The ATO has published Practical Compliance Guideline PCG 2021/5 (“the PCG”) setting out its compliance approach in relation to the imported hybrid mismatch rules.
The approach in the PCG requires Australian taxpayers with international related party dealings to undertake significant enquiries and information gathering from their foreign related entities to be considered at low risk of incorrectly claiming deductions for cross-border payments. Some welcome relief is provided for smaller taxpayers and taxpayers whose otherwise deductible related party cross-border payments were less than $2 million.
What are the imported hybrid mismatch rules about?
The hybrid mismatch rules broadly seek to neutralise the effects of tax benefits arising from the differences in how two countries treat particular payments or entities under their domestic tax laws. The imported hybrid mismatch rule operates to disallow deductions for a variety of ordinary cross-border payments (e.g., interest, rent and management fees) if the recipient of the payment sets off the income from the payment, directly or indirectly, against a deduction that arises under a hybrid mismatch arrangement in an offshore jurisdiction.
The imported hybrid mismatch rules complement the five basic categories of hybrid mismatch rules contained in Division 832 of the Income Tax Assessment Act 1997 and operate to deny an Australian entity a deduction if the entity “imports” an offshore hybrid into Australia through payments (directly or indirectly) made to the “offshore deducting entity” which has the hybrid mismatch outcome outside of Australia. This will generally occur where the offshore hybrid mismatch is not otherwise neutralised by foreign hybrid mismatch rules (i.e., a foreign country’s laws that correspond to Australia’s hybrid mismatch rules).
Who do the rules apply to?
The hybrid mismatch rules do not have de minimis carveouts for smaller entities and as such the entire population of Australian taxpayers (including individuals) are potentially subject to the rules.
The imported hybrid mismatch rules apply to any entity that is claiming Australian deductions for payments made to related parties (or unrelated parties where the hybrid mismatch is priced into or a design feature of the arrangement).
Where the hybrid mismatch is not priced into or a design feature of the arrangement, the imported hybrid mismatch rules only apply to payments made within a taxpayer’s Division 832 control group, broadly being an accounting consolidated group or a group of entities under 50% or greater common control.
Critically, for payments within a Division 832 control group, there does not need to be any relationship or nexus between the payment made by the Australian taxpayer and the payment that gives rise to the offshore hybrid mismatch. Both payments merely need to occur in the same period.
Additionally, an importing payment may be made directly or indirectly to the offshore deducting entity. That is, the Australian taxpayer may indirectly import an offshore hybrid mismatch by making a deductible payment to a foreign related entity if that foreign entity makes a deductible payment to the offshore deducting entity (or does so through a series of other foreign entities). Similarly, there does not need to be any relationship or link between any such payments when tracing through a chain of entities.
The PCG (click here) is focussed on those imported hybrid mismatches that arise within a Division 832 control group.
What is an example of how the rules operate?
While the hybrid mismatch rules can be somewhat complex, the true difficulty they pose is that they may require Australian taxpayers to have detailed information about what payments are occurring within their entire global group and how those payments are treated under foreign income tax laws.
For example, if an Australian taxpayer purchases trading stock from a non-resident related party, that may give rise to an imported hybrid mismatch resulting in the Australian taxpayer being denied a deduction if the non-resident related party has a hybrid mismatch with another entity (i.e., it claimed a foreign tax deduction for interest paid to a company which treated it as a tax-free equity distribution in its country).
The Australian taxpayer thus needs substantially more information to comply with the imported hybrid mismatch rule than ordinarily required to meet their other tax obligations. To determine the tax deductibility of one particular payment, it may need to obtain information about (and understand the tax treatment of) potentially thousands of other payments that have occurred in foreign jurisdictions throughout its entire corporate group.
From when do the rules apply?
The imported hybrid mismatch rules applied to payments within Division 832 control groups from income years commencing on or after 1 January 2020. Therefore, the 30 June 2021 income year represents the first year for which the PCG will be relevant.
What is the PCG trying to achieve?
While the rules are designed to prevent multinational groups from avoiding double non-taxation outcomes and achieving a competitive advantage over domestic groups, they may apply to any cross-border payments regardless of any tax avoidance purpose. The PCG therefore has a crucial role to play in providing a practical solution for taxpayers to limit the compliance burden.
