Following on from the Australian Taxation Office’s (ATO’s) concerns in TA 2017/1, the Government has proposed sweeping changes to the tax laws that will impact on a range of stapled and non-stapled structures. The measures will:
- apply a 30% withholding tax rate to most income derived from cross-stapled arrangements;
- treat ownership of agricultural land as a trading business, even if used for rental purposes;
- expand the thin capitalisation rules to require gearing to be calculated on a look-through basis for interests of 10% or more; and
- limit the exemptions currently enjoyed by foreign sovereign entities and pension funds.
This Tax Brief focuses on the impact of the measures on the real estate sector. A separate Riposte addresses the impact on the infrastructure sector.
Generally, the measures should not affect stapled groups that do not have material cross-staple dealings.
ATO Taxpayer Alert
Taxpayer Alert 2017/1 set out a number of stapled structures with which the ATO was concerned. At the heart of its concern was the perception that income that should have been taxed at the corporate rate was instead being taxed at concessional managed investment trust (MIT) withholding rates. The ATO stated:
"We are reviewing arrangements which attempt to fragment integrated trading businesses in order to re-characterise trading income into more favourably taxed passive income. Our concern arises where a single business is divided in a contrived way into separate businesses. The income that might be expected to be subject to company tax is artificially diverted into a trust where, on distribution from the trust, that income is ultimately subject to no tax or a lesser rate than the corporate rate of tax."
In effect, the ATO was stating that while it was comfortable with the concept of a stapled group of independent businesses (e.g., a landlord and a developer) it may not accept the validity of a structure where one “side” of the stapled group leased or licensed property to the other “side” of the group.
The ATO’s concerns in this area were sometimes difficult to follow. If it is accepted that:
- the MIT concessions would apply if of the relevant asset were leased to an unrelated party; and
- the arm’s length rule in the MIT provisions limits the amounts paid under cross-staple arrangements to an arm’s length amount,
then there is no clear mischief resulting from the stapled arrangement. The cross staple rental income would be no more than would arise if the asset were leased to an unrelated party.
Following consultation, the ATO sought to limit the scope of its Taxpayer Alert to arrangements where there was no real market for unrelated party leases for the relevant asset. Despite this, the Government embarked upon a broader review of stapled arrangements as it considered that there were wider integrity concerns.
Cross staple arrangements
The Government’s proposals draw on the “fragmentation” concerns raised by the ATO and proceed on the basis that
“The MIT regime was aimed at increasing the attractiveness of Australia’s fund management industry (especially commercial and retail property funds) to mobile foreign investment. It did this by lowering the withholding taxes on certain distributions to foreign investors, particularly rental income. In recent years, the withholding tax rate has generally been 15 per cent.”
This statement is not accurate, as the MIT regime was expressly introduced with the purpose of developing the Australian funds management industry rather than specifically attracting mobile capital. Indeed, the Government amended the MIT provisions shortly after enactment to bolster the requirement for investment management in Australia and rejected arguments that attracting capital was a sufficient benefit from the MIT regime. Further, there was no mention in the original MIT rules of an intention to limit the measures to commercial and retail property. It is not clear that existing stapled structures are inconsistent with the original intention of the MIT provisions.
Nonetheless, the Government appears to be of the view that the concessional MIT tax rate is effectively being accessed by trading businesses through the use of stapled arrangements. They state:
" .. the tax rate differential [between the MIT rate and the corporate rate] encouraged an increase in the use of stapled structures to convert active business income into passive rental income. For example, a single business would be split between a MIT and an operating company. The land assets necessary for use in the business would be held in a MIT but leased to an operating company. The taxable income of the operating company would be reduced by rental payments to the MIT. The rental payments would obtain access to the 15 per cent MIT withholding tax rate when distributed to foreign investors. In this way, the active income of a trading business was converted into concessionally taxed rental income."
To eliminate this outcome, the Government proposes that income from cross-staple arrangements will not qualify for the MIT concessional rate. Trusts with cross-staple arrangements will continue to qualify as flow-through trusts and MITs, but the rate of withholding will be 30% for all non-residents.
