The Australian Treasurer recently released the first exposure draft in respect of Treasury’s proposed reforms to address integrity concerns with the use of stapled structures.
A link to the Exposure Draft Treasury Laws Amendment (Stapled Structures and other Measures) Bill 2018 (the “ED”) and to the explanatory materials to the ED (the “EM”) can be found here.
The ED contains proposed amendments to give effect to the first four elements of the Treasurer’s Integrity Package, released on 27 March 2018, apart from the conditions that stapled entities will be required to adhere to in order to access transitional arrangements as well as the new infrastructure concession. We understand that draft legislation to give effect to these provisions, as well as the fifth element (preventing agricultural MITs), is intended to be released in a subsequent stage.
While the terms of the ED are generally consistent with what was previously announced by Treasury as part of its Integrity Package, the ED provides further useful detail regarding how these amendments may operate. We have made submissions to Treasury expressing our views on the scope of the proposed reforms, as well as technical concerns with certain aspects of the ED.
This purpose of this article is to highlight detail contained in the ED that was not present in the Integrity Package. It then summarises our key concerns with the ED, which we discuss in further detail in our submission to Treasury, a copy of which is available here.
Overview of the detail contained in the ED
A summary of the key elements of the Integrity Package were outlined in our previous alert.
Restricting access to the 15% MIT withholding tax rate
Scope of payments caught by the higher MIT rate
The ED provides that the highest corporate tax rate will apply to managed investment trust (“MIT”) fund payments to the extent that they are attributable to “non-concessional MIT income”.
“Non-concessional MIT income”
There are a number of conditions that must be satisfied in order for an amount of assessable income of a MIT to fall within the definition of “ non-concessional MIT income”:
- Firstly, there must be an amount of assessable income that is, or is attributable to, an amount derived, received or made from a separate entity (the “second entity”) other than specified excluded amounts (namely dividends, interest, royalties, capital gains from non-taxable Australian property, or amounts which are not Australian sourced); and
- Secondly, either of the following must be satisfied:
- the MIT is an “asset entity”, the second entity is an “operating entity” and each of the MIT and thesecond entity is a “stapled entity” in relation to a “ cross-stapled arrangement”; or
- the second entity is an “asset entity”, a third entity is an “operating entity” and each of the second entity and the third entity is a “stapled entity” in relation to a “ cross-stapled arrangement”.
The above conditions turn on a number of further definitions which are set out in the ED. Broadly, for these purposes:
- an “asset entity” is an entity that does not carry on or control a trading business. That is, a passive investment entity that only derives income from eligible investment business;
- an “operating entity” is an entity that carries on an active trading business;
- a “cross stapled arrangement” will be entered into by two or more entities if, at least one entity is an asset entity and one entity is an operating entity, and a common investor or investor(s) has a total participation interest of at least 80% in each party to the arrangement; and
- each of the entities that have entered into a cross stapled arrangement is a “stapled entity”.
The definition of cross stapled arrangement is mechanical and care will need to be taken when applying it. In particular, it provides that in determining the participation interest of common investors across a staple, where there are differing levels of ownership only the lowest participation interest is required to be taken into account. As a result not all stapled structures will be satisfy the definition of a cross stapled arrangement.
Importantly, non-concessional MIT income includes the specified cross-stapled payments or other income and also amounts attributable to the net income of trading trusts or partnerships that would have been classified as a trading trust had they been a trust even where such income is derived from a non-stapled arrangement.
Even where the above conditions are satisfied, an amount will not be taken to be non-concessional MIT income if it falls within one of the following three exclusions:
- Third party rent: an amount of rent derived by an operating entity from an unrelated third party that flows through to a MIT as part of a cross staple payment will not be non-concessional MIT income and will continue to attract the 15% MIT withholding tax rate;
- de minimis exception: if a MIT is an asset entity, thede mininimis exception applies if the non-concessional MIT income of a MIT in the previous income year did not exceed 5% of the total assessable income (disregarding net capital gains) of the MIT for the previous income year. If the non-concessional MIT income was attributable to a payment made by another trust, those payments must also not exceed the 5% threshold. If the second entity is the asset entity, then broadly, the 5% threshold test is applied to the second entity on the assumption that the second entity is a MIT.
- 15 year approved economic infrastructure exception: an amount attributable to a cross-staple arrangement will not be non-concessional MIT income if the amount is rent, the cross staple payment is in relation to an asset that is covered by an approval by the Treasurer and the payment is made within 15 years of the asset being first put to use. The ED sets out further detail regarding the kinds of projects that will be approved to access the 15 year concessional MIT rate. The relevant criteria are:
- the asset is an “economic infrastructure asset”;
- Aneconomic infrastructure asset is an asset that is any of the following:
- transport infrastructure for public purposes;
- energy infrastructure for public purposes;
- communications infrastructure for public purposes;
- water infrastructure for public purposes.
