Explanatory Memorandum
(Circulated by authority of the Minister for Revenue and Financial Services, Minister for Women and Minister Assisting the Prime Minister for the Public Service, the Hon Kelly O'Dwyer MP)Chapter 2 - Hybrid mismatches
Outline of chapter
2.1 This Chapter explains the ways in which the Multilateral Convention will modify Australia's Covered Tax Agreements to ensure that those agreements produce appropriate outcomes when applied to fiscally transparent entities such as partnerships and trusts.
Context of amendments
2.2 Chapter 14 of the BEPS Final Report on Action 2 (Neutralising the Effects of Hybrid Mismatch Arrangements) recommended modifications to tax agreements to clarify the application of treaty benefits to income derived by or through fiscally transparent entities or arrangements.
2.3 A fiscally transparent entity is not taxed on its income. Rather, the entity's income is taxed in the hands of its members. Most partnerships and trusts are treated as fiscally transparent entities under Australia's domestic law.
2.4 Difficulties can arise under bilateral tax agreements where one jurisdiction treats an entity as fiscally transparent under its domestic law and the other jurisdiction treats the entity as fiscally opaque and taxes the entity itself.
2.5 The key treaty issues associated with income derived by or through fiscally transparent entities were considered in the 1999 OECD Partnership Report [1] (the Partnership Report), the conclusions of which were reflected in the Commentary on Article 1 (Persons covered) of the OECD Model. Chapter 14 of the BEPS Final Report on Action 2 recommended a new provision that both confirms the conclusions of the Partnership Report and extends the application of these conclusions to other fiscally transparent entities and arrangements, such as trusts.
2.6 In the 2017 update of the OECD Model, OECD members adopted new Article 1(2) of the OECD Model, which reflects the recommendation contained in Chapter 14 of the BEPS Final Report on Action 2.
2.7 Article 3(1) of the Multilateral Convention allows Parties to implement the Action 2 recommendation and adopt the new Article 1(2) OECD Model provision in existing Covered Tax Agreements.
2.8 Article 3(2) is aimed at ensuring that excessive relief from double taxation is not granted where both jurisdictions that are parties to a tax agreement tax the same income in the hands of different taxpayers.
2.9 The BEPS Final Report on Action 6 (Preventing the Granting of Treaty Benefits in Inappropriate Circumstances) recommended modifications to tax agreements to clarify that treaty benefits are not granted in certain inappropriate circumstances. Article 3(2) of the Multilateral Convention implements the recommendation in paragraph 64 of the Action 6 Final Report for situations where both parties to a tax agreement seek to tax the same income as the income of one of their own residents. This can occur where one party taxes the worldwide income of a resident entity and the other party views that entity as fiscally transparent and therefore taxes the members of that entity who are that other party's residents on their respective share of the income.
2.10 Chapter 15 of the BEPS Final Report on Action 2 (Neutralising the Effects of Hybrid Mismatch Arrangements) recommended modifications to tax agreements to address concerns that the use of the exemption method (as opposed to the credit method) to eliminate double taxation could result in inappropriate outcomes. The exemption method can result in double non-taxation when applied to income that is not taxed in the source jurisdiction.
2.11 Article 4 of the Multilateral Convention allows competent authorities to determine by mutual agreement the treaty residency of a person (other than an individual) that would otherwise be a resident of both jurisdictions that are a party to the relevant Covered Tax Agreement (Article 4 is discussed in more detail in Chapter 3).
2.12 Article 5 of the Multilateral Convention allows Parties to modify their Covered Tax Agreements to replace provisions that apply the exemption method with provisions that instead apply the credit method to relieve double taxation for their residents. Australia has provisionally nominated not to adopt Article 5 on the basis that the credit method has already been adopted for Australia in all Australia's tax agreements to date.
2.13 The Government has also announced it will amend Australia's domestic tax laws to address hybrid mismatch arrangements in line with the BEPS Final Report on Action 2. These amendments will be brought forward in a separate bill.
Summary of new law
2.14 Part II (Hybrid mismatches) of the Multilateral Convention contains three Articles:
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- Article 3 - transparent entities;
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- Article 4 - dual resident entities; and
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- Article 5 - application of methods for elimination of double taxation.
2.15 Article 3 ensures that income derived by or through a fiscally transparent entity or arrangement is considered to be income of a resident of a Party to a Covered Tax Agreement for treaty purposes but only to the extent that that Party treats the income as income of one of its residents under its domestic law.
