Hybrid Mismatch Rules

Division 832 contains a number of key terms/concepts that are worth exploring.

Structured arrangement

Section 832-210 provides that a payment that gives rise to a hybrid mismatch is made under a structured arrangement if:

• the hybrid mismatch is priced into the terms of a scheme under which the payment is made; or
• it is reasonable to conclude that the hybrid mismatch is a design feature of a scheme under which the payment is made.

Whether the hybrid mismatch is a design feature of a scheme is determined by reference to the facts and circumstances that exist in connection with the scheme, including the terms of the scheme.

A scheme is defined broadly by reference to section 995-1 of the ITAA 1997 as any agreement, arrangement, understanding, promise, undertaking, scheme, plan or proposal.

In LCR 2019/3, ATO provides guidance on the question of whether a hybrid mismatch is considered to have been either priced into the terms or was a design feature of a scheme.

In relation to whether a hybrid mismatch is priced into the terms of a scheme, key indicators include:

• where there is divergence in the price from market rate (e.g. the amount the borrower pays the lender over the term of the arrangement is discounted, explicitly by reference to the tax rate of the lender, or where pricing is above (or below) market rate if the divergence is explicable by reference to a hybrid mismatch).
• an entitlement to terminate the arrangement if the tax benefits were no longer available.

In relation to whether it is reasonable to conclude that the hybrid mismatch is a design feature of a scheme, key factors could include (in the context of an imported hybrid mismatch):

• the making of the importing payment;
• the character and quantum of the importing payment;
• the arrangement under which the importing payment arises;
• how the arrangement was conceived and the circumstances in which the taxpayer adopted the arrangement (including whether the arrangement was marketed to the taxpayer with the hybrid mismatch clearly demonstrated);
• any other payments by interposed entities making up the scheme (including particulars of any such interposition); and
• any overarching commercial nexus between the importing payment and the payment by the offshore deducting entity giving rise to the offshore hybrid mismatch.

The explanatory notes to the ITAA also provide an additional list of non-exhaustive indicators that the hybrid mismatch is a design feature:

• an arrangement that is designed, or is part of a plan, to create a hybrid mismatch
• an arrangement that incorporates a term, step or transaction used in order to create a hybrid mismatch
• an arrangement that is marketed, in whole or in part, as a tax-advantaged product where some or all of the tax-advantage derives from the hybrid mismatch
• an arrangement that is primarily marketed to taxpayers in a jurisdiction where the hybrid mismatch arise.
• an arrangement that contains features that alter the terms under an arrangement, including the return, in the event that the hybrid mismatch is no longer available, and
• an arrangement that would produce a negative return absent the hybrid mismatch.

An entity that entered into or carried out the scheme or any part of the scheme is a party to the structured arrangement unless:

• the entity could not reasonably have been expected to be aware that the scheme gave rise to a hybrid mismatch; and
• no other entity in the same Division 832 control group as the entity could reasonably have been expected to be aware that the scheme gave rise to a hybrid mismatch; and
• the financial position of each entity in the Division 832 control group would reasonably be expected to have been the same if the scheme had not given rise to the hybrid mismatch.

Division 832 control group

Section 832-205 provides that two or more entities are in the same Division 832 control group if any of the following apply:

• each of the entities is a member of a group of entities that are consolidated for accounting purposes as a single group;
• one of the entities holds a total participation interest of 50% or more in each of the other entities;
• a third entity holds a total participation interest of 50% or more in each of the entities.

Subject to Australian income tax

Section 832-125 provides that an amount of income or profits is subject to Australian income tax in an income year if it is an amount that is included in an entitys Australian assessable income for the income year. In respect of a trust or partnership, an amount of income or profits is only subject to Australian income tax to the extent it reasonably represents amounts included in the Australian assessable income of another entity that is not a trust or partnership (unless the trustee is liable to be assessed and pay tax). This is because trusts and partnerships are a flow-through vehicle meaning it is the beneficiaries and partners who ultimately wear the tax burden (or relief) under these structures according to their interest share.

Subject to foreign income tax

Section 832-130 provides that 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 (except certain excluded taxes) are 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.

