Tax Brief. 29 May New International Tax Measures. Re-written Interest Withholding Tax Exemption. Background

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1 Tax Brief 29 May 2007 New International Tax Measures The Government introduced the Tax Laws Amendment (2007 Measure No 3) Bill 2007 ("the Bill") into Parliament on Thursday 10 May. The Bill contains a collection of diverse legislative amendments designed to give effect to various announcements and Press Releases - including proposals which had been announced in the Budget only 2 days before. The Bill was referred to the Senate Economics Committee for a report by 6 June. It is not clear whether that process will lead to any significant changes. This Tax Brief examines five of the more significant international tax measures contained in the Bill: the re-written amendments restricting access to the exemption from interest withholding tax; the imposition of a withholding obligation under the pay-as-you-go (PAYG) regime on various distributions from Australian managed funds; the imposition of tax on a resident trustee where a non-resident beneficiary is the trustee of another trust; rules to mesh the system for taxation of trust income and the conduit foreign income measures; and a provision extending the period during which a taxpayer can defer having to apply the International Financial Reporting Standards for the purposes of the thin capitalisation rules. Re-written Interest Withholding Tax Exemption The Bill proposes amendments to the current exemption from interest withholding tax ( IWT ) for payments to non-residents under certain debt interests. These changes have been a long time coming. Indeed, there has already been one false start; this is the second attempt to draft the amendment that Treasury wants to secure. Background

2 Under current law, interest payments to non-residents can enjoy the benefit of an exemption from IWT under section 128F of the Income Tax Assessment Act 1936 if the instrument is offered in a way that meets certain conditions, and either: is in the form of a debenture; or meets the definition of a debt interest under the debt-equity rules. The addition of the debt interest option was made in 2005 to align the IWT rules with the debt-equity rules already in the legislation. However, in early 2006, Treasury began discussions on a proposal to wind back the exemption from IWT just to instruments in the form of a debenture and to dividends on shares that were re-characterised as debt interests. In Treasury s view, the 2005 expansion to permit the possible exemption of interest on any kind of debt interest for example, an interest-bearing account with an Australian financial institution had been a drafting mistake. Industry groups made detailed submissions to Treasury recommending modifications and qualifications to the proposal, particularly in relation to syndicated loans and the transitional rule for the new test. Nevertheless, the Government proceeded to release amendments largely giving effect to the original Treasury proposal in December 2006 in Tax Laws Amendment (2006 Measures No 7) Bill The release of the Bill prompted renewed and ultimately more fruitful discussions directly with the Government and eventually those provisions were excised from the Bill in March 2007 so that the balance of the Bill could be passed. The Revised IWT Exemption The Bill contains a second attempt to re-write the test for access to the exemption from IWT. It re-asserts Treasury s preferred position that an exemption from IWT is available only if the instrument is a debenture, with only two exceptions: dividends on non-equity shares and interests in certain syndicated loans. So, under the revised test, in general terms, the benefit of the exemption from IWT will now be available for payments made by resident companies which are: 1 interest paid on debentures, where the issue of the debenture satisfies the public offer test. (This is the familiar IWT exemption that has been in operation, with modifications, since 1971 and remains unaffected by the Bill); 2 dividends paid on shares that are re-classified as debt under the debt equity tests, where the share issue satisfies the public offer test. (These dividends currently qualify for an IWT exemption and will remain unaffected by the Bill); and 3 interest paid on syndicated loans exceeding $100m, where the invitation to participate in the syndicate satisfies an adapted public offer test and other tests. 2 New International Tax Measures

