A recent CAMAC report proposes that a separate legal entity structure replace the current legal framework for Australian managed investment schemes.  The proposal is a positive step but could have gone further and recommended a broader range of legal structures.  To be successful, the proposal should be coordinated with tax reform.

A Corporations and Markets Advisory Committee 2012 report (CAMAC Report) outlines some of the existing shortcomings of the current legal framework for Australian managed investment schemes and proposes that schemes be established as a separate legal entity. 

The proposed new structure would be a positive development and bring Australia’s regime closer to investment fund regimes in other countries. The proposal could have gone further and recommended a broader range of legal structures such as corporate vehicles and limited partnerships. Having a broader range of structures would better facilitate Australian managers managing assets of non-residents.

The CAMAC Report acknowledges the proposed structure should be revenue neutral but does not cover the Australian tax issues that currently arise through the use of unit trust structures for managed investment schemes. The current Australian tax system effectively prevents the structuring of managed investment schemes as separate legal entities.

It also creates significant barriers and difficulties with respect to the use of unit trusts to conduct managed investment schemes. These issues were identified in the Johnson Report1, particularly in the context of non-resident investors. These issues have been reviewed by the Board of Taxation. The Government is yet to respond to the Board’s review.

There is real merit in the separate legal entity proposal put forward in the CAMAC Report. Any reforms in this area must be the product of coordinated efforts between the corporate, Federal and State tax regulators and policy-makers if the proposal is to be successful. In other words, the key requirement if a new legal framework is to be developed for Australian managed investment schemes is to ensure that the new framework is developed in conjunction with changes to the taxation regime applicable to Australian managed investment schemes. Moreover, it must address the key tax problems associated with the current tax treatment associated with managed investment schemes. Any new legal framework should also provide for a broader range of investment vehicles that are likely to be understood by both domestic and international investors.

Why was the CAMAC Report commissioned?

The CAMAC Report was prepared in response to the collapse of a number of agricultural schemes and the difficulties faced in unravelling these schemes. The CAMAC Report also recognises the extensive development in the use of trusts for corporate activity and considers whether the existing law appropriately reflects these developments.

The current legal framework contemplates two main structures for managed investment schemes:

  • a contract based structure, where, typically, each member of the scheme enters into one or more contracts with the responsible entity of the scheme and the responsible entity then carries on various activities on behalf of the members. This structure was predominantly used in agricultural schemes where, for example, the members entered into a lease or licence in relation to an area of land and then engaged the responsible entity to perform various services on the land (such as planting and harvesting trees); and
  • a trust structure, where each member of the scheme acquires interests in a trust for which the responsible entity is the trustee. The responsible entity holds legal title to the property of the scheme and transacts with third parties as principal. The responsible entity will usually have a right of indemnity out of scheme assets for liabilities that it incurs as responsible entity.

CAMAC identified the following three key issues associated with the current legal framework:

  • it can be difficult to replace the responsible entity of a scheme, due to the personal liability of the new responsible entity for liabilities of the retiring responsible entity incurred in relation to the scheme;
  • difficulties are likely to arise in winding up a managed investment scheme, particularly where the affairs of the responsible entity and the scheme are entangled; and
  • a counterparty to an agreement with the responsible entity is unable to claim directly against the property of the scheme and generally must rely on the responsible entity’s right of indemnity out of the assets of the scheme.

On a day-to-day basis, an entity based outside Australia that wants to contract with a responsible entity in relation to a managed investment scheme can find it difficult to understand how Australian trusts operate, whether the trust is a separate legal entity and why a responsible entity will seek to limit its liability when the responsible entity contracts with the entity.

CAMAC’s proposed separate legal entity structure

CAMAC proposes a legal structure that involves a separate legal entity.

