Tax Brief. 23 April Investment Manager Regime Element 3. 1 Background

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1 Tax Brief 23 April 2013 Investment Manager Regime Element 3 Treasury has released an Exposure Draft of the legislation needed to enact Element 3 of the Investment Manager Regime. The major beneficiaries of this measure will be foreign fund managers who trade in Australian debt and equity securities for their investors. This Tax Brief examines the main provisions of the Exposure Draft, its principal effects and some of the issues that it will raise. 1 Background The background to these measures is usually said to be in the Johnson Report in November That Report drew attention to the complexity of Australia s tax law and claimed that it was a major impediment to non-resident investment funds investing into Australia, via Australia or using the services of Australian fund managers. In fact, ten years earlier, the Ralph Review in 1999 had already noted the imponderable nature of notions of source and whether having fund-related services performed in Australia gives rise to Australian residency or a permanent establishment in Australia. The Johnson Report recommended a dedicated and comprehensive investment manager regime ( IMR ) as a means of addressing the perceived complexity. In the Budget, the Government announced its in principle agreement with the proposals in the Report. Over the 3 ensuing years, the policy and proposals set out in the Johnson Report evolved in important ways. First, the government was convinced that it was desirable to remove, for prior years, the threat of any exposure for foreign funds to the unwanted application of Australian tax law. This was the so-called Element 1 measures (also known as the FIN 48 measures ) enacted in 2012 along with the Element 2 measures provisions designed to remove the potential exposure to Australian tax arising where a foreign fund used Australian resident fund managers. These measures were examined in detail in our Tax Brief available at _International_Tax_Developments_-_17_April_2012.pdf A second elaboration to the Johnson Report proposals occurred during The proposal in the 2009 Johnson Report was simply that,

2 investments in Australian assets [made by a range of offshore retail and wholesale investment vehicles] would for tax purposes be treated the same as if the investments were made directly by the non-resident without the use of any Australian intermediary In other words, non-resident funds would be liable to Australian tax only on Australian-sourced income and capital gains arising from taxable Australian property. However, in December 2011, the Assistant Treasurer announced that, income, gains or losses, which have an Australian source, from portfolio interests or financial arrangements of a foreign managed fund, will be excluded from the calculation of the fund s taxable income (and that of its non-resident investors). This announcement, in fact, picked up a hint in the earlier Henry Review that, the highly mobile nature of some financial services also provides, in theory, a case [for] reducing the source-based taxation of the highly mobile activities undertaken by Australian intermediaries although the Henry Review s eventual recommendation was limited to the less controversial idea of improving the treatment of conduit income. What began as a clarification of the existing law to reduce the complexity that non-resident funds might face if they used Australian managers, especially the exposure to Australian tax on foreign source income became a broader exemption from Australian tax for foreigners investing in certain classes of Australian assets (as well as foreign assets), and available whether or not they used Australian management. This shift in policy now offers non-resident managed funds the ability to earn certain classes of income and gains free from any Australian tax. The major beneficiaries of this measure will be foreign fund managers who make gains from trading in Australian debt and equity securities for their investors. However, it is worth pausing to note that nothing in these measures modifies Australia s existing withholding tax rules. So, income which is in the form of dividends, interest, royalties or distributions from MITs will remain liable to Australian withholding tax. 2 Extending the existing law: in summary The Exposure Draft released by Treasury is built on the provisions already enacted to implement the earlier stages of the IMR, but amends them to broaden the scope of the tax exemption. In summary, the measures enacted in 2012 (which apply from the income year) exempt from Australian tax the income and gains from certain kinds of investments, where the amounts are earned by a widely-held, foreign, managed fund, 2 Investment Manager Regime Element 3

