NATIONAL SUPERANNUATION CONFERENCE

Transcription

1 NATIONAL SUPERANNUATION CONFERENCE Session 4A Written by: Mark Edmonds Partner PricewaterhouseCoopers Presented by: Mark Edmonds Partner PricewaterhouseCoopers Megan McBain Manager Investment Tax First State Super Megan McBain Manager Investment Tax First State Super National Division August 2016 Crown Conference Centre, Melbourne Mark Edmonds and Megan McBain, 2016 Disclaimer: The material and opinions in this paper are those of the author and not those of The Tax Institute. The Tax Institute did not review the contents of this paper and does not have any view as to its accuracy. The material and opinions in the paper should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests.

2 CONTENTS 1 Introduction Asset Allocation and Alternative Foreign Asset Investment trends Overview of the taxation of foreign income derived by superannuation funds Superannuation funds are taxed differently Why are superannuation funds different? What does it mean to be different? Taxation of Foreign Entities for Australian tax Foreign Trusts Foreign Limited Partnerships Foreign Hybrids CFC rules Reform of the CFC rules with particular application to superannuation funds Issues relating to the application of the CFC rules to Australian superannuation funds Treatment of superannuation funds under Double Taxation Agreements (DTA) US FIRPTA Rules What is a qualified foreign pension fund? Base Erosion and Profit Shifting (BEPS) Final Comments...22 Mark Edmonds and Megan McBain,

3 1 Introduction The offshore investment market now represents a central component of the Australian superannuation funds industry. In 2013, Australian superannuation funds had invested approximately 16.4% of its funds under management offshore. 1 This number is expected to increase to 18% by 2020 and 20% by Much of the growth in foreign investment can be attributed to the relatively small Australian investment market and its inability to meet the growing demands of diversification required by Australian superannuation funds. Diversification provides superannuation fund members with the ability to achieve retirement objectives by providing a diverse range of investment opportunities. Offshore investment is an attractive form of diversification and forms an integral part of the overall risk mitigation strategy employed by Australian superannuation funds. Whilst it is acknowledged that superannuation investment in Australia as a whole is concessionally taxed (by policy design), this lightly taxed treatment arguably does not extend to the tax laws relating to foreign investment by superannuation funds. At the very least, superannuation funds should be taxed in the same manner as Australian companies with respect to foreign investment. This is currently not the case, with provisions in the Australian taxation law neither supporting nor encouraging the growth in superannuation funds offshore investments. This is especially the case in relation to non-portfolio interests in alternative assets such as infrastructure, real property and private equity. In a global environment of low interest rates and with the experience of volatility in the equity market, these are important investment assets for the superannuation fund industry. In particular, the Australian Controlled Foreign Company ( CFC ) rules and the laws relating to the taxation of returns from offshore investments should be designed to encourage superannuation investment offshore to attain the diversification benefits discussed above. In this paper, we explore in further detail the taxation of investments in non-portfolio foreign assets by Australian superannuation funds. We look at issues such as how the taxation rules may lead to unnecessarily complex structures, adding to the compliance burden for superannuation funds. We also look at how the taxation rules can lead to tension between consortium members where superannuation funds and corporates club together to acquire assets. The resulting structures can result in value leakage for at least one member. The paper also considers global developments including FIRPTA and BEPS. 1 Financial Services Council (2013), Financial System Inquiry, Chapter One Superannuation Ibid. Mark Edmonds and Megan McBain,

4 2 Asset Allocation and Alternative Foreign Asset Investment trends Asset allocation by Australian superannuation funds % Assets overseas 80.00% Property Life office 60.00% 40.00% Equities 20.00% Other Bonds Short term securities Deposits 0.00% Source: Australian Bureau of Statistics (2016), Managed Funds, Australia March 2016, Catalogue , Table 4. Asset allocation within the superannuation industry still favours the traditional asset classes, such as equities and cash deposits. 3 Similarly, the Australian superannuation industry continues to favour domestic investments. 4 Notwithstanding the home bias of Australian superannuation funds, there is an increasing trend by superannuation funds to invest offshore. 5 This trend is also evident by pension funds around the globe. 6 3 Australian Bureau of Statistics (2016), Managed Funds, Australia March 2016, Catalogue , Table 4. 4 Deloitte Access Economics (2013) Maximising Superannuation Capital A report prepared for the Association of Superannuation Funds of Australia, v. 5 Ibid. 6 OECD (2015) Pension Markets in Focus 2015, 27. Mark Edmonds and Megan McBain,

