Privatisation and Infrastructure Australian Federal Tax Framework (January 2017 Draft)

Transcription

1 Privatisation and Infrastructure Australian Federal Tax Framework (January 2017 Draft) QUALIFICATION THIS DOCUMENT IS A DRAFT. IT IS INTENDED TO GENERATE FEEDBACK FROM STAKEHOLDERS ON THE ISSUES IT RAISES RELATING TO THE TAXATION OF INCOME FROM PRIVATISATION AND INFRASTRUCTURE ACTIVITY. 1

2 Contents Introduction Construction of social infrastructure using the securitised licence PPP model Background Structure of a social PPP Income tax treatment of a social PPP Variation involving a progressive securitisation Variations involving Government contributions GST interaction with PPPs Investor structure of the social PPP Tax treatment of the investor s investment into the social PPP Tax treatment upon exit for investors Privatisation of Government businesses into stapled structures Tax treatment of the asset-level structure Cross-staple loan variation The upstream/feeder-level structure Tax treatment of the upstream/feeder-level structure Restructuring and exiting of an investment Other infrastructure-related issues Customer cash contributions / reimbursements Government grants Gifted assets Capitalised Labour Undergrounding power lines Control for the purposes of Division 6C Areas of ATO compliance focus Abuse of PPP structures Illegitimate use of stapled structures Overshoot of land-rich privatisations into stapled structures Fracturing of control interests Satisfaction of MIT requirements Interposition of a Finance Co owned by a Charitable Trust

3 Introduction The Australian Taxation Office (ATO) recognises the increasing importance that infrastructure investment has to the Australian economy. The ATO plays an integral role in facilitating the continuation and expansion of this industry. For this reason, it is our intention to work collaboratively with industry and state governments to: maximise certainty about the way we administer the law; ensure that the tax system is administered in a sensible and pragmatic way, to the extent the law allows; provide assurance to the federal government that an appropriate amount of tax is collected from these transactions; and minimise the compliance costs of bidders, operators and state governments. What this framework is about This framework sets out our overall position on a range of infrastructure-related tax issues. It is not meant to provide the answer to all your questions or explain the tax treatment of every type of transaction you might enter into. Rather, it is a guide on how the tax law will apply in relation to a number of issues. This framework is also intended to be a living document. As new transactions and issues emerge, the framework may have to be updated to reflect them. The same can be said about changes to tax laws that may impact upon the analysis. Unless otherwise stated, all legislative references are to the Income Tax Assessment Act 1997 and any references to a government and its related entities are stylised as Government. How this framework differs to other ATO guidance products This document does not bind us to a particular view of the law. Only taxation rulings, taxation determinations or private rulings can do that. However, if you have transactions that are similar to the transactions outlined in this document, our officers would be expected to follow the overall views set out here. This includes officers that issue rulings as well as those conducting compliance activities. 3

4 Contents of the framework This framework is in four chapters: 1. Construction of social infrastructure using the securitised licence PPP model 2. Privatisation of Government businesses into stapled structures 3. Other infrastructure-related issues 4. Areas of ATO compliance focus 4

5 1. Construction of social infrastructure using the securitised licence PPP model This chapter sets out how the income tax and the Goods and Services Tax (GST) laws apply to a social PPP. This chapter is structured as follows: 1. Background 2. Structure of a social PPP 3. Income tax treatment of a social PPP 4. Variation involving a progressive securitisation 5. Variations involving Government contributions 6. GST interaction with PPPs 7. Investor structure of the social PPP 8. Tax treatment of the investor s investment into the social PPP 9. Tax treatment upon exit for investors 5

6 1.1 Background A social PPP involves a consortium and a Government agreeing that: the consortium will construct and maintain certain social infrastructure; the consortium will obtain the financing for that infrastructure; and the Government will obtain title to and repay the consortium for the infrastructure, plus interest, over a certain period. Examples of the type of infrastructure that may be subject to this arrangement include schools, hospitals, prisons, roads and public utilities. These are different to economic PPPs which involve user fees being used to repay the consortium s cost of construction and financing, rather than payments from the Government. These are not covered by this chapter. 1.2 Structure of a social PPP This part is about: 1. The substance of the commercial relations between the parties involved in a social PPP 2. The transactions actually undertaken between the parties 3. How the flow of funds operates between the parties The substance of the commercial relations The substance of the commercial relations between the parties involved in a social PPP is as follows: 1. An infrastructure asset is built for the Government by a private sector consortium. Depending on the terms of the PPP, the risks associated with the construction of this asset may be partially or completely borne by the private sector. The period of this construction is called the design and construction phase. The private sector also finances the cost of construction during this phase. 2. Once the design and construction phase is complete, the Government: a. owns the asset; and b. starts paying for the cost of construction, plus interest. It progressively pays down the principal and interest over a defined term, akin to an amortising loan. 6

7 3. During the term of the repayment, the private sector consortium also operates and maintains the infrastructure. The risks relating to this phase of the operation are also partially or completely borne by the private sector, depending upon the terms of the PPP. This phase is called the operations and maintenance phase. The consortium is compensated for providing this service by the Government. 4. The consortium may make profits in two ways: a. the amount it receives from the Government for the cost of construction is more than its actual cost of construction (plus the interest incurred while the construction happened); and b. the amount it receives from the Government to operate and maintain the infrastructure is more than its actual costs for these activities The transactions actually undertaken The transactions actually undertaken between the parties are as follows: 1. Two special purpose project entities are established. These are: a. Project Trust carries out the design, construction, operation and maintenance of the infrastructure asset. Project Trust is usually owned by the private sector consortium s members, and it is Project Trust that makes most of the profits from the project. b. Finance Co obtains senior debt for the project. Finance Co may be held by the consortium s members or by a charitable trust. Finance Co generally does not make profits from the project. 2. Finance Co raises external debt in the form of loans or facility agreements for the design and construction phase of the project. This external debt is repaid at the end of the design and construction phase. 3. Finance Co on-lends these funds to Project Trust (the D&C loan), which procures the design and construction of the asset. 4. In terms of Project Trust itself, a project deed is entered into which sets out its obligations to procure the design and construction of the asset and subsequently operate and maintain the asset. 5. Project Trust obtains consideration for entering into the project deed. Specifically: a. it obtains the construction payment from the Government at the end of the design and construction phase; and 7

8 b. it obtains availability payments from the Government during the term of the operations and maintenance phase. 6. At the end of the design and construction phase, Finance Co raises long-term debt for the duration of the operations and maintenance phase (the O&M loan). This is usually with a consortium of banks. 7. Finance Co enters into the securitisation agreement with the Government under which: a. it is assigned the licence payments that Project Trust pays to the Government in step 11(a); and b. Finance Co pays the receivables purchase payment which is financed by the longterm debt raised at step The Government finances the construction payment to Project Trust, described at step 5(a), from the receivables purchase payment it receives from Finance Co. 9. Project Trust uses the construction payment to repay the D&C loan, and Finance Co in turn uses these funds to repay the design and construction financiers (D&C financiers). In some circumstances, the D&C loan and the O&M loan could be the same loan, and in other cases it may be a different loan with different financiers. 10. The Government makes the availability payments, referred to in step 5(b), out of consolidated revenue. These payments are the mechanism by which the Government pays the consortium for the infrastructure asset, plus interest, over the life of the operations and maintenance phase. These payments also compensate the consortium for actually operating and maintaining the infrastructure, and provide the consortium a return on equity. 11. However, because it is Finance Co that actually raised the senior debt, and not Project Trust, a significant portion of the payments the Government made to Project Trust need to find their way back to Finance Co. This is done in two steps: a. The Project Trust enters into a licence agreement with the Government that gives Project Trust the right to access the Crown land the project is to be undertaken on. The licence payments are ostensibly the consideration for the licence agreement, but in reality are calculated to be sufficient for Finance Co to repay the debt it incurred to its external financiers. b. These licence payments are then immediately paid on to Finance Co under the securitisation agreement in step 7(a). In legal terms, the licence payments are securitised by the Government to Finance Co. 8