3 which engaged an Australian-based financial services intermediary, and the only reason the foreign fund was taxable in Australia was because it had engaged the local financial services intermediary which constituted a permanent establishment. The measure to be enacted is much broader and will exempt from Australian tax the income and gains from certain investments, where the amounts are earned by a widely-held, foreign, managed fund, whether or not the foreign fund engaged an Australian-based financial services intermediary, whether or not the activities of the fund manager would have made the foreign fund a resident of Australia or triggered the existence of a permanent establishment in Australia, and whether or not the income in question would be regarded as sourced in Australia. The new measures will apply from the income year. The Bill also makes a number of technical amendments (for example, to the widely-held test, adding a rule about the start-up phase, permitting active business if carried on outside Australia, and so on all of which are discussed below) which give effect to recommendations made by the Board of Taxation in its report to the Treasurer on the design of the IMR. 3 The detail: delivering the exemption to the foreign fund and its investors The rules already in place address a number of circumstances to accommodate the different vehicles that the foreign investor might have used to structure its investments, and the different tax treatment they attract in Australia and offshore. In all of the structures, two common elements must be satisfied: some form of widely-held investment entity must be involved; and the entity that would ultimately be taxable on the relevant income must be a non-resident. For cases where the investment is made by a foreign company (and thus a separate taxpaying entity), the provisions deliver the exemption from Australian tax to the company. For cases where the investment is made by a foreign trust or partnership (which is assumed not to be a separate taxpaying entity), the provisions deliver the exemption to its beneficiaries or partners provided they are non-residents (and 3 Investment Manager Regime Element 3

4 not trustees or partnerships). It does this by including in the income and capital gains of the non-resident beneficiaries only their share of the non-imr net income and non-imr net capital gain. 4 Requirements Who qualifies As was noted above, at some point in the process an offshore widely-held investment entity (labelled an IMR foreign fund ) must be involved. In order to qualify as an IMR foreign fund the entity must meet a series of tests. The fund will lose its status as an IMR foreign fund if it fails to meet any one of the tests for an income year. Residence. First, the entity must not be a resident of Australia. The Exposure Draft adds the further requirement that the entity must also be a resident of an exchange of information country. This will be difficult to establish in some circumstances. The residence requirement and the focus only on companies, partnerships and trusts as foreign funds creates problems for foreign funds which are essentially contractual in form. These types of funds are common in civil law countries such as Japan. Unless they can qualify as a partnership (for tax purposes, this term covers persons who are in receipt of income jointly) or limited partnership (which are sometimes treated as a company in Australia), they will not qualify as a foreign fund. If they are treated as a partnership or company, they will only qualify as a resident of an information exchange country if they are formed and carry on a business there. Active business. Secondly, the entity must not carry on business other than investing in land primarily for the purpose of deriving rent, or holding or trading in securities. The Exposure Draft Bill: tightens this test by forbidding the IMR foreign fund to control an entity which engages in such activities; but relaxes the test by permitting an IMR foreign fund to undertake (or control an entity which conducts) these kinds of activities if they are undertaken outside Australia. This test may prove problematic. For example, a US managed fund will be disqualified if it has Australian operations which fail the test. It would not be able to quarantine these offending activities by putting them into a separate Australian entity which the US fund manager owned but it might be possible for the US fund manager to address this problem by having its Australian entity owned by another entity in the group. Ownership structure. In order to qualify as an appropriate vehicle, the IMR foreign fund faces two tests: it must meet a widely-held test at all times during 4 Investment Manager Regime Element 3

5 the year of income, and it must not fail a concentration of ownership test (which is being re-labelled, the closely-held test) at any time during the year of income. Much of the Exposure Draft is devoted to fine-tuning these rules. Widely-held test. The foreign entity must be widely held at all times during the year. This test focuses on the types of entity and the number of members it has. A fund can be widely-held if: it is listed on an approved stock exchange; it has at least 25 members. For the purposes of these rules, membership must be traced through any intermediaries which hold interests in the fund to individuals; an individual and their relatives count as one member; and it is not possible to trace to or through discretionary trusts; or the entity is specified in regulations. Hopefully this provision will give some flexibility to the provisions, allowing them to be adjusted without the need for legislation. The track record elsewhere of the government using regulationmaking powers is, however, not encouraging. Concessional rules (discussed below) exist to identify the number of members represented by a foreign life insurance company, superannuation fund or some funds set up by a tax-exempt foreign government agency. The decision to trace through to the underlying individual investors is an important change to the existing rules. This change was made on the recommendation of the Board of Taxation which noted the requirement that funds must have a minimum of 25 members inappropriately exclude from IMR Elements 1 & 2 some funds which use common structures such as "feeder funds" that have large numbers of underlying members. The changes mean that when so-called 'feeder funds' invest in Australia the number of underlying investors in the fund will count towards meeting the requirements to qualify. The widely-held tests for these rules will still differ significantly from the similar tests in the Managed Investment Trust rules. Closely-held test. The second requirement is that ownership of the foreign fund must not be concentrated. This is a two-stage test: no member may hold 10% or more of the foreign fund; and 50% of the ownership interests must not be held by 10 or fewer entities. Again there is a requirement to trace through the holdings of any intermediaries to the individual investors. Concessional rules exist if the intermediary is a foreign life insurance company, superannuation fund or some funds set up by a taxexempt foreign government agency. 5 Investment Manager Regime Element 3

