nsw 9th annual tax forum - amazon s3€¦ · 3. the decision in chevron australia holdings pty ltd...

© Ka Sen Wong, Allen & Overy 2016

Disclaimer: The material and opinions in this paper are those of the author and not those of The Tax Institute. The Tax Institute did not review the contents of this paper and does not have any view as to its accuracy. The material and opinions in the paper should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests.

NSW 9th Annual Tax Forum

Cross-border financing – the hidden cost of

capital

Written by:

Ka Sen Wong

Tax Counsel

Allen & Overy

Presented by:

Ka Sen Wong

Tax Counsel

Allen & Overy

NSW Division

2-3 June 2016

Sofitel Wentworth, Sydney

Ka Sen Wong Cross-border financing – the hidden cost of capital

© Ka Sen Wong, Allen & Overy 2016 2

CONTENTS

1 Introduction .................................................................................................................................... 4

2 The Anti-hybrid rules ..................................................................................................................... 7

2.1 Overview ................................................................................................................................... 7

2.1.1 Where are we now? ........................................................................................................... 7

2.1.2 Is there really a problem? .................................................................................................. 7

2.1.3 Is this the way to solve it? ................................................................................................ 10

2.1.4 Do the rules have retrospective effect? ........................................................................... 10

2.2 Summary of the recommendations ......................................................................................... 11

2.2.1 Debt/equity mismatches (Recommendations 1.1 and 2.1) .............................................. 13

2.2.2 Capital/revenue mismatches (Recommendation 1.1) ..................................................... 16

2.2.3 Timing mismatches (Recommendation 1.1(c)) ................................................................ 18

2.2.4 Payment commuted into tax-preferred form on assignment (Recommendation 1.2(e)) . 18

2.2.5 Payment assigned to a tax-advantaged recipient (Recommendation 1.2(e)) ................. 20

2.2.6 Loan/sale mismatches (Recommendation 1.2(b)) ........................................................... 20

2.2.7 Payments by disregarded entities to their parents (Recommendation 3) ....................... 21

2.2.8 Payments by disregarded entities to third parties (Recommendation 6) ......................... 23

2.2.9 Payments by dual residents to third parties (Recommendation 7) .................................. 24

2.2.10 Payments to disregarded entities by other parties (Recommendation 4) ....................... 26

2.2.11 The imported mismatch rule (Recommendation 8) ......................................................... 27

2.3 Structural concerns with the rules ........................................................................................... 30

2.3.1 Collaboration requirements ............................................................................................. 30

2.3.1.1 Control group ............................................................................................................... 30

2.3.1.2 Related persons ........................................................................................................... 30

2.3.1.3 Structured arrangement ............................................................................................... 31

2.3.2 Application wholly within one jurisdiction ......................................................................... 32

2.3.3 Exceptions ....................................................................................................................... 32

2.3.4 Design .............................................................................................................................. 33


© Ka Sen Wong, Allen & Overy 2016 3

2.3.5 Financial instrument......................................................................................................... 33

2.4 Costs and complexities relating to surveying the law in other jurisdictions ............................ 33

2.5 Restructuring may be subject to Part IVA ............................................................................... 34

3 Diverted profits tax ...................................................................................................................... 36

3.1 Overview ................................................................................................................................. 36

3.2 The operation of the rules ....................................................................................................... 36

3.3 Policy rationale ........................................................................................................................ 38

4 The Chevron decision .................................................................................................................. 41

4.1 Background ............................................................................................................................. 41

4.2 A real life hybrid case study .................................................................................................... 42

4.3 Key findings ............................................................................................................................ 43

5 Dealing with uncertainty .............................................................................................................. 46

5.1 Seeking ATO certainty ............................................................................................................ 46

5.2 Use of experts ......................................................................................................................... 47

5.3 Second opinions ..................................................................................................................... 47

5.4 Exit rights and information rights in documentation ................................................................ 48

5.5 Dealing with legacy issues ...................................................................................................... 49

5.6 Conclusion .............................................................................................................................. 49


© Ka Sen Wong 2016 4

1 Introduction

The title refers to something of an axiom in corporate finance, that debt is “cheaper” than equity, i.e.

an investor’s cost of capital for equity funding is typically more expensive than its cost of capital for

debt funding.

At one level, this is simply driven by the trade-off between risk and return – an equity investor bears

full exposure to the performance of a business and therefore will demand a higher rate of return; a

debt investor has reduced exposure due to its preferred right to coupons and a return of capital

invested, and so requires a lower rate of return.

Tax practitioners know that this difference is illusory. There are debt-like shares (fixed-dividend

redeemable preference shares) and equity-like debt instruments (participating notes, limited recourse

loans), and the risk/return profile of any instrument can be made to match anything that the universe

of investors desires. The real difference between equity and debt – and the real factor that makes

debt cheaper than equity – is tax! Debt returns are tax deductible, reducing the tax payable by a

business on its revenues, and thereby reducing the cost of debt capital.

The availability of tax deductions for financing costs is therefore a key integer in determining the cost

of capital. And uncertainty in respect of such availability is therefore also a key integer. Tax laws of

course carry an unavoidable level of uncertainty, if for no other reason than that they are statute-

based and rely on legal interpretation. But while interpretation is sketched out in various shades of

grey, the actual outcome is binary: an expense is either deductible or it is not deductible.

Nevertheless, with adequate experience and good tax advice, interpretive uncertainty can be

understood and priced in to the cost of capital. That is no easy thing to do, as putting a percentage

probability on a tax outcome is impossible to do accurately (are we assessing discovery? Compliance

action? Litigation? Winning in litigation?), and in any event, each “trial” is unique, meaning that

expected value may not be a sensible approach. It also means that conservative taxpayers are at a

competitive disadvantage at auction against aggressive tax planners. But at least an informed

decision can be made.

By contrast, what can a taxpayer do to factor in retrospective law change? There is simply no way

that a taxpayer can price in unknown and unforeseeable changes in law. These are the costs of

capital that are truly hidden.

In thinking about retrospective changes, the most egregious instances come in the form of a

legislative or administrative change that changes the outcome in a past period. However, there are

more subtle varieties of retrospectivity, including:

1. A legislative or administrative change that changes the outcome in a future period, but for a

transaction entered into in the past.

2. A court decision that introduces a novel approach to existing issues.

The anti-hybrid rules are a prime example of Category 1. They are prospective in the sense that they

are intended to affect future periods only. However, capital structures must be decided at the time of



transacting. Later changes can render an earlier investment decision unprofitable, and when assets

are not 100% liquid, the taxpayer cannot simply reallocate its investment resources.

To be fair, almost all tax changes have shades of retrospectivity. Even a change in something as

simple as the company tax rate impacts assumptions that taxpayers may have made in making

investment decisions in earlier years. Nevertheless, when the change is novel and unforeseeable,

this effect is greatly amplified. This is the case with the diverted profits tax, which will have caught

many by surprise.

As for court decisions, since a Court is only ever ruling on how the law has always applied, its effect is

inevitably retrospective. The concern arises however when novel propositions emerge in an area

where the points of disagreement between taxpayers and ATO were thought to have been well

understood.

When analysing cross-border financing, the key question of deductibility of financing costs will be

affected by a number of considerations, including debt/equity, thin capitalisation, transfer pricing and

Part IVA. This paper addresses the following recent developments, which amount to retrospective

changes to the treatment of cross-border financing:

1. The introduction of anti-hybrid rules;

2. The introduction of the diverted profits tax; and

3. The decision in Chevron Australia Holdings Pty Ltd v Federal Commissioner of Taxation [2015]

FCA 1092 (Chevron).

The anti-hybrid rules will be the dominant focus of this paper. The diverted profits tax is in its infancy,

making detailed analysis difficult. The Chevron decision has been the subject of comprehensive

analysis elsewhere.



Resources

OECD Report on Action Item 2:

http://www.oecd.org/ctp/neutralising-the-effects-of-hybrid-mismatch-arrangements-action-2-2015-final-

report-9789264241138-en.htm

Board of Tax materials in relation to anti-hybrid rules:

http://taxboard.gov.au/consultation/implementation-of-anti-hybrid-rules/#submissions

UK anti-hybrid rules:

http://www.publications.parliament.uk/pa/bills/cbill/2015-2016/0155/160155.pdf

Consultation paper in relation to DPT:

http://www.treasury.gov.au/ConsultationsandReviews/Consultations/2016/Implementing-a-diverted-

profits-tax

UK DPT rules:

http://www.legislation.gov.uk/ukpga/2015/11/pdfs/ukpga_20150011_en.pdf

Chevron decision:

http://www.austlii.edu.au/au/cases/cth/FCA/2015/1092.html

http://www.oecd.org/ctp/neutralising-the-effects-of-hybrid-mismatch-arrangements-action-2-2015-final-report-9789264241138-en.htm

http://www.oecd.org/ctp/neutralising-the-effects-of-hybrid-mismatch-arrangements-action-2-2015-final-report-9789264241138-en.htm

http://taxboard.gov.au/consultation/implementation-of-anti-hybrid-rules/#submissions

http://www.publications.parliament.uk/pa/bills/cbill/2015-2016/0155/160155.pdf

http://www.treasury.gov.au/ConsultationsandReviews/Consultations/2016/Implementing-a-diverted-profits-tax

http://www.treasury.gov.au/ConsultationsandReviews/Consultations/2016/Implementing-a-diverted-profits-tax

http://www.legislation.gov.uk/ukpga/2015/11/pdfs/ukpga_20150011_en.pdf

http://www.austlii.edu.au/au/cases/cth/FCA/2015/1092.html



2 The Anti-hybrid rules

2.1 Overview

New tax regimes are commonly touted as being the most complex tax rules ever devised. The anti-

hybrid rules are poised to take that title convincingly, owing to their novel nature as “meta” tax laws.

Since the rules are aimed at addressing gaps in the international tax system, they by necessity

require the law to define and incorporate the operation of the tax laws in other jurisdictions. This

alone would raise difficult conceptual issues, but the rules go further in that they operate on the

corresponding (i.e. anti-hybrid) rules in other jurisdictions – which in turn operate on other

jurisdiction’s normal and anti-hybrid laws, making them “meta-meta-laws”. As will be seen, this

reference – or deference – to foreign jurisdiction tax treatment is the source of much uncertainty and

complexity in the rules.

2.1.1 Where are we now?

The OECD rendered its final Report on Action Item 2 (the Report) along with the other BEPS Action

Item Reports on 5 October 2015.

The Board of Tax (the Board) was asked to consult on the rules, and issued its report to the

Government on 31 March 2016, recommending the rules be adopted with minor variations, and much

more consideration during design phase.

The Government announced on 3 May 2016 as part of the 2016 Budget that the Board’s

recommendation to adopt the rules would be accepted. This measure would apply from the later of 1

January 2018 or six months following the date of Royal Assent of the enabling legislation. Further

consultation and analysis is now taking place.

2.1.2 Is there really a problem?

The anti-hybrid rules are unique amongst the BEPS recommendations in that of the substantive

measures, they alone are not targeted at identified instances of base erosion and are instead directed

at an amorphous and ill-defined set of perceived abuses of the international tax system.

Any rule that does not have a coherent and well-defined policy objective faces significant challenges

in being successfully legislated, as stakeholders will not be able to agree on what is being targeted,

let alone how best to implement the rules.

The Report expresses the problem in the following equivocal terms:

“…the collective tax base of countries is put at risk through the operation of hybrid mismatch arrangements even

though it is often difficult to determine unequivocally which individual country has lost tax revenue under the

arrangement.”



There is a real question though as to whether a “collective” tax base is a valid concept. The rules are

premised on an assumption that there is an absolute truth in tax. Many of the examples of hybrid

mismatches are driven off a concept of “Book” income, which is considered to be the absolute

representation of the true amount of income, such that tax deviations from Book are regarded as

aberrations in need of correction. In reality, if “Book” were the correct reflex of tax liabilities, all

jurisdictions would be adopting IFRS as the tax base – although even this would not guarantee

harmony between jurisdictions. The minute it is accepted that two jurisdictions might validly apply tax

laws to the same transaction in a different manner, it must also be accepted that mismatches will

occur in the ordinary course, and not merely because of aggressive tax planning.