9 12. The securitisation agreement is important for another reason. It is the mechanism by which the Government originally financed the construction payments to Finance Co in step 5. The financing was done by Finance Co providing the receivables purchase payment to the Government. Legally, this is consideration for the securitised licence payments Finance Co pays to the Government. However, the substance of the securitisation agreement is similar to: a. Finance Co lending money to the Government to have the infrastructure asset designed and constructed - this is the role played by the receivables purchase payment b. once construction is complete, the Government repaying Finance Co for the cost of design and construction, plus interest, over the life of the operations and maintenance phase - this is the role of the securitised licence payments. 13. An equalisation swap confirmation is entered into between Project Trust and Finance Co, under the auspices of an ISDA master agreement, whereby: a. Finance Co s financing costs as modelled at the outset of the agreement are paid to Project Trust; and b. Finance Co s actual financing costs, taking into account any increased or decreased costs of financing as a result of the refinancing of the debt, are paid by Project Trust to Finance Co. The payments under (a) and (b) are netted off against each other. Another way of understanding a social PPP is illustrated in the cash flow diagrams below. 9

10 1.2.3 The design and construction stage 1. Finance Co borrows money from the external D&C financiers in the form of loans or facility agreements. The money may be borrowed entirely up-front or in stages, such as through a facility arrangement. 2. Finance Co uses that money to fund the D&C loan to Project Trust. The interest payments on this loan are capitalised. 3. Project Trust uses that money to fund the design and construction of the infrastructure asset, including payments to the D&C subcontractors. 10

11 1.2.4 End of design and construction Upon the completion of design and construction, the ownership of the infrastructure asset passes to the Government, existing financing unwinds, and new long-term financing put in place. The cash flows to give effect to this are: 4. Long-term loans or facility agreements are entered into with the operations and maintenance financiers (O&M financiers). 5. That financing is used to purchase the securitised licence payments from the Government. The receivables purchase payment is paid in exchange for this. That payment is financed from the borrowing with the O&M financiers. 6. The Government uses the receivables purchase payment to finance the construction payment to Project Trust. 7. Project Trust uses the construction payment to repay the D&C loan with Finance Co, plus interest. 8. Finance Co uses the repayment of the D&C loan to repay the D&C financiers. 11

12 1.2.5 Operations and maintenance stage 9. The Government pays availability payments (also known as service payments or quarterly service payments) to Project Trust over the life of the operations and maintenance phase. The amount of these payments are calculated to be sufficient to: a. cover Project Trust s cost of construction b. cover the interest payments incurred by Finance Co to the external financiers c. pay subcontractors to operate and maintain the infrastructure during the operations and maintenance phase d. provide a return on equity to the consortium members. 10. Project Trust pays some of the money received from the availability payments to subcontractors to operate and maintain the infrastructure and also to fund a return on equity. 11. An amount is paid to the Government in the form of licence payments, calculated by reference to the Government s obligations under the receivables purchase agreement. 12. The licence payments are securitised by the Government and passed straight through to Finance Co by way of a securitisation agreement. 13. Finance Co uses the securitised licence payments to fund the repayment of principal and interest to the O&M financiers. 14. Cash flows under the equalisation swap produce the result that any increase in Finance Co s cost of financing is paid by Project Trust to Finance Co. Any decrease in Finance Co s cost of financing is paid by Finance Co to Project Trust. 12

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14 1.3 Income tax treatment of a social PPP In summary, the income tax treatment of a social PPP is as follows: the loans or facility agreements between the D&C and O&M financiers and Finance Co are financial arrangements to which Taxation of financial arrangements (TOFA) will apply. This means that any loss made by Finance Co from these agreements would generally be deductible on an accruals basis TOFA will also apply to the D&C loan with Project Trust and the securitisation agreement with the Government. This means the agreements will be treated similarly to the loans with the external financiers, and any gain made by Finance Co would generally be assessable on an accruals basis the construction payment and the availability payments will be assessable to Project Trust the licence payments and the payments made to both the D&C and O&M subcontractors are fully deductible to Project Trust TOFA will apply to the D&C loan but not to any of Project Trust s other transactions thin capitalisation will not apply to Finance Co even if the consortium members are nonresidents Project Trust will not be entitled to capital allowances the payments under the equalisation swap will be assessable and deductible to Finance Co and Project Trust subject to the provisos set out below, Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) would not be expected to apply Agreement between the D&C and O&M financiers and Finance Co TOFA applies to the loan or facility agreements with the D&C and O&M financiers because those agreements will be financial arrangements as set out in section There will be a loss from those arrangements under TOFA to the extent that the payments made to the financiers reflect a return on those financiers investment. Unless Finance Co makes an election under Division 230, the accruals or realisation method in Subdivision 230 B will apply to the loss. Except in unusual circumstances, such as the project s viability being unclear or the Government potentially defaulting on its obligations, the accruals method would apply to that loss. 14

15 We will generally accept that the TOFA accruals method could be satisfied by Finance Co relying on the outcome that the effective interest method as set out in AASB 139, as long as this is applied consistently by Finance Co across its financial arrangements The D&C loan TOFA will apply to the D&C loan between Finance Co and Project Trust. There will be a gain for Finance Co from that arrangement under TOFA to the extent that the payments made to Finance Co reflect a return on its investment. Unless Finance Co makes an election under Division 230, the accruals or realisation method in Subdivision 230 B will apply to the loss. Except in unusual circumstances, such as the project s viability being unclear or the Government potentially defaulting on its obligations, the accruals method would apply to that gain. We will generally accept that the TOFA accruals method could be satisfied by Finance Co relying on the outcome that the effective interest method as set out in AASB 139, as long as this is applied consistently by Finance Co across its financial arrangements Securitisation agreement between Finance Co and Government We accept that TOFA will apply to the securitisation agreement. It will apply as though: the receivables purchase payments were the equivalent of a principal investment; and the securitised licence payment was the equivalent of the repayment of that principal with interest. This means that there should be a gain to which the accruals method under TOFA will apply unless the circumstances mentioned above arise. As with the above, we generally accept that the TOFA accruals method could be satisfied by Finance Co relying on the outcome that the effective interest method as set out in AASB 139. This is if the agreement were treated as a loan under that standard, and if it is applied consistently by Finance Co across its financial arrangements Construction payment The construction payment made by the Government to Project Trust constitutes income according to ordinary concepts. It is not capital in nature. As a result, it is assessable income under section 6 5. TOFA will not apply to it because it involves the obligation to procure the design and construction of the infrastructure. 15