Importantly, the following types of foreign taxes do not count as foreign income tax:

• credit absorption tax;
• unitary tax;
• withholding-type tax;
• municipal tax;
• in the case of a federal foreign country – a State tax.

Neutralising amount

A neutralising amount (relevant to several subdivisions) is essentially the amount of a deduction/foreign income tax deduction to be denied or included in assessable income necessary to cancel out the advantage obtained under the relevant hybrid mismatch. It is effectively the mismatch amount less any dual inclusion income.

Dual inclusion income

Section 832-680 broadly provides that an amount of income or profits is dual inclusion income if it is subject to income tax in 2 or more countries. Dual inclusion income can be applied to reduce the neutralising amount for certain mismatches.

There are complex rules set-out in subdivision 832-I regarding eligibility to apply dual inclusion income. 832-I covers matters including the following:

• the effect of Australian foreign income tax offset for underlying taxes;
• effect of credits etc. for underlying taxes;
• extension for certain on-payments through grouped entities;
• when an entity is eligible to apply dual inclusion income;
• interaction with other provisions.

Primary response country

Relevant to subdivision 832-C, D and E (which concern D/NI mismatches), the primary response country is the country in which a deduction (or foreign income tax deduction) for the payment is available. There are separate rules for determining the primary response country in relation to a hybrid mismatch under subdivision 832G (remembering this subdivision concerns D/D mismatches).

Importantly, the primary response country is the country which (under Australian law) is tasked with dealing with the hybrid mismatch by eliminating the availability of a deduction/foreign income tax deduction to the extent necessary. That said, if the primary response country is not Australia, there may be circumstances where it is necessary for Australia (as the secondary response country) to deal with the mismatch by assessing the payment (or part). This is generally only permitted where the primary response country does not have adequately/similar hybrid mismatch rules to deal with advantage obtained by the hybrid mismatch. Note there is no secondary response of inclusion for a hybrid mismatch subdivision 832-E and 832-F as other tax laws would likely apply and be effective to cancel the mismatch advantage otherwise achieved.

A payment

Division 832 is centred around the cross-border tax treatment of a payment. Per section 832-10 and 832-15, a payment is considered to be made to another entity upon there being an entitlement (for the recipient) to receive the payment (not necessary where there is a transfer of funds). A payment also includes the provision of non-cash benefits.

A hybrid financial instrument mismatch is a form of D/NI mismatch. A payment gives rise to a hybrid mismatch if:

• The payment is made under a debt interest, an equity interest, or a derivative financial arrangement (or where an entity acquires any of these interests under a reciprocal purchase agreement, a securities lending arrangement, or a similar arrangement); and
• The payment might reasonably be expected to give rise to a D/NI mismatch; and
• The mismatch, or part of the mismatch, is attributable to differences in the treatment of the debt interest, equity interest or derivative financial arrangement, arising from the terms of the interest or arrangement; or
• If the payment that gives rise to mismatch relates to a reciprocal purchase agreement, a securities lending arrangement or a similar arrangement – the mismatch, or the part of the mismatch is attributable to differences in the treatment of the arrangement; and
• The exception under section 832-220(2) does not apply (the exception relates to instances where the term of the interest or arrangement is less than 3 years and the differences in tax treatments are related to deferral in the recognition of income).

There is also an integrity rule for payments made under an arrangement where a debt interest, equity interest, or derivative financial arrangement is transferred and the payment (or part) is reasonably regarded as having been converted into a form in substitution for a return on the interest or arrangement.

The amount of the hybrid mismatch is the amount of the deduction/non-inclusion mismatch.

Subdivision 832-C only applies where there is a structured arrangement or where the entity that made the payment and each liable entity in respect of the income or profits of the recipient of the payment is related through any of the following ways:

• being in the same Division 832 control group;
• one of the entities holding a total participation interest of 25% or more in the other entity;
• a third entity holding a total participation interest of 25% or more in each of the entities.