3 A corresponding exemption from IWT is also made available to the trustee of an eligible unit trust and for payments made in similar circumstances by non-resident companies in carrying on business through a branch in Australia. The Bill also inserts a power for additional debt interests which are not issued in the form of a debenture to be added by regulation. The power applies to instruments issued by companies or trusts. $100m Syndicated Loans Much of the Bill involves setting up the conditions for access to an IWT exemption for multi-lender syndicated loans where the total initial commitment available to the borrower is at least $100m. The Bill requires that there be a written agreement, which is labelled by the parties as a syndicated loan or a syndicated loan facility and that involves multiple lenders that severally lend to the borrower it may be established with just one lender, but there will need to be more for the exemption apply. An arrangement will not usually qualify as a syndicated loan if there are 2 or more borrowers, unless the borrowers are associated. The Bill adapts the public offer test to make it applicable to syndicated loans. Under this test, the issuer must either invite at least 10 non-associated financial institutions to participate in the syndicate or else widely advertise the syndicate to financial markets by electronic means. Either can be done using a broker or underwriter. Commencement The new rules apply to payments under instruments issued on or after 7 December 2006, the date of introduction of the first version of these rules into Parliament. Where amounts are drawn down after 7 December 2006 under loan facilities that existed at that date, or there is a novation of an existing facility after 7 December, different transitional rules apply. Current law and ATO practice views each draw down of an amount under an existing credit facility as amounting to a new loan. Similarly, ATO practice views the purchase of an interest in a syndicated loan as amounting to a new loan. (This arises principally from the fact that under the terms of syndication agreements the substitution of the purchaser for the original lender is usually effected by novation of the original loan.) Hence, the draw down after 7 December 2006 of additional funds under an existing credit facility, or the sale after 7 December 2006 of an interest in a syndicated loan, would give rise to a new debt interest, which would not be entitled to the benefit of any existing immunity from IWT and which might not qualify for exemption under the new test in this Bill. So, where amounts are drawn down after 7 December 2006 under written loan facilities that existed at 21 March 2005, or there is a novation of a 3 New International Tax Measures

4 written loan facility that existed at 21 March 2005, any payments made under the agreement will still be entitled to keep the benefit of any current IWT exemption to which the non-resident might be entitled. New PAYG Withholding Regime for Managed Fund Distributions to Foreign Residents Background The Bill proposes a new PAYG withholding regime for collecting amounts from distributions of certain types of Australian source income paid by managed funds to foreign residents. This measure will be very significant to the managed funds industry, principally listed property trusts, although wholesale funds and funds in sectors other than property will need to monitor their exposure. Under current collection provisions (modified by the provisions next discussed), a trustee is assessable and must pay tax on a beneficiary s share of the net income of the trust if the beneficiary is a foreign resident at the end of the income year. The rate of tax payable by the trustee depends on whether the foreign resident is a company (30%), individual (29% - 45%) or trustee (currently nil). The same rules apply to private trusts as to managed funds. The amendments will change the collection process by substituting a PAYG withholding regime at the corporate tax rate (currently 30%) on various components of payments made by certain types of trust to certain classes of recipient. This withholding will replace the tax currently assessed on the trustee. In practice, many trust distributions are paid by fund managers to Australian intermediaries (rather than directly to the non-resident investor) and difficult questions can arise about the nature of the relationships between the fund manager, foreign investors and any Australian intermediary, and their impact upon the trustee s obligations. Under the new regime the liability to withhold can be shifted by the managed investment fund onto an intermediary if the intermediary meets certain conditions and the managed investment fund gives a notice to the intermediary of its decision to do so. The operation of the new withholding depends on three key definitions: 1 the paying entity is a managed investment trust or in some cases, an intermediary; 2 withholding only needs to be made from a fund payment; and 3 withholding only need be made from payments made to certain kinds of recipient. Payers Intermediaries 4 New International Tax Measures

5 The PAYG withholding regime can operate differently where fund payments are made by the trustee of the managed investment trust to a resident intermediary, which then pays an amount to the foreign resident. In this situation, the managed investment fund can eliminate any exposure to withhold. To qualify as an intermediary in respect of a payment, the entity must, at the time of receipt of the payment: be an Australian entity; be carrying on business which consists predominantly of providing custodial or depository services pursuant to an Australian financial services licence; and have received a notice (from the trustee of the managed investment trust) in relation to the payment. The status as an intermediary is confined to only those entities which are licensed in Australia to provide custodial or depository services. Trading banks or other collection agents will not ordinarily qualify. A decision whether an entity qualifies as an intermediary must be made on each occasion that a fund payment for a year is made. The notice to the intermediary should set out information that would enable the intermediary to calculate the amount it will need to withhold when it on-pays the amount received to a foreign resident. It will also specify the income year of the paying managed investment to which the relevant fund payment relates. It is not mandatory for the managed investment trust to give a notice to an intermediary. Failure to provide a notice to an intermediary will mean that the withholding obligation would not apply to the intermediary when it on-pays the payment or credits it to the account of the non-resident investor. (Any liability to withhold would remain with the managed investment trust, but since, in many cases, the managed investment trust is paying a resident, it may not have an obligation to withhold.) How this system will work out in practice is not entirely clear. While the regime appears to leave the matter in the hands of the trustee of the managed investment trust, it is likely that custodians would insist on managed funds preparing the notice and paying amounts to them free of withholding. Alternatively, fund managers may decide to prepare periodic distribution statements in a way which routinely provides all of the relevant information (and consequently attempts to absolve the trustee from any liability it might have to withhold). Fund Payment Despite the impression that may have been conveyed so far, the withholding regime is likely to have the highest impact in the property sector. In so far as non-property trusts are caught up in the withholding net, withholding would be 5 New International Tax Measures