Of course, there are situations where different jurisdictions’ laws intersect, e.g. where a jurisdiction’s

tax policy has been set based on assumptions about the tax treatment in another jurisdiction. For

example, a company may afford a participation exemption on an underlying policy assumption that

the exempt dividends are paid from profits that are subject to tax in another jurisdiction. In such a

case, taxpayers may well be achieving abusive benefits where the underlying assumptions are not

made out, i.e. the profits are not subject to tax, but the exempt tax treatment is obtained anyway. It

may be sensible in such a case for a jurisdiction to have regard to the operation of foreign tax laws in

determining its own tax policy settings. Importantly, however, this is not the only way to do it. In

setting the terms of section 768-5 – which was reviewed as recently as 2014 – the availability of a

participation exemption was conditioned on the investment being characterised as equity under

Australian principles. This has the advantage of not making the Australian tax treatment subservient

to the debt/equity principles in other jurisdictions, and is a perfectly reasonable way to set tax policy.

When examining deductions, it is even less clear that the foreign jurisdiction treatment is relevant.

The availability of a deduction has never been premised on an assumption that the amount will be

taxable in the payee jurisdiction. The policy behind the law is that deductions are available for costs

incurred in producing assessable income. The treatment of the receipt in another jurisdiction is not an

integer in the determination of whether a deduction should be available.

In other scenarios, the need for action may be even less clear again. The rules target capital/revenue

mismatches, i.e. a payment is treated as a revenue payment and deductible to the payer in the payer

jurisdiction, but as a capital receipt and non-assessable to the payee in the payee jurisdiction. A

jurisdiction’s tax policy settings in relation to the capital/revenue distinction are more likely to reflect

embedded principles of law, rather than assumptions about how much tax is paid in another

jurisdiction. This applies a fortiori to timing mismatches, which are also a target (at least in the way

the Board has framed its recommendations).

Once we examine why a jurisdiction has adopted particular tax settings, the determination of whether

the jurisdiction’s tax base is being eroded should not be insurmountable. However, the Report

deliberately ignores this question and instead recommends the adoption of arbitrary one-size-fits-all

rules.

As a result, it remains unclear why, if both jurisdictions, having turned their minds to the assumptions

underlying their tax policy settings, conclude that they have not suffered base erosion, anything needs

to be done at all. This is especially the case in Australia, where Part IVA has been sufficient to

address hybrid arbitrage. Sophisticated tax administrators know a base erosion problem when they



see it and will act accordingly, and domestic anti-avoidance rules can be sufficient. The Citi case1 in

Australia and the BNZ case2 in New Zealand show that to be the case, just as the Mills case3 shows

that even if an arbitrage is being achieved, there may be no tax policy concerns with it (there was no

move to overturn the result in Mills legislatively).

More tellingly, if a jurisdiction is not in fact suffering base erosion, but is nevertheless required to

impose further tax to neutralise a perceived mismatch, it is inherently applying double taxation (or

applying single taxation on a nil-profit outcome).

For a capital-importing nation like Australia with a 30% corporate tax rate, which has set the

conditions in which it seeks to impose company tax through an intricate balance of robust rules

including thin capitalisation, debt/equity, transfer pricing and Part IVA, imposing further tax by denying

tax deductions means increasing the cost of foreign investment in Australia for no other reason than

that an investor’s home jurisdiction has applied different settings and not sought to tax the income.

If imposing this further tax could be done without cost to the Australian economy, this would be

achieving free revenue. The reality though is that it there will be a cost to Australia in lost foreign

investment, and the benefit obtained from incurring this cost is nothing more than protection of a

foreign jurisdiction’s tax base – in a situation where that foreign jurisdiction itself does not consider its

tax base to have been eroded.

In fact, one could argue the opposite proposition: that hybrids are beneficial to the Australian

economy. If a foreign investor can structure a hybrid that reduces its cost of capital for investments

into Australia, this will encourage increased foreign investment into Australia. If we are confident that

no base erosion is occurring in Australia (whether or not we believe there is base erosion elsewhere),

this is a costless way for Australia to encourage further investment. One could even think of it in the

following terms: if the base erosion cost falls on the foreign jurisdiction, that foreign jurisdiction’s

corporate tax base is providing a subsidy for investment into Australia, which would in fact increase

the Australian tax base. And to cap it off, there would be no complaints from the foreign jurisdiction

benefactor, which itself does not consider there to be a problem. A win-win situation. Indeed, this

dynamic is precisely why “Australian tax paid” deals could obtain the benefit of ATO rulings in times

gone by – and why “foreign tax paid” deals were challenged aggressively by the ATO.

It is perplexing that in Australia’s current economic environment where the Holy Grail objective must

surely be stimulating foreign investment without reducing the level of tax collected from both foreign

and domestic investors, a measure should be adopted that by design discourages foreign investment

but does not necessarily increase the level of tax collected.

The answer of course is that tax reform is almost by definition political and the anti-hybrid rules are

perceived as a coherent part of a crackdown on multinational enterprises.

Ultimately, the taxation of multinational enterprises comes down to a few simple propositions. Every

MNE will have a value-chain which by definition spans multiple jurisdictions. Each jurisdiction will

assert taxing rights over those elements of the value-chain that are considered within its jurisdiction

under rules it considers appropriate. Another jurisdiction’s failure to assert taxing rights over an

1 Commissioner of Taxation v Citigroup Pty Ltd [2011] FCAFC 61. 2 BNZ Investments Limited & Ors v The Commissioner of Inland Revenue HC WN CIV 2004-485-1059 [15 July 2009]. 3 Mills v Commissioner of Taxation [2012] HCA 51.



element of the value chain might be a warning indicator that we should examine that element very

closely to determine whether it should be regarded as within jurisdiction; but it should not be a

substantive determinant of that outcome.

Returning to the point though, if adoption of the rules is driven by transient political concerns rather

than coherent long-term policy choices, this is cumulative to the uncertainty faced by taxpayers, as it

increases the likelihood of delays and changes during the implementation process, which makes

pricing transactions exceptionally difficult.

2.1.3 Is this the way to solve it?

Even if we accept that there is a problem, a significant difficulty with the Report is that there is no real

coherent framework to the Action 2 recommendations, no clear unifying principle. Rather, the

recommendations appear to have been developed in an “organic” fashion, where a lead rule (the

hybrid financial instrument rule) appears to have been drafted to cover the most obvious scenarios

(debt/equity mismatches), and then this rule appears to have been augmented (by the hybrid transfer

rule and substitute payment rule) in an attempt to cover gaps left by the lead rule. However, no

amount of augmentation is sufficient to allow the hybrid financial instrument rule to deal with hybrid

entity scenarios – necessitating a separate rule (hybrid payer rules). Having combed the back-

catalogue of abusive tax schemes, the drafters appear to have identified further schemes not covered

by both rules, nor within reach of augmentation of those rules – necessitating yet further rules. The

difference between Recommendation 6 and Recommendation 7 is marginal at best, and a far greater

diversity of schemes is dealt with by even the most basic limb of Recommendation 1.

This lack of structure will no doubt find its ways into the various laws implemented by adopting

jurisdictions, and indeed it is specifically recommended that jurisdictions hew closely to the

Recommendations, since consistency across jurisdictions is considered key.

One wonders whether the 2-year timeframe that was ambitiously set – and then commendably

achieved – has nevertheless ultimately proved to be too short a time to address arguably the most

difficult area covered by the BEPS recommendations. As it stands, jurisdictions are being asked to

adopt a disjointed set of principles, and in circumstances where improving upon them would in fact be

counterproductive overall due to the lack of consistency that would arise if different jurisdictions took

different approaches.

Soon, however, the train will have left the station with no way to get off.

2.1.4 Do the rules have retrospective effect?

As with all new laws, the degree of retrospective effect is a significant issue. The only way to achieve

a truly prospective effect is for all pre-existing arrangements to be exempt from the rules (i.e.

“grandfathering”).

However, an explicit objective of the Report is to encourage existing structures to be unwound, and

the Report therefore recommends that there be no grandfathering of existing arrangements. This

means that although the rules would not apply to past payments in prior periods, they would



nevertheless have the retrospective effect identified in the introduction, i.e. business decisions made

in past years based on the law as it stood could be significantly disturbed.

In some cases, taxpayers will be contractually committed to an arrangement that becomes subject to

the rules. Even where the target arrangements are not contractually committed, or can be amended

(e.g. because they are between entities with common ownership), in some industries, such as

infrastructure, where deal cashflows are tightly modelled and tax leakages have a significant impact

on viability, the introduction of the rules may well cause projects to become uneconomical.

The Board has recommended no grandfathering as a general rule, but has nevertheless kept the door

open. There might be limited grandfathering for third party transactions with severe detrimental

impacts. Significant lobbying efforts will no doubt be made over the coming months.

The most positive development is that the Government has accepted the Board’s recommendation to

defer the effective date until 6 months after Royal Assent, so that there will always be 6 months lead

time. Ironically however, this positive development is itself a departure, as the Report recommends

that the rules should only apply from the beginning of a tax period, but the Board’s recommendation

merely states “6 months” (rather than, say, the first income year occurring more than 6 months after

Royal Assent).

2.2 Summary of the recommendations

The unstructured framework means that it is very difficult to encapsulate the recommendations in a

short space. The wording of the recommendations is so vague that without a detailed perusal of both

the explanatory guidance AND the accompanying examples, it is almost impossible to understand

what the rules are saying.

On examination of the examples, it may become clear what the recommendation is directed at. But

there is a real question as to the extent to which the examples are interpretively incorporated into the

rules themselves. Where domestic rules are introduced that are based on international treaties, it is

apparent that international law guidance is a relevant interpretive source (Unisys Corporation Inc v.

FC of T (2002) 51 ATR 386). In this case, however, the status of the examples in the Report is less

clear. In addition, the drafting of the rules is likely going to have to depart from the vague terms of the

Recommendations, further weakening the interpretive value of the examples (notwithstanding that in

many cases they provide the only limiting factor on otherwise vaguely drafted rules). Even if the

examples are valid in applying Australian law, are they also valid in a notional application of a foreign

jurisdiction’s laws that might be necessary to determine the operation of Australian anti-hybrid rules?

The author has identified at least eleven strands to the Recommendations which, in the author’s view,

each represent a conceptually distinct problem (with the exception of 8 and 9), notwithstanding that

the first six are said to be covered by a single rule (the complexities and modifications within that

single rule belie the true position). These are set out below. Some of this thinking builds upon an

earlier paper by Graeme Cooper: “Some Thoughts on the OECD’s Recommendations on Hybrid

Mismatches”, though the author sees different subsets of situations to which the rules apply. Others

may well see similarities or differences within these categories that would suggest more or fewer

categories.



In each case, the rules are subject to a “scoping” rule that requires a degree of assumed collaboration

before the measure will apply. These are discussed at 2.3.1 below, but include a 25% related parties

rule, a common control rule, and a de facto collaboration (“structured arrangement”) requirement.

Description Recommend

ations

Collaboration

thresholds

Primary rule /

defensive rule

1. Debt/equity

mismatches

1.1

2.1

Structured/related

parties

N/A

Deny payer

deduction/include as

ordinary income

N/A

2. Capital/revenue

mismatches

1.1 Structured/related

parties

Deny payer


ordinary income

3. Timing mismatches 1.1 Structured/related

parties

Deny payer


ordinary income

4. Payment commuted

into tax-preferred form

on assignment

1.2(e) Structured/related

parties

Deny payer


ordinary income

5. Payment assigned to a

tax-advantaged

recipient

1.2(e) Structured/related

parties

Deny payer


ordinary income

6. Loan/sale mismatches 1.2(b) Structured/related

parties

Deny payer


ordinary income

7. Payments by

disregarded entities to

their parents

3 Structured/controlled Deny payer


ordinary income

8. Payments by

disregarded entities to

third parties

6 Structured/controlled

(defensive rule only)

Deny parent

deduction/deny

duplicate deduction

9. Payments by dual

residents to third

parties

7 None Deduction denied by

both jurisdictions



10. Payments to

disregarded entities by

other parties

4

5

Structured/controlled

N/A

Deny payer deduction

N/A

11. Imported mismatches 8 Structured/controlled Deny payer deduction

It should also be remembered that for most of these situations, a taxpayer could find themselves on

either side, and be required to apply the primary or defensive rule as appropriate.