5 The trend of investing offshore is not expected to diminish in the near future, but rather, it s expected that we will see superannuation funds invest more and more offshore over the following decades. 7 The domestic market is too small and too concentrated for the significant pools of money to be invested by Australian superannuation funds. 8 As the assets in the superannuation system grow relative to the supply of domestic financial assets, superannuation funds will look towards other asset classes and increase their relative allocation of offshore assets. A report prepared by RiceWarner and commissioned by the Actuaries Institute for the Inquiry, argues it is possible that funds will allocate a higher proportion of their assets to overseas investments because of the reduced capacity for the Australian market to absorb those funds. 9 As such, the overseas markets will continue to provide further investment opportunities for these funds and we can expect Australian superannuation funds to continue increasing allocations to overseas investment Association of Superannuation Funds of Australia (2014), Financial System Inquiry submission, Ibid. 9 RiceWarner, Ageing and Capital Flows Financial System Inquiry Report commissioned by The Actuaries Institute (2014), Maddock, R Professor, (2014) Superannuation asset allocations and growth projections 14. Mark Edmonds and Megan McBain,

6 3 Overview of the taxation of foreign income derived by Superannuation Funds 3.1 Superannuation Funds are taxed differently Australian resident companies and Australian superannuation funds are taxed differently with respect to foreign sourced income. For example: Superannuation Funds are not entitled to CGT participation exemption Broadly, the CGT participation exemption in subdivision 768-G of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) applies to reduce the capital gain or loss realised by an Australian company as a result of a CGT event happening to shares held in a foreign company, where the following conditions are satisfied: the disposed shares are held by the Australian company throughout a 12 month period in the two years before the CGT event; and the disposing company has a total voting percentage (direct and indirect) in the foreign company of at least 10% (non-portfolio interest). 11 The reduction in the capital gain or loss is dependent on the proportion of the foreign company s active assets to its total assets. The CGT participation exemption is however not available to superannuation funds which dispose of their direct non-portfolio interests in foreign companies. Capital gains earned by superannuation funds are nonetheless subject to 15% tax in Australia, with a one-third discount for assets held for more than 12 months. Therefore, the effective tax rate of capital gains earned by superannuation funds on disposal of non-portfolio assets in a foreign company held for a period of 12 months is 10% (i.e. 15% - (15% x 1/3)) compared to 0% if the holder of such interest was an Australian resident company. Superannuation Funds are not entitled to non-portfolio dividend exemption Under the former section 23AJ of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936), nonportfolio dividends received by Australian corporate residents (other than in the capacity of a trustee) from a non-resident company were treated as non-assessable non-exempt income of the recipient company. A non-portfolio dividend is a dividend paid by a company to another company which holds at least 10% of the voting power in the paying company. The exemption provided under section 23AJ was not available where the recipient of the dividend was an entity other than an Australian company e.g. a superannuation fund. 11 Income Tax Assessment Act 1997 (Cth) sub-div 768-G. Mark Edmonds and Megan McBain,

7 The new Subdivision 768-A of the ITAA 1997, which replaced section 23AJ, provides that the nonportfolio dividend exemption now applies to corporate tax entities. This still does not include Australian superannuation funds. As such, superannuation funds are taxed on foreign dividends whereas Australian corporate investors are not. 3.2 Why are Superannuation Funds different? The Ralph Report in 1999 recommended consistent treatment of resident entities deriving foreign source income: Companies currently have access to relief from double taxation on foreign source income not available to other taxpayers. This relief could generally be extended to trusts taxed as entities to align the treatment of companies and trusts in accordance with the neutrality design principle in A Strong Foundation. 12 Further, in relation to the former section 23AJ, the ATO notes (in Taxation Determination 2008/25) that: Section 23AJ was originally introduced to reduce compliance costs for any Australian resident company entitled to a foreign tax credit under section 160AFC for underlying tax paid by a foreign company. Section 23AJ exempted the dividend from income tax in circumstances where a foreign tax credit would otherwise have been allowed. It is unclear to the authors why the above exemptions which apply to companies have not been extended to Australian superannuation funds with accumulation members which are otherwise taxed on the relevant income (albeit at a concessional 15% rate), and are entitled to a foreign income tax offset for underlying foreign tax paid. The former section 23AJ was introduced 3 years after the time at which superannuation funds first became taxable at 15% on earnings of, and contributions to, superannuation funds. However there is no commentary as to why superannuation funds were excluded from the operation of section 23AJ when it was introduced. Indeed, with the recent introduction of the new dividend exemption rules under Subdivision 768-A of the ITAA 1997, it appears little, if any, consideration was given to Australian superannuation funds gaining access to the new rules. The reason may be that superannuation funds are already viewed as being concessionally taxed, and extending the exemptions that currently apply to companies to superannuation funds is a step too far. This may be the view when it is considered Australian shareholders that receive unfranked dividends from Australian companies paid out of exempt foreign income will be subject to full tax in Australia, whereas superannuation fund members may not be taxed on receipt of income from the fund. However, it is by policy design that Australian superannuation funds are concessionally taxed, and if the policy reason for introducing section 23AJ/ subdivision 768-A and subdivision 768-G was to reduce compliance costs for entities entitled to receive FITOs, then we see little reason why superannuation funds should not have access to the same concessions that Australian companies have access to with respect to foreign income. 12 Ralph, John Theodore, A Platform for Consultation, Chapter 32 (1999) Mark Edmonds and Megan McBain,