6 imposed on a relatively small portion of each cash distribution or reinvested amount. The trustee does not simply withhold an amount at the stipulated rate from the gross cash payment or re-invested amount. Rather, in general terms, the trustee must withhold from a payment to the extent that it represents a share of the net income of the trust, is attributable to Australian sources or is a capital gain made on taxable Australian property, and is not already subject to the existing withholding tax regime for dividends, interest and royalties. Limiting the withholding just to a share of the net income of the trust means that cash amounts distributed or reinvested in excess of the net income of the trust estate are not subject to withholding. In other words, no amount need be withheld from cash distributions attributable to tax deferred amounts earned by the trust. Secondly, the trustee need not withhold under this regime to the extent that the payment represents trust income that is dividends, interest and royalties. These payments are excluded from this new withholding regime presumably because existing withholding rules already require the trustee to withhold from these amounts and at different rates. (It is this exclusion which will remove many share trusts and cash management trusts from the new regime.) Thirdly, foreign source income, and capital gains made on assets that are not taxable Australian property, are also not liable to withholding. But, where a payment includes an Australian capital gain which is liable to withholding, the withholding must be made on the undiscounted amount of the gain. Notice finally that there is an important timing dimension to the definition. An amount will be a fund payment provided it is made no later than 3 months after the end of an income year. So, interim distributions made during the income will be fund payments, as will a final distribution, but only if the final distribution is made by 30 September (for a trust with a 30 June year end). A final payment made 5 months after the end of income year is not a fund payment and so is not liable to withholding! While this might seem odd, the consequence is that the trustee is made liable to pay tax by assessment at 46.5% on the undistributed share of net income. (There appears to be no similar time requirement where a managed investment trust pays an amount free of withholding to an intermediary; the intermediary only needs to withhold if and when it pays an amount to the investor.) This regime will force managed investment trusts to make a full distribution of net income within 3 months after the end of its income year. This will be especially significant for trusts that currently retain some net income, where there is some delay in determining the net income of the trust, or where there are subsequent amendments to the accounts which disclose further net income after the 3 month period. It is worth mentioning that the Commissioner does have a discretion to extend the 3 month period and these might be appropriate circumstances to exercise the discretion. 6 New International Tax Measures

7 The new system will also require some careful judgments and accurate predictions to be made in determining the amount to be withheld by trustees of managed investment trusts. First, the amount that must be withheld is based on a share of the net income. This means that expenses must be calculated and attributed to various classes of income. The definition says that deductions relating to dividends, interest and royalties are to be disregarded in determining the amount of fund income. Secondly, if interim distributions are made during the income year, the trustee must predict the future. The regime will, in effect, require the trustee to estimate at the time of the first payment the total net income of the trust estate for the entire year, and the composition of that net income, and to predict what other fund payments will be made by the trust during the year. Thirdly, where additional interim distributions are made during the income year, the trustee apparently has to revisit its prior computations and continually reassess what needs to happen for this payment, in light of what has happened for past distributions. Payment Recipient The requirement to withhold will be triggered where: the managed investment trust makes a payment to a recipient and at that time the recipient is a foreign resident; the managed investment fund makes a payment to the recipient and has reasonable grounds to believe that the recipient is a foreign resident; or the managed investment fund makes a payment to the recipient, it has no reasonable grounds to believe the recipient is an Australian resident, and either the recipient s address is outside Australia, or the payer is authorised to make the payment outside Australia. The formulation in the Bill is not especially comforting. Trustees might expect to be made liable to withhold if they are paying someone they suspect to be a foreign resident, or if they are paying abroad and have not made inquiries. But, under the current formulation, trustees are not immunised against liability if they are paying to an Australian address or if they have made inquiries, if the beneficiary happens in fact to be a non-resident! No withholding is required for a payment made by the trustee of a managed investment trust to an intermediary. The intermediary is required to withhold if and when it makes a payment to the non-resident investor. The rule will therefore trigger difficult questions about whether payment has occurred apart from a physical flow of funds to the non-resident for example, if the custodian credits the distribution to an account it operates for the non-resident, reinvests the 7 New International Tax Measures