The change will not apply:
- where the stapled operating entity receives rent from third parties and this is merely passed through as rent to the MIT; or
- where only a small proportion of the gross income of the MIT relates to cross staple payments
In the property sector, the structures primarily affected by these changes will be hotel stapled groups, as the operating entity in these groups does not derive rental income.
Student accommodation and manufactured home estate stapled groups may fall outside the changes if the underlying arrangements can be structured as leases, rather than licences.
Traditional landlord and developer stapled groups should not be affected by the measure, as cross staple arrangements in these groups are typically limited to assets such as the group headquarters, car parks and conferences spaces. However, it will be necessary to closely examine the scope of the “de minimis” exception. In particular, the proposals are silent as to the treatment of cross-staple interest payments and how this will impact upon the “de minimis” exception.
The change affecting farm land is more wide ranging, as ownership of farm land for any purpose will be treated as a trading activity. This means that public unit trusts owning farm land will be taxed as companies.
The stated reason for this change is:
"foreign investors enjoy lower tax rates on rent and capital gains from agricultural land compared to most domestic investors. This provides foreigners with a competitive advantage over domestic investors when purchasing Australian agricultural land".
The statement applies equally to any MIT and it is apparent that the Government’s concern is simply the potential scale of agricultural MITs and the associated cost to the revenue. There are also inevitable political concerns associated with transfer of farm land to foreign ownership and it can be presumed that the Government does not wish to be seen to be encouraging such transfers.
Under the current law, a taxpayer’s level of gearing under the thin capitalisation provisions must take into account debt in other entities in which the taxpayer has (broadly) a 50% or greater interest. This means that taxpayers holding minority interests can benefit from effective rates of gearing well in excess of the standard 60% rate. For example, if:
- an entity has 60% gearing; and
- a minority investor gears its own stake at 60%,
the look-through gearing rate for that investor is 84%.
The Government’s proposal will require look-through gearing to be determined for thin capitalisation purposes for all interests of 10% of greater.
The thin capitalisation changes are seemingly not limited to stapled groups.
Sovereign immunity and foreign pension funds
Currently, interest income can be paid by a MIT free of withholding tax to:
- certain tax exempt foreign pension funds; and
- foreign sovereign entities (in some cases, even where the entity has a significant equity stake in the payer).
The Government proposes to eliminate these concessions where the foreign entity has a 10% or greater equity stake in the payer or has influence over an entity’s key decision making.
In addition, sovereign immunity will not apply where a foreign sovereign entity derives trading income through a trust, regardless of the stake held by the entity. This position is consistent with the general rule applied by Australia in a treaty context that permanent establishments of a trust are attributed to the beneficiaries. Since a foreign sovereign entity would not be exempt from tax in respect of direct trading income, if the activity of a trust is attributed to its beneficiaries it is appropriate that the exemption is also not available for those beneficiaries.
Timing and transition
The thin capitalisation changes will apply to income years commencing after 1 July 2018. The remaining proposed changes will apply to income years commencing after 1 July 2019.
There is proposed transitional relief for “arrangements in existence at the date of government announcement”. Such arrangements will be subject to the existing laws for a further 7 years (15 years for certain infrastructure staples).
It is not clear whether the “arrangement” referred to here is the stapled structure as a whole, the assets it owns at the relevant date or the leases in place at the relevant date. It is to be hoped that a group would not be denied transitional relief merely because its cross-staple arrangements fall due for renewal shortly after the date of the announcement.
The Government states that:
Treasury will consult separately on the conditions stapled entities must comply with to access the transitional arrangements available under Element A (for example, stronger integrity rules may be needed to protect against aggressive cross staple pricing)."
Interestingly, the Government is proposing to provide Part IVA protection during the transitional period for arrangements covered by these measures. However, other “egregious” arrangements, such as royalty staples, will continue to be potentially subject to Part IVA.