What are the rules about?
The hybrid mismatch rules arose out of the Organization for Economic Cooperation and Development’s (OECD) base erosion and profit shifting (BEPS) project following the 2015 report on Neutralising the Effects of Hybrid Mismatch Arrangements, which sought to address double non-taxation outcomes as a result of different tax jurisdictions treating an entity, branch or financial instrument in different ways.
Learn more about hybrid mismatch rules here.
The OECD sought to address particular instances where a payment gave rise to a tax deduction in the paying country that was not taxable in the recipient country (deduction/non-inclusion mismatches) and where a single payment gives rise to tax deductions in two different countries (deduction/deduction mismatches).
Australia adopted the OECD recommendations and implemented domestic hybrid mismatch rules in mid-2018 with application for income years commencing on or after 1 January 2019. The rules introduce many novel concepts in Australia’s tax legislation, are lengthy and complex and, despite stating that they target multinational groups, in fact apply to all taxpayers regardless of their size with no grandfathering of pre-existing arrangements.
What are the deducting hybrid rules?
When applied, the deducting hybrid rules defer the tax deductions of an entity that made payments giving rise to deduction/deduction mismatches. The ambit of the rules is broad and covers benign scenarios such as an individual claiming a deduction in Australia and overseas for the same expense in respect of a foreign rental property or an overseas work secondment.
The rules operate to (temporarily) deny deductions where the amount of a deduction/deduction mismatch exceeds the entity’s “dual inclusion income” for an income year.
Definition – what is dual inclusion income?
Dual inclusion income is income that is subject to tax in both countries, subject to some statutory adjustments.
A basic example is where an Australian resident taxpayer holds a rental property in New Zealand. If the taxpayer incurred $20,000 of deductible rental expenses and derived $15,000 of rental income, the rules operate to deny the taxpayer $5,000 of deductions in Australia (carried forward to a later year) such that the $5,000 foreign loss is not able to be applied to reduce the taxpayer’s other Australian assessable income that year.
In the following year, if there was $25,000 of rental income and $15,000 of rental expenses, the taxpayer may be able to apply the prior year loss in New Zealand and use the $5,000 prior year deduction denied in Australia under the deducting hybrid rules.
However, the rules regarding dual inclusion income also require a complex adjustment to be made where the income taxable in a foreign country gives rise to a foreign income tax offset (FITO) in Australia such that only the amount assessable in Australia that is not sheltered by the FITO is counted as dual inclusion income. This is based on the rate of tax imposed on the entity in Australia. Therefore, the effect of the FITO could result in the taxpayer not being able to use the prior year deduction and could even result in further deductions being denied in the current year based on the applicable rates of Australian and foreign tax payable on the income.
What are some of the concerns with the rules?
The concept of dual inclusion income created issues for certain categories of taxpayer.
For individuals, determining the rate of tax imposed in making the adjustment for FITOs gives rise to confusion given that taxes are paid at marginal rates with the effective rate changing as soon as a deduction is denied, leading to a circular calculation process. Further, the effect of levies and offsets based on the amount of income further distorted such calculations.
For trusts, a special rule applies such that the trust is required to consider how its net income flows through to beneficiaries (including through multiple layers of interposed entities) and the effect of the FITO in the hands of the ultimate beneficiary in the chain. For a widely held trust e.g. a collective investment vehicle such as a managed investment trust (MIT), this creates particular complexity given that the trust would not be privy to this information. Additionally, where a trust has foreign beneficiaries that are not assessed in Australia on foreign source income, such amounts are not considered to be dual inclusion income, resulting in a greater level of Australian deductions denied to the trust that disproportionately affects Australian resident investors.
For superannuation funds such as SMSFs, the FITO adjustment can result in substantial deductions being denied.
What changes are being made?
The Federal Government announced in the 2019-20 Budget that changes would be made to clarify the operation of the hybrid mismatch rules. In December 2019, exposure draft legislation was released for public consultation. This included a series of technical amendments to the hybrid mismatch rules but unfortunately did not address the key concerns with the deducting hybrid rules that affected many smaller taxpayers.
Pitcher Partners advocated for various changes to the rules for the middle market in our submission to the exposure draft, our 2020-21 Pre-Budget submission to Treasury and a series of discussions with the ATO and Treasury.
It is therefore pleasing that many of our concerns have been addressed in the Treasury Laws Amendment (2020 Measures No. 2) Bill 2020 introduced into Parliament on 13 May 2020.
Most relevantly, the amendments proposed by the Bill will simplify the deducting hybrid rules in the following ways:
Narrowing the scope of deducting hybrids – The current rules include as a deducting hybrid any entity that is a “liable entity”, being an entity that is taxable on its own profits (rather than a flow-through entity), in at least one of the two countries. The Bill proposes to amend this so that a deducting hybrid is:
- an entity that is a liable entity in one but not both deducting countries,
- a dual resident entity, or
- a member of a tax consolidated group.
Therefore, individuals (other than dual residents) will no longer be subject to the deducting hybrid rules. Further, many non-consolidated companies, superannuation funds and trusts will now also be excluded from the scope of the deducting hybrid rules, which will now only apply where the entity itself is a hybrid (e.g. an Australian unit trust that is taxed like a company in New Zealand or “checked closed” to be treated as opaque for US tax purposes). The explanatory memorandum to the Bill acknowledges the narrower scope of the rules:
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.
Simplification of dual inclusion income rules for trusts and partnerships – The Bill contains an amendment to how dual inclusion income is calculated for partnerships and trusts such that any income from a foreign source will count towards dual inclusion income regardless of whether it is included in the Australian assessable income of a partner or beneficiary. This overcomes the problem where foreign partners or beneficiaries result in there being a lesser amount of dual inclusion income and a greater denial of deductions to the trust or partnership.
Limiting the FITO adjustment for dual inclusion income to corporate tax entities – The Bill removes the requirement to adjust the amount of dual inclusion income for FITOs for any entity other than companies. For individuals (that may still be deducting hybrids if they are dual residents), this overcomes the complex iterative calculations required. For trusts and partnerships, this removes the need to know how the FITO flows through any distribution chain, which could involve hundreds of separate investors for collective investment vehicles. Superannuation funds that are considered to be deducting hybrids (where they are treated as flow-through in a foreign country) will not be required to adjust for FITOs thus ensuring that they won’t be exposed to disallowed deductions pursuant to the hybrid mismatch rules.
When do the changes apply from?
These changes are to apply retrospectively from the commencement of the hybrid mismatch rules, being for income years beginning on or after 1 January 2019. For taxpayers with financial years ending on 30 June, the proposed changes may result in favourable outcomes for the first year of operation of the rules (i.e. the year ended 30 June 2020). For 31 December taxpayers who may be looking to lodge tax returns shortly for the first year of the hybrid mismatch rules (i.e. the year ended 31 December 2019), the changes may result in less tax payable than anticipated as a result of the proposed narrower scope of the deducting hybrid rules.
What are the next steps?
For more information and to determine what action is required in relation to your unique circumstances contact a Pitcher Partners representative.