- the estimated capital expenditure on the asset is $500 million or more;
- the asset is yet to be constructed, or the asset is an existing asset that will be substantially improved;
- the asset will significantly enhance the long‑term productive capacity of the economy;
- approving the asset is in the national interest.
The higher MIT rate is intended to apply to fund payments on or after 1 July 2019. This is subject to transitional relief of 7 years for existing stapled structures and 15 years where the MIT payment relates to an economic infrastructure asset.
The ED expands on the requirements that must be satisfied in order to access the transitional relief. In particular:
- either a contract in respect of the acquisition or creation of an asset has been entered into, or an Australian Government Agency has approved the acquisition or creation of an asset, before 27 March 2018;
- it must be reasonable to conclude that a cross staple arrangement will be entered into in relation to the asset;
- all the entities that will be stapled entities in relation to the cross staple arrangement must already exist before 27 March 2018; and
- each entity that is a stapled entity in relation to thecross staple arrangement, or that will become astapled entity in relation to the cross staple arrangement, must make a choice in writing to apply the transitional relief.
If the transitional relief is available, then no amount of the fund payment will be non-concessional MIT income.
As already noted, the conditions that a stapled entity will have to satisfy to access the transitional relief (and the ongoing infrastructure concession) are still to be drafted and will be released separately.
Thin capitalisation changes to prevent “double gearing” structures
The ED implements the thin capitalisation changes by lowering the associate entity threshold under the thin capitalisation rules from 50% to 10% for the purposes of determining associate entity debt, associate entity equity and the associate entity excess amount. In addition, for the purposes of determining the arm’s length debt amount, an entity must consider the debt to equity ratios in entities that are relevant to the considerations of an independent lender or borrower.
The thin capitalisation changes will apply from 1 July 2018.
Changes to foreign pension fund withholding tax
The ED implements the changes to foreign pension fund withholding tax by limiting the withholding tax exemption for superannuation funds for foreign residents to portfolio investments only – that is, where the superannuation fund does not either hold an ownership interest of 10% or more or, where it has an ownership interest of less than 10%, it does not have influence over an entity’s key decision making.
For the purposes of the exemption, the foreign superannuation fund’s interest in the entity is determined both when the payment is made and throughout any 12 month period that began no earlier than 24 months before that time and ended no later than that time.
Rights which may be taken to confer “influence” over the entity and result in a deemed 10% interest include rights to:
- vote at a meeting of the Board of Directors of the entity;
- participate in making financial, operational and policy decisions in respect of the entity; or
- to deal with assets of the entity.
In ascertaining the above, rights can be disregarded if they are conferred by a debt interest and arise because of a breach of terms of that debt interest.
These measures are intended to apply from 1 July 2019, with transitional rules applying to investment assets held on or before 27 March 2018. Under the transitional rules, the amendments will apply to existing assets from 1 July 2026.
Modification of the sovereign immunity exemption
The ED proposes a legislative framework for the existing sovereign immunity tax concession and limits the exemption to portfolio investments.
The ED includes a definition of “sovereign entity”, being an entity that satisfies all of the following requirements:
- the entity is an “exempt foreign government agency”, or an entity in which an exempt foreign government agency holds a total participation interest of 100%;
- the entity is a foreign resident;
- all of the entity’s investments are funded by public monies and all returns on those investments are public monies;
- the entity is not asuperannuation fund for foreign residents;a public non‑financial corporation or a public financial corporation (other than a public financial corporation that only carries on central banking activities).
There are a number of conditions that must be satisfied in order for income derived by a sovereign entity to be characterised as non assessable non exempt income. One of these conditions is that the total participation interests of the sovereign entity, and any other sovereign entity of the same foreign country, in the paying entity is less than 10%. Another condition is that, if the paying entity is a trust, the trust is a MIT.
Again, as for the foreign superannuation fund exemption, a sovereign entity will be deemed to have a 10% total participation interest (and therefore will not be able to access the exemption for a payment) where they have rights to:
- vote at a meeting of the Board of Directors of the entity;
- (participate in making financial, operational and policy decisions in respect of the entity; or
- to deal with assets of the entity.
In ascertaining the above, rights can again be disregarded if they are conferred by a debt interest and arise because of a breach of terms of that debt interest.
These amendments are to apply from 1 July 2019. Limited transitional rules apply to investments held by a foreign sovereign where the sovereign acquired the assets on or before 27 March 2019; on or before that date the sovereign had received a private ruling from the Commissioner of Taxation; and the private ruling still applied on 27 March 2018. In these circumstances, the amendments would not apply until the later of 1 July 2026 or the date the private ruling ceases to apply.
Policy concerns with the proposed amendments
Residual policy concerns
The proposal to introduce the higher MIT rate for certain stapled structures gives rise to the following key policy concerns:
- Linking the rate of withholding for non-concessional MIT income to the corporate tax rate will place foreign investors at a significant disadvantage as compared to Australian superannuation fund investors. As a consequence of this, foreign investors may not be able to compete in many situations with Australian investors on a pricing basis going forward or may otherwise choose to allocate their investment mandates to countries other than Australia.