2.16 Australia has provisionally indicated it will adopt Article 3 and make the reservation permitted by Article 3(5)(d) to not modify its Covered Tax Agreements that already have a detailed fiscally transparent entity provision.
2.17 As noted in Chapter 1, Article 4 is discussed in detail in Chapter 3 of this explanatory memorandum.
2.18 Article 5 modifies Covered Tax Agreements that apply the exemption method for relieving double taxation. It provides three alternative approaches to guard against the possibility of avoiding income tax in both jurisdictions.
2.19 Australia has provisionally indicated that it will not adopt Article 5 as its tax agreements do not require Australia to apply the exemption method for relieving double taxation for Australian residents. Australia has also provisionally indicated that Australia will not prevent other jurisdictions from adopting Article 5 in relation to their own residents.
Detailed explanation of new law
Clarifying the treatment of fiscally transparent entitles
2.20 Australia has provisionally adopted Article 3, but has indicated that it will make the reservation contained in Article 3(5)(d) to not modify Covered Tax Agreements that already have a detailed fiscally transparent entities provision.
2.21 Article 3 of the Multilateral Convention modifies applicable Covered Tax Agreements to ensure not only that benefits are granted in appropriate cases (where at least one of the two jurisdictions treats the income as income of one of its residents, either at the entity level or the level of the partner or beneficiary) but also ensures that these benefits are not granted where neither jurisdiction treats the income as the income of one of its residents.
2.22 Article 3 replaces existing bilateral provisions in jurisdictions' Covered Tax Agreements that apply to income derived by or through fiscally transparent entities or arrangements (or applies in the absence of such bilateral provisions). This modification is designed to provide the appropriate application of treaty benefits to fiscally transparent entities and their members. Income derived by or through a fiscally transparent entity, such as a partnership or a trust, will be considered income of a resident of a Contracting Jurisdiction for treaty purposes, but only to the extent that the Contracting Jurisdiction treats the income as income of a resident under its domestic law. [Articles 3(1) and (4) of the Multilateral Convention]
2.23 An entity or arrangement is considered fiscally transparent if its income is not taxed at the level of the entity or arrangement but is instead taxed in the hands of the person who has an interest in the entity or arrangement (see paragraph 9 of the Commentary on Article 1 (Persons covered) of the OECD Model).
2.24 As per paragraphs paragraph 4 of the Commentary on Article 1 (Persons covered) of the OECD Model, whether Article 3(1) applies to collective investment vehicles depends on whether there is a specific provision under a Covered Tax Agreement dealing with collective investment vehicles or the legal form (or type) of the collective investment vehicle. For example, Article 3(1) would not apply to income received by an Australian managed investment trust to which paragraph 7 of Article 4 (Resident) of the New Zealand convention applies.
2.25 Article 3(1) is not intended to replace integrity rules clarifying how a provision in a Covered Tax Agreement applies to a particular item of income derived by a resident of a jurisdiction, such as deeming a beneficiary of a business trust to have a permanent establishment and attributing a share of profits to that permanent establishment (see paragraph 45 of the Explanatory Statement to the Multilateral Convention). For example, paragraph 7 of Article 7 (Business Profits) of the New Zealand convention would not be affected.
2.26 Article 3(3) modifies Article 3(1) to clarify that it does not prevent either Party from taxing its own residents. This clause will only apply if a Party has made the reservation in Article 11(3)(a) of the Multilateral Convention to opt out of Article 11. Article 11 is discussed in more detail in Chapter 3. [Article 3(3) of the Multilateral Convention]
2.27 Australia has provisionally not indicated that it will make such a reservation as it has provisionally adopted Article 11 of the Multilateral Convention.
2.28 Article 3(2) also provides that a Party is not required to give relief for any tax imposed by the other Party solely on the basis that it is derived by a resident of the other Party. This will help prevent double non-taxation, where an entity's income is not taxed in either Party's jurisdiction, and will ensure excessive relief for double taxation is not granted where both Parties tax the same income in the hands of different taxpayers.