A payment gives rise to a hybrid payer mismatch if:

• The payment gives rise to a deduction/non-inclusion mismatch; and
• The payment is made by a hybrid payer; and
• The mismatch would not have arisen, or would have been less, if the payer was an ungrouped entity (as set out in section 832-315).

An entity is a hybrid payer if a payment it makes is disregarded for the purposes of the tax law of one country (resulting in non-inclusion) but is deductible for the purposes of the tax law of another country.

The amount of the hybrid mismatch is lesser of:

• the amount of the deduction/non-inclusion mismatch; and
• certain excess amounts (if applicable) as set-out in section 832-310(2)(b)).

Subdivision 832-D only applies where there is a structured arrangement or where the hybrid payer and each liable entity in respect of the income or profits of the recipient of the payment are in the same control group.

A payment gives rise to a reverse hybrid mismatch if:

• The payment gives rise to a deduction/non-inclusion mismatch; and
• The payment is made directly or indirectly through one or more interposed entities, to a reverse hybrid; and
• The mismatch would not have arisen, or would have been less, if the payment had instead been made directly to an investor in the reverse hybrid.

An entity (the test entity) is a reverse hybrid if it is transparent for the purposes of tax law of the country in which it is formed, but non-transparent for the purposes of the tax law of the country in which investors in it are subject to tax (note that an investor broadly refers to an entity that is liable in respect of income or profits of the test entity), resulting in non-inclusion.

Take the example of Entity A which makes a payment to Entity B (the test entity). Entity B is an Australian formed entity which is transparent for tax purposes in Australia. Entity A and the Entity B are in the same control group. The sole beneficiary of Entity A is Entity C which is a foreign entity. Here, a reverse hybrid mismatch is likely on the basis that:

• the tax laws of Australia treat Entity B (the test entity) as a transparent entity and consequentially Entity C (as sole beneficiary) is a liable entity in respect of the income or profits of Entity B.
• the tax laws of the foreign country treat the Entity B as a liable for its own income or profits i.e. those laws consider that Entity B should be taxed on profits (as a non-transparent entity) and the not the beneficiaries.

The amount of the hybrid mismatch amount is the lesser of either:

• the amount of the deduction/non-inclusion mismatch; and
• certain excess amounts (if applicable) set out in section 832-400(2)(b).

Subdivision 832-E only applies where there is a structured arrangement or where the entity that made the payment, the reverse hybrid and each entity that is an investor are in the same control group.

A payment gives rise to a branch hybrid mismatch if:

• The payment gives rise to a deduction/non-inclusion mismatch; and
• The payment is made directly or indirectly through one or more interposed entities, to a branch hybrid; and
• The mismatch would have not arisen, or would have been less, if the residence country had not recognised the permanent establishment.

An entity is a branch hybrid in relation to a payment made to it if, for the purposes of the tax law of the country in which it is a resident, the payment is treated as being allocated to a permanent establishment in another country, but in the other country, the payment is treated as not being allocated to a permanent establishment in that country.

The amount of the hybrid mismatch amount is the lesser of either:

• the amount of the deduction/non-inclusion mismatch; and
• certain excess amounts (if applicable) referred to in section 832-475(2)(b).

Subdivision 832-F only applies where there is a structured arrangement or where the entity that made the payment and the branch hybrid are in the same control group.

A payment gives rise to a deducting hybrid mismatch if it made by a deducting hybrid.

An entity is a deducting hybrid in relation to a payment if:

• The payment gives rise to a deduction/deduction mismatch (i.e. the payment is deductible for the purposes of the tax law of 2 or more countries); and
• The entity makes the payment; and
• The entity is a liable entity in one deducting country (but not both); or
• The entity satisfies the relevant residency test (in section 832-555(9)) in both deducting countries, and is also a liable entity in both deducting countries; or
• Is a member of a consolidated group or a MEC group.

Importantly, the rules can also apply beyond an actual payment to notional amounts that represent the decline in value of a depreciating asset (i.e. depreciation deductions) and for amounts that represent a share in the net loss of a partnership or other transparent entity.

