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Hybridicity is History

Hybridicity is History

Alia Lum and Liam Delahunty review the exposure draft legislation relating to "hybrid mismatches" released by Treasury today.

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On 24 November 2017, the Government released Exposure Draft (ED) legislation to counteract “hybrid mismatches”. This follows from its commitment in the 2016 Federal Budget to adopt the key recommendations set out in Action 2 of the Organisation for Economic Co-operation and Development's (OECD) Base Erosion and Profit Shifting (BEPS) project following a review by the Board of Tax. Australia now joins the United Kingdom (UK), which released equivalent rules last year and New Zealand, which released draft legislation in September 2017. 

At first glance, the ED is broadly consistent with the Board of Tax’s recommendations and previous Government announcements, but new targeted integrity measures will also be developed. 

The “hybrid mismatches” to which the legislation is directed include hybrid financial instruments that are debt in one jurisdiction and equity in another, and hybrid entities that are treated as taxable in one jurisdiction but tax transparent in another jurisdiction. Such structures can give rise to double deductions (where deductions arise in more than one jurisdiction for the same payment) or deduction/non-inclusion outcomes (where payments are deductible in one jurisdiction but not assessable in the other).

As well as financing payments, the hybrid mismatch rules can apply to royalties, rents and service payments.

Where a hybrid mismatch arises, the legislation will either deny a deduction for an otherwise deductible payment, or tax a receipt which would otherwise be non-taxable. The response depends on the tax treatment in other jurisdiction, which could fluctuate over time and as more countries introduce hybrid mismatch rules.

An important extension of these rules is to indirect or “imported” mismatches, which can arise where there is a non-hybrid financing instrument, which is seen as “vanilla” debt by both issuer and holder, but the holder is separately a party to an “upstream” hybrid instrument. This class of mismatch is significant in that it could encompass an Australian entity which has borrowed under vanilla debt, even where it has no knowledge of the upstream funding arrangements of its immediate lender. There was hope that these rules would be wholly or partially deferred until other countries introduce their mismatch rules to reduce the compliance burden on taxpayers, but this has not been adopted in the ED.

The draft legislation also contains changes for hybrid regulatory capital for banks, which are broadly consistent with the Government’s previous announcement but with some mechanical changes. The ED does not include the extended recommendations released by the OECD in July this year applicable to branch mismatch arrangements, but the Government has announced today that it will be adopting these rules.

The Government has also announced today new integrity rules will be developed to deal with multinational groups that structure out of the hybrid mismatch rules in a manner which achieves double non-taxation outcomes (for example, investing through zero tax countries). Both the new integrity measure and the branch mismatch rules are intended to commence at the same time as the general hybrid mismatch rules.

The three broad categories of hybrid mismatches are discussed below, along with a common example and how the rules could apply:

Outcome Example Potential consequences
Deduction/Non-Inclusion mismatches Mandatorily Redeemable Preference Shares are issued by Australian company (classified as debt, with interest deductible) to foreign holder (classified as equity, with “dividends” exempt) Interest deduction is denied for Australian issuer (where the corresponding “dividend” is exempt for the foreign holder), but Australian interest withholding tax will still payable
Double-Deduction mismatches Vanilla debt is issued by a partnership which is part of an Australian tax consolidated group (with interest deductible) but may also be seen as (or as part of) a foreign entity (with interest also deductible in that foreign jurisdiction) Interest deduction is denied for Australian issuer, but Australian interest withholding tax will still payable
Indirect/Imported mismatches Vanilla debt is issued by an Australian company to a foreign affiliate, which is taxable on the interest income, but itself is financed by a hybrid mismatch arrangement with another entity Interest deduction is denied for Australian company – even though Australian company may not be aware of “upstream” or indirect hybrid mismatch


The ED is open for consultation until 22 December 2017, although we expect the key principles will not be altered and, with bipartisan support, the resultant Bill is likely to experience a smooth passage through Parliament early next year. The key question then is the likely start date – which could well be in the latter half of 2018.

Inbound and outbound multinational groups need to consider the application of these rules to their existing and proposed arrangements, and review restructuring or refinancing options before the rules commence.

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