16 In determining the timing of the assessability of income, consistent with the ideas and principles set out in IT 2450, a method of accounting which has the effect of allocating, on a reasonable basis, the ultimate profit or loss made by Project Trust in relation to the construction over the years taken to complete the construction, will be acceptable. However, the conditions and provisos around the reasonability and consistency of the method chosen as set out in IT 2450 would similarly apply in this situation. To avoid doubt, the profit on the construction, if any, should emerge over the construction phase, not over the term of the overall project Availability payments Similarly, the availability payments made by the Government to Project Trust constitute income according to ordinary concepts. They are not capital in nature. As a result, they are assessable income under section 6 5. TOFA will, subject to the discussion at Chapter 4, not apply to them Payments to the D&C and O&M subcontractors The payments to the subcontractors are made for Project Trust to fulfil its contractual obligations to build the infrastructure assets, and thus earn the assessable income referred to above. Therefore, the expenditure falls within the first limb of section 8 1. Additionally, the incurring of the construction costs will not result in any tangible asset or enduring benefit for the Project Trust because they are not the legal owner of the infrastructure asset legally the State owns the relevant asset. Therefore, the expenditure does not fall within the capital-related negative limb of section 8 1. The determination of the timing of any deduction to the D&C contractor would need to be done consistently with the timing of the derivation of income as set out in section Construction payment Licence payments The licence payments are purportedly made periodically to secure Project Trust s ongoing right to access the land. Notwithstanding, the payments will be set at a level able to be sold by the state to fund the construction cost. In the context of a social PPP which structures its tax affairs consistently with the overall intent of this information, we will not seek to challenge the contractual characterisation. Project Trust requires access to fulfil its contractual obligations and thereby derive assessable income. Based on the contractual characterisation, the expenditure falls within the first limb of section

17 The recurrent payments meet Project Trust s continuous need to access the land. The payments do not enlarge Project Trust s profit-yielding structure or secure any enduring benefit. As a result, the expenditure does not fall within the capital-related negative limb of section Thin capitalisation Section Section exempts certain special purpose entities from the application of thin capitalisation. Consistent with TD 2014/18, this exemption will generally apply to Finance Co. See also: TD 2014/18 Income tax: can the exemption in section of the Income Tax Assessment Act 1997 apply to the special purpose finance entity established as part of the 'securitised licence structure' used in some social infrastructure Public Private Partnerships?; That said, as set out in Chapter 4, the ATO will generally regard a PPP as high risk if the Finance Co is financed using related party funding. This is because the thin capitalisation rules, due to the exemption in section , will not operate to control the quantum of related party debt the consortium will enter into The equalisation swap Under the equalisation swap, the net: receipts will be assessable to Project Trust and Finance Co payments will be deductible to Project Trust and Finance Co. We do not consider the payments under the equalisation swap from Finance Co to Project Trust to represent an application of income derived. For completeness, we have general concerns with the use of swaps which shift economic returns between entities. Specific guidance should be sought in relation to swaps outside of this limited context Capital allowances Project Trust will not be entitled to capital allowances under Division 40 because: it will not hold any depreciating asset under section 40 40; and even if it did, there would not be a cost for the asset. In relation to the hold question, the reason: item 2 does not apply is because the agreements do not give Project Trust a right to remove any of the infrastructure 17

18 item 3 does not apply is because Project Trust does not use the asset for its own use item 6 does not apply is because Project Trust will not have a right against the state to become the holder of the asset item 10 does not apply is because Project Trust has no legal title to the assets. There will be no cost for Division 40 purposes (section ) because none of the payments, either to the subcontractors or the Government, consists of an amount that is of a capital nature. Neither will there be deductions under Division 43, because the payments do not constitute capital expenditure (subsection 43 70(1)). The fact that there are no capital allowances also means that Division 250 has no application (paragraph (d)) Part IVA If taxpayers adopt the exact structure outlined above, Part IVA would not be generally expected to apply because no aspect of the transaction structure appears to be driven predominantly by tax considerations. There may, of course, be exceptions. In particular, the following aspects of the above transaction structure, without more, would not generally concern us from a Part IVA perspective: the application of the exemption for special purpose entities in section to Finance Co the fact that Project Trust secures greater deductions under section 8 1 than what would be available under Division 43 under a counterfactual in which Project Trust constructs the asset and retains title to it, and transfers it to the Government at the end of the operations and maintenance period. However, the ATO has seen a number of variations on this structure that it regards as high risk. These variations fall into three broad categories: 1. Arrangements attempting to bring forward deductions and/or defer income. 2. Arrangements attempting to disguise capital outgoings as deductible payments. 3. Arrangements which attempt to fragment integrated trading businesses in order to recharacterise trading income into more favourably taxed passive income. These variations are outlined in detail in Chapter 4. 18

19 The ATO discourages taxpayers from entering into structures or transactions that depart from the type set out in this Chapter. To be clear, this means that taxpayers should not enter into transactions of the type described above, or those that possess the features described above or in Chapter 4. However, the ATO acknowledges that there may be other variations that represent a low compliance risk. If such variations are to be proposed, the ATO would want to understand the nature and rationale for this, and expect that you would approach us to discuss your proposal. 19

20 1.4 Variation involving a progressive securitisation A variation on the securitised licence model outlined above is the progressive securitisation model under which: Government pays construction payments to Project Trust during the construction period, according to the achievement of certain milestones; and these construction payments are financed by the receivables purchase payment paid to the Government, and are similarly progressively over the course of the construction period. All of the other aspects of this model are materially the same as the model outlined above. The availability payments are similarly used by Project Trust to finance the licence payments, which in turn are securitised to Finance Co, with Finance Co using those funds to repay the external financiers. This approach minimises the extent to which the Project Trust incurs deductible capitalised interest expenses without having assessable income to set off against those expenses. This causes the Project Trust s carry-forward loss balance to be reduced. In the event there is a change of ownership in the D&C phase, it will reduce the adverse consequences if the Project Trust were to become disentitled to those carry-forward losses Tax treatment of Finance Co Consistent with the previous model, TOFA will apply to the securitisation agreement composed of: the receivables purchase payment that is paid in instalments (similar to a loan being gradually drawn-down); and the securitised licence payments (similar to that loan gradually being repaid with principal and interest). Note that consistent with the accounting treatment of the securitisation, it is not necessary for Finance Co to start accruing, under TOFA, the entire gain it will make from the securitisation agreement from the time the first receivables purchase payment is made. Rather, the gain under TOFA is worked out by applying a rate of return to an outstanding balance. An example of how this is done is provided below. It can be seen from the example below that an accrual only commences once the receivables purchase price is provided. The accrual is calculated only with reference to an outstanding balance rather than the entire gain that is predicted from the arrangement. 20

