On 31 January 2017, the Commissioner of Taxation issued Taxpayer Alert TA 2017/1 (the Alert) expressing his concern over arrangements that fragment integrated trading businesses in order to recharacterise trading income into passive income which may be taxed more favourably. The Commissioner's concerns regarding stapled and fragmented structures and the Commissioner's position on a wider range of issues were further reiterated in the draft Privatisation and Infrastructure Australian Federal Tax Framework (the Framework) (collectively, the Publications) released later that day. The Publications state that the ATO is reviewing the effectiveness of the arrangements detailed in the Publications under the substantive provisions of the tax law. However, even if the arrangements comply with those provisions, it is concerned that these arrangements may be being entered into or carried out for the dominant purpose of obtaining a tax benefit which may attract the operation of the general antiavoidance provisions in the Tax Act. Although our understanding is that the Publications are not directly aimed at A-REITs, there are key issues raised by the ATO that could impact on many real estate funds
In TA 2017/1, the Commissioner acknowledges that stapled structures have been used for many years in the commercial property investment sector. Nonetheless, TA 2017/1 is a warning about activities that are causing the Australian Taxation Office (ATO) concern. We note that the Alert was not subject to public consultation. In addition to the publication of TA 2017/1, the Commissioner also released the long awaited updated draft of the Framework. The Framework provides more guidance on the Commissioner's concerns outlined in TA 2017/1 and conveys the position adopted by the ATO across a range of key issues in relation to the infrastructure industry. The document does not bind the Commissioner to a particular view as expressed in the Framework, however ATO officers are expected to follow the guidelines provided.
The Commissioner confirms that the Alert does not extend to Australian real estate investment trusts (AREITs) which derive all or most of their rental income from unrelated third party tenants. However, outlined below are the key concerns expressed by the ATO in the Publications that could still impact the A-REIT and broader real estate industry:
1. The Alert highlights the stapled structures which are raising the most concern in the eyes of the ATO, i.e. those where trading income is, in the ATO's view, being re-characterised as passive income and diverted to a flow-through trust with the result that:
a. the Asset Trust is a flow-through entity for tax purposes where the investors are ultimately subject to tax on the net income of the trust;
b. distributions from the Asset Trust may be subject to tax at rates between 0% to 30% in the hands of investors; and
c. the Operating Entity is unlikely to have significant taxable income, largely because of deductions in respect of payments to the Asset Trust.
The Alert identifies finance staple, synthetic equity staple, royalty staple, and rental staple arrangements that are of concern. Of relevance to the real estate industry is the finance and rental staple arrangements. The Alert specifically states that "taxpayers and advisors who implement these types of arrangements will be subject to increased ATO scrutiny". As a consequence, we would expect that FIRB will also be more diligent when reviewing arrangements of this nature.
In regards to the finance staple, the Commissioner is concerned that the Asset Trust may, through its cross staple loan, be able to control the operating entity for the purposes of Division 6C and provides an example where the operating entity's continuation as a going concern is contingent on Asset Trust not exercising a right it has to trigger the operating entity's insolvency. Further, the Commissioner reiterates the application of section 974-80 as a potential issue (which can deem the cross staple loan to be treated as equity for tax purposes)
In regards to the rental staple (i.e. where Asset Trust leases property to Operating Entity), the Commissioner is concerned that the Asset Trust may be not be investing in land for the primary purpose of deriving rent, where the overall structure ultimately re-characterises trading business income from the operating entity as renting income via the cross staple lease. The Commissioner states that it will be focusing on ensuring the operating entity retains a sufficient share of profits.
2. Although the Framework is directed towards the infrastructure industry, of particular interest and relevance to the real estate industry are the following:
a. The Commissioner will be dedicating compliance resources to ensure that trusts genuinely qualify as Managed Investment Trusts (MITs), with a particular focus on the substantial proportion of investment management activities carried out in Australia test and the Managed Investment Scheme test.
b. Continuing from the Commissioner's comments in the Alert regarding cross staples leases, the Commissioner has expressed his position on how the pricing mechanism for a cross staple lease should be undertaken in certain circumstances. The Commissioner's states that notwithstanding analysis may have been undertaken to determine an appropriate arm's length amount for the purposes of satisfying the non-arm's length income rule contained in the MIT rules, the Commissioner may consider certain methodologies inappropriate in the context of certain business that have integrated arrangements. We note that although the Commissioner's comments were made in the context of an infrastructure privatisation, it will be interesting to see whether this line of thought impacts real estate structures as well.
c. In respect of determining interest income distributions and the associated withholding tax for the Asset Trust, the Commissioner raises a concern regarding how interest expenses are allocated to rent and interest income derived by the Asset Trust.
d. In respect of testing whether a trust is a public unit trust for the purposes of Division 6C and tracing through trusts to determine the total number of persons is required, the Commissioner has stated that in the circumstances where the question of the existence or nature of the trustee-beneficiary relationship is argued to affect the application of the tracing rules, taxpayers are strongly encouraged to contact the ATO to discuss the issue. Of note, the Commissioner acknowledges that they are aware that this issue can arise with certain off-shore pension funds.
The issues covered in the Publications are not new and have been discussed with the ATO in extensive consultations over a number of years, especially in the infrastructure industry. The release of the Alert specifically was not expected and notwithstanding it states that it is not intended to apply to A-REITs which derive all or most of their rental income from unrelated third party tenants, it nonetheless raises more questions than answers for the real estate industry.In particular:
- Stapled structures have been used for over 20 years in the Australian real estate and market so it is not clear why a general alert (and not a more targeted alert) has been issued.
- The Alert does not identify the relevant industries to which the Alert could apply and it does not specify the type of assets that would be acceptable to be held in stapled structures, eg hotels, retirement villages, student accommodation and agriculture.
- There is no detail as to whether the Alert applies to existing stapled structures or whether it will apply prospectively to new structures established. In addition, the Alert does not distinguish between restructuring an existing business without an ownership change to other circumstances such as establishing a new business.
- There appears to be no distinction between greenfield and brownfield assets (as new businesses are also targeted as rental staples) and whether this distinction would have any impact on whether stapled structures would be acceptable to use.
- As tax outcomes and tax conditions have become far more relevant in the Foreign Investment Review Board (FIRB) process, where FIRB approval is required, the release of the Alert may make the approval process more complex for investors.
- The uncertainty regarding the application of section 974-80 continues, even after the ATO released Taxation Determination 2015/10 that confirmed cross staple loan arrangements, in themselves, should not trigger the application of section 974-80 to typical A-REITs that derive both rental and interest income from cross staple arrangements. Further, the Alert makes no mention that section 974-80 may be re-drafted.
A majority of the issues raised in the Framework were subject to a detailed consultation process with the infrastructure industry. However, the Commissioner's position on some key matters equally apply to the real estate industry. For example, the ATO will be focusing the investment management activities in Australia test to achieve MIT status. This is of high importance to all MITs and in particular foreign investors looking establish MIT structures with no presence in Australia.
In light of the positions expressed by the Commissioner in the Publications, we suggest that taxpayers be proactive in reviewing their existing cross staple arrangements, particularly in respect of any cross staple loans or leases and their supporting arm's length documentation.
Going forward, it will be important to engage with the ATO in relation to any stapled structure to understand the ATO's position as to whether any particular stapled structure would be acceptable in the relevant circumstances.
Also, given the increased focus on MIT qualification, for those taxpayers which have not already the right controls and checks in place, it may be prudent to re-visit and regularly check their existing MIT structures and critically for new MIT structures, it will be important to ensure that the investment management activities test in Australia is satisfied.