Where there is a deducting hybrid mismatch, it is important to correctly identify the primary response country and the secondary response country. The primary response country is given preference to utilise its own hybrid mismatch rules (if they exist) to neutralise the advantage of the mismatch by denying the deduction (to the extent necessary). Australia may have rights to deny the deduction (or part) as a secondary response country where the primary response country does not have similar hybrid mismatch rules that deal with the mismatch.

Subdivision 832-G only applies where there is a structured arrangement or where the deducting hybrid each liable entity (in respect of the income or profits of the deducting hybrid in the deducting country) are in the same control group.

A payment gives rise to an imported hybrid mismatch if the payment is an importing payment in relation to an offshore hybrid mismatch.

Broadly, a payment an entity (the payer) makes is an importing payment in relation to an offshore hybrid mismatch if, during the relevant times:

• the payment (or part) gives rise to a deduction, or foreign income tax deduction in a foreign country; and
• the payment is made directly, or indirectly through one or more interposed entities, to another entity (the offshore deducting entity); and
• the offshore deducting entity is either: (i) the entity that made the payment that gave rise to the offshore hybrid mismatch; or (ii) if the offshore hybrid mismatch is a deducting hybrid mismatch – the deducting hybrid.

The deduction referred to here must be available in an income year/foreign tax period that both:

• ends at or after the end of the foreign tax period in which the deduction for the offshore hybrid mismatch arises; and
• has at least on day in common with that period.

In essence, an imported hybrid mismatch involves testing whether a hybrid mismatch involving 2 foreign countries has been effectively imported into Australia by a deduction. Put another way, an imported hybrid mismatch occurs where an Australian entity is considered to be funding a mismatch that takes place entirely between foreign countries (and consequentially would not be covered under Australian hybrid mismatch rules apart from under this subdivision).

Importantly, a payment can be deemed to fund a mismatch even where the payment does so indirectly, including where the funds flow through a chain of interposed entities provided that each payment through that chain must:

• give rise to a foreign income tax deduction in a country that does not have foreign hybrid mismatch rules; and
• not give rise to a deduction/non-inclusion mismatch.

Keep in mind that it is not strictly necessary for there to be a clear flow of equivalent payments – for example, it is not necessary to show that one payment funds the next (and so forth) until the offshore deducting entity receives the funds.

Also note that even where a chain of payments is broken, a payment may still be a deemed an indirect payment where all the following conditions are satisfied:

• A payment is made to an entity (the first entity);
• Another entity (the second entity) makes a payment (the second payment) to a third entity;
• The first entity and the second entity are in the same Division 832 control group; and
• Under the law of a foreign country relating to foreign income tax: (i) a foreign income tax deduction arises in respect of the second payment; and (ii) the foreign income tax deduction may, as a result of a concessional feature of that law, be transferred to, shared with, or otherwise applied by, the first entity.

The broad scope of this subdivision means that imported hybrid mismatches can arise notwithstanding no clear connection between payments that demonstrate a mismatch is being funded.

There are important priority rules that allocate the neutralisation of the mismatch between countries that have mismatch rules.

The amount of the hybrid mismatch amount is worked out as the lowest amount calculated under the two (somewhat complex) methods set out in section 832-630.

Subdivision 832-H only applies where:

• the importing payment is made under a structured arrangement and the payer of the importing payment, the offshore deducting entity, and each interposed entity (if applicable), are all parties to the structured arrangement; or
• the payer of the importing payment, the offshore deducting entity, and each interposed entity (if applicable) are in the same Division 832 control group.

As provided for in section 832-720, subdivision 832-J contains an integrity measure that disallows an Australian deduction for a payment of interest (or a payment of a similar character) made by an entity (the paying entity) under a scheme to a foreign entity (the interposed foreign entity).