21 Example: TOFA accrual calculation on a 35-year progressive securitisation Financial model TOFA accrual calculation Year Receivables purchase payment provided ($) Securitised licence payments ($) Net cashflows ($) Opening value ($) TOFA accrual ($) Closing value ($) ,000, ,000, ,000, ,000, ,000,000 5,000, ,967 30,475, ,000, ,000,000 30,475,967 2,901,112 83,377, ,000, ,000,000 83,377,080 7,936, ,314, ,000,000 7,000, ,314,031 10,596, ,910, ,500,000 7,500, ,910,397 10,938, ,349, ,000,000 8,000, ,349,114 11,266, ,615, ,500,000 8,500, ,615,173 11,576, ,692, ,000,000 9,000, ,692,141 11,869, ,562, ,500,000 9,500, ,562,015 12,143, ,205, ,000,000 10,000, ,205,083 12,394, ,599, ,500,000 10,500, ,599,753 12,622, ,722, ,000,000 11,000, ,722,381 12,824, ,547, ,500,000 11,500, ,547,068 12,998, ,045, ,000,000 12,000, ,045,454 13,141, ,186, ,500,000 12,500, ,186,476 13,249, ,936, ,000,000 13,000, ,936,117 13,321, ,257, ,500,000 13,500, ,257,118 13,351, ,108, ,000,000 14,000, ,108,676 13,337, ,446, ,500,000 14,500, ,446,103 13,274, ,220, ,000,000 15,000, ,220,458 13,157, ,378, ,500,000 15,500, ,378,140 12,982, ,860, ,000,000 16,000, ,860,445 12,742, ,603, ,500,000 16,500, ,603,082 12,432, ,535, ,000,000 17,000, ,535,639 12,045, ,581, ,500,000 17,500, ,581,003 11,573, ,654, ,000,000 18,000, ,654,717 11,009, ,664, ,500,000 18,500, ,664,288 10,344, ,508, ,000,000 19,000, ,508,416 9,567,742 91,076, ,500,000 19,500,000 91,076,158 8,669,853 80,246, ,000,000 20,000,000 80,246,012 7,638,894 67,884, ,500,000 20,500,000 67,884,906 6,462,198 53,847, ,000,000 21,000,000 53,847,104 5,125,891 37,972, ,500,000 21,500,000 37,972,995 3,614,780 20,087, ,000,000 22,000,000 20,087,775 1,912,225 0 Totals $100,000,000 $449,500,000 $349,500,000 $349,500,000 21

22 This example assumes that the cash flows occur at the end of each income year. If they occur part way through an income year, there would be a need to apportion the accrual across two income years. It also assumes that Finance Co has chosen yearly accrual intervals under TOFA. This is not a formal election it is something done by Finance Co when filling out its income tax return in a certain way Tax treatment of Project Trust Consistent with the previous model, the construction payments are assessable income of Project Trust. 22

23 1.5 Variations involving Government contributions As part of a social PPP, the Government may provide its own contributions. Here we discuss the forms these contributions may take and their tax outcomes Cash payment that must be used for certain purposes The first type of Government contribution may be the provision of cash to Project Trust on condition that it be used for certain purposes. Contractually, the Project Trust will provide either goods or services to the Government in consideration for a cash payment. Taxation Ruling TR 2006/3 contains the principles for determining whether a cash payment by the Government to Project Trust, on condition that it be used for certain purposes, will be assessable income under sections 6 5 or While it is difficult to generalise, the cash payment is likely to be included in assessable income under sections 6 5 or on condition that it be used: as part of the design and construction of the asset; or as part of the operations and maintenance of the asset. In working out the timing of the recognition of this income, a method of accounting which has the effect of allocating, on a reasonable basis, the ultimate profit or loss made by Project Trust in relation to the construction over the years taken to complete the construction, consistent with the ideas and principles set out in IT 2450, will be acceptable. However, the conditions and provisos around the reasonability and consistency of the method chosen as set out in IT 2450 would similarly apply in this situation. There may be capital gains tax (CGT) implications if the payment is not assessable under sections 6 5 or See also: TR 2006/3 Income tax: government payments to industry to assist entities (including individuals) to continue, commence or cease business Payment on completion of design and construction Another type of contribution involves the Government contractually incurring part of the cost of construction on its own account. In this situation it will not include the value of that contribution in the availability payments made to the Project Trust. Examples of this would include the Government incurring the costs for the entry ramps on a toll way and the parking around a football stadium. The Project trust will then be responsible for the maintenance of both the part of the infrastructure funded by the Government and the part funded by itself. 23

24 Unlike example the amount of the Government contribution does not form part of the assessable income of the Project Trust. In these instances it is appropriate to treat the construction like a joint venture and the Project trust would only treat as part of its profit the amount attributable to its portion of the infrastructure. The critical point of distinction between and is that in the Government contribution is a contractual payment to Project Trust for goods or services whereas in the Government contribution is on the account of the Government and no tax benefits or attributes pass to the Project Trust as a consequence of the Government contribution Early completion payments In some circumstances the Government may agree to pay an amount to which provides an incentive for early completion of the design and construction phase. This is an amount that is usually prorated depending on the number of days or weeks the design and construction phase was completed in advance. The early completion payments would be assessable income under section Government lending to enable purchase of securitised licence receivables The last type of Government contribution is where the Government lends money to Finance Co to enable it to finance the receivables purchase payment. The tax treatment of the Government lending to Finance Co is the same as the treatment of the D&C and O&M loans Buy-back of securitised licence payments Under some social PPPs, the Government and Finance Co might agree that, after a few years following the commencement of the O&M phase, the Government will purchase a portion of the securitised licence payments and pay a lump sum to Finance Co as consideration for that. This lump sum payment will be, in turn, used by Finance Co to make an early repayment on the loan to the O&M financiers. The purchase of the securitised licence payments however will be usually on satisfaction of certain benchmarks for the O&M phase as set out in the project deed. The price paid for the buy-back may or may not vary depending upon prevailing interest rates or the need for the Government to use the price paid to provide the consortium with an incentive to satisfy certain benchmarks. As stated above, we will accept that Division 230 will apply to the securitised licence payments and the receivables purchase payments as though they were one financial arrangement. 24

25 The presence of the potential right to buy-back the securitised licence payments should be generally disregarded when working out whether the accruals method provided for in Subdivision 230-B, and the amount of any accrual, applies. However, once there is a buy-back, there may be additional implications under Division 230. We will accept that the approach provided for in AASB 139 in relation to partial transfers of financial assets that are a part of a larger financial asset would satisfy the requirements of Division 230, provided this is done consistently. Broadly, the approach in AASB 139 would firstly compare the carrying amount of the derecognised financial asset with what is received in respect of the buy-back. The extent of any difference would be profit or loss. The effective interest method then continues in relation to the part of the larger financial asset that was not transferred. The following page is a continuation of the example discussed previously, where 20% of the securitised licence receivables were bought-back at the end of $24,323,035 is paid by the Government to Finance Co representing the present value of the securitised licence receivables foregone, and discounted using the original rate of return of 9.52% that was initially calculated in the financial model. 25

26 Year Example: 20% of securitised licence receivables bought-back at end 2022 Receivables Purchase Payment ($) Original Financial Model Buy-back Securitise d Licence Payments ($) Net cash flows ($) Nominal value of rights disposed ($) Buy-back gain/loss PV of rights disposed using existing discount rate ($) Gain / loss on disposal ($) Calculating new accrual value Remaining cash flows after buyback ($) PV of remaining cash flows ($) TOFA Accrual Calculation Comparison of cash flows to TOFA gain/loss ,000, ,000, ,000,000-5,000, ,000, ,000,000 5,000, ,967 30,475,967-25,000, , ,000, ,000,000 30,475,967 2,901,112 83,377,080-50,000,000 2,901, ,000, ,000,000 83,377,080 7,936, ,314,031-20,000,000 7,936,951 Opening value ($) TOFA Accrual ($) Closing value ($) Net cash flows ($) Total TOFA gain/loss ($) ,000,000 7,000, ,314,031 10,596, ,910,397 7,000,000 10,596, ,500,000 7,500, ,910,397 10,938, ,349,114 7,500,000 10,938, ,323,035 8,000,000 32,323, ,349,114 11,266,060 97,292,139 32,323,035 11,266, ,800,000 6,800,000 1,700,000 1,552,237 6,800,000 6,208,949 97,292,139 9,261,574 99,753,713 6,800,000 9,261, ,200,000 7,200,000 1,800,000 1,500,689 7,200,000 6,002,758 99,753,713 9,495, ,049,612 7,200,000 9,495, ,600,000 7,600,000 1,900,000 1,446,376 7,600,000 5,785, ,049,612 9,714, ,164,066 7,600,000 9,714, ,000,000 8,000,000 2,000,000 1,390,166 8,000,000 5,560, ,164,066 9,915, ,079,803 8,000,000 9,915, ,400,000 8,400,000 2,100,000 1,332,800 8,400,000 5,331, ,079,803 10,098, ,777,905 8,400,000 10,098, ,800,000 8,800,000 2,200,000 1,274,905 8,800,000 5,099, ,777,905 10,259, ,237,655 8,800,000 10,259, ,200,000 9,200,000 2,300,000 1,217,004 9,200,000 4,868, ,237,655 10,398, ,436,363 9,200,000 10,398, ,600,000 9,600,000 2,400,000 1,159,537 9,600,000 4,638, ,436,363 10,512, ,349,181 9,600,000 10,512, ,000,000 10,000,000 2,500,000 1,102,865 10,000,000 4,411, ,349,181 10,599, ,948,893 10,000,000 10,599, ,400,000 10,400,000 2,600,000 1,047,285 10,400,000 4,189, ,948,893 10,656, ,205,694 10,400,000 10,656,801 26