Of course, the emphasis here is on inbound financing, and the effect of the rules on financing

payments. The measures will have varying relevance to such transactions. For example, a number

of the measures are capable of applying to payments other than financing payments, or to non-

payments. These are not discussed in this paper in detail. The various examples following are

reproduced from the Report, with the focus on those most likely to arise in conventional financing.

2.2.1 Debt/equity mismatches (Recommendations 1.1 and 2.1)

This rule applies to financial instruments, and more specifically, financing arrangements, that have

both debt and equity characteristics and which give rise to a mismatch in tax treatment between the

two jurisdictions involved. In particular, the rule applies if a payment under the financial instrument is

deductible in one jurisdiction, i.e. is treated as a debt payment, but enjoys exempt treatment in the

payee jurisdiction as a result of being treated as an equity payment.

This is illustrated in Example 1.1 of the Report using a simple loan recharacterised as equity.

Example 1.1

An example in the Australian context is a redeemable preference share, treated under our debt/equity

rules as debt. Indeed, it might be suggested that Australia has become something of a hotbed for the

use of RPS precisely because Division 974, while purporting to be a “substance over form” regime, so

closely hews to its own, specific form-based rules that differ so widely from other jurisdictions’ rules.

However, other simpler forms of debt financing may also attract the operation of the rules. For

A Co

B Co

Interest / Dividend

Loan



example, highly subordinated debt may be treated by the laws of other jurisdictions as equity. The

Report shows an example where otherwise ordinary loans from shareholders are recharacterised on

account of nothing more than having been issued in proportion to the shareholders’ shareholdings.

Financing arrangements with hybrid debt/equity characteristics are the most “obvious” area in which

the hybrid rules apply, and will probably be the first example given when explaining the operation of

the rules as a whole to a layperson. Indeed, many will regard the anti-hybrid rules as synonymous

with this rule alone, notwithstanding that this only represents one part of a single recommendation.

Unfortunately, this has the effect of papering over the real design uncertainties that plague many of

the other targeted situations.

The rules are structured in a complex fashion:

1. Under Recommendation 2.1, jurisdictions are supposed to enact a rule preventing exempt

treatment from arising for dividends that are deductible in the payer jurisdiction.

2. Under Recommendation 1.1, jurisdictions are supposed to identify situations where, due to the

nature of the financial instrument involved, a payment that is deductible in the payer jurisdiction is

excluded from ordinary income in the payee jurisdiction, thereby giving rise to a “D/NI”

(deductible, not included) mismatch outcome. Once identified:

1. under Recommendation 1.1(a) – the “primary” rule – the payer jurisdiction is supposed to

deny the deduction for the payment,

2. under Recommendation 1.1(b) – the “defensive” rule – the payee jurisdiction is supposed to

deny the exemption and include the payment in ordinary income if the payer jurisdiction has

not “neutralised” the mismatch by applying Recommendation 1.1(a).

The two rules identified in Recommendation 1.1 are the hybrid mismatch rules, i.e. they only operate

where a hybrid mismatch is identified, and only where there mismatch is due to the terms of the

financial instrument (or, it is said, the relationship between the parties). They are also subject to a

collaboration requirement, i.e. the parties must be related parties or the arrangement must be a

structured arrangement.

By contrast, Recommendation 2.1 is not couched as a hybrid mismatch rule and does not depend on

identifying a hybrid mismatch outcome. Rather, it is expressed as a change to the domestic laws of

the payee jurisdiction that govern whether exempt treatment will be available for a dividend received

from offshore. It is not limited by any collaboration requirement. Essentially, the Recommendation is

that jurisdictions should change domestic tax policy so that exemptions are not afforded to payments

that are deductible elsewhere.

The interaction of the rules is not straightforward:

1. The defensive rule in Recommendation 1.1(b) is clearly subordinate to the primary rule in

Recommendation 1.1(a), but its content is otherwise the same as Recommendation 2.1, so that if

a jurisdiction had implemented Recommendation 2.1, it is unlikely to operate.

2. The circularity between the primary rule and Recommendation 2.1 is irreconcilable, as the

primary rule has as an input whether an exemption is available in the payee jurisdiction, but the



availability of such exemption has as an input whether a deduction is available in the payer

jurisdiction. This is a classic self-reference problem.

3. The guidance on the interaction of the rules ignores the circularity. (A circularity problem is

acknowledged in Example 1.4, but no real solution proposed.)

One solution to the circularity may be that Recommendation 2.1 only has regard to deductibility under

the payer jurisdiction’s “normal” rules (i.e. rules other than anti-hybrid rules). This would cure the

circularity, as it would give proper priority to Recommendation 2.1 over the primary rule, as seems to

be intended, but drafting the rule in this way would mean the taxpayer in the payee jurisdiction must

have so complete an understanding of the payer jurisdiction’s tax laws that they can distinguish

between its anti-hybrid laws and its normal rules.

The Board of Tax has endorsed Recommendation 2.1, but has not made any specific

recommendation to solve the circularity. In the context of inbound cross-border financing, this solution

is one that would need to be adopted by the payee jurisdiction. The Australian taxpayer must then

obtain so complete an understanding of the payee jurisdiction’s anti-hybrid laws that they determine

whether or not that solution has been adopted.

Double taxation outcome

Importantly, in identifying a D/NI outcome as giving rise to a hybrid mismatch, the Recommendation

fails to give due regard to the situation where a payee jurisdiction exempts a dividend, but also denies

deductions for financing costs relating to that exempt dividend. For example, what if there was no

equivalent of section 25-90 in the foreign jurisdiction, and the investment was wholly debt-funded?

The lack of deductions in the payee jurisdiction would neutralise the tax benefit of the exempt

dividend. No arbitrage outcome would be achieved, but the application of the rules would still require

that the payer jurisdiction deny the deduction.

Foreign tax credits and withholding tax

The rules also apply where the payments are creditable under the law of the foreign jurisdiction rather

than exempt, but only where the credit is one for underlying foreign tax paid. By contrast, withholding

taxes on financing payments are ignored, both for the purposes of determining whether a payment

has been included in ordinary income, and it seems for the purposes of denying relief.

Very little attention is paid to withholding taxes in the Report. In Australia, withholding tax is a proxy

for the corporate income tax, so it is not clear why a differing treatment should arise.

In the context of cross-border financing, the issue is the 10% interest withholding tax. The Board

concluded that interest withholding tax should still apply even if deductions have been disallowed,

notwithstanding that this would produce a worse outcome than ordinary equity (i.e. an effective 40%

tax rate). The justification is that the rules are supposed to encourage restructuring to simpler

arrangements and so a penalty tax rate is not inherently objectionable. We discuss at paragraph 2.5

why that may in fact itself be subject to general anti-avoidance rules.

As with the Report itself, this approach fails to acknowledge that a hybrid arrangement may arise

between related parties out of purely commercial circumstances. The assumption is that related party

structuring is necessarily tax-driven.



Related parties

Perhaps the chief uncertainty in the debt/equity rules is that they apply to any transaction between

related persons. The related persons threshold is set at only 25%. It operates on trace-up/trace-

down approach, i.e. two entities with a common 25% stakeholder will be considered within the same

control group.

If this remains unchanged, the rules will apply to transactions between what we might ordinarily

regard as unrelated parties.

Overall

In the author’s view, there is plenty of water to go under the bridge before we arrive at sensible,

workable rules aimed at debt-equity mismatches. In the meantime, taxpayers will need to monitor

both Australian developments and developments in parent jurisdictions and other jurisdictions where

target financing counterparties may be resident. Some practical suggestions are made at 5.4.

2.2.2 Capital/revenue mismatches (Recommendation 1.1)

Recommendation 1.1 also requires the neutralisation of mismatches between characterisation of a

payment as a receipt of a capital amount, i.e. principal, or a revenue amount, i.e. interest income.

Thus, a bond issued at a discount by an Australian entity may accrue a deductible expense under the

TOFA rules, but may be treated as a capital return in the payee jurisdiction and not taxable. Note

also that this example indicates that a “hybrid mismatch” can occur wholly within a single jurisdiction –

discussed further at 2.3.1.

Example 1.13

Interest free loan

A Co 1

A Co 2 Operating income



A buyback of a loan with accrued interest could have the same effect. Similarly, a payment for the

acquisition of a share that carries an interest component, which is deductible in the payer jurisdiction,

but treated as a receipt of purchase price in the payee jurisdiction, may also be subject to the rules.

Example 1.27

This may arise in the context of vendor financing where payment of the acquisition price may be

deferred and interest paid by the purchaser. Depending on the drafting of the contract, and taking

into account the effect of the BHP4 and Northumberland5 cases, the purchaser may seek to claim a

deduction for the interest.

The Recommendation contemplates that a sale transaction may not be treated as a financial

instrument on the payee side, however, this would only mean that the payee jurisdiction need not

apply the defensive rule, not that the payer jurisdiction need not apply the primary rule (although how

this squares with the seeming requirement in the wording of the Recommendation that it be a financial

instruments in both jurisdictions is not clear).

There is a real question as to why, if the laws of both jurisdictions are operating as intended, anything

needs to be done about this “mismatch”. In particular, certainly in the Australian context, the

characterisation of an amount as a deductible loss under section 8-1 or TOFA is informed by an

analysis of whether it is a cost incurred in producing assessable income; the treatment in another

jurisdiction is not, even in an indirect or implicit fashion, an input into the Government’s willingness to

afford deductible treatment, particularly where there is no question of an equity interest

characterisation.

This applies all the more when you consider that the payee might be taxable in its home jurisdiction

under rules equivalent to our capital gains tax rules. In this case, the payment will still form part of the

tax base of the payee jurisdiction, but the rule would still apply to deny a deduction.

As mentioned above, the Report suggests the capital/revenue mismatches that occur wholly within a

single jurisdiction should also be dealt with under the anti-hybrid rule.

4 Federal Commissioner of Taxation v Broken Hill Pty Co Ltd [2000] FCA 1431. 5 Federal Commissioner of Taxation v Northumberland Development Co Pty Ltd (1995) 138 ALR 89.

Shares

Transfer

Purchase price + interest

B Co A Co



2.2.3 Timing mismatches (Recommendation 1.1(c))

Recommendation 1 is also intended to neutralise mismatches between timing if they do not equalise

within a “reasonable period”. This could occur, for example, if accrued interest is deductible as it

accrues, but is not taxable in the payee jurisdiction until receipt. Australian examples of accruals

deduction regimes would include TOFA or Division 16E.

The Report gives an example of a loan with contingent interest deferred for a long period.

Example 1.21

The UK has allowed for 12-month deferral period in its rules.

The Board has recommended that a deferral for up to 3 years be acceptable, but that the mismatch

rules apply for longer deferrals. However, in a rare departure from the Recommendations, the Board

has recommended that the deduction should again be available when the income is recognised.

Of course, this raises the complexity of tracking the other jurisdiction’s treatment of the particular

payee on an ongoing basis.

If the payee is at arm’s length (and is within scope only because the arrangement is “structured” or

there is a common 25% holder), this will be exceedingly difficult to administer.