8 3.3 What does it mean to be different? Given Australian superannuation funds are heavily reliant on the FITO system to alleviate the double taxation of foreign sourced income, this has necessarily led to acquisition structures being considered transparent from an Australian tax perspective. The increased allocation of investment to offshore alternative assets has increased the importance of such structures. Unfortunately such structures do not come without some cost. It means a greater amount of tax due diligence is required when assessing an offshore asset, as having a detailed understanding of the relevant foreign tax regime and the legal nature of the foreign entity is critical to the analysis of whether a foreign tax credit may be available to the Australian superannuation fund. In many cases, it can mean greater complexity associated with structures. Transparent structures generally lead to greater levels of filing obligations by the superannuation funds themselves in foreign jurisdictions. Whilst in the past, Australian superannuation funds may have gone to great lengths to avoid filing obligations in foreign jurisdictions, many superannuation funds now see it as a necessary requirement to meet the objective of tax efficiency of foreign investment in alternative assets, in a world where superannuation funds have moved to after-tax investment and reporting. All this has generally contributed to the superannuation funds themselves bolstering their own inhouse tax resource capability in recent years. There is of course the flow on impact of increased pressure on governance and risk management frameworks as a result of superannuation funds establishing their own investment structures. Being taxed differently to corporates can also result in interesting implications where corporates and superannuation funds join consortiums to bid on foreign assets. A corporate member of the consortium would often prefer to receive a dividend from a foreign company which would be exempt to the company, rather than receive a distribution from a foreign trust or partnership, and have to rely on the FITO rules. This is the case especially given a corporate member may not have other foreign income on which they would be paying Australian tax and therefore little scope to utilise any excess FITO s in any given year. This generally leads to either value leakage for a particular investor, or further complexity in investment structures. Mark Edmonds and Megan McBain,

9 4 Taxation of Foreign Entities for Australian tax The tax treatment that applies to foreign investments will depend on the classification of the foreign investment entity under Australian tax principles. Australia s tax rules are designed to apply differently depending on whether the investment vehicle is classified as a: Company (including an entity which is deemed to be taxed like a company for Australian tax purposes); Partnership (including foreign hybrid entities which are deemed to be taxed as partnerships for Australian tax purposes); or Trust. As discussed above, Australian superannuation funds commonly invest via entities which are considered tax transparent from an Australian tax perspective. Of the entities mentioned above, trusts and certain partnerships are considered transparent from an Australian tax perspective. Classifying a particular foreign entity as one of the above types of entities for Australian tax purposes can often be difficult, and understanding the legal character of the entity and the foreign legal framework within which the entity operates is key. 4.1 Foreign Trusts The rules relating to the taxation of foreign trusts are complex, however the repeal of the foreign investment fund (FIF) rules has meant we have one less regime to consider. Generally, Australia's domestic trust taxation provisions apply to non-resident trusts in the same way as to resident trusts. However, the deemed present entitlement provisions do affect how these domestic trust provisions apply to non-resident trusts. Under the deemed present entitlement provisions, if a beneficiary holds an interest in a non-resident trust, including a contingent or future interest, then the beneficiary is deemed to be presently entitled to the relevant share of the income of the trust. That is, the beneficiary is deemed to have received income from the trust and will be taxed on it accordingly, regardless of whether or not the income was in fact received. These deemed present entitlement provisions have a broad potential scope of operation. Their operation in practice is therefore uncertain and problematic. The government previously announced its intention to repeal the deemed present entitlement provisions, however no amending legislation has been prepared which would impact foreign trusts, and no indication has been given of when this might occur. This increasingly looks unlikely with the Attribution Managed Investment Trust ( AMIT ) rules coming into effect for a particular range of trusts. Mark Edmonds and Megan McBain,