2.29 Article 3(2) provides that a Party to a Covered Tax Agreement is not required to provide relief from double taxation to its residents, under a provision in a Covered Tax Agreement that is broadly equivalent to Articles 23A or 23B (Methods for elimination of double taxation) of the OECD Model, in situations where the other Party imposes tax at source solely because the income was derived by a taxpayer that is a resident of that other Party. Article 3(2) therefore ensures that a Party is only required to provide relief from double taxation to the extent that the relevant income is taxable in the partner jurisdiction in accordance with the source taxing rights allocated under the relevant tax agreement (for instance, where that partner jurisdiction is the jurisdiction of source of the relevant income or the jurisdiction where there is a permanent establishment to which the relevant income is attributable). [Article 3(2) of the Multilateral Convention]
2.30 Paragraph 64 of the BEPS Final Report on Action 6 included a draft proposal for changes to Article 23A (Exemption method) and Article 23B (Credit method) of the OECD Model and the Commentary on Articles 23A and 23B but noted the intention to finalise the work on the draft proposal subsequently. That subsequent work is reflected in the 2017 update to the OECD Model and the guidance reflected in paragraphs 11.1 and 11.2 of the Commentary on Articles 23A and 23B of the OECD Model is therefore relevant in interpreting Article 3(2) of the Multilateral Convention.
2.31 Australia has provisionally made the reservation allowable in Article 3(5)(d) to not modify Covered Tax Agreements that already contain a detailed fiscally transparent entity provision. Australia has provisionally indicated that its tax agreements with France and Japan already contain such a provision. [Article 3(5) of the Multilateral Convention]
2.32 The replacement of an existing bilateral 'fiscally transparent entity' provision is only effective if both Parties to a Covered Tax Agreement do not make the reservations contained in Articles 3(5)(a) or (b) (to not apply Article 3 at all or only apply Article 3 if the relevant Covered Tax Agreement does not already contain a transparent entities provision) and notify the Depositary of the affected bilateral provisions to be replaced. [Article 3(6) of the Multilateral Convention]
2.33 Australia has provisionally indicated that Australia's tax agreements with Mexico, New Zealand and the United States contain a provision that would be modified.
2.34 Otherwise, the provision contained in Article 3(1) will modify Australia's Covered Tax Agreements to the extent of any inconsistency between Article 3(1) and the relevant provisions of those agreements, subject to any reservations made by the relevant Parties to a Covered Tax Agreement. [Article 3(6) of the Multilateral Convention]
2.35 Based on the known or proposed adoption positions of other Signatories to the Multilateral Convention, Article 3 is expected to modify Australia's tax agreements with: Argentina, Belgium, Chile, Fiji, Ireland, Malaysia, Mexico, the Netherlands, New Zealand, Norway, Poland, Romania, Russia, the Slovak Republic, South Africa, Spain, Turkey and the United Kingdom.
Restricting methods for the elimination of double taxation
2.36 Australia has provisionally indicated it will not adopt Article 5. On this basis, Article 5 will not modify the provisions in Australia's Covered Tax Agreements that require Australia to provide Australian residents with relief from double taxation.
2.37 Article 5 allows a Party to the Multilateral Convention to replace a provision of a Covered Tax Agreement that would otherwise exempt foreign income from domestic tax (the exemption method) with a provision that instead relieves double taxation by crediting foreign tax paid against domestic tax imposed on the same foreign income (the credit method). The exemption method can lead to double non-taxation when applied to income that is not taxed in the source jurisdiction.
2.38 Article 5 provides three options to allow a Party to the Multilateral Convention to adopt a credit method to provide its residents with relief from double taxation for tax imposed in the other jurisdiction on:
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- income the Covered Tax Agreement allows the other Party to exempt or tax at a reduced rate (Option A);
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- dividends that are tax deductible in the other jurisdiction (Option B); or
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- all types of income the Covered Tax agreement allows the other jurisdiction to tax (other than income that that other jurisdiction is taxing solely because the relevant income is also income derived by a resident of that jurisdiction) (Option C).
[Articles 5(1) to (7) of the Multilateral Convention]
2.39 It is unnecessary for Australia to choose any of the options provided in Article 5 because all of Australia's tax agreements already specify the credit method for Australia to relieve double taxation for Australian residents.
2.40 Australia has provisionally indicated that it will not prevent its Covered Tax Agreement partner jurisdictions from applying their chosen option with respect to their own residents. That is, Australia has provisionally indicated that it will not make a reservation under Article 5(8) for Article 5 not to apply to its Covered Tax Agreements. [Article 5(8) of the Multilateral Convention]