2.2.4 Payment commuted into tax-preferred form on assignment (Recommendation

1.2(e))

A comparatively obscure component of Recommendation 1 is the substitute payment rule. It purports

to operate when there is a transfer of a financial instrument that carries an “accrued” return, and the

transferee compensates the transferor for such accrued return. This return could be interest on a

debt security, but also an earnout on the sale of shares. The rule applies (Recommendation 1.2(e)(i))

where the transferor enjoys a preferred tax treatment on the compensation amount as compared to

what would have applied had the transferor continued to hold the asset, e.g. a dividend would have

been assessable if received, but the compensation is treated as purchase price (similar to the

capital/revenue mismatch).

Loan

Contingent interest

A Co

B Co



Example 1.30

The rule also applies (Recommendation 1.2(e)(iii)) if the interest would have been exempt, but that

exemption was itself part of a hybrid mismatch. In the example below, a loan is transferred cum

interest in circumstances where the interest would have generated a hybrid mismatch had it been

paid to B Co.

Example 1.36

Where Australian underlying assets are involved, the relevant issues are usually withholding tax

issues, rather than corporate tax issues. The interest withholding tax provisions would treat a

compensation payment as interest under the washing arrangement rules. However, as discussed at

2.2.1 above, the Report seems to treat withholding tax as a distinct and separate issue not covered by

Recommendation 1.

C Co Interest

Loan transfer

Purchase price + premium

50% 50%

Loan

A Co B Co

C Co

Share

transfer

Purchase price + earnings adjustment

B Co A Co



While this Recommendation is perhaps less likely to operate in respect of a conventional financing, it

could arise in the earnout scenario described above.

2.2.5 Payment assigned to a tax-advantaged recipient (Recommendation 1.2(e))

The substitute payment rule also applies (Recommendation 1.2(e)(ii)) where the transferee enjoys

exempt treatment on receiving the accrued return, but can still deduct the compensation payment.

The acquisition of shares that pay franked dividends might have this effect, e.g. if you were to acquire

shares cum dividend, but had negotiated to pay the benefit of the dividends to the vendor.

For present purposes, the situations the rule is directed at are those involving derivative-like

transactions (the exchange of economic exposure), rather than financing transactions per se.

2.2.6 Loan/sale mismatches (Recommendation 1.2(b))

Hybrid transfers refer to transfers of securities subject to an obligation to redeliver the same or similar

securities. Common examples are “repos” or sale and repurchase agreements, and stock loans.

The key requirement is that both transferor and transferee must be regarded as the “owner” of the

securities for the purposes of the law of their respective jurisdictions. The requirement that the hybrid

mismatch occur under a financial instrument is deemed to be satisfied in this circumstance. In the

example below, the manufactured dividend is deductible to B Co, but is exempt for A Co, who is

regarded as continuing to hold the shares and receiving the manufactured dividend as a proxy for the

actual dividend.

Example 1.32

The examples indicate that the mischief targeted by these rules is not in fact a doubling up of exempt

treatment, but simply the fact that the manufactured dividend is deductible to B Co and exempt to A

Co. If the actual dividend were taxable to B Co, the rules are said to still apply.

Manufactured dividend (70)

Shares

Share transfer Dividend (70)

B Co A Co

Repo



There are significant uncertainties in the rules. For example, although repos and stock loans are

functionally similar transactions, the examples given of a repo transaction and stock lending

transaction each identify the opposite party as the “payer” and “payee” in a D/NI mismatch.

Hybrid transfers concern transactions involving a change in exposure, rather than the raising of

finance as such. While such arrangements are common in the equity financial markets, they are

perhaps less common in conventional financing.

2.2.7 Payments by disregarded entities to their parents (Recommendation 3)

Recommendation 3 applies to “hybrid payers”, which are broadly entities that are ignored or treated

as fiscally transparent by the jurisdiction of their parent or investor, but which are given recognition as

separate taxpayers in the establishment jurisdiction.

A payment from the hybrid payer to its parent or investor will be disregarded in the payee (i.e. parent)

jurisdiction, but will be deductible in the payer (i.e. establishment) jurisdiction, generating the

mismatch.

Interestingly, though not on point in the present context, the rule applies not just to financing or equity

payments, but to any deductible payment, e.g. service fees.

The main example, and the evident target of the rules, is the check-the-box rules in the US that allow

a company to elect to be treated as disregarded or as a flowthrough. Even an Australian company

can therefore be a hybrid payer, if it makes a payment under an ordinary loan from a US parent. In

the following example, B Co 1 is disregarded in Country A, but recognised and grouped with B Co 2 in

Country B. The interest is therefore ignored in country A, but is deductible in Country B.

Example 3.1

A Co

B Co 1

B Co 2

Interest (200)

Loan

Interest (300)

Hybrid loan

Operating income (400)



The other main example is a branch of a foreign resident that is given separate tax recognition in the

payer jurisdiction, but is treated as a part of the foreign resident in the parent jurisdiction. In the

following example A Co 1 and A Co 2 are grouped in Country A. A Co 2 has a branch in Country B

which is grouped with B Co. The branch’s interest payment is deductible in Country B, but ignored in

Country A.

Example 3.2

There is a real question about whether a branch does in fact count as a hybrid payer if the payment is

made to its head office. Such a payment is not actually a payment for the purposes of the rules, as

the definition of payment requires the creation of economic rights between different “parties”. A party

would usually be thought of as a person or entity. Therefore, as a branch is not a different person or

entity (Max Factor6), a “payment” to its head office is not in fact a payment. This result might be

overturned by a separate entity deeming, as occurs under Part IIIB for Australian branches of foreign

banks, but in other cases, payments from branches to head office are merely proxies for the

attribution of third party expenses to the branch. In this case, the mismatch may amount to a simple

mismatch between transfer pricing approaches taken by the jurisdiction (e.g. separate entity approach

versus expense allocation approach). It is not clear that this is the kind of mismatch the rules are

targeting.

6 Max Factor and Co. v. FC of T (1984) 84 ATC 4060.

A Co 1

A Co 2

PE

B Co

Interest (300)


Loan




2.2.8 Payments by disregarded entities to third parties (Recommendation 6)

Disregarded entities also present another, conceptually distinct, opportunity for arbitrage. This occurs

where the entities makes payments to third parties which are deductible both in the establishment

jurisdiction and the parent jurisdiction.

Example 6.2

Of course, the availability of deductions in two jurisdictions for the same amount is not of itself

problematic if the income to which the expenses relate is also assessable in both jurisdictions –

known as dual inclusion income. The rule therefore only applies if the deduction is available to shelter

income that is not dual inclusion income.

The parent jurisdiction is supposed to apply the primary rule, with the establishment jurisdiction

applying a defensive rule. (Incidentally, this can produce perverse results. In Example 6.1 in the

Report, the parent jurisdiction has to unwind the effect of a bonus depreciation scheme,

notwithstanding that the bonus depreciation is not available in both jurisdictions.)

It must be the case that both jurisdictions allow excess deductions to be offset against non-dual

inclusion income for the rules to apply; otherwise there is no mismatch benefit.

As most jurisdictions would presumably allow deductions only on the expectation of income, the rule

is aimed at a timing issue rather than a permanent difference. Excess deductions are able to be

carried forward until sufficient dual inclusion income has been derived.

Ironically, although aimed at a timing difference, the rule still applies even if there is no timing

difference, for example because the entity is in a tax loss position. That is, even if the deductions are

not available to shelter non-dual inclusion income in one jurisdiction in the same year – such that no

timing difference occurs – the rule applies, i.e. the other jurisdiction must defer deductions available

until dual inclusion income is derived. This means that, quite apart from denying a timing benefit, the

rules are imposing a timing detriment! The only exception seems to be if the taxpayer can

demonstrate that deductions are irretrievably quarantined against dual inclusion income – a very high

bar.

A Co

Bank Country B PE

Interest

Loan



Again, is it sensible for jurisdictions that have presumably fine-tuned their policy settings so far as they

relate to when excess deductions are allowed to shelter other income, to disturb these policy settings

for the simple reason that another jurisdiction applies different principles in that same determination?

The Report acknowledges the inherent unfairness, and recommends that if the relevant losses are

stranded, i.e. losses will never be able to be used, the rule should be relaxed.

It will be apparent from the above that the system needs to record the running balance of denied

deductions and track the amount of dual inclusion income, i.e. it must track the tax treatment of

income derived in the other jurisdiction on an ongoing basis. If the other jurisdiction is in a loss

position, it must also track the ongoing availability of those losses in the other jurisdiction.

In the context of cross-border financing, double deduction scenarios could arise easily through the

consolidation system, as interest deductions on financing by one entity will be available for deduction

against group income. If another jurisdiction treated the borrower entity as flowthrough, the rules

could apply.

The Board has recommended that “a simple dual inclusion income approach be taken to avoid

unnecessary complexity and minimise compliance costs for taxpayers”. How this will be achieved

remains to be seen.

2.2.9 Payments by dual residents to third parties (Recommendation 7)

The Report identifies the same double deduction (DD) issues with dual-resident entities as with

payments by hybrid payers. That is, an expense is deductible in both jurisdictions, and if both

jurisdictions allow the expense to shelter tax on unrelated income (i.e. non-dual inclusion income),

there is a hybrid timing mismatch that will not reverse until sufficient dual inclusion income has been

derived to offset the deductions. In the following example, A Co 2 is a dual resident that is able to

deduct interest income in two jurisdictions, and is able to utilise the deductions against non-dual

inclusion income in both.



Example 7.1

The only reason dual residents are covered by a separate recommendation is because the particular

remedial framework adopted for hybrid payer scenarios involves one jurisdiction (the parent

jurisdiction) applying a primary rule, and another jurisdiction (the establishment jurisdiction) applying a

defensive rule. In the case of dual residents, there is considered to be no sensible way to distinguish

between which jurisdiction should act first, and the Recommendation therefore states that both

jurisdictions should deny the deduction.

This creates an obvious instance of double taxation. The report breezes over this effect, suggesting

at one point that the jurisdictions should simply adopt an “adjustment [that is] no more than is

necessary to neutralise the hybrid mismatch and [which] should result in an outcome that is

proportionate and that does not lead to double taxation”. However, it is not clear how one would

achieve this.

The only example given in the Report recommends full disallowance in both jurisdictions,

notwithstanding that this creates a double taxation outcome. Its rationale is that “structuring”

opportunities would be available to relieve the double tax – yes, a Report whose main complaint is

about tax-based structuring reducing tax liabilities specifically condones, indeed recommends, that

taxpayers should adopt tax-based structuring solutions to reduce their tax liabilities! And why?

Because such structuring is necessary to cure a double taxation result that the Report itself

recommends should be implemented! This suggested “solution” also does not contemplate a general

anti-avoidance such as section 177CB which on a literal reading could prohibit simple tax planning

decisions.

In the Australian context, dual residency is not difficult to achieve due to the many and varied ways

that a company can be regarded as Australian resident, and the fact that Australia does not have a

A Co 1

A Co 2

B Co

Bank

Operating Income (300)

Interest (150)

Operating Income (350)



residence tiebreaker rule in its domestic law. This applies all the more to limited partnerships carrying

on business in Australia, due to the low residence threshold for such vehicles.

Nevertheless, Australia’s prescribed dual resident rules already go some way to preventing the very

issues identified by this recommendation, by precluding such entities from grouping and thereby

surrendering excess losses to other companies.

2.2.10 Payments to disregarded entities by other parties (Recommendation 4)

This rule applies where a payment is made to a person that is treated as transparent under the laws

of the establishment jurisdiction, but as a separate entity by the parent or investor jurisdiction.

The mismatch is said to occur as a result of the payment received by a reverse hybrid being sheeted

home to the parent, and possibly exempt as a result. The parent jurisdiction will, it is thought, ignore

the payment, because no distribution has been made to the parent and the separate entity recognition

will mean there is no attribution of the income back to the parent.

This combination of effects will mean that the payment is not taxed in either jurisdiction, but the payer

may still obtain a deduction for making the payment, i.e. a D/NI outcome. As with other D/NI

scenarios, the payer jurisdiction is supposed to deny the deduction as the primary rule. In the

following example, interest paid to B Co is sheeted home to A Co and untaxed in B Co. For Country

A purposes, amounts paid to B Co are not recognised, as B Co is a separate entity.

