($8,000) that is available to be applied by the deducting hybrid. However, if the earlier year application of the deducting hybrid mismatch rule to disallow a part of the deduction in the 2020-21 income year is disregarded, the integrity rule would have applied to deny a deduction (assuming the principal purpose test in paragraph 832-725(1)(h) is satisfied) for the whole amount of the interest payment in that income year.Therefore, subsection 832-565(2A) prevents Aus Co from being able to claim a deduction under subsection 832-565(2) for the interest payment in the 2022-23 income year.

Example 1.6 The facts are the same as Example 1.5 except that:

·
in the 2020-21 income year, Australia is identified as the secondary response country with respect to the deducting hybrid mismatch under section 832-555; and
·
the relevant primary response country has foreign hybrid mismatch rules.

As a result, the additional requirements in section 832-535 for a secondary response are not met and section 832-530 does not apply to disallow any deduction for the interest payment that gives rise to a deducting hybrid mismatch.Subsection 832-725(7) allows the integrity rule to apply to the interest payment to deny a deduction for the interest payment that was not denied under section 832-530 - that is, $10,000.The conditions for applying the integrity rule in subsection 832-725(1) are satisfied (assuming the principal purpose test in paragraph 832-725(1)(h) is satisfied) in relation to the interest payment (and none of the exceptions in subsections 832-725(4) to (6) apply).Therefore, as subsection 832-530(2) has not applied to deny a deduction for the interest payment to any extent, subsection 832-725(3) will apply to deny the entire deduction for the interest payment.

Adjustment under the hybrid financial instrument mismatch rule where a payment is taxed in a later income year may be denied

1.109 If a payment gives rise to a hybrid financial instrument mismatch in an income year, a deduction may be denied in that income year for the deduction component of the mismatch (section 832-180).

1.110 As the payment gave rise to a hybrid financial instrument mismatch in that income year, the integrity rule does not apply in that income year (subsection 832-725(6)), even though the conditions to apply the integrity rule (as set out in subsection 832-725(2)) would be satisfied in relation to that payment. That is, the hybrid financial instrument mismatch takes precedence over the integrity rule.

1.111 If some or all of the payment is subject to foreign income tax or Australian income tax in a later income year, then the hybrid financial instrument mismatch rules apply to allow a deduction for the taxed amount of the payment in the later income year (section 832-240).

1.112 To protect the integrity of the hybrid mismatch rules, this later year deduction will not be allowed if a deduction would have been denied in the earlier income year under the integrity rule (on the assumption that the integrity rule applied to the payment in that earlier income year). [Schedule 1, item 52, subsection 832-240(2A)]

1.113 This reflects the outcome that would arise if the integrity rule (rather than the hybrid financial instrument mismatch rule) had applied in the earlier income year. That is, if the integrity rule applies to deny a deduction for a payment in an income year and some or all of the payment is subject to foreign income tax or Australian income tax in a later income year, a deduction is not allowed for the payment in that later income year.

Example 1.7 At the start of the 2020-21 income year, Aus Co enters into a 5 year interest bearing loan, borrowing from Interposed Foreign Co. Under the terms of the loan arrangement, Aus Co is required to make a lump sum payment for the accrued interest at the end of the arrangement.Interposed Foreign Co is a resident of a foreign country that has a corporate tax rate of 8 per cent. Both Aus Co and Interposed Foreign Co are members of the Global Co corporate group.The interest bearing loan is a Division 230 financial arrangement for Australian income tax purposes. Aus Co is entitled to a deduction in respect of accrued interest under the loan for the 2020-21 income year due to sufficiently certain (and fixed and determinable) financial benefits (being the interest payment made by Aus Co) to be provided on maturity under the terms of the loan arrangement.For purposes of applying the hybrid mismatch rules, the accrued interest is a payment made by Aus Co to Interposed Foreign Co and gives rise to a hybrid financial instrument mismatch.A deduction/non-inclusion mismatch arises because:

·
Aus Co is entitled to a deduction in respect of the interest payment on an accruals basis (under the taxation of financial arrangements regime) in the 2020-21 income year; and
·
the interest payment will not be subject to foreign income tax in a foreign tax period ending within 12 months after the end of the 2020-21 income year - that is, under the law of the foreign country in which Interposed Foreign Co is a resident, Interposed Foreign Co is taxed only when the cash payment is received in 2024-25 income year (when the lump sum payment is made at the end of the loan arrangement).

