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Debt, equity and hybrid mismatches: Australia's treatment of hybrid loans

Australia's treatment of hybrid loans

Grant Wardell-Johnson and Robyn Basnett discuss Australia's treatment of hybrid loans in regards to the OECD's BEPS recommendations for these transactions.


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Recently we contributed a paper to Bloomberg BNA Tax Management International Forum (Forum). The Forum is a comparative tax law journal which poses a cross-border tax issue to be addressed by each Forum Member from the perspective of their own country.

The Spring (June) 2017 issue of the Forum examined how countries deal with transactions that may fall under the Organisation for Economic Co-operation and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) recommendations dealing with hybrid transactions in the form of loans. The OECD’s principal rule calls for a “payer jurisdiction” to deny a deduction if a payment gives rise to a deduction/non-inclusion outcome. 

The Forum presented the example of a corporation (FCo) in a foreign country (FC) that has advanced funds to a corporation (HCo) in your country (HC), where the transaction is recorded as a liability by HCo. The tax treatment of this transaction, and the possibility of the tax authorities recharacterising the loan, were then considered under the following scenarios:

  • FCo does/does not treat the transaction as a loan for FC accounting and tax purposes.
  • the difference if a loan agreement of some sort exists.
  • general rules regarding the deduction of interest paid to a non-resident lender.
  • specific limits to an interest deduction based on the ratio of debt to equity.
  • limits on interest deductions based on other factors.
  • possibility of a transaction being bifurcated into a portion that permits deductible interest and a portion that does not effect of an income tax treaty between Australia and FC.
  • the difference if FCo were an entity that is treated as transparent for FC tax purposes.
  • the difference if FCo has a permanent establishment in Australia.

A key characteristic of Australian income tax law is the set of substance-over-form debt and equity rules in Division 974, that are fundamental to the tax treatment of financing arrangements. The rules formed the basis of our paper’s discussion into the Australian Taxation Office (ATO) ability to recharacterise transactions (the loan will be assessed against the Div 974 criteria), the lack of loan documentation (in itself does not affect the assessment), and the consequences for thin capitalisation and transfer pricing purposes.

We noted that Australia has rejected the OECD’s approach to limiting interest deductions, but has embraced rules to eliminate hybrid mismatch arrangements. Australia was also one of the first signatories to the OECD’s Multilateral Instrument (MLI) in June 2017, and (like the recent Australia-Germany tax treaty) any tax treaty development going forward is likely to include anti-abuse measures.

Originally published in the Tax Management International Forum, 38 FORUM 14, 6/5/17. Copyright _ 2017 by The Bureau of National Affairs, Inc. (800-372-1033) Reproduced with permission of Bloomberg BNA.

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