The primary cross border tax disclosures are contained in the International Dealings Schedule (IDS). When the IDS was initially introduced some 10 years ago to capture all international dealings (to replace the Schedule 25A) it was primarily focused on transfer pricing disclosures at Section A of the IDS. However, year on year the IDS has evolved and now has a far greater focus on cross border income tax regimes/activity through Sections B-G.
Perhaps the most complex and the newest addition to the IDS is with respect to the hybrid mismatch provisions. That said, there are a number of complex regimes and issues to disclose, with work being required in advance of being able to make positive and informed disclosures. This is particularly important in the current environment of the ATO undertaking systematic reviews of large, and now middle market enterprises. Such reviews place greater emphasis and scrutiny of disclosures made and international transactions in general.
A particular disclosure that often gets overlooked, and indeed most likely due to the work involved where an entity has a complex capital structure, are the disclosures at Section B. These disclosures require an analysis to be done with respect to related party financing arrangements in order to understand how these instruments are treated for accounting versus the debt/equity provisions, and treatment under the Taxation of Financial Arrangement (TOFA) provisions. Where an entity has a number of unusual instruments on issue to related parties, this may involve significant work to determine the treatment under each of those regimes.
The questions are intended to draw out risks in relation to wrongly treating instruments as debt and claiming deductions, or as equity and franking those distributions. The questions may also highlight risk with respect to hybrid instruments or thin capitalisation calculations.
It is therefore very important to understand how your related party financing arrangements are treated for tax purposes, and to disclose accordingly.
Interests in foreign entities
Section C deals with a number of provisions dealing with interests in foreign entities, and in particular the Controlled Foreign Companies (CFC) provisions which can operate to attribute income to Australian taxpayers. The CFC provisions are complex and detailed in their operation notwithstanding they have been around for 30 odd years.
The number and detail of disclosures in Section C has increased year on year, and it is important for taxpayers to be able to disclose positively across a large number of queries, but most importantly whether there is any attributable income under the provisions or whether they meet the active income test for example. Again, determining your position under the CFC provisions may take considerable work and preparation well in advance of the filing of your tax return.
Section D regarding the application of the thin capitalisation provisions has remained consistent, but the application to foreign owned Australian groups, or Australian groups with offshore operations remains as complex as ever. Needless to say, disclosing your position under the thin capitalisation provisions is important, and is an area of focus of the ATO in the current round of Combined Assurance Reviews.
Financial services entities
Section E relating essentially to offshore financial service entities or banks is industry specific but contains detailed disclosures that need to be adhered to.
Hybrid mismatch provisions
Relatively new disclosures are required at Section G regarding the hybrid mismatch provisions that have been in operation since 1 January 2019. The provisions broadly operate to eliminate tax benefits achieved through hybrid arrangements within corporate groups or even with third parties in some instances under so called structured arrangements. The provisions are without doubt some of the most complex in the tax legislation and remain widely misunderstood due to that very complexity. That said, they are increasingly the focus of the ATO and should a deduction, for example, be denied under the provisions this could result in a substantial underpayment of tax with associated penalties and interest.
The disclosures at Section G have been expanded for the 2022 income tax year specifically with respect to the imported hybrid mismatch provisions. Very broadly, an imported hybrid mismatch arises where an Australian entity makes a deductible payment to a related foreign entity (directly or indirectly through one or more interposed entities) and the income from such a payment is set-off directly or indirectly, against a deduction that arises under a hybrid mismatch arrangement in an offshore jurisdiction.
Towards the end of last year, the Commissioner finalised its Practical Compliance Guideline PCG 2021/5. The PCG sets out the expectations regarding the Commissioner's assessment of risk in connection with the imported hybrid mismatch rules, including the Commissioner's approach to reviewing whether a taxpayer has undertaken reasonable enquiries in relation to the rules for non-structured arrangements. This includes the level of supporting information the Commissioner requires in order to demonstrate compliance in connection with non-structured arrangements.
In short, the taxpayer is expected to enquire and document appropriately the flow of payments throughout a global group structure to determine whether a payment out of Australia is the subject of a hybrid mismatch within the group.
In order to substantiate deductions claimed for related party offshore payments, and in order to make positive disclosures in the return, the expectations of the Commissioner under the terms of the PCG are significant, requiring significant work to be carried out prior to lodgement of the return. Taxpayers required to file a Reportable Tax Position Schedule (RTPS) are required to self-assess their compliance risk in accordance with the method set out in the PCG.
In addition to the imported hybrid mismatch disclosures, taxpayers are also required to disclose payments of interest or akin to interest to low tax jurisdictions. The “integrity” measure is aimed at financing structures where an entity in a low tax (less than 10% tax rate) or no tax jurisdiction is interposed between a foreign parent and Australia.
These disclosure requirements in the context of related cross border payments are more than likely the most challenging for MNEs for the 2022 income tax year, and without doubt in the sights of the ATO.
Finally, at Section F of the IDS are some miscellaneous cross border related disclosures. The one that is most commonly forgotten about or incorrectly disclosed is relating to Conduit Foreign Income (CFI). It is important to continuously maintain a correctly calculated CFI balance with respect to, for example, exempt foreign dividend income received or exempt foreign branch income.
As can be seen from the above, the IDS Sections B to G are an inevitable minefield for MNEs operating in Australia, and go way beyond traditional transfer pricing disclosures. It is important to be aware of the substantiation requirements for each area, and to be prepared well in advance of the tax return due date, especially if the MNE is a significant global entity and exposed to very significant Failure To Lodge (FTL) penalties.