Consequently, sections 832-180 and 230-522 apply so that Aus Co is not entitled to a deduction for the payment (being a taxation of financial arrangements loss) in the 2020-21 income year.In the 2024-25 income year, the cash payment of the interest is subject to foreign income tax in the foreign country in which Interposed Foreign Co is a resident.Under the current law, section 832-240 would apply to allow a deduction to Aus Co for the payment in the 2024-25 income year.However, if the payment had not given rise to a hybrid financial instrument mismatch in the 2020-21 income year, the conditions for applying the integrity rule in subsection 832-725(1) would have been satisfied (assuming the principal purpose test in paragraph 832-725(1)(h) is satisfied) in relation to the interest payment (and none of the exceptions in subsections 832-725(4) to (6) would have applied). Therefore, the integrity rule would have applied to deny a deduction for the payment in the 2020-21 income year.Consequently, subsection 832-240(2A) prevents Aus Co from being able to claim a deduction under subsection 832-240(2) for the whole amount of the interest payment in the 2024-25 income year.

Foreign municipal taxes and State taxes continue to be recognised

1.114 The amendments which clarify that, for the purposes of applying the hybrid mismatch rules, foreign income tax does not include any foreign municipal taxes and State taxes do not affect the operation of the hybrid mismatch integrity rule.

1.115 That is, for the purposes of applying the hybrid mismatch integrity rule, in working out whether foreign income tax has been imposed on the payment in a foreign jurisdiction at a rate of 10 per cent or more, any foreign municipal taxes and State taxes will be taken into account. [Schedule 1, item 38, subsection 832-725(1A)]

1.116 In this regard, the hybrid mismatch integrity rule is intended to apply only if a scheme results in the total foreign income tax being imposed on a payment is at a rate of 10 per cent or less.

Franking benefits on distributions made on Additional Tier 1 capital instruments issued in Australia

1.117 Additional Tier 1 capital can be issued by ADIs and insurance companies and other entities that are grouped for prudential purposes. If an ADI or insurance company (or other grouped entity) that has a foreign branch issues Additional Tier 1 capital, part of the Additional Tier 1 capital may be attributable to the foreign branch (depending on the laws of the particular foreign country) because the relevant entity is carrying on business in the foreign country where the branch is located (whether or not the Additional Tier 1 capital is issued in Australia).

1.118 An issue has arisen with the operation of the hybrid mismatch rules because all or part of the distribution on Additional Tier 1 capital issued by an Australian entity that is attributed to a foreign branch located in some foreign jurisdictions may be deductible in one or more of those foreign jurisdictions.

1.119 In this regard, currently the hybrid mismatch rules operate to deny imputation benefits on a distribution if all or part of the distribution gives rise to a foreign income tax deduction (paragraph 207-145(db), paragraph 207-150(1)(eb) and section 207-158). An amount that reflects all or part of the distribution will give rise to a foreign income tax deduction if an entity is entitled to deduct the amount in working out the tax base for a foreign tax period under the law of a foreign country dealing with foreign income tax (section 830-120).

1.120 The amount of the deduction entitlement in the foreign country for a distribution on the Additional Tier 1 capital instrument issued by an Australian ADI or insurance company may be for a comparatively small part of the distribution. However, regardless of how small the foreign income tax deduction is compared to the amount of the distribution, this will result in the denial of franking benefits on the whole distribution to investors in the Additional Tier 1 capital instrument. This would have a significant impact on the pricing of Additional Tier 1 capital instruments in Australia.