27 ,800,000 10,800,000 2,700, ,035 10,800,000 3,972, ,205,694 10,681, ,086,941 10,800,000 10,681, ,200,000 11,200,000 2,800, ,303 11,200,000 3,761, ,086,941 10,669, ,556,883 11,200,000 10,669, ,600,000 11,600,000 2,900, ,236 11,600,000 3,556, ,556,883 10,619, ,576,367 11,600,000 10,619, ,000,000 12,000,000 3,000, ,942 12,000,000 3,359, ,576,367 10,526, ,102,512 12,000,000 10,526, ,400,000 12,400,000 3,100, ,500 12,400,000 3,169, ,102,512 10,385, ,088,356 12,400,000 10,385, ,800,000 12,800,000 3,200, ,959 12,800,000 2,987, ,088,356 10,194, ,482,465 12,800,000 10,194, ,200,000 13,200,000 3,300, ,347 13,200,000 2,813, ,482,465 9,946, ,228,511 13,200,000 9,946, ,600,000 13,600,000 3,400, ,674 13,600,000 2,646, ,228,511 9,636,291 97,264,802 13,600,000 9,636, ,000,000 14,000,000 3,500, ,931 14,000,000 2,487,724 97,264,802 9,258,972 92,523,774 14,000,000 9,258, ,400,000 14,400,000 3,600, ,098 14,400,000 2,336,392 92,523,774 8,807,657 86,931,430 14,400,000 8,807, ,800,000 14,800,000 3,700, ,143 14,800,000 2,192,574 86,931,430 8,275,302 80,406,733 14,800,000 8,275, ,200,000 15,200,000 3,800, ,026 15,200,000 2,056,105 80,406,733 7,654,194 72,860,927 15,200,000 7,654, ,600,000 $15,600,000 3,900, ,699 15,600,000 1,926,794 72,860,927 6,935,883 64,196,809 15,600,000 6,935, ,000,000 $16,000,000 4,000, ,107 16,000,000 1,804,430 64,196,809 6,111,115 54,307,925 16,000,000 6,111, ,400,000 $16,400,000 4,100, ,195 16,400,000 1,688,780 54,307,925 5,169,758 43,077,683 16,400,000 5,169, ,800,000 $16,800,000 4,200, ,900 16,800,000 1,579,602 43,077,683 4,100,713 30,378,396 16,800,000 4,100, ,200,000 $17,200,000 4,300, ,161 17,200,000 1,476,644 30,378,396 2,891,824 16,070,220 17,200,000 2,891, ,600,000 $17,600,000 4,400, ,913 17,600,000 1,379,651 16,070,220 1,529, ,600,000 1,529,780 Total 100,000,000 24,323, ,100,00 0 $288,423,035 85,400,000 24,323, ,600,000 97,292, ,423, ,423, ,423,035 27

28 In this example, the carrying amount of the financial asset disposed is $24,323,035. Because the amount paid for the buy-back exactly equals the carrying amount, there is no profit or loss, and therefore no assessable income or allowable deductions on the buy-back. The remaining financial asset is subject to an accrual on the remaining cash-flows. However, there may be scenarios under which the buy-back amount is based on the market value of the rights bought back, rather than the carrying amount. An example of this is where the buy-back amount is $20,000,000 because of changes in market interest rates. In such a situation, there would be a deduction of $4,323,035 in the year of buy-back. Additionally, there may be incentive payments built into the buy-back price in order to encourage the consortium to meet certain benchmarks. For example, if there was an incentive component in the buy-back price of $10,000,000, this would mean the buy-back amount would be $34,323,035. In such a case, the buy-back amount exceeds the carrying amount of the asset transferred by $10,000,000. This would result in profit, and therefore assessable income, of $10,000,000 in the year of the buy-back. In any case, the remaining financial asset will be subject to an accrual on the remaining cash-flows. We will accept that the approaches described above in relation to partial transfers of financial assets that are a part of a larger financial asset would satisfy the requirements of Division 230, provided this is done consistently. 28

29 1.6 GST interaction with PPPs In determining the particular taxable supplies and creditable acquisitions associated with PPP arrangements, careful consideration needs to be given to the precise terms of the relevant agreement General observations about GST and PPPs The following observations are made concerning GST issues that arise in typical PPP scenarios: where a government agency grants a development lease to allow a developer to undertake development works on the land, the government agency makes a supply of land to the developer by way of lease or licence. The developer also makes a corresponding acquisition of land by way of lease or licence in completing the development works on the land, in accordance with the terms of a development lease arrangement, the developer makes a supply of development services to the government agency. The government agency will make corresponding acquisitions on satisfactory and practical completion of the infrastructure project, the developer may be entitled to the grant of operating rights or lease over the completed development for a period. The grant of this lease or operating rights will be a supply of rights or real property made by the Government. The developer will make a corresponding acquisition the total consideration for the supply of the rights or lease over the land comprises any payment made by the developer for the rights or lease, plus a non-monetary component being the development works. Typically, regular rental payments associated with the rights or lease do not form part of the consideration for the supply of the operating rights or grant of lease for a specified period Description of PPPs from a GST perspective Not all arrangements will be the same and the creation of different rights and obligations can result in different GST implications. However, in relation to the infrastructure arrangement outlined in this framework, we note the following: it is assumed that the relevant infrastructure project being built or developed by the Government is not something that would be an input taxed supply or GST-free supply the PPP entities that are party to the arrangements are: o o registered for GST purposes; making supplies that are connected with the indirect tax zone in carrying on their enterprises; and 29

30 o in the case of Finance Co, exceeding the financial acquisition threshold. The diagrams below identify the cash flows that arise to give effect to a typical arrangement. However, in the context of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act), it is necessary to identify the relevant supplies being made. To understand the GST consequences of the arrangements entered into, the diagrams below are relevant. They represent the same transactions as outlined in the income tax section of this chapter, but with an emphasis on the elements of the transactions that are pertinent for GST. The design and construction stage The steps in the transactions in the design and construction stage pertinent to GST are as follows: 1. D&C financiers provide a loan to Finance Co either entirely up-front, or in stages, such as through a facility arrangement. 2. Finance Co uses that money to provide a loan to Project Trust. 3. Project Trust uses that money to fund the design and construction of the infrastructure asset, including payments for the services. These services are provided by the D&C subcontractors to Project Trust. 4. Project Trust supplies design and construction services of the infrastructure asset to the Government. 30

