Another limit on deducting interest

12 April 2019

The ATO has released the draft of a proposed Ruling on the so-called hybrid mismatch ‘integrity rule.’ This provision was legislated at the same time as the anti-hybrid mismatch rules but it effectively operates as a stand-alone regime unconnected to hybrids.

How the integrity rule works

The integrity rule is an Australian invention, tacked onto the legislation enacted to implement the OECD anti-hybrid rules.  The OECD had assiduously avoided triggering the anti-hybrid rules just because money went to a tax haven; many OECD member countries have dependent tax havens, while other countries wanted to protect important taxpayers who use them.  It was for this reason that the OECD’s report had recommended that the hybrid financial instrument rules should only be triggered because the mismatch arose from the terms of the relevant instrument.

Not content with this approach, the Australian anti-hybrid legislation was supplemented by the integrity rule which was (at least initially) directed at interest paid to a group subsidiary located in a tax haven (defined to mean a country with a tax rate of 10% or less), where the foreign tax payable would have been greater if paid to the parent of the group (rather than the interposed subsidiary), and there was a principal purpose of getting the deduction in Australia and the low tax rate overseas. Before the Bill went to Parliament its scope had already been expanded to cover scenarios where the group subsidiary was in the same country as the parent, which meant it could potentially apply even if a tax haven was not involved but for some other reason the foreign tax payable by the interposed subsidiary on the interest would be less than the parent.

When the relevant conditions are met, the integrity rule makes the interest non-deductible.

The Budget announcement

Because the integrity rule was being developed at the same time as the anti-hybrid rules, there was one point of connection between them: under the current drafting, the integrity rule was switched off completely if the interest payment gave rise to one of the specified types of hybrid mismatch. That is, if the anti-hybrid rules were triggered, the integrity rule wasn’t. This was consistent with the idea that the integrity rule was intended to capture arrangements that engineered the same result as a hybrid mismatch, but through using an interposed entity in a tax haven rather than an instrument or entity treated differently in different countries.

The Budget announcement proposes to change that approach: the regimes will not be mutually exclusive, they will accumulate.  The Budget promises an amendment, ‘specifying that the integrity rule can apply where other provisions have applied …’.  So if the anti-hybrid rules have been triggered and denied part of a deduction, or potentially have been triggered but don’t deny any part of a deduction, the integrity rule will still operate and may deny the balance. Precisely what amendments they have in mind and hence the potential impact are unclear from the Budget papers. Given the imminent election and caretaker mode, we are unlikely to have any answers soon.

The draft Ruling

The draft Ruling focuses on a few of the issues lurking inside the integrity rule as it currently stands.   

Membership of multiple groups.
  The integrity rule is enlivened only for intra-group payments and so identifying membership of the group is vital.  The draft Ruling emphasises that there are 2 tests in
the legislation: if the entities are consolidated for accounting purposes or there is at least 50% ownership. The Ruling takes the view that these tests are applied in isolation.  So an entity can be in a group based on accounting consolidation, and a second group based on ownership, and the integrity rule is applied twice – once to each group. This is particularly relevant to investment vehicles, which may be consolidated for accounting purposes with a manager, despite the manager not having anything close to majority ownership.

Rate of foreign tax
.  The interest must be subject to foreign income tax at a rate of 10% or less, and the ruling sets out various circumstances which in the ATO’s view will meet this test, for instance, where the headline tax rate is higher than 10% but tax concessions apply in relation to the interest or the interest is not taxed because it hasn’t been remitted to the country.

It is not yet clear how this test will play out in the context of some of the more complex scenarios that result in non-taxation overseas that currently trigger one of the specific hybrid mismatch rules, which the Budget announcement says will no longer be exempt from the integrity rule.

.  The critical element in the integrity rule is the requirement that, ‘the entity … [which] carried out the scheme … did so for a principal purpose … of enabling a deduction to be obtained in respect of the payment ...’.

The legislation says that the finding about purpose is to be decided having regard to ‘[all] the facts and circumstances that exist in relation to the scheme’ and then lists some specific additional criteria – for instance, where did the lending entity get the money it lent to the Australian company (from another group entity or from outsiders) and does it undertake functions that make it akin to a bank (or is it more akin to a SPV)?

In-house finance companies. 
The Ruling examines an in-house finance company structure and concludes that the purpose condition:

  • would likely be triggered if the entity doesn’t raise funds externally
  • would probably not be triggered if the entity sourced its funds from a mixture of equity from the parent, external borrowings and its own retained earnings.

This creates some uncertainty for group finance companies that are subject to a low or zero tax rate overseas and are funded by a not immaterial amount of equity.

Back-to-back arrangements. 
Where the entity lending to the Australian borrower has entered into a related back-to-back arrangement, e.g. a borrowing on matching terms, for the purposes of the integrity rule the counterparty to the back-to-back arrangement is effectively deemed to be the entity to which the Australian borrower is paying the interest. This would address a scenario, for instance, where you have the actual lender to Australia in a non-tax haven country, but it has entered into a back-to-back arrangement with another group member that is in a tax haven.

The ruling sets out a broad interpretation of what could qualify as a back-to-back arrangement for these purposes, potentially even including equity funding in some scenarios. Taxpayers are likely to face ongoing uncertainty in applying this test.


Taxpayers that are funded by group members from low tax rate jurisdictions, or which enjoy tax concessions, should review their positions in light of the draft ruling, in particular taking into account the ATO’s views on the types of factors relevant to the purpose test and the scope of the ‘back-to-back’ concept.

Taxpayers that have previously not had to consider the integrity rule in relation to financing arrangements because they triggered one of the specific hybrid mismatch rules, but without full denial of deductions, will also need to consider how the Budget announcement could affect them.




Julian Pinson



Andrew Hirst

Partner, Head of Financial Services