10 A further issue is that a functional currency election cannot be made in relation to a foreign trust. As such, a foreign trust will need to calculate its income and its deductions in Australian dollars. Therefore, for example, repayments of foreign denominated debt could give rise to foreign exchange gains to the trust, which may be subject to tax in the hands of the Australian superannuation fund. There are also the practical implications of using the correct exchange rates to translate income and expenses of the trust. We also provide comments later in this paper on the interaction between Division 250 of the ITAA 1997 regarding the tax preferred use of assets and the taxation of foreign trusts. 4.2 Foreign Limited Partnerships It is common for Australian superannuation funds to invest in offshore funds structured as foreign limited partnerships (LPs) e.g. a US LP. Where the foreign LP is not regarded as a CFC for Australian income tax purposes, the foreign LP will likely be considered a corporate limited partnership (CLP). This CLP is treated as a public company for Australian income tax purposes. 13 In this case, sections 94L and 94M of the ITAA 1936 are relevant in determining the taxation treatment of any distributions or credits made in respect of the investment in the foreign LP. Relevantly, section 94L of the ITAA 1936 provides that a dividend for Australian tax purposes includes a distribution made by a partnership to its partner. Furthermore, section 94M of the ITAA 1936 provides that payments or credits made to a partner by a CLP against its profits or anticipated profits are also regarded as dividends. It is unclear what credits for the purposes of section 94M means. If credit is interpreted broadly, it could include a mere allocation (of income and unrealised gains) by the General Partner to a LP s capital account. Accordingly, there could be misalignment between the amounts received by the partner and the amount which the partner is taxed on. In many cases, an Australian company treats such a deemed dividend as exempt in any case (see above). However, a superannuation fund would not be able to avail itself of such an exemption. Furthermore, the credit to the LP s capital account may not increase the partners tax cost base in the LP by the amount of the dividend. As a result, where the partners then sell the LP interest upon the LP receiving such credit, the partners may be taxed on a higher gain (which includes the deemed dividend component). If credit is interpreted narrowly such that a deemed dividend arises only where a partner is able to demand payment, the impact of the misalignment should be reduced. In this respect, the Australian Taxation Office (ATO) has released a Private Binding Ruling 14. The Private Binding Ruling concludes that no deemed dividend arises under section 94M of the ITAA 1936 where an amount reflecting the partner's share of income and gains is credited to the partner's capital account, but no legal right to receive the amount on demand arises. Notwithstanding this, taxpayers must be mindful that the 13 Income Tax Assessment Act 1936 (Cth) s 94J. 14 Australian Taxation Office, Private Binding Ruling Authorisation Number: Mark Edmonds and Megan McBain,

11 contents of the Private Binding Ruling cannot be relied on by third parties. The ATO has also advised that the contents of the Private Binding Ruling should not be considered as definitive guidance on the views of the ATO. The ATO is currently undertaking consultation with industry with regards to the application of these provisions and intends to issue a ruling on the meaning of credits for the purposes of section 94M of the ITAA The delay in the release of the ruling is to allow the ATO to refine some of the more complex examples to be included in the ruling. Last year an amendment was made to section 94L of the ITAA 1936 to clarify that section 44(1A) of the ITAA 1936 does not operate for the purposes of determining whether a payment made by a corporate limited partnership is a dividend under section 94L. This is to ensure that a corporate limited partnership can effectively return capital to partners. These are steps in the right direction to make the tax outcome of foreign investments by Australian superannuation funds more certain. 4.3 Foreign Hybrids Typically, where an overseas limited partnership constitutes a CFC for Australian tax purposes, the foreign hybrid company/limited partnership regime often applies to the investment. This regime comes with a significant increase in the compliance burden to comply with the technical requirements set out in the Income Tax Assessment Act. Specifically, the foreign hybrid limited partnership provisions deem the relevant overseas limited partnership to be a partnership for tax purposes. 15 means that a net income calculation needs to be prepared for the overseas limited partnership. 16 exercise of calculating the net income for a multi-levelled flow through structure can prove to be difficult. This issue is further complicated where the investment into the overseas limited partnership is made through an Australian unit trust, which is required to distribute either in accordance with the new AMIT regime or Division 6 of the ITAA For example, the true components of the distributed income of the trust may not be known until the net income calculation is determined. This determination is dependent on sufficient information from the overseas general partner/manager of the overseas limited partner. Furthermore, the year-end data required for Australian tax purposes does not generally align with the tax year in the offshore jurisdiction. This means that typically the information which is provided by a general partner of the overseas partnership has not been the subject of a year-end audit. Although it may be possible to obtain a substituted accounting period to align with the offshore limited partnership which would typically ease the timing burden of the Australian year-end compliance process and strengthen the quality of the data received from the overseas counterparty, the ATO s view as outlined in PS LA 2007/21 is that controlled entities (i.e. the overseas limited partnership) should align with the Australian entities. However, again, this causes a significant amount of practical issues, particularly where there are several tiers of entities in the investment structure, some of which are not controlled by Australian entities. This The 15 Income Tax Assessment Act 1936 (Cth) s 94(D). 16 Income Tax Assessment Act 1936 (Cth) s 92. Mark Edmonds and Megan McBain,