31 Operations and maintenance stage The steps in the transactions in the operations and maintenance stage pertinent to GST are as follows: 5. The Government grants a licence to Project Trust for the right to access the Crown land that the project is to be undertaken on. As consideration, the Government receives the licence payments. 6. Project Trust also supplies ongoing operational and maintenance services to the Government. 7. The Government assigns their right to receive the licence payments to Finance Co. 8. Long-term loans or facilities are provided by the O&M financiers to Finance Co. 9. Finance Co and Project Trust are each exchanging rights to make a payment based on Finance Co s financing cost, which is the supply of a derivative. 31

32 1.6.3 GST treatment In summary, the typical GST treatment will be as follows: the loans or other financial facilities with the external financiers, or by Finance Co to Project Trust, are input taxed financial supplies by both the relevant lender and borrower the securitisation agreement involving the supply of the right to receive cash payments under an agreement will also be an input taxed financial supply by the Government the construction payments are consideration for a taxable supply made by Project Trust to the Government being the provision of design and construction of the infrastructure. As a result, GST is payable on the consideration for the supply by Project Trust, and the Government can claim a corresponding GST credit the supplies by the design and construction subcontractors to Project Trust are taxable supplies by those subcontractors. These supplies also constitute a creditable acquisition by Project Trust, and it is entitled to claim the GST credits the availability payments paid by the Government are a consideration for a taxable supply made by Project Trust to the Government being the operations and maintenance of the infrastructure. As a result, GST is payable on the consideration for the supply by Project Trust, and can be claimed back as a GST credit by the Government the licence granted by the Government is a taxable supply. Project Trust as the recipient makes a creditable acquisition from the Government. As a result Project Trust will be entitled to claim a GST credit for this acquisition the payment that arises from the equalisation swap represents consideration for an input taxed supply being made by either Finance Co or the Project Trust. Funding arrangements between Finance Co and the external financiers When Finance Co enters into debt funding arrangements (on either a short or long-term basis) with the external financiers, we accept that: Finance Co is acquiring an interest in a credit arrangement for consideration and is making an input taxed financial supply Finance Co is not liable to pay GST on this supply and generally has no entitlement to a GST credit for anything acquired or imported to make the supply (unless the thing acquired or imported qualifies as a reduced credit acquisition). This means that GST is not payable on the amounts loaned and repaid under these financial supplies (i.e. the principal), and is not paid on the consideration received for making those loans (i.e. the 32

33 interest or charges). As no GST is payable, there are no GST credits to claim in respect of the movements of principal, the interest or charges. Funding arrangement between Finance Co and Project Trust When Finance Co enters into the D&C loan with Project Trust, we accept that: Finance Co is providing an interest in a credit arrangement to Project Trust for consideration and is making an input taxed financial supply to Project Trust Finance Co is not liable to pay GST on this supply and generally has no entitlement to a GST credit for anything acquired or imported to make the supply (unless the thing acquired or imported qualifies as a reduced credit acquisition) Project Trust, in acquiring an interest in a credit arrangement from Finance Co for consideration, is also making an input taxed financial supply to Finance Co while Project Trust is not liable to pay GST on this supply, it may be entitled to a GST credit on things acquired or imported to make the supply. This is due to Project Trust being able to enjoy the benefit of either the financial acquisition threshold or borrowings rule concessions where Finance Co has a right against Project Trust to on-charge the costs it incurs (as a principal) in borrowing funds from the external financiers, the payment of this amount by Project Trust to Finance Co may be a further consideration for financial supplies depending on the documentation (see paragraphs of GSTR 2002/2). Securitisation arrangement between the Government and Finance Co When the Government enters into the securitisation agreement with Finance Co for the securitisation of the licence fee payments that Project Trust is required to make to the Government, we accept that: the Government is not liable to pay GST on this supply and will be entitled to a GST credit for anything acquired or imported to make the supply, where it is able to take advantage of the financial acquisition threshold concession where the Government is not able to access this concession, it will generally not be entitled to a GST credit for anything acquired or imported to make the supply (unless the thing acquired or imported qualifies as a reduced credit acquisition) the Government is entitled to GST credits on the acquisition of the asset being designed and constructed by Project Trust depending upon whether the acquisition is found (based on an objective assessment of the facts and surrounding circumstances) to have a sufficient 33

34 connection to the financial supply that the Government makes to Finance Co under the terms of the securitisation agreement GSTR 2008/1 provides our views on when an entity acquires or imports anything solely or partly for a creditable purpose. In this case, based on the facts and circumstances described, and the guidance provided by GSTR 2008/1, we consider that the Government would be entitled to a GST credit in respect of the asset as the acquisition does not have a sufficient connection to the financial supply that the Government makes to Finance Co Finance Co, in acquiring an interest in a debt from the Government for consideration, is also making an input taxed financial supply to the Government Finance Co is not liable to pay GST on this supply, and generally has no entitlement to a GST credit for anything acquired or imported to make the supply (unless the thing acquired or imported qualifies as a reduced credit acquisition) the assignment of the licence fee income stream does not change the underlying supply that the Government is providing to Project Trust for these payments. The Government retains the obligation to make this supply and remits any GST liability in respect of that supply. So long as the Government continues to make the underlying supply, it will be entitled to claim GST credits on its acquisitions to make that supply in much the same manner as before the assignment occurred. Equalisation swap agreement between Finance Co and Project Trust When Finance Co and Project Trust enter into an equalisation swap, under the auspices of the ISDA master agreement, the following observations are made: both parties are exchanging rights to make a payment dependent upon the value of Finance Co s financing costs. This constitutes to each party making an input taxed financial supply of a derivative to the other for the consideration of the rights exchanged Finance Co is not liable for GST on this supply and generally has no entitlement to a GST credit for anything acquired or imported to make the supply (unless the thing acquired or imported qualifies as a reduced credit acquisition) Project Trust is similarly not liable for GST on this supply, but will be entitled to a GST credit on things acquired or imported to make the supply if it is able to take advantage of the financial acquisition threshold concession no GST consequences arise from either party making a payment to the other in discharge of its equalisation swap obligation. 34

35 Attribution rules The timing of an entity s GST liabilities and GST credit entitlements is driven by the tax period, either monthly or quarterly, to which that obligation or entitlement is attributed. In the context of a PPP, where a party to the PPP accounts for GST on a non-cash basis, attribution of a GST liability or a corresponding GST credit entitlement is required in the earliest tax period in which either: a monetary payment is received some or part of the non-monetary consideration is received an invoice is issued. If the arrangement provides for the payment of rent for lease or the operating rights, then the rules in Division 156 of the GST Act about progressive and periodic supplies will apply to attribute any GST liability on a progressive basis. Understanding when a GST liability is triggered in these types of arrangements assists the developer to ensure that they have adequate cash flow for the life of the project. Valuation PPP arrangements can also raise issues regarding how to determine the appropriate market value of any non-monetary consideration provided. We accept that parties dealing with each other at arm s length can use a reasonable valuation method as agreed between them to determine the GST inclusive market value of any non-monetary consideration for supplies arising in the context of a PPP. Administration matters - offsetting We maintain running balance accounts for various taxes. These taxpayer accounts record obligations, payments and credit entitlements under tax laws. In general, where the taxpayer is due a credit entitlement or refund of payment, this amount may be reduced due to offsetting. Use of the term offsetting describes when an amount that we owe to the taxpayer is applied or allocated against another debt owed by the taxpayer, therefore reducing their refund. In circumstances where a taxpayer has no outstanding tax debts or other Commonwealth liabilities to offset, we are required to refund the credit to the taxpayer. However the taxpayer can request that this refund be offset against the taxation debt of another taxpayer. In the context of PPP arrangements, circumstances may arise where one party, for example Project Trust, becomes entitled to a GST refund after the lodgement of an activity statement. In such a 35