6 Special rules for offshore pension funds, life insurers and government bodies. The legislation contains several important adjustments where an offshore entity is: a foreign life insurance company; a foreign superannuation fund with at least 50 members; or a pension or disability fund set up by a tax-exempt foreign government agency. First, where one of these entities is investing directly, it is deemed to satisfy both the widely-held test and the closely-held test, and thus automatically to be an IMR foreign fund. There is no need to trace through them to underlying owners. Secondly, where one of these entities holds its interest through another fund that is the investor, the rules treat the life company etc. as representing a number of individuals. The number of members is 50 multiplied by the fractional interest in the intermediate fund (rounded up if need be). So, for example, if a foreign life company holds 40% of a foreign fund, the fund has 20 members by virtue of the life company s holding, and needs only 5 more members in order to be an IMR foreign fund. Thirdly, for the purposes of the closely-held test, the interest held by one of these entities is deemed to be held evenly by the putative individuals. So, for example, if a foreign life company holds 40% of a foreign fund, the 20 members it represents each hold 2% of the fund. Start-up and wind-down. Special rules exist to accommodate possible breaches of the definition of IMR foreign fund where the ownership structure during the start-up and wind-down phase of a fund might cause problems. Notification requirements. Two new administrative requirements are added by the Exposure Draft. These rules are onerous and may prove difficult to comply with. The consequences of non-compliance can be significant. One is a requirement that the fund give the ATO every year a notice in the approved form setting out its place of residence and other required information. The penalty for failing to file this form is that the fund cannot be an IMR foreign fund for that year. A fund which is a trust or partnership must give to its beneficiaries or partners an annual notice stating that the fund is an IMR for that year. A financial penalty is imposed for failing to satisfy this requirement. Types of income and investments The object of this regime is to entice foreign fund managers to increase their portfolio investment in Australia and so the measures only apply to various types of passive income and gains from portfolio investments. This outcome is brought about in several steps. 6 Investment Manager Regime Element 3

7 First, as noted above, a fund cannot be an IMR foreign fund if it undertakes active trade or business operations in Australia, or it controls or can control an entity which does. Secondly, the various amounts of IMR income and IMR net capital gains are income and gains derived from holding or dealing in financial arrangements. These will be principally gains from disposing of debt instruments, shareholdings in companies and units in trusts. The Exposure Draft proposes some changes to the basic definition to widen with scope of the exclusion from these measures of investments connected with land in Australia. Thirdly, the current law disqualifies any income or gains that arise where the IMR foreign fund has 10% or more of the investee entity, counting interests held directly and through other intermediaries. The principle of this requirement is being retained but it is being implemented in a different way. The new rules will permit an IMR foreign fund to own more than 10% of an investee but, if it does, the tax exemption will only apply to income or gains from the non-portfolio holding where several conditions are satisfied: most importantly, if the only reason the foreign fund was taxable in Australia was because it had engaged the local financial services intermediary and this triggered the existence of an agency permanent establishment. This rule will have the effect that Australia s current claim to tax gains made on non-portfolio interests in land-rich entities will not be affected. 7 Investment Manager Regime Element 3

8 For further information, please contact Sydney James Pettigrew phone Andrew Mills andrew.mills@gf.com.au phone Andrew White andrew.white@gf.com.au phone Melbourne Perth Toby Eggleston toby.eggleston@gf.com.au phone Nick Heggart nick.heggart@gf.com.au phone G&F document ID _2.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 Level 39 MLC Centre Martin Place 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 Investment Manager Regime Element 3