The separate legal entity would be managed by a responsible entity. The separate legal entity will not have any directors, officers, employees or members and will act exclusively through the responsible entity as disclosed agent for the scheme.  The separate legal entity will:

  • hold legal title to the property of the scheme (or engage a custodian to hold legal title to the property of the scheme);
  • not hold property of the scheme on trust for the members. Members will instead have residual rights to any property of the scheme on completion of the winding up of the scheme; and
  • be able to sue and be sued.

Counterparties will contract with the responsible entity as disclosed agent for the separate legal entity. Counterparties will not be able to seek remedies against the scheme members themselves.

The responsible entity will cease to owe its duties to the members of the scheme and will instead owe it duties to the scheme. The scheme will then have a right of action against the responsible entity if the responsible entity acts outside its powers as agent or breaches its duties in relation to the scheme. This right will be able to be exercised by various parties other than the responsible entity (such as ASIC or a scheme member).

CAMAC proposes that the responsible entity and the directors of the responsible entity would be personally liable if, at the time the responsible entity enters into an agreement in relation to the scheme, the scheme is insolvent (that is, the property of the scheme is insufficient to meet all the claims that can be made against that property as and when those claims become due and payable).

A number of existing provisions in the law are intended to remain if the separate legal entity proposal is implemented. For example, the responsible entity will continue to:

  • manage the scheme on a day-to-day basis;
  • have a compliance plan that sets out measures the responsible entity will apply in operating the scheme to ensure compliance with the Corporations Act and the scheme’s constitution;
  • maintain books and records for the scheme; and
  • be required to hold an Australian financial services licence to operate the scheme

There are a number of benefits that may arise if managed investment schemes are established as separate legal entities. These include:

  • having a vehicle for managed investment schemes that may be more readily understood by investors and counterparties outside Australia;
  • simplifying contracting in relation to managed investment schemes, by allowing counterparties to have a direct right to recover out of scheme property (rather than relying on the responsible entity’s right of indemnity);
  • ensuring that the assets of the responsible entity are not available to satisfy a liability in relation to the scheme, provided the responsible entity has entered into the relevant contract in relation to the scheme as an agent for a disclosed principal and within its powers as responsible entity;
  • schemes no longer being governed by trust law principles that were not developed in the context of the trusts that are used primarily for commercial purposes;
  • separating the assets of the scheme from the assets of the responsible entity, as the assets of the scheme will be held by the separate legal entity (or a custodian on behalf of the separate legal entity) rather than by the responsible entity;
  • facilitating the replacement of the responsible entity of the scheme, due to the new responsible entity no longer assuming the liabilities and responsibilities of the retiring responsible entity;
  • an external administration process for the scheme that is simpler than the external administration process that would need to be developed for a scheme structured as a common enterprise scheme or a trust; and
  • removing the risk that a scheme which is structured as a trust could be “resettled” as a result of amendments to the constitution for the scheme.

Taxation of the proposed separate legal entity structure

It is difficult to see how CAMAC’s proposal could be effective without significant reform to the existing taxation regimes. While CAMAC intends that the separate legal entity proposal be revenue-neutral (that is, the “flow-through” taxation treatment of a scheme will continue to apply), the CAMAC Report does not identify what changes that would need to be made to Australian taxation laws to achieve this.

The availability of “flow through” tax treatment for trusts can be seen to be at least one reason – if not the main reason – why managed investment schemes have, to date, been structured as trusts. Regardless of the regulatory issues associated with the use of corporate or limited partnership based structures for managed investment schemes, the use of such structures is not feasible under the existing Australian tax system. This is on the basis that such structures are generally separately taxed at the corporate tax rate (30%) and any returns generated are distributed to investors on a post-tax basis.

Various attempts have been made to create favourable tax structures for collective investments through corporate or limited partnership based structures, such as the “listed investment company” and the “venture capital limited partnership” regimes. These regimes have achieved limited success to date. These regimes have not been sufficiently broad or flexible to achieve any significant departure from the usual trust structures for managed investment schemes.

