Australia’s Tax and Superannuation Laws Amendment (2015 Measures No.1) Bill 2015 received Royal Assent on June 25, 2015. Therefore, the third and final element of the Investment Manager Regime (IMR 3) has now become law (the Act).
Broadly, the Act exempts foreign funds (including eligible US onshore and offshore funds) from Australian tax on Australian-source gains. The final legislation addresses a number of issues identified in the last exposure draft, discussed in the March 19, 2015, PwC Insight.
The Act applies to assessments for the 2015-2016 tax year and subsequent years. Entities have the option to apply the amendments to earlier tax years beginning July 1, 2011, through June 30, 2015.
For some time now, widely held foreign funds have faced significant uncertainty regarding the Australian tax treatment of investments in both Australian securities and foreign securities when the services of Australian-based intermediaries were used. Such uncertainly existed, for example, when an Australian advisor/manager was utilized, possibly creating an Australian permanent establishment (PE) for the foreign fund.
The Australian Financial Centre Forum was established in 2008 to examine ways to address this uncertainty. The release of the Johnson Report in 2009, followed by recommendations from the Board of Taxation in August 2011, culminated in the Australian government’s release of the first and second tranches of the IMR:
- IMR 1, the ‘Fin48 exemption,’ was implemented to address concerns raised in applying US reporting requirements for uncertain tax positions. IMR 1 exempted profits made on qualifying Australian investments for periods up to June 30, 2011, for eligible widely held funds.
- IMR 2, the ‘conduit income’ measure, confirmed that a widely held foreign fund with a permanent establishment (PE) in Australia arising solely from the use of an Australian intermediary would not be taxed on profits arising from portfolio investments in foreign assets. This measure applied to tax years commencing on or after June 30, 2011.
The Act — i.e., IMR 3 —is the third and final tranche of Australia’s investment manager regime.
What are IMR 3’s goals?
- extends IMR 1 to place individual foreign investors in the same position whether they invest themselves or through a foreign fund
- extends IMR 2 to cover Australian securities, thus placing foreign investors in the same position whether they invest directly in Australian securities or through an independent Australian fund manager, and
- simplifies the eligibility criteria, in particular the scope of the ‘widely held’ test.
How does IMR 3 make these changes?
The existing IMR provisions have been replaced and extended in certain circumstances (note that many key provisions of IMR 3 are based on the UK Investment Manager Exemption). IMR 3’s provisions apply when a foreign fund invests in certain Australian securities either directly (Direct Concession), or indirectly through an ‘independent Australian fund manager’ (Indirect Concession).
When the requirements of IMR 3 are met, the returns, gains, and losses from the disposal of assets that qualify as ‘IMR financial arrangements’ generally would be disregarded (or treated as ‘Non-Assessable Non- Exempt’) for tax purposes.
Once a foreign fund is established as an ‘IMR entity’ (broadly defined as an entity that is a foreign resident at all times during the tax year and does not carry on, or control, a trading business in Australia), the Direct Concession applies when:
- the foreign fund is a ‘widely held entity’ for the entire year (there are certain exemptions for entity start-up, wind-down, and temporary breaches that may occur during the year)
- the interest in the Australian issuer of the financial arrangement does not entitle the holder to a 10%-or-greater interest in the total paid-up share capital, the right to vote, or the right to profits of the issuing company, and
- none of the returns or gains are attributable to a PE of the foreign fund in Australia.
The provisions require detailed tracing through interposed entities to the ultimate individual investors.
A foreign fund generally would be considered a ‘widely held entity’ if:
- it is one of the specified widely held entities such as foreign life insurance companies, certain complying foreign superannuation/pension funds, managed investment trusts, and foreign government pension funds, or
- no member of the entity holds a participation interest of 20% or more, or there are not five or fewer members with a combined participation interest of at least 50%.
Observation: Importantly, a foreign fund need meet only one of the above two requirements to be considered a widely held entity (subject to satisfying the residual requirements outlined previously for the Direct Concession).
