The Government has today released the draft legislation for final “third” element in the Investment Manager Regime (IMR) (being, “IMR 3” or the “full” IMR).
The release of draft legislation in relation to IMR 3 is particularly welcome. It has been long awaited by managers of, and investors in, foreign funds. The implementation of this “full” IMR was one of the key recommendations from the report by the Australian Financial Centre Forum (the Johnson Report) in 2009.
It is anticipated that the release of the “full” IMR will provide greater flexibility and tax certainty to managers of foreign funds. This is on the basis that the “full” IMR should provide certainty and flexibility to such managers that they are able to engage Australian intermediaries (such as brokers or other service providers) without subjecting the relevant foreign fund to Australian tax.
Managers of foreign funds should, however, review the terms of the amendments closely. In particular, the “full” IMR imposes certain limitations on the foreign funds that are able to obtain the benefit of the exemption.
The “full” IMR exemption applies from the 2011-12 income year.
Background to IMR 3
The Johnson Report had found that various uncertainties and scope of Australia’s tax system acted as an impediment to foreign funds investing in Australia. The introduction of an IMR, with clear and comprehensive statutory rules was proposed as the means of addressing the impediments and to encourage the use of Australian financial service intermediaries. In this regard, it had been found that, despite having a significant funds management industry in Australia, only a small percentage of funds under management were from foreign investors.
To date, legislation dealing with the first element of the IMR (the so called “FIN 48 issues”) and the second element of the IMR (the conduit income concession) has been passed. In particular:
- Element 1 (FIN 48)(or “IMR 1”) - addressed the 'FIN48' issue by amending the law to effectively exempt foreign funds (wherever located) from Australian tax on passive portfolio investments. They restricted the Commissioner of Taxation's ability to raise assessments in respect of income of a widely held foreign managed fund for the 2010-11 and prior income years;
- Element 2 (Conduit income) (or “IMR 2’) - addressed the tax uncertainty where a widely held foreign managed fund engaged an Australian-based financial services intermediary with respect to foreign investments and Australian assets that were only subject to capital gains tax. The provisions ensured that income from such investments would be exempt from Australian tax if the only reason it was taxable was because the foreign fund used the financial services intermediary. The change applied from the 2010-11 income year.
However, neither of the above changes dealt with the issue of foreign funds deriving Australian sourced gains on revenue account for the period post 2011, particularly where such Australian source arose from using local intermediaries. These were typically the gains derived by most foreign funds from dealings in their Australian assets. That position has now been addressed by IMR 3.
IMR 3 – “Full" IMR
Where a foreign fund meets the definition of an “IMR foreign fund” then, in essence, Australian sourced capital gains and revenue gains in respect of passive portfolio investments (with the exception of certain real property interests) will be exempt from Australian tax. Income from dividends, interest and royalties that is subject to withholding tax remains unaffected by the changes.
IMR foreign fund
To be an IMR foreign fund a foreign fund must:
- Not be an Australian resident at any time during the income year;
- Not undertake a trading business in Australia at any time during the year (or control such a trading business). As such, a trading business outside Australia is acceptable;
- Be resident in an information exchange country at all times during the income year (although Australia now has a broad list of information exchange countries, there are still some significant exclusions in the context of the global managed funds industry such as Luxembourg and Hong Kong);
- Must pass a “widely held” and “closely held” test; and
- Must give an annual information statement to the Commissioner each year and make available certain information to beneficiaries and members.
Special rules also ensure that the IMR exemption only flows to foreign resident beneficiaries and partners where the IMR foreign fund is a trust or partnership.
There are three ways that a foreign fund can satisfy the widely held test. These are:
- the units or shares of the entity are listed on an approved stock exchange;
- the entity has 25 or more members (determined in accordance with the new membership counting rules); and
- the entity is of a kind specified in regulations.
In determining whether a fund is widely held, entities that are interposed between a fund and individual interest holders or foreign widely held entities are disregarded. Further, foreign widely held entities are allocated 50 notional ‘individual’ members meaning that if a single foreign widely held entity holds a total participation interest of 50 per cent or more in a fund, the fund will pass the widely held test (as it will be treated as having at least 25 members). This change has overcome a major issue with IMR 1 & 2 where tracing through intermediate entities was by no means certain.
Closely Held test
A foreign fund will breach the closely held test if:
- any one of the fund’s members holds a total participation interest in it of 10 per cent or more (determined in accordance with the new membership counting and tracing rules noted above); or
- the sum of any 10 or fewer of the fund’s members’ total participation interests in it is 50 per cent or more (determined in accordance with the new membership counting rules noted above).
The new rules also allow voting interests to be ignored when applying the widely held and closely tests. This caters for the situation where, say, a General Partner of a LP may have a larger voting interest than their rights to participate in income. This will address a key concern which arose under the rules relating to IMR 1 & 2.
Further, there are start-up and wind down rules that allow funds to qualify when commencing (or closing) and the number of members are below the threshold because the fund is building (or reducing) its capital. It will apply for the income year in which the fund was created, as well as for the next income year if it was created in the second half of the income year.
As the requirements to qualify as an IMR foreign fund are highly prescriptive and technical, early feedback suggests that it will be critical to include a safe harbour for temporary or inadvertent breaches of those requirements. A similar safe harbour is contained in the MIT rules in order to deal with temporary circumstances (see, for example, section 275-30 of the Income Tax Assessment Act 1997 (“the 1997 Act”)).
IMR income and capital gains/ losses – Portfolio Investments
In order for a return or gain from a financial arrangement to qualify as IMR income or an IMR capital gain under IMR 3, an interest of the fund in another entity must not breach the non-portfolio interest test contained in section 960-195 of the 1997 Act. Thus the fund will be taken to have a non-portfolio interest in another entity if the sum of its direct participation interests in the other entity and the direct participation interests of its associates in the other entity is 10 per cent or more.
However, the amendments also extend IMR 2 (Conduit income) to qualifying financial arrangements with entities in which an IMR foreign fund holds a non-portfolio interest. This is consistent with the principle that all eligible conduit income should be exempt from Australian tax (irrespective of the size of the interest held). Although IMR 2 has been extended in relation to the above, it appears that it will also be confined at the same time to an IMR Fund which is resident in an information exchange country (previously this requirement was understood to only apply to IMR 3, and this restriction was not previously mentioned in prior Government announcements relating to IMR 2).
Further, a gain or loss from a financial arrangement that is also a direct or indirect real property interest cannot generally be an IMR capital gain or an IMR capital loss
An annual statement must be given by the fund to the Commissioner. The statement must be in the approved form, and must be provided within three months of the end of the relevant income year (being the income year in relation to which the entity was an IMR foreign fund). Notification must also be given to members. This will add to the compliance burden for foreign funds.
Further, given that a fund will fail to qualify as an IMR foreign fund if notice to the Commissioner is not given (as opposed to simply incurring a penalty which is the case if a fund fails to notify members) funds should consider whether some further safe harbour rule should be included to allow for inadvertent failures.
Submissions are due by 26 April 2013.
A link to the changes is here.