However, the approaches outlined in the PCG may not practically achieve any meaningful reduction in compliance costs as it requires significant enquiries and information gathering and analysis for taxpayers to be considered “low-risk”. In the absence of such enquiries, taxpayers face administrative penalties for lack of reasonable care should an adjustment be made.
Importantly, at paragraph 24 of the PCG, the ATO takes the approach that a taxpayer should not claim a deduction for a payment unless they are able to obtain sufficient information to support a conclusion that the deduction in respect of the payment is not disallowed under the imported hybrid mismatch rules.
What is the compliance approach outlined in the PCG?
The PCG contains two ATO recommended approaches, being a top-down approach and a bottom-up approach, which can be used as alternatives or in combination. The PCG also contains an Appendix with a guide as to the categories of information that may be required. This Appendix includes an extensive list of queries which would impose an onerous compliance cost on taxpayers if adopted. While only a general guide, it seems likely that taxpayers will be requested to provide such information in any ATO review.
The top-down approach requires the taxpayer to obtain key information from the Head of Tax of the global group about any hybrid mismatches that exist anywhere in the group, closely consider the mismatch at the local level (e.g., with the local tax manager) including whether it is neutralised by foreign hybrid mismatch rules and then identify any other payments within the group to determine whether the offshore hybrid mismatch has been imported by the Australian taxpayer. Essentially, this approach requires the taxpayer to identify any hybrid mismatches within the group and trace backwards to determine if it is imported into Australia.
The bottom-up approach is essentially the opposite. It requires the taxpayer to trace all deductible related-party cross-border payments out of Australia and determine (e.g., through a local tax manager) if the foreign recipient of those payments has any offshore hybrid mismatches of its own and then keep tracing through to other entities in the group that the first foreign entity made deductible cross-border payments to. This process is repeated until all possible payment chains are exhausted.
Although the PCG states that the guidelines will be under continuous review, the approach adopted by the ATO appears to impose a heavy burden on taxpayers who in many cases will find it extremely difficult or costly to be able to obtain and properly analyse the information expected by the ATO in the approaches outlined in the PCG. This may be the case in situations where the taxpayer is a small subsidiary of a foreign parent that makes up a fraction of the global group’s turnover. In addition, some Division 832 control groups may include wholly unrelated businesses owned by a common parent such as a private equity fund which will make information gathering extremely problematic.
It is also unfortunate that the ATO has not sought to publish its views about which countries have rules (i.e., foreign hybrid mismatch rules) that correspond to Australia’s rules. This would have significantly reduced the compliance burden on taxpayers by essentially allowing them to ignore payments through such countries as there cannot be an importing hybrid mismatch in Australia if another country is allowed to neutralise the offshore hybrid mismatch under their rules.
What are the risk zones in the PCG?
The PCG contains 8 different risk zones based on the level of enquiries made by the Australian taxpayer. Those taxpayers who have to lodge a Reportable Tax Position (RTP) Schedule will be required to disclose which risk zone they fall into.
A welcome approach for the middle market is to automatically classify taxpayers in the Green Zone and at low risk of compliance activity with respect to imported hybrid mismatches if the total deductible cross-border payments made to other group members during the year was less than $2 million. This was advocated by Pitcher Partners in consultation on the PCG and achieves a sensible balance given the otherwise disproportionate compliance costs that could be imposed on smaller taxpayers.
Other taxpayers in the middle market (those with Australian group turnover of less than $250m) may also fall into the Yellow Zone if their group adopts an acceptable global policy to manage the imported hybrid mismatch rules. Being in the Yellow Zone means the taxpayer is rated as moderate risk with the PCG stating that ATO may review the methodologies adopted (i.e., to understand the group’s approach to identifying potential imported hybrid mismatches where it is otherwise differs from the ATO’s recommended approach in the PCG)
Other taxpayers have to demonstrate compliance with the ATO’s recommended approach (or otherwise not claim deductions) to be in the Green Zone. If the recommended approach was followed for at least 90% of total payments made to group members, the taxpayer may be in the Blue Zone meaning the ATO will only conduct a limited review to confirm arrangements are low risk. Otherwise, taxpayers may fall into one of two Red Zones which increases the risk of ATO review as well as the application of penalties should the ATO take the view that the deductions cannot be substantiated.
What are the next steps?
Clients should contact their Pitcher Partners representative to review their existing arrangements and determine what action is required in light of the finalisation of the PCG.