12 5 CFC rules The CFC rules broadly operate to include in the assessable income of certain Australian tax residents, on an accruals basis, their share of certain specified income of a foreign company in which they have a controlling interest. Practically, this means that these Australian tax residents are assessed on their share of the CFC s attributable income although they have not actually received any income from the foreign company and may not have the necessary funds to pay the associated tax liability. The policy objective of the CFC rules is to ensure that passive investment decisions of Australian resident taxpayers are not distorted by tax considerations, thereby protecting the Australian tax revenue. 17 In introducing these rules, the Government also understood that compliance and administrative costs should be minimised in achieving this objective Reform of the CFC rules with particular application to superannuation funds Discussions surrounding a reform of the CFC rules commenced in October The various consultation papers and exposure draft legislation to follow proposed various changes to the CFC rules which would largely have addressed the problems created for Australian superannuation funds. That is, they proposed to exempt certain lightly taxed entities, such as complying superannuation funds, from the operation of the CFC rules. It was noted in the July 2010 consultation paper that the Government considered that because complying superannuation funds are only subject to tax at 15%, the benefits received by complying superannuation funds from the deferral of taxation of income earned by the CFCs of the funds would be minimal. 19 The exemption for complying superannuation funds under the proposed CFC rules mirrored the exemption that was available under the former Foreign Investment Funds (FIF) rules. Unfortunately however, following years of discussions and consultations, the Australian Treasury announced in December 2013 that it decided not to proceed with further consultations on the proposed CFC rules. As a result, the problems faced by Australian superannuation funds in respect of the Australian CFC rules persist. 17 The Commonwealth of Australia, Attorney-General s Department, Reform of the controlled foreign company rules (Consultation Paper, Commonwealth of Australia, January 2010), Ibid. 19 Ibid. Mark Edmonds and Megan McBain,

13 5.2 Issues relating to the application of the CFC rules to Australian superannuation funds We have summarised below some of the issues associated with the application of the existing CFC rules to Australian superannuation funds, which may impact upon decisions with respect to making investments offshore Upward attribution problem Under the existing CFC rules, a non-australian company is treated as a CFC at a particular time if the company, at the time, satisfies one of the stipulated control tests at the end of the relevant company s statutory accounting period. Broadly, two of the tests require taxpayers to take into account the aggregate of direct and indirect control interests held by an entity and the entity s associates in the foreign company (the CFC) in determining whether control exists. The definition of an associate in section 318 of the ITAA 1936 is so broad that a foreign company can be regarded as a CFC although no Australian entity has substantial influence or holds a controlling direct or indirect interest in the foreign company. For example, two Australian superannuation funds, Aus Super1 and Aus Super2, each hold a 10% interest in ForSub and the remainder of the 80% interest is held by another foreign tax resident company, ForCo1. ForCo1 also holds a 100% interest in an Australian tax resident company, AusSub, which is unrelated to ForSub and unrelated to Aus Super1 and Aus Super2. ForCo1 Aus Super1 Aus Super2 100% 80% 10% 10% AusSub ForSub In this example, ForSub is not directly controlled by Australian entities as the majority of the interest in ForSub is held by ForCo1. However, ForSub is a CFC under the strict control test as a group of five or fewer Australian entities (being Aus Super1, Aus Super2, and AusSub) holds an associate inclusive control interest of 100% in ForSub, as follows: Aus Super1 has direct control interest of 10% in ForSub; Aus Super2 has direct control interest of 10% in ForSub; and Mark Edmonds and Megan McBain,

14 18 Ibid. ForCo1 is an associate of AusSub as ForCo1 holds a majority voting interest in AusSub. 20 As ForCo1 holds 80% of the interest in ForSub, AusSub has an associate-inclusive control interest of 80% in ForSub. As Aus Super1 and Aus Super2 each hold at least 10% in ForSub, they are each an attributable taxpayer in respect of the CFC and are required to include their respective share of ForSub s attributable income in their Australian assessable income. This issue is commonly known as an upward attribution problem. This problem is not limited to superannuation funds, but with non-portfolio investments by superannuation funds (without necessarily taking control of the foreign assets) rising, a problem increasingly faced by superannuation funds. Australian investors (including superannuation funds), bear the risk of unintended non-compliance, and, where the relevant information is available: bear the burden of calculating the attributable income of the foreign companies under the CFC rules; and must meet the complex record keeping requirements to perform the calculations. The above may be the case despite the fact that the foreign company is not controlled or significantly influenced by any Australian entities The interaction between the CFC rules and the FITO rules In calculating the attributable income of a CFC, section 393 of the ITAA 1936 provides that the CFC should be able to claim, as a notional allowable deduction against its notional assessable income for the relevant period, any foreign tax or Australian tax paid by the CFC is respect of amounts included in the notional assessable income of the CFC for that particular period. Further, the FITO rules deem attributable taxpayers which are Australian resident companies (not superannuation funds, as they are not structured as companies), to have paid the foreign income tax and withholding tax paid by a CFC in respect of the CFC s attributable income that is included in the Australian resident companies Australian assessable income under the CFC rules. As a result, an attributable taxpayer company is entitled to claim the foreign income tax and withholding tax paid by the CFC as an offset against its Australian income tax liability to the extent that the amount in respect of which the tax was paid is included in its Australian assessable income. 21 In the case of corporate attributable taxpayers therefore, the double taxation of the CFC s attributable income from an Australian tax perspective is prevented by virtue of the application of the CFC allowable deduction and the FITO rules. This is not the case for superannuation funds. 20 Income Tax Assessment Act 1936 (Cth) s 318(2)(d), s 318(2)(f). 21 Note that the Australian attributable taxpayers are required to gross up for the tax that the CFC has claimed as an allowable deduction under section 393. Refer Example 1.16 in the Explanatory Memorandum to Tax Laws Amendment (2007 Measures No. 4) Act Mark Edmonds and Megan McBain,

