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One step closer: hybrid mismatch and interposed entity bill introduced

Hybrid mismatch and interposed entity bill introduced

Alia Lum and Peter Madden discuss the recently introduced hybrid mismatch and interposed entity bill.

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Black and white pebbles

On 24 May 2018, the Government introduced the Tax Laws Amendment (Tax Integrity and Other Measures No.2) Bill 2018 and accompanying Explanatory Memorandum (EM) which addresses hybrid mismatch arrangements and interposed entity financing transactions through low or no tax jurisdictions. This follows on from the earlier Exposure Drafts issued on 24 November 2017 and 7 March 2018.

Hybrid mismatch rules

Although the Bill is substantively the same as the March 2018 draft, it does include a number of refinements to clarify the operation of the rules and interaction with other parts of the tax law. In addition:

  • The start date for the hybrid mismatch and financing integrity rule will be income years starting on or after 1 January 2019. The start date of the direct and indirect imported mismatch rule (but not the structured arrangement rule) has been delayed to income years starting on or after 1 January 2020, to better align with the expected introduction of the EU rules. This delay is welcome, given the potential breadth of the full suite of imported mismatch rules
  • Foreign bank branches under Part IIIB previously caught by the intra-branch payment hybrid rules will welcome the new safe harbour exception which deems a mismatch not to have arisen where the foreign bank adopts a recognised transfer pricing methodology in allocating expenditure and income between itself and its branches.

Interposed entity financing integrity rule

This measure can apply to deny a deduction for interest or derivative payments on financing arrangements made via an interposed related entity in a jurisdiction with a corporate tax rate of 10% rate or less or with a territorial regime system of tax (such as Hong Kong or Singapore). There are a number of changes from the previous Exposure Draft:

  • The integrity rule can apply where it is reasonable to conclude that the entity or entities entered into or carried out the scheme for the “principal purpose” of obtaining the Australia deduction and low/no foreign tax outcome, replacing the ambiguous “designed to produce” test in the previous draft.
  • The factors relevant to the designed to produce test that were in the previous EM (e.g. regional holding company with substantial economic activity) have been replaced with specific matters in the legislation such as the source of funds and whether the interposed entity engages in substantial commercial activities in carrying out a banking, financial or other similar business. Whilst broader facts and circumstances still remain relevant, these changes suggest a narrowing of the exceptions.
  • The EM notes that particular regard should be had to whether payments to an interposed entity instead of to the ultimate parent entity effectively replicate a deduction/non-inclusion outcome. An explicit statement on the conversion of taxable interest income to exempt dividends and the addition of a shareholder loan example in the EM, leaves little doubt that equity funding provided by a parent company to an interposed entity in low/no tax jurisdictions that is on-lent to the Australia operation is squarely in the firing line. Further guidance is also included on back-to-back loans.
  • A legislative instrument power has been introduced, to enable the Minister to determine that specific types of schemes are caught by the integrity rule.

Now that the hybrid rules and financing integrity rule are close to becoming law and a firm start date has been set, multinational groups need to move quickly on restructuring or refinancing before the end of the year. Further, despite the welcome delay for the imported mismatch rules, groups should be mindful that unconnected hybrid arrangements anywhere in the global group could have significant adverse consequences in Australia unless unwound in the next 18 months or so.

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