Example 4.1

In the Australian context, the main examples of transparent entities are partnerships or trusts.

However, since partnerships and trusts are “fully distributing” in the same period, it is not clear that

this situation creates the feared mismatch, as the distribution would presumably be taxable in the

payee jurisdiction (if an exemption did not apply). The Report however specifically ignores the effect

of a later distribution and insists that the mismatch is present at the time of the payment.

The Board of Tax has not made any specific comment on this recommendation.

A Co

B Co Borrower Co

Interest

Loan



It should be noted that the term “reverse hybrid” is slightly misleading, as it implies that the

mechanism generating the mismatch is something that is similar to that operating for hybrid entity

payments but operating in reverse. In fact the reverse hybrid situation bears little resemblance to the

hybrid payer mechanism. Where the hybrid payer rule relies on the disregarded nature of the hybrid

payer in the payee jurisdiction giving rise to disregarded treatment for the payment, the reverse hybrid

scenario relies upon the disregarded nature of the hybrid payee in the payee jurisdiction causing the

payment to be sheeted home to an investor – and assumes that this would result in non-taxation in

the payee jurisdiction.

Recommendation 5 is, like Recommendation 2, a recommendation to change domestic policy so that

reverse hybrid scenarios are less likely to arise. The Board has recommended deferring

Recommendation 5 on the basis that no integrity issues have been identified.

2.2.11 The imported mismatch rule (Recommendation 8)

The imported mismatch rule is arguably the most complex aspect of the anti-hybrid rules. While the

earlier recommendations often require a mastery of a foreign jurisdiction’s tax laws, the imported

mismatch rule requires a mastery of multiple foreign jurisdiction’s laws, and in particular, their anti-

hybrid tax laws.

The rationale for the imported mismatch rule rests on the proposition that not all jurisdictions will adopt

the anti-hybrid rules. Imperfect uptake will mean that taxpayers can structure a hybrid mismatch

between two non-adopting jurisdictions and be free from the rules (and the Report will have provided

a roadmap as to how to do this!).

If uptake is widespread, the universe of potential locations will narrow, hopefully to obscure

jurisdictions with few trading partners. Without actual business activity in those jurisdictions, there will

be no income against which hybrid deductions might be offset, rendering them useless as locations in

which to structure a hybrid mismatch.

This is where importation comes in. Income can be shifted from a mainstream jurisdiction where

there is tax capacity through deductible/assessable payments such as interest or fees. Viewed in

reverse, the hybrid deduction is being shifted or “imported” into the mainstream jurisdiction, where

there may be other income that can be sheltered by the deduction.

The imported mismatch rule therefore asks taxpayers to look upstream to see if there is a hybrid

mismatch elsewhere.



Example 8.5

The mode of importation is varied. The primary rule suggests that if payments are all under the same

structured arrangement, there is importation. This is a factual question.

A second rule suggests that even if not part of the same arrangement, the effect of a mismatch can

still be imported into the first jurisdiction if the deductions directly shelter income payments from the

first jurisdiction. In the example, C Co’s hybrid deductions directly shelter interest received from D Co.

A third rule suggests that the effect of a mismatch can be imported into the first jurisdiction if the

deductions shelter income payments that are deductible in another jurisdiction that shelter income

payments from the first jurisdiction. In the example, C Co’s hybrid deductions shelter interest received

by D Co, and D Co’s deductions shelter interest received from G Co – an “indirect” importation of

deductions from C to G.

It should be remembered that the anti-hybrid rules remain completely agnostic about which jurisdiction

is suffering the base erosion. In the case of D/NI situations, deductions are denied as a primary resort

for no principled reason other than convenience of application. However, every mismatch has two

components. The mismatch could also be imported into a third jurisdiction on the income side, e.g. by

running the investment through a series of jurisdictions providing for participation exemption. Any

jurisdiction in that chain could lay claim to having had their tax base eroded, on the basis that the

exempt dividend had its ultimate origin in a payment that is deductible in another jurisdiction,

however, this mode of importation has not been addressed.

The argument has already been made that the availability of deductible treatment is not premised on

the payment being taxable in the payee jurisdiction. The imported mismatch rule makes this

B Co

E Co F Co

D Co

G Co H Co

A Co

C Co

Hybrid financial instrument

Payment (200)

Loan

Loan Loan Interest (300)

Interest (200)

Loan Loan Loan



distinction even clearer. Should the availability of an exemption in a downstream (or upstream)

jurisdiction really be a criterion for deductibility in Australia?

Compliance

The Board recognises the complexity and compliance costs associated with these rules:

One of the difficulties associated with the imported mismatch rule is that taxpayers will need

to understand the tax treatment of payments in the hands of parties other than those with

whom they are directly transacting. That is, taxpayers will need to understand the foreign tax

treatment of payments that may have no direct connection with their particular operations,

and will need to keep abreast of any legislative developments in those foreign jurisdictions

that may change the position taken in Australia. This assumes there is an appropriate level of

transparency within the group. Additionally, taxpayers will need to understand implications of

foreign currency and valuation differences.

The Board recommends considering de minimis exemptions, even if as a transitional measure. It is

thought that the uptake of the rules throughout the OECD will cure the issue. But in theory at least, a

debt/equity mismatch between two other jurisdictions can always be imported on the deduction side

through as many jurisdictions as is necessary, and can be imported on the exemption side through

any jurisdictions that provide for a participation exemption.

Importation rules must yield to other rules

The interaction of the imported mismatch rule with other jurisdiction’s rules will be critical. On the face

of the recommendations, the defensive rules do not yield to the operation of the imported mismatch

rule in a third jurisdiction, nor do the imported mismatch rules yield to the operation of the defensive

rules.

The effect may be that two jurisdictions both seek to neutralise the mismatch – and double

neutralisation must mean double taxation.

This problem has been addressed in the UK rules, by making the imported mismatch rule yield to any

other anti-hybrid rules operating that might operate to neutralise the mismatch. That is, the imported

mismatch rule only operates if it is reasonable to suppose that no other anti-hybrid rules in any other

jurisdiction operate to neutralise the mismatch7.

So even if a payment is sheltered by a hybrid deduction, if the mismatch giving rise to that hybrid

deduction has been neutralised in another jurisdiction, e.g. due to the operation of defensive rules, the

imported mismatch rule will not apply.

Of course, this only solves the problem if every jurisdiction solves it in the same way.

7 Section 259KA Taxation (International and Other Provisions) Act 2010, proposed to be inserted by Schedule 10

Finance (No. 2) Bill.



2.3 Structural concerns with the rules

This section identifies various concerns with the design of the rules in general.

2.3.1 Collaboration requirements

Many of the rules are expressed only to apply where the relevant transaction occurs under a

structured arrangement or either between related persons (Recommendation 1) or between members

of the same control group (Recommendations 3, 4, 6 and 8).

2.3.1.1 Control group

The control group definition is generally aimed at entities under common control, either formal (50% or

greater interest) or informal (an investor has “effective control”, e.g. over appointment of directors).

Other proxy tests are also picked up, i.e. entities that are consolidated for accounting purposes, or

that are regarded as associated under Article 9 of the OECD model tax convention (entity participates

in the management, control or capital of an enterprise).

Persons acting together will be aggregated for these purposes. This includes family members, de

facto control situations (similar to the “sufficient influence” test in section 318), arrangements that

“materially impact value or control” (e.g. options, but not shareholders’ agreements on ‘standard’

terms).

Importantly, it prima facie also includes entities under common management, unless the entities can

positively demonstrate that they are not in fact acting together. In the case of actively managed

funds, where investors have very little oversight, as is the case with many private equity funds, this

may be difficult to make out.

2.3.1.2 Related persons

The related persons test is an alternative, and lower, threshold that applies for Recommendation 1

only (in relation to hybrid financial instruments). The reasons for the lower threshold are not clear.

The related persons threshold is very low at only 25%. It operates on trace-up/trace-down approach,

i.e. two entities with a common 25% stakeholder will be considered within the same control group.

If this remains unchanged, the rules will apply to transactions with what we might ordinarily regard as

unrelated parties. It is not uncommon for partially-nationalised entities to have government stakes of

over 25%, but for those entities to be managed completely independently from one another.

Furthermore, in the current era where mutual funds, hedge funds and super funds control a large

portion of the funds under management, commonality may be increasingly common.

In all submissions received by the Board, none of the commentators raised any concerns with this low

threshold, notwithstanding that the normal thresholds under Australian law for association are set at

40% or 50%.



It is not clear whether the related persons rule also operates for the purposes of determining for

Recommendation 8 (imported mismatch) purposes whether a Recommendation 1 mismatch in

another jurisdiction is subject to the imported mismatch rule, or whether the imported mismatch must

itself be between control group members.

2.3.1.3 Structured arrangement

A structured arrangement is defined in the Report as:

“any arrangement where [i] the hybrid mismatch is priced into the terms of the arrangement or [ii] the facts and

circumstances (including the terms) of the arrangement indicate that it has been designed to produce a hybrid

mismatch”.

The Board has recommended this definition be adopted.

The Report also stipulates a number of situations that will be taken to satisfy the second limb. The

Board has recommended these additional factors should be confined to guidance issued by the ATO.

The Board has suggested that the ATO’s guidance should make it clear that widely held instruments

or marketable securities are not caught, but it is not clear that this would be consistent with the

Report, which does not make any such allowance.

A number of the stipulated conditions would throw up significant concerns should they be adopted too

closely by the ATO. In particular, marketing an arrangement as a tax-advantaged product is said to

be sufficient. It would be expected in the ordinary course that any marketing of an arrangement must

highlight any benefits of the arrangement, including potential tax benefits. This is particularly the case

with widely offered arrangements. Will mere tax disclosures in information memoranda or similar

documents be sufficient, if they identify and comment on the tax treatment in various jurisdictions?

Similarly, marketing an arrangement primarily to taxpayers in a jurisdiction where the hybrid mismatch

arises is considered indicative. It is a real possibility that such an occurrence could be coincidental,

i.e. a hybrid mismatch occurs because of purely commercial terms, and the key target jurisdiction

happens to carry that mismatch result. This will particularly be the case with marketing into the United

States, which is home to both the largest capital markets, and many of the rules that trigger hybrid

mismatches.

If commercial terms are contingent on the availability of the hybrid mismatch outcome, this is also said

to be sufficient. An example would be in an Additional Tier 1 capital issuance by a bank where the

non-availability of franking credits means the cash return increases. But many debt instruments

include “tax call” events that allow an issuer to wind up the scheme in the event of adverse tax

circumstances. The Report suggests that these sorts of rights are acceptable, but it is not clear where

the line would be drawn.

The definition operates “objectively”. In other words, even if there was no subjective intention to

structure a hybrid mismatch, the rules can still apply if a reasonable person would conclude that the

arrangement was designed to engineer a mismatch in tax outcomes.



2.3.2 Application wholly within one jurisdiction

It is apparent that the rules may apply even where there is only one jurisdiction. This is explicitly

stated to be the case for Recommendation 1 (hybrid financial instruments), notwithstanding that the

references to payer jurisdiction and payee jurisdiction would lead one to presume that two different

jurisdictions must be involved.

As a practical matter, it is difficult to think of scenarios where hybrid mismatch outcomes might

eventuate wholly within Australia, as many of the outcomes are things that can only happen cross-

border. More specifically, intra-jurisdiction tax arbitrages have largely been eliminated in Australia by

simple application of a coherent tax framework. So for example, the existence of a separate entity for

tax purposes is unlikely to be disputed by two parties, just as the debt/equity characterisation of an

instrument should also be uncontroversial (at least between the parties to it; the Commissioner might

be a different story).