The deduction will be disallowed if all of these conditions are satisfied, including that:

• the paying entity makes payment under a scheme to a foreign entity (the interposed foreign entity), either directly or indirectly through one or more interposed Australian trusts or Australian partnerships;
• the ultimate parent entity is not controlled by any other entity (other than an entity that is not a member of the Division 832 control group);
• the payment is of an amount of interest or an amount under a derivative financial arrangement;
• an entity is entitled to a deduction in an income year in respect of the payment (disregarding this subdivision);
• the payment is not subject to Australian income tax; and
• the highest rate of foreign income tax (the foreign country rate) on the payment is 10% or less; and
• it is reasonable to conclude (having regard to those matters described under the below heading principal purpose test) that the entity, or one of the entities, that entered into or carried out all or part of the scheme did so for a principal purpose including a purpose of enabling a deduction to be obtained in respect of the payment, and enabling foreign income tax to be imposed on the payment at a rate of 10% or less.

Subdivision 832-J also only applies where the paying entity, the interposed foreign entity and another foreign entity (the ultimate parent entity) are in the same Division 832 control group.

Subject to foreign tax at a rate of 10% or less

Importantly, foreign income taxes levied on the payment at the national, state and municipal level can all be taken into account in assessing the rate of foreign income tax a payment is subject to. However, the taxpayer is also required to factor in any credits, rebates or similar concessions for taxes imposed at the different levels within the foreign country.

Back-to-back arrangements

The integrity rule can also apply to certain back-to-back arrangements as described in section 832-730. A back-to-back arrangements involves the following:

• An entity (the original paying entity) makes a payment of interest (or a similar payment) to another entity; and
• the other entity, or a further entity, pays an amount of that kind to a foreign entity; and
• the payments mentioned in the two above points are made under an arrangement involving back-to-back loans (or an arrangement that is economically equivalent and intended to have a similar effect to back-to-back loans).

Under a back-to-back arrangement the recipient of a payment has an effective obligation to pass on substantially all of the payment amount to another entity under another loan or similar arrangement. If the relevant conditions are met, the original paying entity is treated as having made the payment of interest (or a similar payment) directly to the foreign entity.

Ordinarily, equity interests do not constitute part of an arrangement which is economically equivalent to a back-to-back loan on the basis that returns on equity are usually discretionary only. However, there are exceptions to this basic position where entities are part of a consolidated group or subject to group relief.

Principal purpose test

Per section 832-725(2), when it comes to assessing the principal purpose of a scheme, regard must be had to the following matters:

• the facts and circumstances that exist in relation to the scheme;
• if the payment is an amount of interest —the source of the funds used by the interposed foreign entity to provide the paying entity with the loan or other debt interest in respect of which the payment of interest is made;
• whether the interposed foreign entity engages in substantial commercial activities in carrying on a banking, financial or other similar business.

In LCR 2019/3, the ATO expresses views on the principal purpose test and provides a number of practical examples. The ATO equates the principal purpose test in Division 832 with the principal purpose test set out in multinational anti-avoidance legislation (MAAL) and diverted profits tax law (DPT). Refer to paragraph 11 to 16 of LCR 2015/2 for further information.

ATO Guidance on Hybrid Mismatch Rules

The ATO has released the following guidance on certain aspects of the hybrid mismatch rules:

• PCG 2018/7 – Part IVA of the Income Tax Assessment Act 1936 and restructures of hybrid mismatch rules
• LCR 2019/3 – OECD hybrid mismatch rules – concept of structured arrangement
• LCR 2021/1 – OECD hybrid mismatch rules – targeted integrity rule
• PCG 2021/5 – Imported hybrid mismatch rule – ATOs compliance approach
• TD 2022/9 – Whether section 951A of the US Internal Revenue Code (which contains the US Global Intangible Low Taxed Income (GILTI) rules) corresponds to Australias controlled foreign company (CFC) rules.

Note this article has not addressed Subdivision 832-K which relates to modifications applying to gains and losses from financial arrangements under Division 230 of the ITAA 1997 (about taxation of financial arrangements).

Valuation of trading stock

Per section 832-60, if:

• an amount of a deduction for an outgoing is disallowed under Division 832; and
• the outgoing related to acquiring an item of trading stock; and
• that item remains on hand at the end of the income year;

the amount disallowed under Division 832 is ignored for the purposes of section 70-45 of the ITAA 1997 in working out the value of the item of trading stock (under the applicable valuation method e.g. cost, market selling value, replacement value) at the end of the relevant income year.