36 scenario, Project Trust can request that the amount to be refunded be offset against the debt of another taxpayer, such as the Government. We are under no obligation to act on the parties request. However, such a request may be agreed to, taking into account the following considerations: the recipient of the GST credit has no outstanding debt or other Commonwealth liabilities to offset the parties agree to coordinate the lodgment of their respective business activity statements the criteria set out in paragraph 40 of Law Administration Practice Statement PS LA 2011/21 Offsetting of refunds and credits against taxation and other debts, being: o o o the risk associated with granting the request is appropriate and in accordance with the requirements of PS LA 2011/6 Risk management in the enforcement of lodgment obligations and other debt collection activities paying the refund in this manner is an efficient, effective, economical and ethical use of public resources (section 15 of the Public Governance, Performance and Accountability Act 2013 (PGPA Act)) the offset satisfies our obligation to pay the refund the taxpayer is entitled to under Division 3A of Part IIB to the Taxation Administration Act In accordance with paragraph 41 of PS LA 2011/21, any such request must: be made by the taxpayer or an authorised representative of the entitled taxpayer include a statement by the taxpayer or an authorised representative of the entitled taxpayer that they understand the refundable amount will be offset against a different taxpayer s tax debt state how much of the refundable amount is to be offset against the other taxpayer s debt provide sufficient details to enable identification of the taxpayer and the debt against which the entitled taxpayer wants to have the refundable amount offset. See also: Reasons for offsetting explained PS LA 2011/21: Offsetting of refunds and credits against taxation and other debts 36

37 1.7 Investor structure of the social PPP Typically, the consortium members will subscribe to equity in a holding trust (Project Hold Trust), which will in turn subscribe to equity in Project Trust. Some of the consortium members may initially invest into Project Trust for the purpose of making a profit from the sale of their interests within a few years after the end of the design and construction phase. Other investors will have longer time horizons. These investors may also be non-residents. The non-residents would typically hold their investment through an Australian resident holding trust. In some structures, the equity in Finance Co would be held by a charitable trust via a holding company. 37

38 1.8 Tax treatment of the investor s investment into the social PPP This part will examine the tax treatment of the investors into the social PPP The charity In the event that Finance Hold Co makes a profit, there may be a distribution to the charity. A discussion on the taxation arrangements applying to charities is out of the scope of this framework and is dealt with in the relevant sections of our website. Where the taxable income allocated to the charity aligns with its economic result, for example the charity receives distributions broadly aligning with the profit of Finance Hold Co or its net income (where trusts are used), Part IVA is unlikely to apply The Australian long-term investor Assessability of distributions received from the Project Hold Trust. Where the Australian long-term investor is presently entitled to a distribution from Project Hold Trust, the assessable income of the Australian long-term investor will be a proportionate share of the net income of Project Hold Trust. The net income of Project Hold Trust is broadly defined to be its taxable income. These concepts are elaborated upon in Division 6 of the ITAA Tax deferred distributions In some income years, the trust distributions may be comprised of accounting income in excess of the net income of Project Hold Trust determined under Division 6. The extent to which the distribution is in excess of the net income is a tax deferred distribution (TDD). Broadly, under our compliance approach, on the assumption that the Australian long-term investor holds its investment on capital account, the TDDs will be treated as non-assessable amounts under the CGT cost base and reduced cost base rules. See also: Our compliance approach 38

39 1.8.3 The Australian short-term investor The Australian short-term investor purchases units in Project Hold Trust with a view to selling those units for a profit within a few years after purchasing them (usually after the end of the D&C phase). Often, one of the consortium members will also be the D&C contractor. It may be the case that their purpose in being a participant in the project is to make a short-term profit from the construction of the asset, with no intention of maintaining their ownership of the Project Trust during the O&M phase. In this circumstance, the units are held on revenue account and any gain or loss from the sale of them may be treated as ordinary income under section 6 5 or deductible under section 8 1. See Taxation Ruling TR 92/3 as to when this may occur. Additionally, if the Australian short-term investor receives a TDD (as explained above) under our compliance approach, the TDDs will not be assessed as ordinary income. This is provided that the TDDs, including CGT concessional amounts, are fully taken into account in working out revenue gains and losses on those units. See also: TR 92/3 Income tax: whether profits on isolated transactions are income Our compliance approach Hold Trust 1 and Hold Trust 2 The tax treatment of Hold Trust 1 and Hold Trust 2 will depend upon whether they are managed investment trusts (MITs). If the trusts are not managed investment trusts If Hold Trust 1 and Hold Trust 2 are not MITs, then Division 6 and CGT will apply similarly to the way those provisions applied to the Australian investors. However, as the beneficiaries of Hold Trust 1 and Hold Trust 2 are non-residents the trustee of Hold Trust 1 and Hold Trust 2 will be taxed in relation to the beneficiaries. The trustee is taxed to assist in the collection of Australian tax on relevant income. Specifically, under section 98 of the ITAA 1936, the trustee of the trusts will be liable to pay tax on the foreign resident investor s share of the net income of those trusts. If the foreign resident investors are companies, the current rate of tax is 30%. If it is an individual or a trustee of another trust, the current tax rate is 47.5%. If the trusts are managed investment trusts Hold Trust 1 and Hold Trust 2 may be MITs as defined in section See our publication What is an MIT under the new rules for the requirements for a trust to be an MIT. 39

40 If the trust is an MIT, then: a special MIT withholding rate may apply the trustee assessment mentioned above will not occur. Generally, the MIT withholding rate will be 15% for beneficiaries that are residents of tax information exchange countries. Details of the tax rates that apply to particular types of beneficiaries and types of investments are set out in withholding tax arrangements for MIT fund payments. However, one of the key issues whether Hold Trust 1 and 2 would qualify as MITs, relate to the requirement that these trusts not control, or not be able to control, a trading business. The business of the Project Trust is a trading business. If these trusts control the affairs and operations of the Project Trust, they will not qualify to be MITs. The concept of control is discussed in Chapter 3. Additionally, in determining whether Hold Trust 1 and 2 qualify as MITs, and/or are entitled to the MIT withholding rate of 15%, particular care should be taken to ensure that: the trust is a managed investment scheme (within the meaning of section 9 of the Corporations Act 2001) a requirement that may be difficult to satisfy where there is a single beneficiary of that trust; a substantial proportion of the investment management activities are in substance carried out in relation to the trust in respect of the assets of the trust are carried out in Australia. The ATO will be undertaking compliance resources in order to ascertain whether purported MITs or withholding MITs do actually satisfy these requirements The foreign resident investors If the foreign resident investor holds units in a trust that is not an MIT, the tax assessed to the trustee in relation to the foreign resident investor is generally not a final tax. If the trustee is assessed under subsection 98(3) of the ITAA 1936 in respect of an individual or company beneficiary, those beneficiaries are assessed under subsection 98A(1) and allowed a credit under subsection 98A(2) for tax paid by the trustee. If the trustee is assessed under subsection 98(4) in respect of a trustee beneficiary, the trustee beneficiary and any later trustee in the chain of trusts, is not assessed again on that amount under sections 98, 99 or 99A. However, an amount may be taxed to an ultimate individual or company beneficiary under section 97, subsection 98A(3) or section 100 and allowed a credit under section 98B. However, if the trust is an MIT and MIT withholding tax was applied to the payment, then the distribution to the foreign resident investor will be non-assessable, non-exempt income. 40