There is more scope for capital/revenue mismatches and timing mismatches, though many such

mismatches might be dependent on the circumstances of the taxpayers rather than the terms of the

financial instrument, and therefore be excluded from the operation of the rules. And regimes such as

TOFA, Division 16E, Division 240 and others are aimed at achieving coherent tax treatment to parties

to financial arrangements.

However, the substitute payment rule could conceivably apply in a wholly domestic context. For

example, the loan of franked stock to a borrower (assuming they satisfy the 45-day rule) could trigger

the rule. Similarly, the sale of securities cum-distribution could attract that rule.

Furthermore, the rules of other jurisdictions may not be so clear. Any domestic hybrid mismatch in

another jurisdiction could easily be imported into Australia through a simple loan, as identified in the

discussion on importation. This adds to the already considerable burden attached to the imported

mismatch rules.

2.3.3 Exceptions

Exceptions are recommended for certain special purpose vehicles (SPVs) from Recommendation 1.

The defensive rule may still apply, but the exemption means the SPV can remain tax neutral in its

jurisdiction of establishment.

The Board has recommended this exception be implemented.

The Board has also recommended that financial traders and managed investment trusts should be

exempt – the reasons are not clear. It should be noted the new attribution managed investment trust

rules contain a debt unit provision that provides for distribution on units with certain debt-like

characteristics to be deducted.

It should also be noted that exemptions in one jurisdiction need not be respected by the defensive

rules in the other jurisdiction.



2.3.4 Design

The Board recommended that the hybrid mismatch rules be drafted as a separate regime in

Australia’s tax law that applies in priority to all other parts of Australia’s tax law8.

It is not entirely clear what this means. It presumably does not mean that if a deduction is not denied

under the anti-hybrid rules, that the deduction cannot be denied under any other regime. It seems

that the rules operate before Part IVA, and Part IVA may apply if the anti-hybrid rules do not apply.

Since the anti-hybrids rules are designed to address issues left by gaps in the rules in different

jurisdictions, it is perhaps surprising that they do not operate as a rule of last resort.

The Report suggests that the rules should operate before interest limitation rules such as the thin

capitalisation rules, and that debt interests on which deductions have been denied should not also be

included in gearing ratios. The Board has recommended further work be done on thin capitalisation

interactions, as it is not a fait accompli that denied hybrids should be excluded from thin cap ratios if

the assets acquired with them are included in asset ratios.

2.3.5 Financial instrument

The hybrid financial instrument rule only applies to financial instruments: “A financial instrument

means any arrangement that is taxed under the rules for taxing debt, equity or derivatives under the

laws of both the payee and payer jurisdictions…”

The Board recommends that to maximise international harmonisation, the OECD’s definition of

‘financial instrument’ in the Action 2 Report should be used in Australia’s hybrid mismatch rules:

However, the Board recommends that the scope of the definition should be limited to where the

instrument is also a ‘financial instrument’ for the purposes of Australian accounting standards and

accounting principles. The Board recommends that leases be specifically carved out of the definition

of a ‘financial instrument’.

It is not clear what it means for an arrangement to be “taxed” under the rules for taxing debt, equity or

derivatives. Does this mean TOFA? Is Division 974 a “taxing” provision?

Nevertheless, in the context of cross-border financing, it is clear enough that all financing

arrangements will be subject to the rules, and the main ambiguities will arise at the margins, for

example in relation to vendor financing or earn-out scenarios.

2.4 Costs and complexities relating to surveying the law in other

jurisdictions

The rules require taxpayers to understand not just the operation of laws in another jurisdiction, but

also:

8 Recommendation 16, BOT report.



1. whether another jurisdiction’s law is specifically an anti-hybrid law; and

2. the reason a particular treatment is afforded. E.g. if an exemption is afforded because of entity

status, this can affect whether there is a hybrid mismatch. If an entity is taxable because they are

a trader, this is different from if an entity is taxable on an instrument per se.

This will require tax advisers to have a granular understanding of tax laws in other jurisdictions. It will

be self-evident that the rules will result in a substantial compliance cost increase even for

straightforward arrangements, as taxpayers will need to satisfy themselves about the tax treatment in

foreign jurisdictions.

In the current environment, when structuring a cross-border arrangement, it would not be uncommon

to seek separate tax advice from practitioners located in the target jurisdiction on local laws. It will

become quite costly if a local law tax advisor needs to skill up on the tax treatment in other

jurisdictions.

This may even change how tax advice is rendered. In a fast-paced business environment, tax advice

often needs to be reduced to the headline conclusions. Tax advice is often provided through oral

recommendations, emails, short structure papers and memos. The anti-hybrid rules may see a return

to the days of 100-page tax opinions providing detailed overviews of how the tax laws in the

jurisdiction operate, as these will be necessary for tax advisors in other jurisdictions to apply their anti-

hybrid rules.

One can readily see situations arising where structuring advice must be provided iteratively: a tax

advisor in one jurisdiction renders advice that is subject to the tax advice from the advisor in another

jurisdiction, who in turn renders advice that is subject to the further tax advice from the first advisor.

This will quickly become an expensive process.

It will also tend to place unfair competitive pressures on local tax advisory firms without international

operations.

Finally, as a practical matter, if seeking to resolve an anti-hybrid matter with the ATO, it is likely to

become necessary for legal professional privilege over foreign tax advice to be waived and that

advice provided to the ATO or a Court. This is because the onus will be on the taxpayer to convince

the ATO or Court about how the foreign tax laws operate. As a practical matter, since tax reports for

provision to the ATO or Court will need to be prepared by independent advisors or expert witnesses

(as the advisor’s independence may otherwise be questioned), this will necessitate retaining

additional advisers for this purpose. The costs of advice will proliferate dramatically.

2.5 Restructuring may be subject to Part IVA

Submissions to the Board supported restrictions on Part IVA where taxpayers restructured to avoid

the effect of the anti-hybrid rules, given an explicit objective of the rules is to encourage restructuring.

This makes sense: if Part IVA does not already apply to the deductions, there is presumably no policy

issue in allowing the deductions. If the Australian tax base is not being eroded, then denying the

deductions would amount to double taxation. Therefore, any restructure that preserved deductibility



in Australia must inherently be acceptable, since the shift from hybrid structure to non-hybrid structure

must by definition not be making the situation worse.

The concern with Part IVA then is that a purely mechanical operation of Part IVA (particularly after the

2013 changes) would simply see a scheme that had the effect of avoiding the operation of the anti-

hybrid rules.

Of course, the complexity of Part IVA is such that the Board ultimately concludes that it is not possible

to deal with the point through legislation.

Importantly, the Board notes the position of Hill J in CPH9, where he stated that Part IVA must be

tested at the time of entry into the scheme, and on the law as it then stood.

Hill’s comments however were qualified where the scheme was entered into in one year, but carried

out in another year – so any restructure would have to occur and be carried out before the rules came

in. This puts more pressure on forward-planning, but also on industry being given sufficient time to

react to the rules. The reality though is that it is simply not feasible for all extant transactions to be

restructured prior to enactment. Thus there remains a real risk that Part IVA would apply to a

restructure, notwithstanding that a clearly intended policy outcome of adopting the rules is for

taxpayers to carry out restructures.

2.6 New categories of hybrids

It should also be noted that the OECD’s work on hybrid mismatches is continuing. Consultation is

occurring on “branch mismatches”, i.e. a mismatch between whether the source country and the

residence country consider there to be a PE in the source country. If the source country does not

consider there to be a PE, it will not tax profits of the enterprise. The same profits may escape

taxation in the residence country as being attributable to a foreign PE. This dual non-inclusion

situation is not covered by the current rules.

Alternatively, if the source country considers there to be a PE, but the residence country does not,

there could be a double deduction outcome. It may be that such outcome would be subject to

Recommendation 6.

9 CPH Property Pty Ltd v Federal Commissioner of Taxation (1998) 88 FCR 21.



3 Diverted profits tax

3.1 Overview

The Australian Government announced as part of the Federal Budget for 2016-2017 that it will

introduce a “diverted profits tax” (DPT) from 1 July 2017. This will be a 40% tax on the profits of

multinational corporations that are “artificially diverted” from Australia.

The DPT is to be based on the UK’s equivalent rules. At the time of writing, there is little information

available other than a consultation paper.

Like the anti-hybrid rules, no grandfathering is contemplated, giving rise to a retrospective effect on

transactions already entered into at the time of commencement. Taxpayers will need to give

consideration to how financing transactions entered into today will be impacted by the rules when they

are ultimately introduced. Needless to say, this is an exceedingly difficult exercise with so little

information available.

The author suggests that scrutiny of the UK’s DPT rules, which will significantly influence the

development of the Australian rules, is likely to give Australian taxpayers a sense of what to expect.

However, detailed analysis of the UK rules is beyond the scope of the author’s present paper, and this

paper will therefore provide no more than a broad overview of the design of the rules and some of the

uncertainties flowing from them.

3.2 The operation of the rules

There are 4 key requirements for the rules to apply:

1. The taxpayer is part of a large global organisation with material Australian operations.

The rules apply to a “significant global entity” (the same concept used in the multinational anti-

avoidance law), being one that has income of $1 billion or more on an accounting consolidated

basis, that has Australian turnover of $25 million or more.

2. The transaction must be between related parties. Importantly the related parties need not be

members of the same global organisation. The use of the phrase “related parties”, rather than

say “associates” is interesting, as no definition is given of “related parties”. This may suggest an

intention to adopt the definition from the anti-hybrid rules, which as discussed at 2.3.1.2 is a 25%

common ownership threshold. This would widen the scope of the DPT significantly.

3. The transaction shifts profits to a low tax jurisdiction. An “effective tax mismatch” will occur

where the arrangement results in the amount of tax paid overseas being less than 80% of the

amount of tax that would have otherwise been paid in Australia. This appears to be calculated on

a gross basis, i.e. this amounts to a requirement that a payment that is deductible in Australia

must be taxable in the payee jurisdiction at 24% or greater. Taxpayers should note that the



average corporate tax rate across the OECD is approximately 23%10. Determination of the tax

reduction also requires a comparison to a particular counterfactual, but there is no guidance as

yet as to how the counterfactual should be constructed – other than to say the ATO will have very

wide powers to reconstruct.

4. The transaction has insufficient economic substance. The determination of whether an

arrangement has sufficient economic substance will be based on whether or not it is “reasonable

to conclude” that the arrangement was “designed to secure a tax reduction”. Where the non-tax

financial benefits of the arrangement exceed the financial benefit of the tax reduction, the

arrangement will be taken to have sufficient economic substance. No guidance is given on how

to quantify or measure non-tax financial benefits. Non-financial benefits are not relevant.

If the rules apply, the ATO is permitted to raise an assessment on the basis of a “provisional” diverted

profits amount. If the scheme involves a deduction of an amount considered to exceed an arm’s

length amount, the provisional amount will be 30% of the entire expense. It should be noted that the

30% is not based on the corporate tax rate per se; rather it is an arbitrarily chosen fraction of the

expense that will be presumed to be excessive, and which can be adjusted subsequently as further

information comes to light.

The rules are also clearly stated to apply even if the transaction is conducted at arm’s length rates. In

that case however the “provisional” diverted profits amount will be based on the ATO’s best estimate.

The rules are designed to place the onus on the taxpayer to provide information to the ATO to combat

any assessment, and this is a key plank in this reform.

Furthermore, the DPT provides for extremely stringent payment arrangements. On the making of a

provisional assessment, the taxpayer will have limited time to correct factual matters, and may not

otherwise dispute the assessment for a period of 12 months, nor can payment be deferred until

resolution. Only after the 12-month period has expired can taxpayers challenge the assessment

through the normal means.

Application to financing arrangements

In a significant departure from the UK rules on which the DPT is based, the Australian rules are

proposed to apply to financing arrangements, whereas the UK rules expressly exclude loan

arrangements and related hedges – ostensibly because loan arrangements are to be dealt with by the

BEPS initiatives such as the anti-hybrid rules and enhanced transfer pricing rules. It is unclear why

Australia has departed from the UK position in this regard, given that Australia is similarly committed

to implementing the BEPS proposals.

