The Australian government on March 12, 2015, released revised exposure draft legislation for the third and final element of the Investment Manager Regime (IMR 3). Broadly, the revised exposure draft exempts foreign funds (including eligible US onshore and offshore funds) from Australian tax on Australian-source gains. The revised draft also addresses a number of industry concerns regarding previous exposure drafts, by better aligning the draft IMR3 provisions with the UK’s Investment Manager Exemption (IME) equivalent.
Consultation on the revised exposure draft legislation closes on April 9, 2015.
For some time now, widely held foreign funds have faced significant uncertainty regarding the Australian tax treatment of investments in both Australian securities and foreign securities when the services of Australian-based intermediaries were used. Such uncertainly existed, for example, when an Australian advisor/manager was utilized, possibly creating an Australian permanent establishment (PE) for the foreign fund.
The Australian Financial Centre Forum was established in 2008 to examine ways to address this uncertainty. The release of the Johnson Report in 2009, followed by recommendations from the Board of Taxation in August 2011, culminated in the Australian government’s release of the first and second tranches of the IMR:
IMR 1: The ‘Fin48 exemption’ — implemented to address concerns raised in applying US reporting requirements for uncertain tax positions by exempting profits made on qualifying Australian investments for periods up to June 30, 2011 for eligible widely held funds.
IMR 2: The ‘conduit income’ measure — confirmed that a widely held foreign fund with a PE in Australia arising solely because of the use of an Australian intermediary would not be taxed on profits arising from portfolio investments in foreign assets. This measure applied to tax years commencing on or after June 30, 2011.
On March 12, 2015, the Australian government released revised exposure draft legislation for IMR 3, the third and final tranche of Australia’s investment manager regime.
What are IMR 3’s goals?
IMR 3 would:
- extend IMR 1, to place individual foreign investors in the same position whether they invest themselves or through a foreign fund.
Note: As discussed below, the so- called ‘Direct Concession’ would not apply to the period from July 1, 2011, to June 30, 2015.
- extend IMR 2 to cover Australian securities, thus placing foreign investors in the same position whether they invest directly in Australian securities or through an independent Australian fund manager.
- simplify the eligibility criteria, in particular the scope of the ‘widely held’ test.
How would IMR 3 do this?
Existing IMR provisions would be replaced and extended in certain circumstances. (Note that many key provisions of IMR 3 are based on the UK IME). IMR 3’s provisions would apply when a foreign fund invests in certain Australian securities either directly (Direct Concession), or indirectly through an ‘independent Australian fund manager’ (Indirect Concession).
When the requirements of IMR 3 are met, the returns, gains and losses from the disposal of assets that qualify as ‘IMR financial arrangements’, generally would be disregarded (or treated as ‘Non-Assessable Non- Exempt’) for tax purposes.
Once a foreign fund is established as an ‘IMR entity’ (broadly defined as an entity that is a foreign resident at all times during the tax year and does not carry on, or control, a trading business in Australia), the Direct Concession applies to a tax year when:
- the foreign fund is a ‘widely held entity’ for the entire year (there are certain exemptions for entity start- up, wind down, and temporary breaches that may occur during the year)
- the interest in the Australian issuer of the financial arrangement does not entitle the holder to a 10%-or- greater interest in the total paid-up share capital, the right to vote, or the right to profits of the issuing company, and
- none of the returns or gains is attributable to a PE of the foreign fund in Australia.
The provisions require detailed tracing through interposed entities to the ultimate individual investors.
A foreign fund generally would be considered a ‘widely held entity’ if:
- it is one of the specified widely held entities such as foreign life insurance companies, certain complying foreign superannuation/pension funds, managed investment trusts, and foreign government pension funds, amongst others, or
- no member of the entity holds a participation interest of 20% or more or there are no five or fewer members with a combined participation interest of at least 50%.
Observation: Importantly, a foreign fund need meet only one of the above tests for a widely held entity, in addition to the residual requirements, to qualify for the Direct Concession.
