Edited version of private advice

Authorisation Number: 1051901180535

Date of advice: 17 September 2021

Ruling

Subject: Hybrid mismatch rules

Question 1

Do the expenses incurred by Company X give rise to a foreign income tax deduction under section 832-120 of the Income Tax Assessment Act 1997 (ITAA 1997), such that there is a deduction/deduction mismatch for the purposes of section 832-110 of the ITAA 1997?

Answer

Yes.

Question 2

If the answer to question 1 is yes, is the amount of the foreign income tax deduction, and therefore the amount of the deduction/deduction mismatch, limited to the amount that is represented in the tax base of Company Z, being no more than the proportionate share of the total expenses incurred by Company X?

Answer

Yes.

Question 3

If the answer to question 1 is yes, in considering the effect of section 832-530 in relation to a deduction that would otherwise be allowable to Company Y (as the provisional head company of the MEC group that Company X is a subsidiary member of), is the amount of dual inclusion income under section 832-680 of the ITAA 1997 limited to the amount included in the tax base of Company Z on which tax is payable, being no more than the proportionate share of the total income derived by Company X?

Answer

Yes.

Relevant facts and circumstances

The description of the scheme is drawn from information provided by the Applicant in their private binding ruling application.

1.         The Applicant is part of a multinational group headquartered in Country A.

2.         Company X was incorporated in Australia and is a resident of Australia for income tax purposes.

3.         Company X and Company Y are part of a multiple entry consolidated group (MEC group) with Company Y as the provisional head company (PHC).

4.         Company X is treated as a partnership for US purposes.

5.         The income derived and expenses incurred by Company X are ultimately distributed to two foreign resident entities, one being Company Z.

6.         Company Z is a resident of the US for income tax purposes and treated as a partner in Company X for US income tax purposes.

7.         Relevant agreements are in place that ensure Company Z receives a proportionate share of Company X's income and expenses.

8.         Company Z includes its distributive share of Company X's income and expenses in its tax base in the US.

9.         Company X's expenses are deductible to Company Y as PHC of the MEC group.

10.      Company Z and Company Y have the same income year.

11.      Income derived and expenses incurred by Company X are not subject to foreign income tax in any jurisdiction except for the US.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 770-15

Income Tax Assessment Act 1997 section 770-15(1)

Income Tax Assessment Act 1997 Subdivision 832-G

Income Tax Assessment Act 1997 section 832-110

Income Tax Assessment Act 1997 section 832-110(1)

Income Tax Assessment Act 1997 section 832-110(2)

Income Tax Assessment Act 1997 section 832-110(3)

Income Tax Assessment Act 1997 section 832-120

Income Tax Assessment Act 1997 section 832-125

Income Tax Assessment Act 1997 section 832-130

Income Tax Assessment Act 1997 section 832-130(7)

Income Tax Assessment Act 1997 section 832-530

Income Tax Assessment Act 1997 subsection 832-530(1)

Income Tax Assessment Act 1997 subsection 832-530(2)

Income Tax Assessment Act 1997 section 832-545

Income Tax Assessment Act 1997 section 832-545(1)

Income Tax Assessment Act 1997 section 832-545(2)

Income Tax Assessment Act 1997 section 832-545(4)

Income Tax Assessment Act 1997 section 832-550

Income Tax Assessment Act 1997 subsection 832-550(a)

Income Tax Assessment Act 1997 subsection 832-550(b)

Income Tax Assessment Act 1997 subsection 832-550(c)

Income Tax Assessment Act 1997 section 832-555

Income Tax Assessment Act 1997 section 832-560

Income Tax Assessment Act 1997 section 832-680

Income Tax Assessment Act 1997 subsection 995-1(1)

Reasons for decision

Question 1

Do the expenses incurred by Company X give rise to a foreign income tax deduction under section 832-120 of the Income Tax Assessment Act 1997 (ITAA 1997), such that there is a deduction/deduction mismatch for the purposes of section 832-110 of the ITAA 1997?

Answer

Yes. The expenses incurred by Company X are included in the calculation of Company Z's tax base and give rise to a foreign income tax deduction for Company Z in respect of its proportionate share of Company X's expenses. A deduction/deduction mismatch occurs because Company X's expenses are also deductible for Company Y as the PHC of the MEC group.