A notable improvement from the exposure draft is that the independent fund manager’s rights or interests in the IMR entity that reflect its fund management role (i.e., entitlement to seed capital, flat fees, profit incentives, and returns payable on such amounts) may be disregarded for purposes of the above test when subject to either Australian or foreign tax in the year in which such rights or interests are received.
Charitable foundations and endowment funds are not included in the definition of specified widely held entities. Accordingly, when such entities are significant investors in a foreign fund, the fund may not satisfy the widely held test. There is an allowance in the law for additional entities to be included in the definition of specified widely held entities such that these entities could conceivably be included in the definition of a specified widely held entity in the future.
Once a foreign fund is established as an ‘IMR entity,’ the Indirect Concession applies to a tax year when:
- the financial arrangement is made on the foreign fund’s behalf by an ‘independent Australian fund manager,’ and
- the interest in the Australian issuer of the financial arrangement does not entitle the holder to a 10%-or-greater interest in the total paid-up share capital, the right to vote, or the right to profits of the issuing company.
To qualify as an ‘independent Australian fund manager,’ the managing entity must be an Australian resident and carry out ‘investment management activities’ (within the ordinary meaning of that term) for the foreign fund, in the ordinary course of its business. The independent Australian fund manager also must receive an arm’s-length level of remuneration for its services.
To further ensure the managing entity is genuinely independent, either:
- the foreign fund must be widely held (as defined above) or
- no more than 70% of the income of the independent Australian fund manager is received from the foreign fund or its connected entities.
Observation: The 70% test is also satisfied when the manager has been carrying out investment management activities for 18 months or less and is taking all reasonable steps to ensure the 70% threshold is met during the tax year in which the 18 months ends.
If the independent Australian fund manager or a connected entity has a right to receive either directly or indirectly 20% or more of the foreign fund’s profits for the year (such as by virtue of a carry/profits interest) and the fund is not a ‘widely held entity’ as defined above, the IMR concession could be reduced by an equivalent amount.
Note, however, that such a reduction should not occur with respect to an independent fund managers rights or interests in the IMR entity, which reflect its fund management role, where such amounts have been subject to Australian or foreign tax during the year.
In addition, this outcome would not arise if the fund manager’s entitlement does not, on average, exceed the 20% profits test over a qualifying period (of up to five years), or the circumstances of the breach are outside the control of the IMR entity /fund manager and the fund manager is taking steps to address these circumstances.
The explanatory memorandum accompanying the Act confirms that investing in qualifying IMR financial arrangements using the services of a broker/agent falls within the ordinary meaning of ‘investment management activities’ of an independent Australian fund manager for the purposes of the Indirect Concession.
Consistent with the earlier exposure draft the Act does not require the entity to be resident in an ‘Information Exchange Country’ (i.e., such that foreign funds resident in jurisdictions that are not Information Exchange Countries, such as Luxembourg and Hong Kong, may be able to use the IMR concession), or require the entity to file an annual information statement with the Australian Taxation Office. Instead, a self-assessment system will be used to determine whether there is a filing obligation.
As noted above, the Act applies to assessments for the 2015-2016 tax year and subsequent years. Entities have the option to apply the amendments to earlier tax years beginning July 1, 2011 through June 30, 2015.
In applying IMR1 to earlier income years, the new rules allow funds to align certain definitions, such as ‘IMR entity’ and ‘widely held test’ so that the rules can be applied consistently.
Observation: An enhancement from the earlier exposure draft is that the Direct Concession now applies for the period July 1, 2011, to June 30, 2015.
Now that all tranches of the IMR legislation have been passed, foreign funds should consider in detail how the rules apply to their particular facts and circumstances. While the Act is broader than prior exposure drafts, not all funds may qualify for the concession. If they do not qualify, they may be subject to Australian tax and have a filing obligation in Australia.
Foreign funds that invest in Australia should consider undertaking rigorous analysis to confirm whether they qualify for either the Direct or Indirect Concession and whether it is beneficial to apply the modified rules to earlier income years.