With respect to the second test for a widely held entity, the positive change in both thresholds from earlier exposure drafts (i.e., previously, no member of the foreign fund holding at least 10%, or 10 or fewer members holding 50%), is a welcome amendment.
Once a foreign fund is established as an ‘IMR entity,’ the Indirect Concession applies to a tax year when:
- the financial arrangement is made on the foreign fund’s behalf by an ‘independent Australian fund manager’, and
- the interest in the Australian issuer of the financial arrangement does not entitle the holder to a 10%-or- greater interest in the total paid-up share capital, the right to vote, or the right to profits of the issuing company.
To qualify as an ‘independent Australian fund manager,’ the managing entity must be an Australian resident and carry out ‘investment management activities’ within the ordinary meaning of that term, for the foreign fund, in the ordinary course of its business. Furthermore, the independent Australian fund manager must receive an arm’s-length level of remuneration for its services.
To further ensure the managing entity is genuinely independent, either:
- the foreign fund must be widely held (as defined above) or
- no more than 70% of the income of the independent Australian fund manager and it’s connected entities for the year is to be received from the foreign fund.
If the independent Australian fund manager or a connected entity has a right to receive either directly or indirectly 20% or more of the foreign fund’s profits for the year (such as by virtue of a carry/profits interest) and the fund is not a ‘widely held entity’ as defined above, the IMR concession would be reduced by an equivalent amount.
This outcome would not arise if the foreign fund lodges an application which satisfies the Commissioner that:
- it is intended that the relevant rights to profit would be reduced to 20% or less within five years after the determination, and
- the investment in the foreign fund is actively marketed.
While investing in eligible Australian financial arrangements through the use of an independent Australian broker/agent should expect to qualify for the Direct Concession, where the Australian broker/agent does not give rise to a PE for the foreign fund, it is not clear whether investing in qualifying IMR financial arrangements using the services of a resident broker would fall within the ordinary meaning of ‘investment management activities’ of an independent Australian fund manager for the purposes of the Indirect Concession. Further guidance on this point is required to confirm eligibility of independent Australian brokerage arrangements for the Indirect Concession.
The revised exposure draft does not require the entity to be resident in an ‘Information Exchange Country.’ The absence of this requirement suggests that foreign funds resident in jurisdictions that are not Information Exchange Countries, such as Luxembourg and Hong Kong, now may be able to use the IMR concession.
The revised exposure draft also does not require the entity to file an annual information statement with the Australian Taxation Office. Instead, a self-assessment system will be used to determine whether there is a filing obligation.
The revised exposure draft does not appear to have addressed industry concerns regarding treating charitable foundations and endowment funds as widely held entities, although the IMR regulations could be amended in the future to address this issue.
The proposed amendments would apply to assessments for the 2015- 2016 tax year and subsequent years. Entities will have the option to apply the amendments (with the exception of the Direct Concession) to earlier tax years beginning from July 1, 2011, to June 30, 2015.
Observation: The inability to apply the Direct Concession for the above period does not appear to align with earlier Treasury announcements. It appears to preclude otherwise eligible foreign funds from applying the IMR exemption to gains recognized during this period when the foreign funds have invested directly, or through an intermediary other than an independent Australian fund manager (i.e., including a foreign broker or agent) and the gains are considered attributable to an Australian source.
PwC will work with industry bodies to prepare a response to the Australian government on this issue.
While still in exposure draft form and subject to consultation, the revised exposure draft legislation appears to address a number of industry concerns with respect to eligible investment activities in Australia. This has been achieved by broadening the IMR’s application, such that a number of investors that may not have previously been afforded protection under earlier drafts of the IMR are now eligible for the concession.
Investors will still need to carefully consider application of the draft provisions to their particular investments in Australia. However, we see the proposed reforms as a positive response to industry concerns, although the new exposure draft will require additional changes. Consultation on the revised exposure draft closes on April 9, 2015.