Inbound cross-border financing transactions by definition will have the effect of reducing Australian

tax liabilities and increasing liabilities in other jurisdictions. While the anti-hybrid rules require exempt

treatment in the other jurisdiction, the DPT could apply even if the financing payment is wholly taxable

in the other jurisdiction, but the rate of tax happens to be lower.

The interaction of the anti-hybrid rules with the DPT will be a complex affair. The DPT could

potentially apply to any transaction that the anti-hybrid rules will apply to. The ordering of the rules

10 OECD Tax Database as at 20 May 2016: http://www.oecd.org/tax/tax-policy/tax-database.htm#C_CorporateCaptial

http://www.oecd.org/tax/tax-policy/tax-database.htm#C_CorporateCaptial



will therefore be important. If a diverted profits outcome is achieved for no other reason than because

of a hybrid mismatch, one might question whether the DPT should have any operation.

There are also significant interaction issues with other parts of the tax law. Is the DPT an income tax?

Is it subject to the operation of treaty rules? How will it interact with Part IVA? The paper indicates

that franking credits will be available, but if the tax is a tax on profits shifted out of Australia, does this

create a mismatch as there may be no Australian profits from which to pay a franked dividend?

Would the DPT be creditable in other jurisdictions?

3.3 Policy rationale

As with the anti-hybrid rules, the policy rationale for the DPT has not been made particularly clear.

The discussion paper seems to frame the issue in terms of taxpayer co-operation and compliance:

9. Australia’s strong integrity rules together with the MAAL address many arrangements of multinational entities

designed to avoid Australian income tax. However, as a practical matter, these rules can be difficult to apply and

enforce in certain situations — particularly where the taxpayer does not cooperate with the ATO during an audit.

10. In the 2016-17 Budget, the Government announced that it will introduce a DPT to help ensure that entities

operating in Australia cannot avoid Australian taxation by transferring profits, assets or risks offshore through related

party transactions that lack economic substance, and to discourage multinationals from delaying the resolution of

transfer pricing disputes.

…

13. By imposing a penalty rate of tax, requiring the tax to be paid upfront and expanding the scope for identifying

corporate tax avoidance, the DPT will:

• increase compliance by large multinational enterprises with their corporate tax obligations in Australia, including

under our transfer pricing rules; and

• encourage greater openness with the ATO, address information asymmetries and allow for speedier resolution

of disputes. (Emphasis added.)

It appears to be driven by ATO concerns that the ATO is unable to obtain sufficient information from

taxpayers to assess compliance. Considering how extensive the ATO’s information gathering powers

are, one can infer that a chief complaint of the ATO is a refusal by offshore parties to comply with

offshore information notices (the remedy for which is only that the information or documents are not

admissible in tax proceedings).

Non-compliance with offshore information notices appears to be a serious concern in the ATO’s view,

and many initiatives appear to have been taken to improve the ATO’s ability to collect information

from offshore parties, including the recent enlisting of the Foreign Investment Review Board to make

compliance with tax information requests a condition of foreign investment approval11, and the entry

by Australia into the multilateral convention on multilateral convention on mutual administrative

11 FIRB taxation conditions homepage: http://firb.gov.au/2016/05/taxation-conditions/

http://firb.gov.au/2016/05/taxation-conditions/



assistance in tax matters12. Along with implementation of the OECD’s recommendation on country by

country reporting, one might have thought there were other more convenient avenues to address

these concerns than the invention of a completely new tax regime.

This however appears to be consistent with the UK experience, where the primary objective of the

rules is to place the onus for provision of information on the taxpayer. Effectively, the idea is to force

taxpayers to agree transfer pricing arrangements with the ATO.

A new paradigm in tax?

However, it seems that on top of the concerns about information asymmetry, there is another

objective, which is nothing less than to create a new paradigm in tax, that it is not enough to price

transactions at arm’s length, rather taxpayers must not engage in tax structuring per se.

In particular, the UK rules allow reconstruction of the transaction on the basis of what would have

been done if tax – in any jurisdiction – had not been a relevant consideration. In the Australian

context at least, this is a singularly novel and unique proposition. Whilst an economist might explain

that tax incentives and disincentives are distortive of investment and business decisions, and while

tax theory suggests that a tax is at is most efficient when behaviour is not distorted by the imposition

of the tax, tax policy has always been grounded in the reality that taxes do in fact affect behaviour.

Corporate taxpayers have a duty to their shareholders to maximise returns, which may include

reducing taxes where possible. To impose a rule that requires taxpayers to ignore taxes in their

decision-making is to impose a complete fiction upon taxpayers. It ignores the fact that tax laws are

not perfect, that arbitrary differences in structure or activity can change tax outcomes, and that any

rational actor will move to reduce the costs incurred in respect of accomplishing its objectives. In

short, it is nonsensical to expect taxpayers not to have regard to tax in making their decisions. In fact,

in many cases tax policy relies upon taxpayers changing their behaviour in response to tax incentives

and disincentives.

If this is in fact the new paradigm, taxpayers, and corporate taxpayers in particular, are in for a rude

shock. Compliance with the tax law will require taxpayers to subject themselves to unparalleled

mental gymnastics as they seek to ignore otherwise obvious tax issues. Ordinary commercial

decisions made with one eye on tax could be impugned as profit-shifting schemes, on the rationale

that taxpayers should ignore tax in every decision.

Indeed, it goes further than that, since under the DPT as proposed, it is not a defence to demonstrate

that there are significant non-tax benefits – or even that the same structure would have been adopted

ignoring taxes. Instead, one must demonstrate that non-tax financial benefits exceed the tax benefits

(with no guidance on how one is supposed to value a concept as amorphous as “non-tax benefits”).

Non-tax non-financial benefits would not be relevant.

Choosing between two methods of achieving the same objective that have differential tax outcomes

will become fraught with risk. How can one quantify the non-tax benefits of funding a business

through debt instead of equity in order to demonstrate that they exceed the benefit of tax deductions?

A debt structure would presumptively be a profit-shifting scheme. This is particularly the case for

12 OECD Convention on Mutual Administrative Assistance in Tax Matters:

http://www.oecd.org/ctp/exchange-of-tax-information/conventiononmutualadministrativeassistanceintaxmatters.htm

http://www.oecd.org/ctp/exchange-of-tax-information/conventiononmutualadministrativeassistanceintaxmatters.htm



shareholder debt, but even third party debt could be impugned, i.e. simple debt pushdowns could be

prohibited, even if within thin capitalisation and transfer pricing constraints.

Under this paradigm, there would be a complete reversal of the “choice principle”: risk could be

eliminated only by consistently choosing the highest taxpaying alternative.

While it remains speculative as to the shape the rules will ultimately take, as has been mentioned,

without a clearly articulated policy rationale, the uncertainty faced by taxpayers in the interim period

will make it extremely difficult for taxpayers to price in the potential effects of retrospective legislation.



4 The Chevron decision

The Chevron decision is one of the most significant tax decisions in recent years, and has significant

implications for cross-border financing.

Damian Preshaw has written a comprehensive and insightful analysis of the case to which the author

has little to add: Transfer Pricing and the Chevron Case. Evidential aspects are also the subject of

another paper at this Tax Forum. Rather than re-treading old ground, this paper merely summarises

the highlights and adds some of the author’s own observations.

4.1 Background

The following factual summary and diagram have been reproduced from Damian’s paper with his

permission:

On 6 June 2003, CAHPL and ChevronTexaco Funding Corporation (CFC) entered into a Credit Facility Agreement

under which CFC agreed to lend CAHPL up to the Australian dollar equivalent of USD2.5 billion. Interest was payable

monthly by CAHPL at a rate equal to 1-month AUD-LIBOR +4.14% per annum (based on CAHPL having a credit

rating of BB (S&P scale). The loan was repayable in full after five years but with provision for early repayment at

CAHPL’s option. The total amount borrowed by CAHPL was AUD 3.7 billion.

CAHPL did not provide any guarantee or security to CFC and had the right to prepay any advance made to it. CFC

was entitled to terminate the Credit Facility Agreement at any time without cause. CAHPL and CFC are related, each

having a common parent, Chevron Corporation (CVX). CFC was a subsidiary of CAHPL. CAHPL paid interest on the

loan to CFC and received dividend income from CFC in the years in dispute, totalling $1,110,559,595. The dividends

received were non-assessable non-exempt income under s23AJ of the ITAA 1936.

The funds lent to CAHPL by CFC were raised by CFC issuing US dollar denominated commercial paper (CP) in the

United States. The CP issued by CFC was guaranteed by CVX (a AA rated entity). The interest rate paid by CFC on

its CP was approximately 1.2% at the time of issue of the CP.

The key elements of the Credit Facility are shown in the following diagram.



4.2 A real life hybrid case study

It will be immediately apparent that any interest payments made by CAHPL were received by CFC in

the US – a higher tax rate jurisdiction than Australia. So what was happening? The transaction was

structured so that the deductible interest payments would not be subject to full tax in the US.

The case however was not an anti-hybrid case (i.e. not a Part IVA case); it was a transfer pricing case.

The treatment of the interest in the US was only indirectly relevant in that the ATO attempted to use

the hybrid nature of the transaction to demonstrate that the CVX group was incentivised to increase

the interest payments from Australia to the US beyond the arm’s length amount.

How would the anti-hybrid rules apply to this case?

It is first necessary to establish the precise US tax treatment. The details do not appear from the case,

but it appears that CAHPL was a “check the box” entity for US tax purposes, meaning that it was

treated as a branch of CAHPL’s immediate parent. The interest paid by CAHPL was therefore

deductible both in Australia and in the US. The deduction in the US was equal and offsetting to the

same amount received by CFC.

The ATO claimed that this meant that CFC’s margin was not taxable in either jurisdiction. CAHPL

claimed that this was wrong on the basis that dividends paid from CFC to CAHPL would have been

taxable in the US.

Applying the rules, it is clear enough that CAHPL would be a hybrid payer. This would have given

rise to a double deduction mismatch to the extent that the deductible interest exceeded any dual

inclusion income. Notwithstanding CAHPL’s submission as to the taxability of the dividends, the anti-



hybrid rules typically ignore the effect of subsequent distributions, so that the taxability or otherwise of

dividends would be unlikely to affect the outcome. Recommendation 6 would therefore apply so that

the US would disallow the deduction, to the extent that the interest payments exceeded any dual

inclusion income. As discussed, Recommendation 6 is primarily aimed at a timing difference, but

where there is no dual inclusion income, this becomes a permanent difference.

If the US were not to implement the anti-hybrid rules – a distinct possibility – Australia would be left to

apply the defensive rule and deny the deductions in Australia in their entirety, unless and until there

was dual inclusion income to offset the interest.

Importantly though, the Chevron case is about transfer pricing, i.e. whether the interest was set at too

high a rate. That is, the ATO was not concerned that a double deduction outcome was being

achieved, merely that the double deduction outcome was being inflated. If anti-hybrid rules were in

operation in Australia but not the US, the entire interest amount would be non-deductible if there were

no dual inclusion income.

But is this the right outcome? Setting aside the transfer pricing aspect, the Commissioner otherwise

accepted that the interest was properly incurred in producing Australian assessable income. The

non-taxability of the interest in the US reflects the exigencies of the US tax rules allowing the taxpayer

to treat interest deductions incurred in Australia (and relating to Australian operations) as deductible in

the US.

Or put in the terms described at 2.1.2 above – the US’s failure to tax means that the US revenue was

essentially subsidising Chevron’s investment into Australia. Imposing anti-hybrid rules against

Chevron would presumably cause Chevron to restructure, and it would be short odds that the new

structure would still involve Australian debt deductions – but this time with interest being fully taxable

in the US. Chevron’s cost of capital would rise making it more expensive for Chevron to invest in

Australia. If this resulted in a reduction in future investment, Australia would be the ultimate loser and

the US revenue the ultimate winner.