8 distribution, or if the intermediary applies some of the distribution toward the custodian s fee. Credits for Amounts Withheld Unlike the withholding tax on dividends, interest and royalties, this PAYG withholding regime is not a final liability on gross payments. This means that nonresidents with expenses in earning the trust income or with a lower marginal tax rate than 30% (principally non-resident individuals) can file an Australian tax return and claim a refundable credit for the Australian tax withheld against their actual Australian tax liability. Interaction with Existing Assessing Provisions It was mentioned above that under current law, a trustee is assessed in respect of the share of the net income of a resident trust to which a non-resident beneficiary is presently entitled. The new withholding regime does not sit well with such a system, so the Bill proposes that the trustee s liability to be assessed on behalf of a non-resident will be eliminated where the withholding regime is triggered the trustee of a managed investment trust will not be assessed if the trustee would have a liability to withhold if there were a distribution of that amount. In order to make the withholding regime work properly, the beneficiary will instead be liable to include the amount from which withholding was collected in its assessable income. Making the beneficiary liable to tax on this amount allows the beneficiary to claim its refundable tax credit for the amount withheld by the trustee under the new withholding regime. But there is an important elaboration to deal with the situation where the trustee does not distribute the share of the trust s net income within 3 months of the end of the income year, with the effect that the withholding regime is not triggered. The Bill provides that if the trust s net income is not fully distributed within 3 months after the end of the year of income, the income will be treated as income to which no beneficiary is entitled. Deeming this position to arise re-imposes tax on the trustee (and reverses the tax on the beneficiary), and imposes tax at the rate of 46.5%, on the undistributed amount. This tax cannot be reversed or credited by the beneficiary if the trustee subsequently makes a supplementary distribution, although the beneficiary should not thereafter be assessable on the distribution. Commencement This measure will apply to the first income year beginning on or after 1 July following Royal Assent. Assuming the Bill receives Royal Assent before 30 June of this year, that will mean the income year commencing on 1 July 2007 (for trusts with a 30 June year end). 8 New International Tax Measures

9 That raises the issue of managing the transition from the old system to the withholding regime that is, distributions made after 1 July 2007 of net income derived in the year of income. It is not clear from the text whether the new measures apply to all distributions occurring after the Bill receives Royal Assent, or only to distributions (made after that date) of income earned after the date of Royal Assent. This uncertainty will need to be resolved quickly, given that some managed investment trusts may be making final distributions for the current year shortly after 1 July Non-Resident Beneficiaries of (other) Resident Trusts Background A third and related measure in the Bill is designed to deal with other kinds of trusts that have non-resident beneficiaries. It extends a trustee s tax liability in relation to income to which a non-resident beneficiary is entitled where that beneficiary is itself the trustee of another trust. Under current legislation, a trustee is liable to pay tax on a share of the net income of a trust to which a non-resident beneficiary is entitled where the nonresident beneficiary is a company or individual. There is, however, no provision which makes the trustee liable to pay tax if the non-resident beneficiary is the trustee of another trust. Proposed Changes A trustee will now be liable to pay tax on any share of the net income of a trust to which a non-resident beneficiary which is a trustee is presently entitled. Withholding regime for managed investment trusts. The new measure will not, however, apply to income which is included in a payment by an Australian managed investment trust or Australian intermediary under the measures discussed above. Hence, this measure tightens the collection regime principally for trusts other than listed or widely held trusts in the property sector. Non-resident trusts. The proposed rules are not limited to imposing tax on the trustees of Australian resident trusts. They will also make the trustee of a nonresident trust liable to tax if the trust has derived income from Australian sources and a non-resident beneficiary which is a trustee is presently entitled. Extending trustee liability to non-resident trustees can cause complications if the income of the non-resident trust was already subject to these rules for example, if a resident trust has earned Australian source income and a non-resident trust is entitled to a share of that income. In order to prevent the double tax imposition, the trustee of a (non-resident) trust in a chain of trusts will not be liable to pay tax on an amount included in the net income of that trust if that amount is reasonably attributable to an amount that has already been taxed in the hands of a (resident) trustee of a trust earlier in the chain. 9 New International Tax Measures

