Stapled structures have been used in Australia since the 1980’s but have been the focus of much more recent attention with the Australian Taxation Office publishing Taxpayer Alert 2017/1 in January 2017 and Treasury releasing its Consultation Paper regarding potential reforms in March of the same year. After such a flurry of activity, 12 months later, Treasury has announced the details of a proposed ‘Integrity Package’ focussed on stapled structures and designed to rebalance the tax concessions available to foreign and domestic players in property intensive investments.
It’s worth noting that property intensive investment has long been conducted using trust structures. One of the main reasons for doing so, other than the flexibility these offer, was to attract flow-through taxation. This results in investors being taxed according to their own profile rather than the tax being levied on the structure, at least for passive property investments. In terms of after-tax returns, this is particularly important given that foreign investors cannot get credit for - and therefore do not value - franking credits attached to dividends if they invest in a company or a Division 6C (trading) trust. The advent of the managed investment trust regime and the reduction in the withholding tax rate applicable to distributions from MITs to 15% was another reason for doing so but this reduction was also specifically designed to attract foreign investment (which is acknowledged in the announcement).
Treasury’s view, as outlined in the 2017 Consultation Paper, is that there has been significant growth in the number of arrangements that re-characterise trading income into more favourably taxed passive income and that such arrangements have expanded into new sectors, beyond their traditional use in the property and infrastructure space. Further, these structures have been viewed as providing a greater scope for trading income to be re-characterised than is possible in most other countries. The Treasury announcement on 27 March further emphasises the view that the foreign investment pendulum may have swung too far and that stapled structures are being used in mischievous ways to convert what would otherwise be ‘active income’ to ‘passive income’ which in turn has produced a competitive advantage. This focus on the conversion had already been telegraphed by the ATO in the Taxpayer Alert.
The Integrity Package includes:
- An increase in the MIT withholding rate on ‘active business income’ from 15% to 30% (subject to certain transitional measures and exceptions set out below).
- Lowering the thin capitalisation associate test from 50% to 10% or more to prevent the use of ‘double gearing structures’.
- Limiting the withholding tax exemption for foreign pension funds to interest and dividend income derived from portfolio like interests.
- Enshrining in legislation the administrative sovereign immunity tax exemption for non-commercial investments and limiting it to portfolio-like interests of less than 10% and only where the sovereign investor cannot influence key decision-making of the portfolio entity.
- Excluding from ‘eligible investment business’ income, rent and capital gains derived by a MIT from agricultural land, meaning that such income will be ineligible for the MIT concessional withholding rate of 15%.
Treasury has been careful not to propose restricting the concessions entirely. As an acknowledgement of Australia’s reliance on foreign capital to plug the infrastructure funding gap, the concessional MIT withholding rate of 15% will still be available for ‘new investment in economic infrastructure assets approved by the Government’. However, the concession will be time limited to 15 years after which the withholding rate will revert to the corporate tax rate (whatever that may be, noting that the current Government proposes to progressively reduce that rate from 30% to 25% by 2026). As announced, the higher withholding tax rate won’t apply to a structure where rental income is generated by the operating entity and passed through as rent to the passive trust (i.e. commercial and retail property investments).
But what about existing property intensive investments? Many of these investments have been committed to and priced based on an effective 15% tax rate on the passive income generated from those investments. Debt and equity has been sized accordingly. Treasury has announced transitional periods as follows:
- A general 7-year transitional period (other than for thin capitalisation measures).
- A 15-year transitional period for economic infrastructure stapled structures.
- The thin capitalisation changes will apply from 1 July 2018.
The transitional relief will only be available for investments made or committed to prior to the date of the announcement. The transitional relief is welcome, but has the obvious result of kicking the can down the road – that is, there will be an eventual impact on the modelled outcomes of existing investments. There has been some commentary regarding the fact that many stapled structures have been the subject of private binding rulings issued by the Australian Taxation Office and that the existence of such rulings, even if requested in respect of discrete matters, provided implicit approval of stapled structures themselves. Even if this was the case, it is worth noting that a private ruling will usually remain binding if the law is amended but expresses the same principles. It will, however, cease to be binding to the extent that the law is substantially changed. We consider that the proposed measures are likely to fall within the latter category. That is, the proposed measures reflect a shift in policy.
Even with the above exceptions and the transitional relief, the proposed measures will clearly have an impact on the returns from significant existing and future long-term property intensive investments. We expect that there will be a flow on impact on the pricing of new projects (particularly those that do not qualify as new investment in economic infrastructure assets approved by the Government) and the value of existing investments. Many funds will now be forced to consider implementing complex restructures, or those impacted by the changes to the foreign pension fund withholding and the sovereign immunity exemption may need to progressively reduce their investment exposure. This may involve substantial cost to industry (and ultimately local and foreign investors), including the potential for substantial stamp duty costs associated with restructuring landholding vehicles. The sweeping nature of the changes (and effective doubling of the tax rate for many foreign investors) raises the sovereign risk question yet again for foreign institutional investors called upon to support vital Australian sectors, including capital intensive agricultural investment.
The announcement, whilst giving a clear indication of the shift in policy, raises a number of questions, including:
- What conditions will be developed and need to be satisfied in order to fall within the transitional rules?
- What is ‘nationally significant infrastructure’ and how will ‘new investment’ in that infrastructure be defined for the purpose of the 15 year exemption? How will this impact brownfield investment and M&A in that space?
- How will the proposed measures apply to stapled structures that do not involve any movement of funds from the ‘active side’ to the ‘passive aide’?
- What conditions will be imposed on the pass through of the rent (i.e. in commercial and retail property investment)?
- In the commercial/retail setting, what level of variance between the rent passed from the operating entity to the passive trust will be tolerated? What impact would other operating income have on this concession (i.e. would it infect the rent)?
- How will the 15-year exemption and the transitional measures respond to changes in ownership of or new investment in stapled structures?
- What will the ATOs view be regarding restructures of existing investments (e.g. from an anti-avoidance perspective)?
- For the sovereign immunity tax exemption test, what will constitute ‘influence over the entity’s key decision-making’? Will it extend to shareholder reserve matters or matters put to fund advisory committees?
The announcement suggests that there will be a limited consultation on certain aspects of the proposed Integrity Package. However, it is likely that the answers to some of the questions above will not become apparent until draft legislation is released. Corrs will be involved in this process.
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