15 It would appear incongruous that an entity that is meant to be taxed concessionally would not receive at least the same income tax offset that is available to an Australian company The interaction between the CFC rules and Division 250 The purpose of Division 250 of the ITAA 1997 is to deny certain capital allowance deductions that taxpayers would otherwise have been entitled to claim in respect of the assets it owns where the assets are put to a tax preferred use and the taxpayer lacks a predominant economic interest in the assets. This is unless any of the exemptions within Division 250 apply. An asset is put to a tax preferred use if the asset is, amongst other criteria, leased to a non-resident and is used wholly or principally outside of Australia. This has considerable impact on the calculation of the CFC attributable income under the CFC rules. For example, consider a scenario where a CFC is a foreign real estate company located in an unlisted country, the tenant of which is a non-resident. Given that the majority of the income derived by this CFC would be rental income (i.e. passive income), the active income test is unlikely to be satisfied. As a result, all of the rental income of the CFC would be attributable under the CFC rules (unless the CFC is a resident of a listed country). For the purposes of calculating the attributable income of that CFC, Division 250 would need to be considered. As the lessees in respect of the CFC s leased properties are non-australian residents, the CFC s properties are put to a tax preferred use and Division 250 would apply to deny the CFC from claiming tax depreciation in respect of the leased properties as notional allowable deductions against its notional assessable income. The Australian investors in the CFC would be required to include their share of the CFC s rental income less any deductible expenses (excluding deductions for tax depreciation deductions) in their Australian assessable income. This is clearly an undesirable outcome and arguably not how Division 250 was intended to apply. It should be further noted that the level of debt which would trigger the application of Division 250 in the context of non-resident entities is lower than that applying to resident property owners. Therefore, the CFC is not only denied the depreciation deduction, but is also disadvantaged when taking out local bank debt in the foreign jurisdiction to gear the investment and to provide a natural hedge against currency fluctuations. An outcome which also defies policy consideration arises where the Australian investor funds the acquisition by internal debt, lowering foreign tax but returning the income as taxable income to Australia. The internal funding may again cause the application of Division 250. That outcome can be avoided by reducing the debt level and paying more tax overseas, which cannot be in line with Australian policy considerations. It is noted that the above application of Division 250 is equally relevant to assets held in a foreign trust or foreign partnership where a net income calculation determined under Australian tax law is required. Mark Edmonds and Megan McBain,

16 6 Treatment of superannuation funds under Double Taxation Agreements (DTA) Not all DTAs that Australia has entered into specifically include an Australian superannuation fund as a resident of Australia for the purposes of the DTA. Further, it is not clear in all DTA s that superannuation funds are recognised as the beneficial owner of amounts of income paid to them, for the purposes of qualifying for reduced withholding tax rates prescribed by the treaties. As such, there are circumstance where Australian superannuation funds may technically be subjected to higher rates of withholding tax on distributions from certain countries, than would be the case if such distributions were made to Australian companies. For example, ASFA notes in their submission with respect to consultation on Australia s tax treaty negotiation program that: Taiwan takes a look through approach to establishing the beneficial owners of the income and requires Australian superannuation funds to provide additional, detailed and extensive documentation in respect of funds underlying members. In the case of our largest superannuation funds, this would require the provision of details for more than 1 million members which may not be practical or possible due to the operation of privacy laws. It may be appreciated that, unless the quantum of dividend income from these jurisdictions is very large, the compliance costs in obtaining this documentation may easily outweigh the potential benefits from the application of the lower withholding tax rate specified in the treaty. 22 The UK/US double tax treaty for example, specifically includes a pension scheme as a resident of a Contracting State for the purposes of the treaty. Further, payments of dividends to a pension scheme of either country will not attract withholding tax. Earlier this year, the OECD invited public comments on a discussion draft that included proposals for changes to the OECD Model Tax Convention concerning the treaty residence of pension funds. This discussion draft included draft changes to Articles 3 and 4 of the OECD Model Tax Convention, and to the Commentary on these Articles, that will ensure that a pension fund is considered to be a resident of the State in which it is constituted for the purposes of tax treaties. As treaties are renegotiated, Australian superannuation funds should be specifically included as entities that can benefit from DTA s, and importantly, they should be recognised as being capable of being the beneficial owner of amounts of income they receive. Further, there would seem to be no compelling reason why Australia should not seek to include an exemption in its treaty negotiations for withholding taxes on dividends and interest income. Indeed, Australia already provides exemption from withholding tax in section 128B(3)(jb) of the Act, for payments of interest and dividends to exempt foreign pension funds. 22 ASFA, Submission to Treasury, Australia s tax treaty negotiation program, 8 August 2014, 2. Mark Edmonds and Megan McBain,