- The limited transitional arrangements are not sufficient for existing infrastructure investments, which are intended to be held and operated over significant periods of time. The effect of the proposal is to retrospectively apply a change in law to the taxation of these investments.
Structural and timing recommendations
Given the significance of the reforms, we have recommended to Treasury that the ED is not finalised until the exposure draft bill containing the remaining elements of the Integrity Package is also released and considered. This is because it will be important that the ED is considered in conjunction with the proposed new integrity provisions that will be required to be adhered to in order to access the transitional rules.
Recommended technical clarifications
We have a number of concerns with the ED from a technical perspective. We have outlined these concerns in our submission to Treasury, along with our recommendations to address these concerns. At a high level our recommendations are designed to achieve greater certainty for regulators and taxpayers alike. They are also intended to be broadly consistent with the policy framework expressed in the Integrity Package.
A summary of our recommendations is outlined below.
Non-concessional MIT Income
- Switch off Part IVA: the proposed drafting to switch off Part IVA may not be sufficient to achieve the objective. We recommend that Part IVA be specifically amended to provide that the establishment and use of an “asset entity” and “operating entity” in a cross-staple arrangement the subject of the relevant election, insofar as it relates to cross-staple payments, cannot be subject to a Part IVA determination by the Commissioner.
- Treatment of capital gains on sale of properties as non-concessional MIT income: we recommend it be made clear that capital gains made by an asset entity on a sale to a non-asset entity are not to be treated as non-concessional MIT income.
- Clarification of assets included in economic infrastructure assets: we recommend that further detail/examples be given of the meaning of “ energy infrastructure”. We also recommend further clarification be given to the meaning of the new “public purpose” definition.
- Clarify concept of asset: we recommend that the concept of asset be expanded/clarified so that it covers the concept of asset enhancement/alteration, the concept of asset scope increasing and also to contemplate groups of assets that operate in an integrated manner.
- Clarify concept of rent: “rent” is an integral concept to the reforms. We recommend that “rent” should be defined for the purposes of providing clarity as to whether payments from a non-stapled entity are eligible to be treated as non non-concessional MIT payments.
Application and Transitional Provisions
- Clarify assets eligible for transitional relief: the concept of “asset” should also be clarified in respect of the transitional relief.
- References to committed v contracted: we recommend that paragraph 9 of the transitional rules refer to contracts or arrangements having been entered into by parties which contemplate the acquisition or creation of one or more assets.
- Requirement to have established stapled entities as at 27 March 2018: in our view, the transitional relief should not be limited to entities already in existence as at 27 March 2018. It should include entities intended to be established, pursuant to the relevant contract or commitment.
Superannuation Funds for Foreign residents
- Participation interest should be tested at level of originator of dividend or interest payments: we recommend that the participation interest for the purpose of section 128B(3CA) should be tested at the level of the originator of the interest or dividend payment, in order to avoid anomalous outcomes in certain circumstances.
- Clarify that standard investor protections should not result in deemed 10% interest – debt interests: we have a number of concerns with the breadth of proposed new section 128B(3CB)(b), which operates to deem a foreign superannuation fund to have a 10% interest in particular circumstances in the context of “debt interests”. We recommend that the provision be modified to make clear that rights conferred that are consistent with arm’s length financings are to be disregarded.
- Clarify that standard investor protections should not result in deemed 10% interest – equity investments: There seems to us to be no policy reason for the provisions in proposed new section 128(3CB) to be applied where a party has an economic or voting interest of less than 10 per cent. We recommend paragraph 128B(3CB)(b)(ii) be removed.
Sovereign wealth funds
- Participation interest should be tested at level of originator of dividend or interest payments: we recommend that the participation interest for the purpose of section 880-105(1)(d) should be tested at the level of the originator of the interest or dividend payment, in order to avoid anomalous outcomes in certain circumstances.
- Clarify that standard lender protections should not result in deemed 10% interest: section 880-105(2) should make clear that rights conferred that are consistent with arm’s length financings are to be disregarded.
- Clarify that standard investor protections should not result in deemed 10% interest – equity investments: we recommend that section 880-1-5(2)(b)(ii) be removed.
- Sovereigns from the same country should not be combined in determining level of participation interest: in our view, interests of sovereign entities are only combined where they are acting in concert.
- Clarify definition of sovereign entity: the definition of sovereign entity is narrower than the approach historically adopted by the ATO. In our view, it should amended to align more closely with how the provisions have historically been applied.
- Transitional relief should not be limited to those sovereigns with private rulings: we believe the transitional provisions should apply to arrangements or assets in existence at the date of the announcement that either: (i) had previously been subject to an ATO ruling which had lapsed; or (ii) had some other form of written comfort from the ATO; or (iii) only change in identity of legal owner of asset / investment and not beneficial ownership.
- Requirement to be a MIT: It is unclear why a sovereign fund should be required to invest or derive its income in Australia through a trust that is a MIT. We recommend that this requirement be removed.