Detailed reasoning

Hybrid mismatch rules generally

1.         A hybrid mismatch arises if double non-taxation results from the exploitation of differences in the tax treatment of an entity or financial instrument under the laws of 2 or more countries.

2.         There is double non-taxation if a deductible payment is not included in a tax base (this is called a deduction/non-inclusion mismatch), or if a single payment gives rise to deductions in two jurisdictions (this is called a deduction/deduction mismatch). Disallowing a deduction, or including an amount in assessable income, neutralises this tax advantage.

3.         The hybrid mismatch provisions generally apply to income years commencing on or after 1 January 2019.

Deduction/deduction mismatch

4.         Section 832-110 explains when a payment gives rise to a deduction/deduction mismatch:

(1)  A payment gives rise to a deduction/deduction mismatch if the payment, or a part or share of the payment:

(a)  gives rise to a *foreign income tax deduction in a foreign country in a *foreign tax period; and

(b)  also gives rise to:

                                                            i.        a deduction in an income year; or

                                                           ii.        a foreign income tax deduction in a foreign country (other than the country mentioned in paragraph (a)).

Note: A deduction/deduction mismatch might give rise to a deducting hybrid mismatch (see Subdivision 832-G).

(2)  Each of the following is a deduction component of the *deduction/deduction mismatch:

(a)  the *foreign income tax deduction mentioned in paragraph (1)(a);

(b)  the deduction mentioned in subparagraph (1)(b)(i), or the foreign income tax deduction mentioned in subparagraph (1)(b)(ii), as the case requires.

...

5.         Relevantly, the scope for the deduction/deduction mismatch condition to be satisfied beyond mere payments is extended to amounts representing the decline in value of an asset (paragraph 832-110(4)(a)).

Is there a payment?

6.         The relevant payments are all of the expenses (see paragraph 33) incurred by Company X in respect of the decline in value of assets and deductible payments made by Company X to third party recipients outside of the MEC group.

7.         For the purposes of Division 832, when identifying payments made or received by an entity, the single entity rule in subsection 701-(1) is disregarded per subparagraph 832-30(1)(a).

8.         Therefore, the expenses incurred by Company X are payments for the purposes of subsection 832-110(1).

Is there a foreign income tax deduction?

9.         A foreign income tax deduction is defined in section 832-120:

(1)  An amount of a loss or outgoing is a foreign income tax deduction in a foreign country in a *foreign tax period to which an entity is entitled, if the entity is entitled to deduct the amount in working out its tax base for the foreign tax period under a law of the foreign country dealing with *foreign income tax (except a tax covered by subsection 832-130(7)).

(2)  To avoid doubt, an amount of a loss or outgoing may be a foreign income tax deduction in a foreign country in a *foreign tax period even if the relevant entity's tax base is nil, or a negative amount.

...

10.      The Explanatory Memorandum to the Treasury Laws Amendment (Tax Integrity and Other Measures No. 2) Bill 2018 (the 2018 EM) provides relevant guidance on foreign income tax deductions at paragraphs 1.84 to 1.86:

1.84 An amount of a loss or outgoing is a foreign income tax deduction in a foreign country in a foreign tax period to which an entity is entitled if the entity is entitled to deduct the amount in working out its tax base for the foreign tax period under a law of the foreign country dealing with foreign income tax. [Schedule 1, items 1 and 13, subsection 832-120(1) and the definition of 'foreign income tax deduction' in subsection 995-1(1)]

1.85 An amount of a loss or outgoing may be a foreign income tax deduction in a foreign country in a foreign tax period even if the entity's tax base is nil or a negative amount. [Schedule 1, item 1, subsection 832-120(2)]

1.86 An amount is taken to be deducted in working out the tax base of an entity under a law in the foreign country for the foreign tax period if it is applied to reduce the amount of tax payable by the entity in the foreign country in any way. This could include, for example:

•         an amount that specifically reduces the amount of tax payable by the entity in the foreign country (akin to an amount that is a deduction under the Australian income tax law); or

•         an amount that is an element in the calculation by the entity of a net amount that is included in the tax base under the law in the foreign country.

