The question of whether a taxpayer’s gains are on capital account or on revenue account has attracted much publicity in the context of Texas Pacific Group’s (TPG) disposal of its investment in Myer. In the context of a similar issue faced by Australian managed investment trusts (MITs), exposure draft legislation has been issued with a view to providing some clarity in this area. Capital treatment is often preferred as it may allow fund investors to enjoy a capital gains tax (CGT) discount on gains on certain underlying investments.
In the 2009-10 Budget the Australian Government announced that it would allow MITs to make an irrevocable election to treat gains and losses on the disposal of certain assets (primarily shares, units and real property) as on capital account for taxation purposes, subject to appropriate integrity rules (see our previous Legal Update).
The parallels with the TPG situation are interesting (our comments on TPG were provided in a recent Legal Update). As a result of the Australian Taxation Office’s (ATO) actions in the TPG case, the importance of the capital/revenue distinction in the context of foreign investment in Australia has been highlighted.
Currently, gains and losses on disposals by MITs of investment assets may be on revenue or capital account depending on the circumstances of the holding of those assets. As a result calls have been made on the Government to provide some certainty in this area. In 2008 it was the threat by the ATO to treat most gains by funds as being on revenue account which led to the Government’s announcement in May 2009 that MITs would be able to make an irrevocable election to have gains from the disposal of certain eligible assets taxed exclusively under the CGT regime.
Following the Government’s announcement, on 10 December 2009 exposure draft legislation was released which provided that eligible MITs may irrevocably elect to apply the CGT provisions as the primary code for taxation of gains and losses on disposal of certain assets (shares, units and real property), rather than being taxed on revenue account.
Once passed, the changes will impact on the taxation planning of eligible Australian MITs, who will be forced to make a decision on the taxation regime they wish to apply to investment assets under their control.
How and when will the new provisions apply?
Under the proposals, for a MIT to obtain capital account treatment for gains and losses on disposals of investment assets the following general requirements must be met:
- the trust must be an eligible MIT;
- the asset must be an eligible asset; and
- the MIT must elect to apply the CGT provisions as the primary code for taxation.
What is an “eligible” MIT
A MIT is a unit trust that is listed, widely held or publicly offered. An “eligible” MIT is one that meets the definition of a MIT in Subdivision 12-H of the Taxation Administration Act 1953 (TAA), or the extended concept of MIT under the draft legislation. In broad terms, a trust will be a MIT within the TAA definition if it is:
- an Australian resident trust;
- a managed investment scheme operated by a financial services licencee with appropriate authorisations; and
- widely held (a trust will be widely held if it has at least 50 members; its units are listed on an approved stock exchange; or a member of the trust is a specified type of widely held entity itself, such as another MIT, a life insurance company or a complying superannuation fund with at least 50 members).
Trusts that do not satisfy the existing TAA definition of a MIT may nevertheless be treated as a MIT under the exposure draft legislation. For example, certain unregistered trusts may be treated as MITs for these purposes.
Trusts that will not qualify include trusts that are public trading trusts or corporate unit trusts (and taxed on a similar basis to a company) and certain closely held trusts.
What is an eligible asset?
Where an eligible MIT makes a valid election to apply CGT provisions, these provisions will be the primary code for taxation of gains and losses on the disposal of the following eligible assets:
- shares in a company;
- units in a unit trust;
- real estate (including an interest in real estate); and
- a right or option to acquire or dispose of an asset of a kind mentioned above.
Eligible assets do not include “financial arrangements” (for the purposes of the taxation of financial arrangements rules), or debt interests.
How do you make an election and what consequences will this have?
The trustee of an eligible MIT must make an irrevocable election in the approved form, and within a specified time frame (see below), in order to obtain capital account treatment.
Once an eligible MIT has made the election, the disposal or other realisation of eligible assets will be treated as on capital account and any gains or losses on these assets will generally be subject to CGT treatment. There are many significant consequences which flow from this:
- For Australian resident investors, they may be eligible for a CGT discount if the asset has been held for more than 12 months;
- For non-residents, subject to certain exceptions (such as where the gain relates to Australian real estate investments), they will generally not be taxed in Australia on any profits made from the sale of an eligible asset.
What happens if the MIT doesn’t make the election?
If an eligible MIT declines to make an election, or fails to make an election in the time frame set out below, any gains or losses on disposal of eligible assets (other than real estate, an interest in or option over real estate) will be treated on revenue account. This will effectively compel entities that qualify as eligible MITs to make the election if CGT treatment is desired. Except in the case of investments in real estate, the trustee can no longer self-assess treatment based on the traditional capital/revenue distinction.
Timeframe for making an election
For existing eligible MITs, the election must be made by the latest of:
- the end of the 3 month period starting on the date of commencement of the measures;
- the last day of the 2009-10 income year; or
- any later day allowed by the Commissioner;
and, once made, the election will be in force for the 2008-09 income year and later years.
For those entities which become eligible MITs in the 2009-10 or later income years, the choice must be made on or before the date the entity is required to lodge its income tax return for that year. The election will be in force from the income year in which the entity becomes an eligible MIT and later years.
Exception to the rule – proceeds characterised as “carried interests”
One area that has been subject to a degree of speculation over the years has been the tax treatment of ‘carried interest’ derived by managers of investment trusts. Frequently the position has been taken that distributions from, and disposals of, ‘carried interests’ was subject to CGT treatment.
A surprise in the exposure draft legislation is that, even if an election has been made, CGT will not apply to distributions from, and disposals of, ‘carried interest’ in an eligible MIT. A ‘carried interest’ in an eligible MIT is, in general terms, an interest that was acquired by a manager of the MIT (or its employee or associate) because of services to be provided to the MIT. Such amounts will be included in the assessable income of the ‘carried interest holder’ (i.e. the manager, employee or associate) to the extent that they are not already included in their assessable income, and will not be eligible for CGT discount treatment.
For investment trusts that are not MITs eligible to make the capital account election, but which nevertheless seek to rely on the existing capital/revenue distinction to treat its investments as being on capital account, the treatment of distributions from, and disposals of, ‘carried interests’ in those trusts may be subject to increased uncertainty. Indeed, having regard to the proposed changes generally, there may be questions concerning the treatment of its investments as being on capital account.
Comments on the draft legislation in its current form
Submissions on the exposure draft legislation were due by 24 December 2009. The changes proposed will be significant for those investment trusts affected. Should you require any further information or assistance in relation to the changes proposed in the exposure draft legislation, please contact a member of our team listed on the right.