Stapled property groups need to look closely at their cross staple arrangements or risk raising the ire of the ATO. First, the Government introduced a non-arm’s length income rule for MITs to prevent the misuse of cross staple arrangements, now the ATO is looking at taking a big stick where it considers there has been misuse of stapled structures.
In Taxpayer Alert TA 2017/1 the ATO outlines various approaches that it may seek to apply to eliminate the tax benefit generated by such structures including Division 6C and Part IVA. This brief considers the impact of this taxpayer alert on property trusts.
Overall relevance to property trusts
Large property trusts typically operate as part of a stapled structure. There may be some dealings between the ‘passive side’ of the staple (Trust) and the ‘corporate side’ of the staple (Company) that involve some part of the income of the corporate side being paid across to the passive side (eg, interest on a loan).
Although in one sense this involves the conversion of trading income into concessionally taxed passive income, the ATO is not opposed to stapled structures in principle. A Trust which derives all or most of its rental income from unrelated third party tenants and does not enter into any of the transactions outlined below should generally not be affected by the positions taken in the taxpayer alert.
Despite this, TA 2017/1 is of importance to the property trust industry as:
- some Trusts derive rental income from related parties; and
- the examples of problematic transactions are potentially quite broad and will require some property trusts to examine their existing arrangements (within the staple and with third parties).
The ATO does not appear to accept that the “non-arm’s length income rule” under the new managed investment trust provisions is sufficient protection for the revenue against some arrangements. Some structures may be challenged as being wholly ineffective even if they do not give to non-arm’s length income.
Structures that concern the ATO
The primary area in which Trusts could be affected by TA 2017/1 is so-called rental staples. These are stapled groups where the business of the Trust consists principally of a lease of real property to the Company. In these structures, there can be said to be one overall business that is divided between the Trust and the Company. Typically, these structures exist in the areas of hotels, manufactured home estates and student accommodation.
The ATO suggests that some rental staples are not effective as the Trust may control the Company or because the ATO can assess the Trust’s purpose in investing in land by re-characterising the transaction as a single business. The ATO has also raised the previously discarded argument that payments made under a lease may not be “rent” if they convey the benefits of a trading business to the lessor.
There are a number of weaknesses in the ATO’s argument that it can re-characterise payments under a lease or the transaction as a whole. However, regardless of these issues the ATO has made it clear that not all rental staples are inappropriate. The arrangements between a Trust and a Company that the ATO is concerned with are those that are:
"… not transactions that third parties acting at arm’s length would usually enter into, [and where] the business is not one capable of division in any commercially meaningful way."
The ATO also expressly carves out “third party building businesses”, which are arrangements where:
- a building is leased to the Company by the Trust;
- the Company makes a building available to the public for occupation (eg, a hotel); and
- “a common observable market or practice already exists in that industry for building owners .. to lease those types of buildings to unrelated third parties”.
It is not clear why there needs to be examples of actual leases to unrelated third parties if the lease between the Trust and the Company is on arm’s length terms. In our view, a Trust and a Company can enter into an arm’s length arrangement even if there are limited examples of the relevant transaction between unrelated parties.
The ATO suggests that stapled groups operating third party building businesses engage with it to confirm the tax treatment of their arrangements, but does not suggest that such arrangements are necessarily inappropriate.
The primary area of focus for the ATO in the “rental staple” context appears to be leases of isolated fixtures (i.e., not connected to a building owned by a Trust). For example, a lease of an electricity tower owned by a Trust but located on third party land. In these transactions, the ATO suggests that the real property is more than just the setting for the Company’s business and so the business of the Trust and the Company cannot be realistically divided.
Overall, and subject to the application of the non-arm’s length income rules, we would expect that most building based cross staple lease arrangements would be accepted by the ATO.
Synthetic equity structures involve an investment by the Trust in the Company that:
- is not in the form of shares and purports to not provide control over the Company to the Trust; but
- delivers a return contingent on the economic performance of the Company.
In an extreme case, the entire economic return from the Company could be passed across to the Trust in a form that is purported to be passive income.
Such extreme arrangements are not common in the property industry, but the ATO’s concept of synthetic equity is quite broad and extends to turnover based payments. These arrangements would be more common as many Trusts would have turnover based payments in respect of such things as car parks, digital media and retail tenancies.
In our view, it is unlikely that the ATO would have a concern with most such turnover based payments derived by Trusts. The ATO’s concern is based on:
- effective control over the Company, or an exposure to the Company where an arm’s length investor would insist on control; and
- the “primary economic exposure” to the success or failure underlying business being borne by the Trust.
Where the Company or third party entity has other business or the turnover component of a payment is only a portion of the overall return, these arrangements should generally be acceptable. In these cases:
- the Trust would not normally control the counterparty, nor could it be said that control has been removed merely to avoid Division 6C or preserve managed investment trust status; and
- primary economic exposure to the counterparty’s business would remain with the counterparty.
Where a structure is established with almost all of the external equity in the Trust and a loan at interest across to the Company, the Commissioner may:
- seek to deny deductions to the Company on the basis that the loan is in fact an equity interest; or
- argue that the Trust controls of the Company because of the latter’s financial dependence.
These structures have been a concern to the ATO for many years and have been challenged under the debt / equity rules. However, the potential concern in TA 2017/1 is the suggestion that inadequate equity in a debtor Company could attract the operation of Division 6C to the Trust.
During the GFC, many Companies suffered losses that consumed most or all of their equity. Although many groups took active steps to recapitalise their Companies there would have been periods in which they were financially dependent on their stapled Trusts. It is to be hoped that the Commissioner will not apply Division 6C to such temporary losses of equity.
The royalty staple structure involves the Trust acquiring intangible property which is licensed across to the Company and the Company pays a royalty to the (non-public) Trust. The royalty is said to be subject to only royalty withholding tax when distributed to a non-resident.
The ATO considers that these arrangements may in fact not involve royalties for tax purposes. These arrangements are unlikely to be present in the property industry.