1.121 Therefore, the amendments ensure that franking benefits are not denied on distributions made in respect of an equity interest if the interest forms part of the Additional Tier 1 capital for the purposes of:

·
applicable prudential standards (as defined in subsection 995-1)(1) - the prudential standards are defined to mean the prudential standards determined by the APRA and in force under section 11AF of the Banking Act 1959;
·
applicable prudential standards determined by APRA and in force under section 32 of the Insurance Act 1973; or
·
applicable prudential standards determined by APRA and in force under section 230A of the Life Insurance Act 1995.

[Schedule 1, item 63, section 207-158]

1.122 In this regard, the relevant prudential standards apply to the Additional Tier 1 capital of:

·
an ADI;
·
a general insurance company; or
·
a life insurance company; or
·
a non-operating holding company of an ADI, general insurance company or life insurance company.

1.123 In these circumstances, an amount equal to the foreign income tax deduction is included in the assessable income of the entity that made the franked distribution in:

·
if the foreign tax period in which the foreign income tax deduction arises falls wholly in an income year of the entity - that income year; or
·
if the foreign tax period in which the foreign income tax deduction arises straddles two income years of the entity - the later of those income years.

[Schedule 1, item 62, section 15-80]

1.124 A consequential amendment is made to the table that lists particular kinds of assessable income. [Schedule 1, item 61, section 10-5]

Application and transitional provisions

1.125 The amendments relating to distributions made on Additional Tier 1 capital instruments commence on the day that the relevant Act receives the Royal Assent.

1.126 The remaining amendments commence on the first 1 January, 1 April, 1 July or 1 October to occur after the day that the relevant Act receives the Royal Assent.

1.127 The following amendments clarify the operation of the hybrid mismatch rules and ensure that they operate as intended:

·
clarify the operation of the hybrid mismatch rules for trusts and partnerships;
·
clarify the circumstances in which an entity is a deducting hybrid;
·
clarify the operation of the dual inclusion income rule;
·
clarify the operation of provisions that refer to corresponding foreign hybrid mismatch rules;
·
clarify that, for the purpose of applying the hybrid mismatch rules, foreign income tax generally does not include foreign municipal or State taxes; and
·
clarify that the hybrid mismatch rules apply to MEC groups in the same way as they apply to consolidated groups.

1.128 Therefore, these amendments apply to assessments made for income years starting on or after 1 January 2019 - that is, from the time that the hybrid mismatch rules started to apply. [Schedule 1, item 41]

1.129 These amendments are beneficial to affected taxpayers as they will improve the operation of the hybrid mismatch rules by making the rules more certain and removing some anomalous outcomes that arise under the existing law.

1.130 The amendments to clarify the meaning of foreign hybrid mismatch rules apply to assessments made for income years starting on or after 1 July 2020. [Schedule 1, item 51]

1.131 These amendments are intended to clarify the operation of the existing law but apply prospectively because they have not been previously announced.

1.132 The amendments to ensure that the hybrid mismatch integrity rule can apply appropriately to financing arrangements that have been designed to circumvent the operation of the hybrid mismatch rules could disadvantage some taxpayers and therefore apply to assessments made for income years starting on or after 2 April 2019 - that is, to income years starting after the date of announcement. [Schedule 1, item 60]

1.133 In this regard, these amendments will ensure that the hybrid mismatch integrity rule applies as intended. The primary objective of the integrity rule is to prevent the effect of the hybrid mismatch rules to neutralise double non-taxation outcomes from being compromised by multinational groups by using interposed conduit type entities that pay effectively no tax to invest in Australia, as an alternative to investing into Australia using hybrid instruments or entities.

1.134 The amendments relating to distributions made on Additional Tier 1 capital instruments apply to distributions made on or after 1 January 2019. [Schedule 1, item 64]

1.135 These amendments are beneficial to, and have been sought by, affected stakeholders as they will ensure that investors in the Additional Tier 1 capital instruments are not denied franking benefits on franked distributions made in respect of those instruments.


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