11.      Accordingly, a foreign income tax deduction can include an amount of a loss or outgoing that is included as an element in the calculation of a net amount received by an entity (such as a partner in a partnership) if that net amount is taken into account in working out the tax base of an entity in the foreign country.

12.      A foreign tax period is defined in subsection 995-1(1) as follows:

foreign tax period, in relation to an entity, in relation to a foreign tax imposed by a tax law of a foreign country, means the accounting period used by the entity for the purposes of determining the tax base under that law.

13.      The relevant foreign tax period of Company Z corresponds with the period of Company Y as the PHC of the MEC group.

14.      Foreign income tax is defined in subsection 770-15(1) as follows:

(1)  Foreign income tax means tax that:

(a)  is imposed by a law other than an *Australian law; and

(b)  is:

                                                            i.        tax on income; or

                                                           ii.        tax on profits or gains, whether of an income or capital nature; or

                                                          iii.        any other tax, being a tax that is subject to an agreement having the force of law under the International Tax Agreements Act 1953.

Note: Foreign income tax includes only that which has been correctly imposed in accordance with the relevant foreign law or, where the foreign jurisdiction has a tax treaty with Australia (having the force of law under the International Tax Agreements Act 1953), has been correctly imposed in accordance with that tax treaty.

15.      For the purposes of determining whether a foreign income tax deduction exists under section 832-120, taxes included in subsection 832-130(7) are excluded:

(7) This subsection covers each of the following:

(a)  *credit absorption tax;

(b)  *unitary tax;

(c)   withholding-type tax;

(d)  municipal tax;

(e)  in the case of a federal foreign country-a State tax.

Note: The definitions of credit absorption tax and unitary tax are in section 770-15.

16.      For the relevant income years, the expenses incurred by Company X are included in Company Z's tax calculation and ultimately subject to foreign income tax in the hands of Company Z.

Conclusion

17.      The requirements of section 832-120 are met because during the relevant foreign tax period, Company Z is entitled to deduct the amounts represented by a portion of Company X's expenses in working out its tax base.

18.      Therefore, a deduction/deduction mismatch arises pursuant to section 832-110 in respect of Company X's expenses to the extent that those expenses are deductible in Australia and give rise to a foreign income tax deduction for Company Z.

Question 2

If the answer to question 1 is yes, is the amount of the foreign income tax deduction, and therefore the amount of the deduction/deduction mismatch, limited to the amount that is represented in the tax base of Company Z, being no more than the proportionate share of the total expenses incurred by Company X?

Answer

Yes. The amount of the foreign income tax deduction will be limited to no more than Company Z's proportionate share of Company X's expenses. The amount of the deduction/deduction mismatch will also be limited to no more than Company Z's proportionate share of Company X's expenses.

Detailed reasoning

1.         Based on the reasons for decision to question 1, a foreign income tax deduction occurs in the hands of Company Z in respect of the expenses incurred by Company X and a deduction/deduction mismatch arises because the expenses are also deductible in Australia.

2.         Because Company Z only receives a proportion of Company X's income and expenses, Company Z's foreign income tax deduction is limited to the proportion of Company X's expenses that have been allocated to Company Z.

3.         Pursuant to subsection 832-110(3):

The amount of the *deduction/deduction mismatch is the lesser of:

(a)       the amount of the *foreign income tax deduction mentioned in paragraph (1)(a); and

(b)       the sum of the amounts of the deduction, or foreign income tax deduction, mentioned in subparagraph (1)(b)(i) or (ii).

4.         The amount of the deduction/deduction mismatch is the lesser of Company Z's foreign income tax deduction and Company Y's (as the PHC of the MEC group) deduction for Company X's expenses (section 832-110(3)).

5.         It follows that the foreign income tax deduction and the deduction/deduction mismatch will be limited to no more than the amount represented in Company Z's tax base because Company Z is only taking into account a proportion of Company X's expenses in working out its tax base (which are deductible to Company Z as the PHC of the MEC group).

6.         On the basis that Company Z receives only a proportion of Company X's expenses throughout the ruling period, in respect of Company X's expenses, the deduction allowable in Australia to Company Y as the PHC of the MEC group (before any application of the hybrid mismatch rules) should be larger than the foreign income tax deduction to Company Z in each income year during the ruling period.