17 7 US FIRPTA Rules Broadly speaking, non-residents for US tax purposes are subject to US tax on amounts which constitute effectively connected income ( ECI ) or fall within the meaning of fixed, determinable, annual or periodic income ( FDAP ). 23 The Foreign Investment Real Property Tax Act of 1980 (FIRPTA) treats disposals of US Real Property Interests 24 as effectively connected income for the purposes of US tax 25 by virtue of section 897(a)(1) of the Internal Revenue Code of The key property interests caught by FIRPTA include: US Real Property interests; and US Real Property Holding Corporations 27. By way of background, the FIRPTA Act came into being on 5 December Leading up to the introduction of the FIRPTA Act, there was said to be a growing perception within the United States that foreign residents had an unfair tax advantage on investments in US real property compared to US residents. Prior to the introduction of FIRPTA, there was an increasing number of US real properties being acquired by foreign residents, particularly in the farming sector, 29 but also some of the landmark buildings in Manhattan were being acquired by foreign residents. 30 Accordingly, on 5 December 1980, FIRPTA was enacted which caused disposals of US Real Property Interests from 18 June 1980 to be caught within the US tax net. Interestingly, in a bid to encourage private investment in America s infrastructure, the office of the Press Secretary, White House, recognised that foreign pension funds considered FIRPTA as an impediment to investment in US infrastructure and real estate assets. Noting that US pension funds are generally exempt from US tax upon the disposition of US real property investments, the Administration proposed to put foreign pension funds on an equal footing by exempting foreign pension funds from US tax under FIRPTA Section 871(a) and Section 881(a) of the Internal Revenue Code of Section 897(c) of the Internal Revenue Code of Section 897(a) of the Internal Revenue Code of Edward J. Hawkins and Robert J. Eidnier, Taxation of Canadian Investment in United States Real Estate, 8 Can.-U.S. L.J. 1 (2016). 27 Section 897(c) of the Internal Revenue Code of Public Law STAT Petkin, Lisa B (1982) The Foreign Investment in Real Property Act of 1980, Penn State International Law Review: Vol.1: No.1, Article 2, 11, Knakal, R FIRPTA Changes Could be Great for Investment Sales, (3 February 2016), Commercial Observer < 31 Office of the Press Secretary, The Rebuild America Partnership : The President s Plan to Encourage Private Investment in America s Infrastructure, (Statement and Releases, 29 March 2013). Mark Edmonds and Megan McBain,

18 As such, an exemption from FIRPTA for qualified foreign pension funds or wholly owned entities of qualified foreign pension funds was introduced by the Protecting Americans Against Tax Hikes Act of 2015 (PATH Act) at Section What is a qualified foreign pension fund? A qualified foreign pension fund is defined in Section 897(l) of the IRC as follows: 1. Qualified foreign pension fund. For purposes of this subsection, the term qualified foreign pension fund means any trust, corporation, or other organization or arrangement-- (A) which is created or organized under the law of a country other than the United States, (B) which is established to provide retirement or pension benefits to participants or beneficiaries that are current or former employees (or persons designated by such employees) of one or more employers in consideration for services rendered, (C) which does not have a single participant or beneficiary with a right to more than five percent of its assets or income, (D) which is subject to government regulation and provides annual information reporting about its beneficiaries to the relevant tax authorities in the country in which it is established or operates, and (E) with respect to which, under the laws of the country in which it is established or operates-- i. contributions to such trust, corporation, organization, or arrangement which would otherwise be subject to tax under such laws are deductible or excluded from the gross income of such entity or taxed at a reduced rate, or ii. Taxation of any investment income of such trust, corporation, organization or arrangement is deferred or such income is taxed at a reduced rate. As one can see, the definition of a qualified foreign pension fund is very prescriptive. Many industry groups, including the National Association of Real Estate Investment Trusts (NAREIT) (a worldwide representative body for REITs and publicly traded real estate companies with an interest in US real estate and capital markets) have made submissions 33 in a bid to encourage further clarification from 32 Section 897(l)(1)(B) of the Internal Revenue Code of National Association of Real Estate Investment Trusts, Submission to Internal Revenue Service, Notice : Request for Comments Regarding Recommendations for Items that Should be Included on the Priority Guidance Plan, Mark Edmonds and Megan McBain,

