On 27 March 2018, Treasury released an Integrity Package of measures focused on tightenting the rules for stapled structures and limiting the tax concessions available to foreign investors receiving passive income from Australian property investments.
The Integrity Package follows the ATO’s Taxpayer Alert 2017/1 – Re-characterisation of income from trading businesses, issued in January 2017, and Treasury’s extensive consultation regarding potential reforms for stapled structures, conducted throughout 2017.
Broadly, the proposed measures will amend the thin capitalisation rules, increase the withholding rate for certain managed investment trusts (MIT), limit the withholding tax concessions for certain foreign pension funds and limit tax exemptions for foreign Governments.
A key Treasury integrity concern is that the use of existing rules has created a tax bias in investment decisions. That is, foreign institutional capital is attracted towards land-rich businesses rather than businesses that are capital intensive, knowledge based and/or research and development intensive. In addition, most countries do not reciprocate the broad interest and dividend withholding exemptions that Australia’s regime currently offers for foreign pension funds and sovereign wealth funds. The Integrity Package proposes two key start dates for the range of measures it seeks to implement: 1 July 2018 and 1 July 2019.
From 1 July 2018, the amendments to the thin capitalisation rules are proposed to take effect to prevent foreign investors from using multiple layers of flow-through entities to convert trading income into favourably taxed interest income (i.e. ‘double gearing’ structures). This is to be achieved by lowering the thin capitalisation associate entity test (for the purposes of determining associate entity equity and associate entity debt) from ‘50% or more’ to ‘10% or more’ for interests in flow-through entities. In addition, the arm’s length debt test will be clarified to require consideration of gearing against the underlying assets for interests in any entity.
From 1 July 2019, the proposed amendments that will take effect are:
- An increase in the MIT withholding tax rate on ‘active business income’ from 15% to the corporate tax rate, with a 15-year exemption for new, Government-approved national significant infrastructure assets. The higher MIT withholding tax rate will apply to MIT fund payments derived from cross staple rental payments, cross staple payments made under some financial arrangements, or where the MIT receives a distribution from a trading trust. The higher MIT withholding tax rate is not intended to apply where only a small proportion of the gross income of the trust relates to cross staple payments (i.e. conversion of active business income is not central to the structure) or where the stapled operating entity receives rent from third parties that is merely passed through as rent to the trust.
This integrity measure targets the stapled structures being used to convert active business income into passive rental income, where there is no clear commercial justification for the splitting of a single business and the structure appears to be solely a tax driven strategy to reduce effective tax rates for foreign investors. For example, where land assets necessary for use in a business are held by a MIT but leased to an operating company, the taxable income of the operating company would be reduced by rental payments to the MIT and rental payments received by the MIT would be subject to the 15% MIT withholding tax rate when distributed to foreign investors.
- A limit to the foreign pension fund withholding tax exemption for interest and dividends, so that the exemption is only available in respect of portfolio investments.
Whilst one of the key aims of the MIT regime was to increase the attractiveness of Australia’s fund management industry to mobile foreign investment, the pool of funds invested by sovereign wealth funds and pension funds has grown rapidly. As these types of investors have access to a range of additional tax concessions, effective tax rates on distributions from stapled businesses for these investors can be between 0% and 15%.
This integrity measure limits the broad unilateral exemptions from dividend and interest withholding tax available to foreign pension funds, largely because most countries do not provide such broad exemptions and Australian superannuation funds are not generally receiving reciprocal treatment when investing offshore.
- A legislative framework for the existing tax exemption for foreign governments (including sovereign wealth funds), and limiting the exemption so it is only available in respect of portfolio investments.
Similar to the foreign pension fund integrity measure, the proposed legislative framework for foreign sovereign investors aims to limit tax exemptions because most countries do not provide such broad exemptions for Australia’s sovereign wealth funds that invest in those other countries.
- The exclusion of agricultural land from being an ‘eligible investment business’ for an MIT, meaning that income, rent and capital gains from agricultural land will not be eligible for the MIT concessional withholding tax rate of 15%.
This integrity measure is aimed at levelling the playing field between domestic and foreign investors purchasing Australian agricultural land, as the current rules provide foreigners with a competitive advantage over domestic investors.