7.         On the basis that Company Z is allocated only a proportion of Company X's income and expenses, the deduction/deduction mismatch in those years should also be limited to no more than the amount of the foreign income tax deduction included in the calculation of Company Z's tax base in respect of Company X's expenses.

8.         Similarly, if, for any reason, the foreign income tax deduction included in the calculation of Company Z's tax base is larger than the deduction claimed by Company Y (as the PHC of the MEC group) in Australia, the deduction/deduction mismatch would be limited to the lesser amount.

Question 3

If the answer to question 1 is yes, in considering the effect of section 832-530 in relation to a deduction that would otherwise be allowable to Company Y (as the provisional head company of the MEC group that Company X is a subsidiary member of), is the amount of dual inclusion income under section 832-680 of the ITAA 1997 limited to the amount included in the tax base of Company Z on which tax is payable, being no more than the proportionate share of the total income derived by Company X?

Answer

Yes. The dual inclusion income is limited to the proportionate share of Company X's income that is included in the tax base of Company Z.

Detailed reasoning

1.         Dual inclusion income is defined in section 832-680 as follows:

(1)  An amount of income or profits is dual inclusion income if 2 or more of the following outcomes arise for the amount:

(a)       it is *subject to Australian income tax in an income year;

(b)       it is *subject to foreign income tax in a foreign country in a *foreign tax period;

(c)       it is subject to foreign income tax in a foreign country (other than the country mentioned in paragraph (b)) in a foreign tax period.

Note: In certain circumstances, dual inclusion income can be applied to reduce the neutralising amount for a hybrid payer mismatch (see section 832-330) or a deducting hybrid mismatch (see section 832-560).

(1A) In determining for the purposes of subsection (1) whether an amount of income or profits is *subject to Australian income tax, disregard subsection 832-125(2) (which is about when an amount included in the assessable income of a trust or partnership is subject to Australian income tax), so far as it applies in relation to assessable income from a foreign source.

Effect of Australian foreign income tax offset for underlying taxes

(2)  For the purposes of subsection (1), if:

(a) an amount of assessable income of a *corporate tax entity (the assessable amount) would, apart from this subsection and subsection (1A), be *subject to Australian income tax; and

(b) an amount of *foreign income tax (except a tax covered by subsection 832-130(7)) paid in respect of the assessable amount counts towards a *tax offset for an entity under Division 770;

then:

(c) if the amount of the tax offset equals or exceeds the amount of *tax that would, having regard only to the assessable amount and the rate at which tax is imposed on the entity, be payable on the assessable amount--the assessable amount is treated as if it were not subject to Australian income tax; and

(d)       if the amount of the tax offset is a proportion of the amount of that tax--then that proportion of the assessable amount is treated as if it were not subject to Australian income tax.

...

2.         The 2018 EM provides guidance on when an amount will be subject to foreign income tax at paragraphs 1.99 to 1.101:

1.99 An amount of income or profits is subject to foreign income tax in a foreign country in a foreign tax period if foreign income tax is payable under a law of the foreign country in respect of the amount because the amount is included in the tax base of that law for the foreign tax period. [Schedule 1, items 1 and 13, section 832-130 and the definition of 'subject to foreign income tax' in subsection 995-1(1)]

1.100 An amount of income or profits may be subject to foreign income tax in a foreign country in a foreign tax period even if the relevant entity's tax base is nil, or a negative amount. [Schedule 1, item 1, subsection 832-130(2)]

1.101 Therefore, an amount is regarded as being included in the tax base of a law of a foreign country even if the entity applies losses, outgoings or foreign tax credits against the amount to reduce its tax payable.

3.         The income of Company X forms part of Company Y's (as the PHC of the MEC group) assessable income and is therefore subject to Australian income tax.

4.         For the purposes of Division 832, an entity's income or profits is to be identified disregarding the single entity rule in subsection 701-1(1), per subsection 832-30(3). As such, the income of Company X can be appropriately identified.

5.         The income of Company X is subject to foreign income tax in the hands of Company Z which includes it in the calculation of its tax base.

6.         Therefore, the dual inclusion income is limited to the proportion of assessable income allocated to Company Z.