19 US Treasury and the IRS on the meaning of qualified foreign pension funds and specifically alerts the IRS to the US-Australia FATCA Agreement definition of an Australian Retirement Fund. 34 From an Australian context, clarification is required to determine whether Australian superannuation funds would fall within the definition of a qualified foreign pension fund. While each Australian superannuation fund has its own facts and circumstances, there are key issues with the qualified foreign pension fund definition which most Australian superannuation funds would have. It is clear that Australian superannuation funds may provide a wider range of benefits than contemplated by Section 897(l) of the Internal Revenue Code of For example, one of the requirements under the definition of QFPF requires that the pension fund be established to provide retirement or pension benefits to participants or beneficiaries that are current or former employees. This requirement does not seem to reflect the broad member base of Australian superannuation funds, which can include member s spouses. Similarly, the benefits provided by an Australian superannuation fund may not necessarily be retirement benefits, for example, income protection may be a benefit paid to a member by a superannuation fund, or total and permanent disability payments. Again, the benefit payments available under an Australian superannuation fund, seem to be broader than narrow benefit types contemplated within the definition of QFPF which references merely the provision of retirement or pension benefits. The PATH Act provisions also provides the Secretary with the ability to prescribe regulations as may be necessary or appropriate to carry out the purposes of Section 897(l). However, at the time of writing this paper, there has been little guidance or movement by the IRS/Congress on the release of further guidance. Given it is US presidential election year, there is a risk that clarification on the definition of a QFPF is not a high priority for Congress. 34 National Association of Real Estate Investment Trusts, Submission to Internal Revenue Service, Notice : Request for Comments Regarding Recommendations for Items that Should be Included on the Priority Guidance Plan, 23. Mark Edmonds and Megan McBain,

20 8 Base Erosion and Profit Shifting (BEPS) The topic of Australian superannuation funds investing in entities located in low tax jurisdictions such as the Cayman Islands has been the subject of recent commentary in the press, mainly as a result of being raised in Question Time in the last 12 months in the context of the Labor Party s attack on Prime Minister Malcolm Turnbull s personal investments. The purpose of this paper is not to recount the commercial reasons why Australian superannuation funds invest in Funds located in jurisdictions such as the Cayman Islands, as readers of this paper will be understanding of these reasons. However, it is important to differentiate between those investments made in Funds located in low tax jurisdictions to those investments to which the Base Erosion and Profit Shifting (BEPS) regimes being implemented around the world are designed to capture. BEPS refers to tax avoidance strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations. Under the inclusive framework, over 100 countries and jurisdictions are collaborating to implement the BEPS measures and tackle BEPS. The OECD/G20 BEPS project was largely finalised in October The broad objective of this project was to reform the global tax rules on a multi-lateral basis. However, in the meantime, numerous countries, including Australia, have taken unilateral action. In this year s Federal Budget, the Government announced that it will implement the OECD developed anti-hybrid rules with some minor modifications as recommended by the Board of Taxation in its report to the Government. The Australian anti-hybrid rules will apply to payments made on or after the later of 1 January 2018 or six months after the relevant law is enacted. As a general rule, pre-existing arrangements will not be grandfathered nor will transitional rules be introduced. This prospective start date is welcomed news as there is considerable complexity with the OECD developed anti-hybrid rules. Whether such rules will impact Australian superannuation funds will need to be determined on a case by case basis. Indeed, the recommendations included in the 458 page OECD paper on anti-hybrids is largely drafted by reference to example transactions. Whilst it is difficult to analyse the potential impact of the anti-hybrid rules without legislation, the rules should be closely monitored by Australian superannuation funds, especially in the case where outbound structures have the effect of Funds receiving a FITO for foreign taxes paid. That is, whilst Australia may view certain foreign entities as transparent, the foreign jurisdiction may see such an entity as opaque. However, this outcome in itself should not necessarily mean that the anti-hybrid rules apply. Whilst there does not appear to be an on-point example in the OECD s anti-hybrid paper by reference to a fully transparent structure from the Parent jurisdiction perspective, we set out in Appendix A an example from the paper to demonstrate the mischief the laws are aimed at. What this example illustrates is that, in the relevant context, the anti-hybrid rules are primarily aimed at situations where interest deductions are obtained in two jurisdictions and may be offset against a Mark Edmonds and Megan McBain,

21 different income stream. A full deduction for interest expenses in both jurisdictions should be available where the deductions are against income that is taxable in both jurisdictions (so called double inclusion income ). This is often the case with offshore investments by Australian superannuation funds in alternative assets (say a specific property or infrastructure investment) that are geared with both bank debt in the local jurisdiction, and shareholder debt from the superannuation fund itself. There is only one source of income in such cases, and it may be taxed in both jurisdictions. With respect to the ability to claim foreign tax credits, the example also suggests that such credits should be restricted to the tax liability of the net dual inclusion income under the arrangement. Therefore, where the tax liability in the foreign jurisdiction is calculated by reference to the same net income that is also taxable in Australia, then the allowable FITO should be equal to the full foreign tax paid. The question becomes, once the FITO is determined, can excess FITO s be applied to offset against Australian tax payable on other foreign income? This appears to sit outside the OECD s anti-hybrid paper. As we know, in Australia, the rules regarding use of foreign tax credits were specifically amended as recently as 2008, such that all foreign income forms one class and all tax arising in respect of that income is available as a FITO to reduce Australian tax payable. Any departure from this would require an amendment to rules implemented as recently as Mark Edmonds and Megan McBain,