Background

Since announcing in the 2009-2010 Federal Budget that qualifying Australian Managed Investment Trusts (MITs) would be able to make an irrevocable election to apply the CGT regime as the primary method for taxing certain disposals of assets, there has been a great deal of discussion and much anticipation about the final scope of these rules.

On 10 December 2009, the Government released exposure draft legislation (ED) and explanatory material which clarifies some of the uncertainties as to the breadth of the rules but also provides significant surprises, particularly for those entities which choose not to make the election and for recipients of carried interest entitlements.

The purpose of this bulletin is to highlight the key changes and implications of the ED rather than to consider all detailed requirements (this will be the subject of a more detailed analysis in our next Tax update).

Key points

  • The class of entities that can elect, as an MIT, to apply the CGT regime as the primary method for taxing disposals of assets has broadened since the 2009-2010 Federal Budget was announced to include many wholesale funds
  • For existing MITs, which elect within the required timeframe, this deemed capital account treatment applies to asset disposals happening on after the start of the 2008-2009 year of income
  • However, if an election is not made (where it otherwise could be made), deemed revenue treatment will apply to gains from disposals of assets (including currently held assets) which occur on or after the proposed new rules receive Royal Assent
  • Carried interest received from MITs on or after the new rules receive Royal Assent will be taxed on revenue account irrespective of whether an election is made by the MIT.  

Do the rules apply to existing trusts?

These rules are relevant to all trusts (including existing trusts) which meet the eligibility criteria (which are described in more detail below and will be the subject of a more detailed future tax update). However, certain measures within the rules have different commencement dates (see section titled Application of Rules).

Importantly, many trusts – including many private equity style trusts – will not meet the eligibility criteria (despite the expansion of the concept of eligible MIT – see below) (eg a fund with less than 50 members which has members which include individuals or ordinary companies will not be an MIT under the new rules), but the ED is yet another indication that the revenue / capital account distinction will be an issue for any fund manager that is not able to avail itself of any of the legislative "safe harbours" (such as the treatment of carry in VCLPs and ESVCLPs).  

Key changes to existing proposals

The key aspects of the ED which are particularly noteworthy and which represent a material change from the existing proposals are:

  • An expansion of the concept of eligible MIT over that contained in the MIT withholding rules. This change expands the number and types of trusts which now qualify for deemed CGT treatment but which will also be subject to the stings in the tail noted below (eg treatment of carried interest and consequences if the election is not made). One effect of this expansion is that many "wholesale trusts" will now be eligible to elect deemed CGT treatment. For example, a private equity style trust whose unitholders exclusively consist of complying superannuation funds and other eligible MITs will be eligible to elect deemed CGT treatment. Our next Tax update will explore the expanded concept of MIT in detail
  • Where a trust is otherwise eligible to make the election and does not do so, then any gains or losses on the disposal of eligible assets (excluding land, an interest in land, or an option to acquire or dispose of such an asset – the character of such gains will be determined based on ordinary principles) will be on revenue account (see below for phasing in of this amendment)
  • Irrespective of whether or not the election is made, carried interest entitlements (including capital gains from the disposal of assets which give rise to such an entitlement) in respect of an eligible MIT will be treated as being on revenue account (and therefore ineligible for the discount CGT concession) – see below for phasing in of this amendment.

It is also noted that there are certain grandfathering rules which apply to certain categories of trading stock acquired prior to the application date of the election such that those items will continue to receive trading stock treatment rather than capital account treatment. For clarity, we note that not all revenue assets are trading stock.  

Assets covered by deemed GCT treatment

It is further noted that the following assets in an eligible MIT which makes the election will be eligible for the deemed capital account treatment:

  • shares in a company
  • units in a unit trust
  • land (including an interest in land), and
  • a right or option to acquire or dispose of an assets of a kind mentioned in (a), (b) or (c)

Division 230 financial arrangements (ie assets falling within the new taxation of financial arrangements rules) and debt interests (for the purposes of the debt/equity rules) are excluded from (a) – (d) above.  

Application of rules

While the amendments broadly apply in relation to CGT events happening on or after the start of the 2008-2009 income year, it is noted that:

  • The amendments which deem certain assets to be on revenue account when an election is not made, apply to disposals of assets, cessations of ownership of assets and other realisations of assets which take place on or after Royal Assent
  • The amendments affecting the taxation of "carried interests" in eligible MITs apply in relation to entitlements to distributions that arise on or after Royal Assent or disposal of assets (presumably consisting of the unit which gives rise to the carried interest entitlement) that happen on or after Royal Assent; and
  • The amendment which deems that the acquisition of trading stock will be treated on capital account when an election is in force applies in relation to the acquisition of assets on or after the start of the 2008-2009 year.  

Making the election

An election for deemed treatment of gains on capital account is irrevocable. For the purposes of this bulletin, we do not propose to go through the detailed eligibility requirements. However, it is important to note that for those trusts which are eligible to make the election the following timing requirements will need to be met if deemed treatment of gains on revenue account is to be avoided:

  • if the MIT became eligible in the 2009-10 income or later income year (whether or not the trust existed before it became eligible) – then the choice must be made on or before the day it is required to lodge its income tax return for the income year in which it became eligible; or
  • otherwise, on or before the latest of the following days:

               - the last day in the 3 month period starting on the date of Royal Assent;

               - the last day of the 2009-10 income year; and

               - if the Commissioner allows a later day for the MIT, that later day.  

Key observations for the funds industry

Quite a number of the measures in the ED such as the deemed revenue account treatment if the election is not made, and the revenue account treatment of carried interest entitlements, were not expected when the measures were originally announced in the 2009-2010 Budget. While the expansion of the rules for many wholesale funds is a welcome development, the "stings in the tail" associated with not making the election and the treatment of carried interest entitlements mean that the new rules carry significant downside.

The deemed revenue account treatment will effectively turn the regime from what was originally touted as being an elective regime to a mandatory one. This will force many MITs which were quite comfortable taking the position that their holdings of assets were on capital account to make the election for fear of losing what they already have. The deemed revenue account treatment will mean that many existing MITs which fall within the definition cannot avoid dealing with the new rules and making the election.

The provisions dealing with the making of the election also mean that eligible MITs cannot put off the decision until later income years.

The surprise policy change on the treatment on carried interest entitlements is a stark departure afforded to such interests under the VCLP and ESCVLP provisions which provide for a deemed capital account treatment. Unless the treatment for those vehicles is also altered, they appear to provide a better tax outcome for managers although there are limitations associated with the use of such investment vehicles.

Submissions

The Government is calling on submissions on the proposed measures by 24 December 2009. We would be happy to assist affected clients with the making of any submissions on the proposed measures.