In the last year we have seen a number of changes to the tax landscape which have the potential to significantly change the way PE sponsors invest in Australia and also how they receive the returns on those investments.
This article highlights the most important of those changes:
- the proposed introduction of the new collective investment vehicle regime (CIV);
- the foreign resident withholding tax regime; and
- the recent Federal Court decision in Millar which confirmed that capitalised PIK interest is subject to withholding tax at the time it is capitalised.
Ready, steady, go — Australia’s new CIV regime out of the starting blocks…
The proposed collective investment vehicle (CIV) regime will finally allow sponsors to move away from trusts and offer corporate and limited partnership fund vehicles.
This is good news for sponsors seeking foreign capital, as foreign investors are much more familiar with these types of fund vehicles. Domestic investors will also welcome the new CIV regime as it will allow them to invest through a fund vehicle not burdened by the legal restrictions applicable to trusts.
Using trusts as fund vehicles
At the present there are 2 principal “non-corporate” investment vehicles available in Australia for PE sponsors: trusts and limited partnerships. Trusts are a familiar investment vehicle for Australian investors. However, as investment vehicles, they are somewhat inflexible because of the legal and tax restrictions that apply to trusts. To date limited partnerships have been not been particularly attractive for use as fund vehicles because limited partnerships are generally taxed as companies for Australian tax purposes.
The new CIV regime seeks to deal with these issues.
The new regime
It is proposed that the new regime will be introduced in two phases:
- first, with the introduction of a corporate CIV; and
- second, with the introduction of a limited partnership CIV.
The corporate CIV will be introduced from income years starting on or after 1 July 2017. It will be followed by the limited partnership CIV for income years starting on or after 1 July 2018.
It is hoped that the new CIV regime will offer similar tax benefits to managed investment trusts. That is, the ability to obtain deemed capital gains tax treatment and a reduced rate of withholding tax where investors are investing from a “good” country (a country which has entered into an exchange of information agreement with Australia).
Preconditions for using CIVs
The pre-conditions for utilising a corporate CIV or limited partnership CIV are expected to be based on those that currently apply to managed investment trusts:
It is expected that the manager operating the CIV will be required to be licensed.
- Widely held requirement
The new CIVs will need to be widely held. This test may be able to be satisfied if qualifying entities (e.g. complying Australian superannuation funds with 50 or more members, sovereign wealth funds, qualifying foreign collective investments with 50 or more members, and other qualifying funds) hold at least 50% of the fund.
- Trading businesses
It is also anticipated that the regime will be subject to a restriction to prevent it from conducting trading businesses. This will likely be comparable to the current deeming rules, which treat a fund as conducting a trading business if it directly or indirectly controls a trading business. This is the same restriction that currently applies to managed investment trusts.
- Segregation possible
It is hoped the new CIV regime will allow separate classes of shares, which will be segregated for both liability and tax purposes.
- Preferred structure
It is anticipated that the preferred structure will be based either on the UK OEIC legislation or the Luxembourg SICAV legislation.
- Amendments to domestic Corporations law
The key to ensuring the viability of the new corporate CIVs from a practical point of view (aside from their tax benefits) will be amending the Corporations law to provide for a relatively straightforward operation of the new regime.
This will involve the coordination of the disclosure rules with the current managed investment scheme rules. It also requires a separate regime so as to ensure that the new collective investment vehicle is not regulated by the same capital maintenance and dividend rules as apply to companies.
Limited partnership CIVs
As noted above, the current tax laws dealing with limited partnerships in Australia represent a major impediment to their use as an effective collective investment vehicle. This is because limited partnerships are generally taxed as companies (except for certain venture capital limited partnerships).
The new regime will allow “look through” tax treatment for qualifying limited partnerships (similar to that currently available for managed investment trusts).
A key question to be determined for tax purposes will be the extent to which limited liability partners may obtain the benefit of tax losses which accrue within the partnership. Potentially, the rules which currently apply to venture capital partnerships which allow investors to use the losses may provide a useful model for limited partnership CIVs.
A further consideration which will be important for the success of the limited liability partnership regime will be the introduction of a set of national rules that regulate the conduct of limited liability partnerships.
This has the potential to create some difficulty for the introduction of the regime as the limited liability partnership legislation is currently state based, resulting in inconsistent requirements between states.
Next steps for CIVs
The current expectation is that the draft legislation for corporate CIVs will be released later this calendar year. In the meantime we are working with Treasury on the form of the new rules.
New foreign resident withholding tax applies from 1 July 2016
The Myer IPO seems like a long time ago, but its effects are still being felt.
In 2009, following the Myer IPO, the ATO issued assessments to offshore entities associated with TPG. To give effect to those assessments, the ATO sought to have freezing orders imposed on the Australian bank accounts in which the IPO money was held – however, the float money had already left Australia.
This was the apparent genesis of the introduction of a foreign resident withholding tax regime, now enacted with effect from 1 July 2016. From the ATO’s perspective, the advantage of the withholding regime is that in an exit it puts the onus on the taxpayer (buyer) to show that no withholding is required.
Broadly speaking, the regime requires purchasers of companies from foreign sellers to pay 10% of the purchase price to the ATO (subject to certain exclusions). This is effectively a prepayment of the foreign seller’s tax. It is possible to vary this amount where the foreign seller’s tax liability is less than 10% of the purchase price.
Oddly, given its genesis in the Myer IPO, the regime is focused on “land rich” companies. Having said that, it is impacting on most transactions as sellers and buyers seek to agree on an appropriate “risk split” in relation to the withholding tax. For example, it is possible to “turn off” the 10% withholding tax if the seller can give a declaration of Australian residency, or if its shares are not relevant interests in a “land rich” company.
The rules also bite in the case of asset (rather than share) sale transactions in a slightly more egregious way. All sellers are effectively deemed to be foreign residents unless they can produce a residency certificate from the ATO. This makes it important that the application for a residency certificate is built into the exit timetable.
Federal Court confirms withholding tax liability on capitalisation of PIK interest
The recent case of Millar v FCT  FCAFC 94 confirms that a withholding tax liability may arise for an Australian borrower upon the capitalisation of PIK interest payable to offshore lenders.
An Australian borrower is obliged to withhold tax from interest it “pays” to a foreign lender. An Australian borrower is deemed to make a payment when it “applies or deals with the amount in any way on the other’s behalf or as the other directs”. Does this phrase include capitalisation? Yes, according to the majority of the Full Federal Court in Millar v FCT (4 July 2016).
The predecessor provision in the relevant tax legislation, which defined when interest was “paid”, explicitly referred to “capitalisation”. The current provision, however, does not. Despite the omission, the majority of the Full Federal Court concluded that there was no explicit legislative intention to change the substance of the section and the broad “catch-all” phrase (“applies or deals with the amount in any way on the other’s behalf or as the other directs”) encompasses all circumstances (including capitalisation) where money is dealt with as directed.
Going forward it will be important that acquisition structures involving an offshore element take this decision into account. In particular, it will be important to consider whether any PIK interest is to be capitalised before exit.