Limitations of the existing trust taxation regime

At the same time, although the existing regime for the taxation of trusts does provide flow-through taxation, the failure of this regime to provide a simple, practical and certain regime for the taxation of trusts in a managed investments context continues. The complexity of the administration of trust structures from a tax perspective, as well as the extensive uncertainty that exists in this area, have often been cited as the main disincentive to the creation of a managed investment scheme in Australia and their acceptance offshore.

This is certainly consistent with our practical experience. We are aware of many examples where the complexity and uncertainty associated with trust taxation in Australia have dissuaded foreign based fund managers from establishing managed investment schemes in Australia.

These issues were comprehensively addressed in 2009 by the Johnson Report. The Johnson Report identified that:

  • Australia’s tax laws effectively limit the range of vehicles that can be used for managed investment schemes to a unit trust; and
  • non-resident investors in Australian managed investment schemes are more familiar or comfortable with corporate vehicles or limited partnerships, which has often led to Australian fund managers establishing offshore vehicles based in jurisdictions where tax is not paid by the vehicle.

The Johnson Report recommended that the Board of Taxation review the scope for providing a broader range of flow-through collective investment vehicles.

Board of Taxation’s review of the existing regime for investment vehicles

Following the Johnson Report, the Board of Taxation reviewed whether there were any limitations to the taxation regimes for existing collective investment structures, such as “managed investment trusts”, and whether there was any benefit in having a broader range of tax flow through vehicles.

The Board of Taxation’s 2010 Discussion Paper included a chapter that explored the potential to introduce a new collective investment vehicle regime and, in particular, a new corporate collective investment vehicle regime. In that chapter, the Board of Taxation canvassed various models on which such a corporate collective investment vehicle regime could be based, such as a pure “flow through” model, an exemption based model, a distribution model or an integration model.

Current status of the review of the taxation of collective investment vehicles

The Board of Taxation has now completed its review and reported its findings to the Government. However the Government is yet to release the Board of Taxation report or indicate how it intends to respond to the recommendations provided to it.

It appears that the Government’s current focus, to the extent that it relates to the taxation of collective investments, is on refining and improving the existing flow through taxation regime for trust based structure (through the proposed “managed investment trust” regime), rather than creating a new corporate collective investment vehicle based regime.

The timing of the release of the CAMAC Report is interesting given that the Government is currently reviewing the tax treatment of collective investment vehicles more generally. Given that the Government has not released the Board of Taxation report, it will be interesting to see whether the release of the CAMAC Report – and, in particular, its advocacy of a separate legal entity structure for managed investment schemes – triggers a response from the Government.

Coordinated reform is the key

It is difficult to see how CAMAC’s proposed separate legal structure will be successful without significant tax reforms that support and complement the use of a separate legal entity for managed investment schemes.

The CAMAC Report illustrates that what is needed to develop a genuine and workable alternative to the use of trust or contract based structures in a managed investment scheme context is a coordinated response from Government. The Government must take into account not only the limitations of the use of trust or contract based structures from a regulatory perspective, but also the tax issues in this regard.

CAMAC’s separate legal entity proposal is a positive development that facilitates the establishment of a legal structure for Australian managed investment schemes which addresses a number of the issues raised in the Johnson Report.

The establishment of managed investment schemes as separate legal entities is not novel and may encourage the broader use of Australian managed investment vehicles, particularly if the introduction of CAMAC’s proposal is accompanied by changes to the taxation laws that provide certain benefits to investors in relation to the taxation treatment of Australian managed investment schemes. Prior to implementing the separate legal entity proposal, the Government should consider whether instead of, or in addition to, the separate legal entity proposed by CAMAC, managed investment schemes should be structured as a straightforward corporate vehicle or a limited partnership.

A key issue in implementing the separate legal entity proposal will be ensuring that appropriate amendments are made to the Commonwealth and State taxation laws to ensure that:

  • there are no adverse taxation or duty consequences as a result of existing schemes transitioning to a corporate vehicle; and
  • the separate legal entity continues to be a “flow-through” vehicle from a taxation perspective.