10 Tax Rate Where a share of the net income of a trust is assessed to the trustee under the new provisions, the tax rate will be the top personal marginal rate for individuals (currently 45%). It might have been hoped that an amendment like this would make life easier for trustees where the non-resident beneficiary is a kind of entity that is difficult to characterise under Australian law for example, how to classify entities that resemble trusts but are formed in civil law countries which do not acknowledge trusts. However, because the rate of tax imposed on the trustee varies with the identity of the beneficiary (companies 30%, and trustees 45%), it will still be necessary to distinguish and properly classify the status of foreign entities for the purposes of this regime. Credit for Tax Paid by the Trustee Where a trustee is assessed on a share of trust income to which a non-resident beneficiary is entitled, the legislation currently provides that the non-resident beneficiary is also assessable on the same amount. Therefore, the non-resident can file an Australian tax return and claim a refundable credit against its tax for the tax paid by the trustee. The same system will be extended to the tax imposed on trustees by this new measure. The tax paid by a trustee in relation to the non-resident beneficiary will not be a final tax; the beneficiary may file a return and deduct from its tax liability the tax paid by the trustee on that amount and will be entitled to a refund for any excess tax. This will be significant if the non-resident has incurred expenses in earning the income derived through the trust. Date of Commencement The measures will apply to the income of a resident trust derived during and after the income year, regardless of when the Bill is passed. So, once the Bill is passed and receives Royal Assent, trustees will have had an obligation to pay tax under these provisions for any year of income commencing on or after 1 July Conduit Foreign Income Background Australian tax law currently contains measures (the so-called conduit foreign income rules) designed to relieve non-residents of Australian income tax and withholding tax on foreign source income that flows via an Australian company (or series of companies) to the non-resident. Typically, Australian income tax will not be collected from the resident company because it derives foreign source income that is exempt from Australian tax or enjoys a foreign tax credit, but because no Australian tax has been paid, if this income were to leave Australia, it would be as 10 New International Tax Measures

11 an unfranked dividend liable to dividend withholding tax. Hence a special exemption from withholding tax is provided for conduit foreign income. This measure does not currently apply to most Australian trusts presumably on the assumption that it does not need to foreign source income earned by an Australian trust to which a non-resident beneficiary is presently entitled is not liable to Australian tax. However, if the trust derives an unfranked dividend from an Australian company unfranked because it was paid by the company out of foreign source income that was exempt from Australian tax or enjoyed a foreign tax credit that income is likely to be treated as Australian source income and so would not be within the scope of the trust tax measure. Proposal The Bill proposes an amendment which will mesh the tax treatment of trusts and beneficiaries with the conduit foreign income measures. The amendment will trigger consequences where a company has designated a distribution to be conduit foreign income that is, a distribution of foreign source income and the designated amount is included in the net income of a trust. Where a non-resident beneficiary is presently entitled to a share of the trust s income, and this includes an unfranked distribution from an Australian company that is designated conduit foreign income, this distribution will flow through the trust to any non-resident beneficiaries without any Australian tax being imposed, either on the trustee or beneficiary. Extension of Transitional Arrangements for Thin Capitalisation Rules The Bill also gives legislative form to one of the announcements in the 2008 Budget: that the transitional period during which a taxpayer may elect to continue using the accounting and prudential standards that applied prior to 1 January 2005 for thin capitalisation purposes (instead of the Australian International Financial Reporting Standards) has been extended by an additional year. Affected entities may now make up to four consecutive annual elections to use the former accounting or prudential standards commencing in the first income year beginning on or after 1 January For entities with a 30 June year ending, this will be income years up to and including the tax year ending 30 June Further details of this measure are available in our Tax Brief on the Budget. 11 New International Tax Measures

12 For further information, please contact Sydney Melbourne Michael Moschner michael.moschner@gf.com.au Richard Buchanan richard.buchanan@gf.com.au G&F document ID _15.docx These notes are in summary form designed to alert clients to tax developments of general interest. They are not comprehensive, they are not offered as advice and should not be used to formulate business or other fiscal decisions. Liability limited by a scheme approved under Professional Standards Legislation Greenwoods & Freehills Pty Limited (ABN ) Sydney ANZ Tower, 161 Castlereagh Street, Sydney NSW 2000 Australia Ph , Fax Melbourne 101 Collins Street, Melbourne VIC 3000, Australia Ph Fax Perth QV.1 Building, 250 St Georges Terrace, Perth WA 6000, Australia Ph Fax New International Tax Measures