The operation of the DPT would be even more uncertain and it is difficult to speculate. The transfer

pricing aspect of the DPT would presumably do no more than put the onus on Chevron to

demonstrate the arm’s length nature of the arrangement, however, as discussed below, Chevron

already had that onus. The reconstruction aspect of the DPT is arguably different. If the

counterfactual were construed as an equity investment, the entire interest payment would be subject

to DPT at 40%. It is possible however that the counterfactual would have been an ordinary non-

hybrid debt arrangement, in which case the diverted profits would be limited to the part of the interest

claimed to exceed arm’s length rates.

4.3 Key findings

Returning to the subject matter of the case, at the heart of the Chevron decision is a simple finding

that the taxpayer had not shown that the assessment were excessive. It would be oversimplifying the

case to reduce it to a mere onus case, but Chevron fits within an increasingly more common narrative,



supported also by Ausnet13 and RCF14 where expert valuation evidence was insufficient to discharge

the taxpayer’s onus.

The statutory onus of proof is therefore proving to be a significant disadvantage to taxpayers. This is

all the more pronounced when the issue in question is an arm’s length or market valuation rule, as

valuation is an imprecise science at best. If the result in litigation will turn on a battle between

valuation or transfer pricing experts, the ATO expert need only cast sufficient doubt on the taxpayer’s

expert’s position to prevent the taxpayer from showing a comprehensive and accurate determination

of the appropriate tax result. The slightest misstep or misfortune could mean the statutory onus is

failed.

In the Chevron case, certain expert evidence was discounted on the basis that it had not answered

the correct statutory question. This was by no means an error on the part of the taxpayer; the

question put by the taxpayer to the expert would have been consistent with a conventional

understanding of how the transfer pricing provisions operate. However, the Court adopted a

somewhat novel approach in the event – a quasi-reconstruction approach described very clearly as

not being a reconstruction approach – meaning that the evidence was discounted.

Similarly, evidence as to ratings approaches, or comparable loans, was rejected on the basis that

they did not closely enough resemble the approach that a bank would adopt to lending. However, in

the banking industry credit analysis techniques are proprietary, and it is unlikely that borrowers would

have ready access to this kind of expertise.

As mentioned, the evidential aspects of the case are the subject of another paper at this forum.

Ultimately however the Court found that the terms of the loan were so off-market that no independent

parties would ever have agreed to lend on those terms. And further, that if the loan had been struck

on the kinds of terms that might be expected between arm’s length parties, that the interest rate would

have been lower.

The question remains, what if there are multiple forms of agreement that might have been struck

between independent parties? An agreement between independent parties could potentially be very

borrower friendly – just not, on the finding in Chevron, as borrower friendly as the terms used by

CAHPL and CFC – in which case the interest rate would presumably still be very high. Taxpayers

presumably could look to adopt the most borrower-friendly terms that have been accepted by an

independent lender.

This may also mean that taxpayers will need to draft their intercompany loan documents with all of the

provisions expected between arm’s length parties, such as covenants and (if being conservative)

security. This becomes a kind of enforced artificiality. The reason many intercompany loan

documents do not require protections such as covenants and security is because they are at call.

Including such terms in an intercompany loan in order to comply with the requirements of the case is

going to cause more than few raised eyebrows from debt finance lawyers and business managers.

All in all, the Chevron case will, subject to any findings on appeal, cause taxpayers to rethink their

approach to substantiating and defending transfer pricing analysis for cross-border financing. As it

13 Ausnet Transmission Group Pty Ltd v Commissioner of Taxation [2015] HCA 25. 14 Commissioner of Taxation v Resource Capital Fund III LP [2014] FCAFC 37.

http://www.austlii.edu.au/au/cases/cth/HCA/2015/25.html

http://www.judgments.fedcourt.gov.au/judgments/Judgments/fca/full/2014/2014fcafc0037



stands, the decision seems to ask for an almost unachievably high level of diligence from tax

managers. Some practical observations are offered in section 5 as to how to deal with the resulting

uncertainty.



5 Dealing with uncertainty

This section offers some practical observations on dealing with the uncertainty caused by

developments such as the anti-hybrid rules and Chevron.

In the current environment, the conservative approach is to assume that the ATO will review the

issues in question, i.e. not much weight can be placed on there being a low risk of detection. This is

the result of a conflux of factors, including: the increased sophistication of the ATO, due to the

acquisition of a significant amount of private sector expertise; enhanced information and disclosure

obligations on multiple fronts (third party reporting, BEPS related disclosure obligations, FATCA and

CRS, uncertain tax positions); enhanced information exchange between revenue authorities;

improved technology; exposure to data leaks; the requirement under accounting principles to assume

audit when disclosing uncertain tax positions.

5.1 Seeking ATO certainty

In light of the practical difficulties arising from Chevron, in many instances, the only way to eliminate

tax risk will be to seek ATO certainty. The tax environment, including all those factors mentioned in

the previous paragraph, is evolving inexorably towards compelling taxpayers to engage with the ATO,

and this is no doubt the ATO’s preference.

Certainty can be sought from the ATO under an ever-increasing range of products. These include tax

rulings, advance pricing arrangements, tax deeds (a novel product whereby the taxpayer and the ATO

enter into a deed governing the agreed tax treatment of a transaction), administratively binding

guidance, and comfort letters.

The product variation is a positive development that reflects the ATO’s increasing willingness to

engage with taxpayers on a commercial level. Many issues that are not capable of being ruled upon

as a legal matter might be able to obtain comfort from another product. The level of comfort derived

from these various products varies, but it is safe to say that as the comfort level increases, the time

and cost also increase. That said, the increasing sophistication of the ATO appears to be having a

positive effect in terms of reducing costs and time associated with obtaining comfort, and we can only

hope the ATO’s “reinvention” continues. Ironically, having moved to a self-assessment system many

decades ago, this dynamic would lead to a rebalancing back towards the public sector bearing the

brunt of tax assessment work and a commensurate increase in the size of the ATO (currently well

over 20,000 staff and growing).

As a general proposition, the necessary conditions for seeking a ruling or other ATO guidance product

should include the following:

1. There is some uncertainty as to the outcome.

2. You are confident that you will obtain a positive ruling (which may mean making requested

modifications to the arrangement). Or you are indifferent as to the outcome (for example,

competitors are utilising aggressive tax planning to gain an edge).



3. The magnitude of the risk is significant.

4. You have sufficient time and budget in your transaction plan.

5. Reputational concerns weigh in favour of transparency.

These conditions are increasingly more likely to be satisfied in the current environment, and the

approach in the future more and more will be to seek ATO engagement. Nevertheless, in many

cases, seeking ATO certainty will not be appropriate.

For retrospective legislative developments such as the anti-hybrid rules and the DPT, no such

certainty will be available.

5.2 Use of experts

Where taxpayers are not minded to approach the ATO, the result in cases like Chevron where the

evidence of expert witnesses can be so readily dismissed raises a pressing planning issue – what

level of diligence is applied at the time of transaction?

For large risky matters, it may well be that evidence should be gathered on the assumption that it will

face court-level scrutiny. What would this mean as a practical matter? If using valuers or transfer

pricing specialists, it may be advisable to give weight to those practitioners that have experience in

giving expert testimony in litigation. While tax litigation has its differences from commercial litigation, it

remains a highly adversarial process, and expert evidence can be excluded because a witness is

discredited or succumbs to a rival expert.

Importantly, expert witnesses must comply with Federal Court guidelines15. The independence of

such witnesses can be brought into question where they have previously acted in an advisory

capacity to the taxpayer. This can multiply costs, as one valuer or transfer pricing specialist may be

engaged to act in an advisory capacity, and then a second may be needed to act as an expert

witness.

5.3 Second opinions

In the recent Orica case16, the Court found that the taxpayer’s position in relation to a tax avoidance

scheme was not reasonably arguable and applied the commensurate level of penalties. It is perhaps

surprising that the Court’s view about the application of so complex a provision as Part IVA could

have been so clear that the taxpayer’s position was not even “reasonably arguable”. Traditionally this

has been a relatively low threshold. Nor was the taxpayer assisted by having obtained advice from

two senior partners at a major tax advisory firm:

In that regard Orica relied upon having sought advice and assistance from a major international accounting firm

including its two leading tax partners. However, the question about whether the position taken by Orica was

15 http://www.fedcourt.gov.au/law-and-practice/practice-documents/practice-notes/cm7 16 Orica Limited v Commissioner of Taxation [2015] FCA 1399.

http://www.fedcourt.gov.au/law-and-practice/practice-documents/practice-notes/cm7



reasonably arguable is to be determined objectively and not by reference to whether the relevant taxpayer took

reasonable care.

In light of this, there is something to be said for seeking multiple and diverse opinions on significant

tax matters. This might include for example having accounting firm opinions reviewed by law firms,

and vice versa, or, continuing the theme of assuming the worst and that litigation may ensure, by a

tax barrister.

Incidentally, Orica also involved interest that was deductible in Australia and not taxable to the US

subsidiary lender. Although this arose as a result of the availability of US tax losses, rather than any

hybrid treatment, the transaction would have been erosive to the Australian revenue. The case

highlights that the ATO already has a powerful tool in Part IVA to combat base erosion.

5.4 Documentation issues

Given the uncertainty faced by many taxpayers in the current environment, it is important to ensure

that appropriate flexibility is retained in legal documentation. This is particularly the case for

retrospective legislative developments, where it is simply not possible to obtain any certainty at all.

For third party transactions (noting that the rules can apply to “structured arrangements” with third

parties, or to parties with a 25% common stakeholder), this would include having early call or early

termination rights – either absolutely or on the occurrence of a tax event.

As the application of the anti-hybrid rules may depend on the tax treatment of counterparties in other

jurisdictions, you may require rights to request information needed for tax filings, even where this

information relates to the other counterparty’s own tax affairs. This needs to contemplate a

counterparty’s competing privilege claims.

If a third party transaction – e.g. a senior borrowing facility – may be affected by the tax treatment of

an intra-group transaction, such as shareholder debt, the documents should retain full flexibility. For

example, you may wish to ensure you have the ability to restructure without needing the consent of

the financier even if a project’s cash flows, and therefore debt service coverage ratios, are impacted

by the anti-hybrid rules.

5.5 Alignment between tax and legal

A related concern is ensuring that there is unity of minds between the tax director and general

counsel, and similarly the tax advisor and the lawyers implementing a transaction. Many a tax

planning initiative has come undone because the legal documents contained – or omitted – a clause

that contradicted a tax requirement. This will be particularly sensitive where the anti-hybrid rules and

DPT are involved, as the treatment will be heavily dependent on the characterisation and purpose of a

particular document. For example, the terms of a financial instrument such as preference shares may

have been meticulously crafted having regard to debt/equity rules, and then contradictory rights or

obligations may be included in a shareholders agreement. Where the general counsel or transaction

lawyer does not have an intimate understanding of the tax issues, and where the tax director or tax



advisor has not read every last legal document, things can fall between the cracks, and all efforts

should be made to ensure there is cohesion between disciplines.

5.6 Dealing with legacy issues

Finally, even if you are confident of your position, defending it against the ATO through audits and

litigation can be especially costly, particularly where this occurs years later, and possibly after relevant

personnel have left the organisation. Pricing in the expected costs of defending a strong but

potentially controversial position may save you from having to walk back expected profits in a later

period.

In the case of the DPT, taxpayers may need to set aside reserves to fund any provisional ATO

assessment – taking into account the 12-month lock-up period – until such time as it can be

successfully challenged.

5.7 Conclusion

It is said that nothing is certain except death and taxes. Nothing could be further from the truth: both

death and tax are fraught with unparalleled uncertainty!

The author hopes this paper has made some small inroads into reducing that uncertainty, and

therefore into flushing out the hidden costs that now attend every cross-border financing transaction.

As a final observation, when dealing with uncertainty, one should always remember Hofstadter's Law:

It always takes longer [and costs more!] than you expect … even when you take into account

Hofstadter's Law.

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