41 1.9 Tax treatment upon exit for investors Outlined below are the tax outcomes if an investor chooses to exit their investment The long-term Australian investor CGT event A1 will generally occur if the long-term Australian investor sells its units in the Project Hold Trust. In working out the capital gain from CGT event A1, any reduction in the cost base, as outlined above in relation to TDDs, would need to be taken into account The short-term Australian investor As the units are held on revenue account, any gain or loss from the sale of the units may be treated as ordinary income under section 6 5 or a deduction under section 8 1. However, for the short-term Australian investor to avail themselves of our administrative approach in relation to TDDs, as outlined above, those TDDs must be taken into account in working out revenue gains and losses on those interests The long-term foreign investor Generally, CGT will not apply to the long-term foreign investor selling its units in the Project Hold Trust, per subsection (1). This will be true so long as, consistent with the example being used, the assets of the Project Hold Trust do not constitute taxable Australian property as defined in section The short-term foreign investor However, the exemption for the gain upon the sale of the units in the Project Hold Trust will not apply if any income from their sale will be treated as ordinary income under section 6 5. In working out the amount of ordinary income, consistent with our administrative approach in relation to TDDs, the amount of any TDD should be taken into account. The fact that there is an amount of ordinary income does not automatically mean that the gain is taxable in Australia. As the short-term foreign investor is a foreign resident, any income from the sale will only be taxable in Australia to the extent that the income is from an Australian source. In determining whether the income from the sale is from an Australian source, the question is not dependent solely on where the purchase and sale contracts are executed in respect of the sale of the units. While issued in the context of the sale of the shares by a private equity fund, TD 2011/24 outlines some of the factors we will consider when determining the source of the income from the sale of the units. 41

42 Where the short-term foreign investor is a resident of a country with which Australia has a tax treaty, the business profits article will likely determine which country has the taxing rights in respect of any profit. It is generally the case that the country of residence of the profit maker will be entitled to tax those profits, although this may depend upon whether the interests of the short-term foreign investor are being held at or through a permanent establishment located in Australia. If there is no Australian permanent establishment, the short-term foreign investors in treaty countries will not usually be subject to tax on their Australian-sourced business profits, although this will depend upon the terms of the relevant business profits article. That said, if the gain on disposal is not assessed under section 6 5, any residual application of CGT, subject to the provisos outlined above, would need to be considered. See also: TD 2010/20 Income tax: treaty shopping - can Part IVA of the Income Tax Assessment Act 1936 apply to arrangements designed to alter the intended effect of Australia's International Tax Agreements network? TD 2011/24 Income tax: is an 'Australian source' in subsection 6-5(3) of the Income Tax Assessment Act 1997 dependent solely on where purchase and sale contracts are executed in respect of the sale of shares in an Australian corporate group acquired in a leveraged buyout by a private equity fund? TD 2011/25 Operation of the Business Profits Article can be traced through certain limited partnerships 42

43 2. Privatisation of Government businesses into stapled structures Taxpayer Alert 2017/1 sets out the ATO s concerns in relation to arrangements which attempt to fragment integrated trading businesses in order to re-characterise trading income into more favourably taxed passive income. One of the areas of concern stated in that Alert relates to the use of stapled structures. However, that Alert also states that it does not extend to privatisations, and that the ATO would be providing separate guidance in relation to those transactions/structures. This Chapter provides that guidance. It sets out: 1. the types of privatisation, 2. the structure that should be used in order to provide taxpayers certainty that the ATO will not apply compliance resources. The ATO will apply compliance resources to, and discourages taxpayers from: 1. relying on this Chapter for a privatisation into a stapled structure not of a type described in this Chapter; and 2. departing from the structure and tax treatments set out in this Chapter. The ATO will however engage on a transaction-by-transaction basis in relation to potential privatisations. This Chapter is structured as follows: 1. Privatisations to which this Chapter applies 2. The asset-level structure of a privatisation 3. Tax treatment of the asset-level structure 4. Cross-staple loan variation 5. The upstream/feeder-level structure 6. Tax treatment of the upstream/feeder-level structure 7. Restructuring and exiting of an investment. 43

44 2.1 Privatisations to which this Chapter applies The privatisation of a Government business into a stapled structure that the ATO will not apply compliance resources involves: 1 a Government business being privatised that is land rich. A Government business is land-rich if it is effectively land (and land improvement) based or heavily reliant on particular land holdings and related improvements for the purposes of section 102M (the Land Assets). These can include ports and electricity transmission and distribution networks. For the avoidance of doubt, a Government business will not be effectively land (and land improvement) if the assets of the business are moveable property said to be covered by subsection 102MB(1); the granting by the Government to a consortium of a long-term lease of the Government businesses Land Assets, and the consortium agreeing to pay a lease premium in return for that grant; the disposal of the other assets of the Government business that are not assets of the type mentioned above (the Non-Land Assets), including intangibles such as licences to operate the business, to that consortium (either directly or indirectly via a sale of an SPV entity that holds those rights) for consideration; the consortium using the assets acquired above to run the privatised Government business for the period of the lease (for which there may be a renewal at the end of the term); and in some cases, the consortium agreeing to operate, maintain, and sometimes upgrade or expand the assets of the business over the term of the lease. This Chapter does not apply to, and the ATO will apply compliance resources to, privatisations into a stapled structure not of the type described above. The ATO will however engage on a transactionby-transaction basis in relation to potential privatisations. 1 Provided taxpayers also do not depart from the structure and tax treatments set out in this Chapter. 44

45 2.2 The asset-level structure There are typically three stages of the privatisation of a land-rich Government business: 1. The initial construction and acquisition of the assets of the business by the Government. This may occur many years prior to privatisation. 2. The establishment of the stapled entities prior to privatisation. 3. The privatisation of the business into the stapled entities Initial construction of the asset Before the Government business is privatised, the assets would have been acquired and/or constructed by a government agency or body, or a government-owned corporation (the Government entity ), such as a port. The construction of the assets will likely involve the Government entity incurring construction expenditure, as well as salary and wages expenses. Additionally, the Government entity may have undertaken capital improvements to the asset prior to privatisation. If it was a government agency or body that acquired or constructed the assets, at some stage prior to privatisation, the Government entity may have vested ownership of the assets in a governmentowned corporation Establishment of consortium entities prior to privatisation In the lead-up to the privatisation, the Government and/or the consortium will set up a number of entities. These entities are: An Operating Trust (which actually may be a trust or a company but for present purposes will be referred to as a trust), whose role it is to operate and maintain the privatised business. Specifically, the Operating Trust will: o o o own the assets of Non-Land Assets; charge customers for the use of those assets (such as electricity tariffs, or port usage charges); and be vested with the assets or may pay consideration for the acquisition of these assets. 45

46 An Asset Trust, whose role it is to: o o o lease the Land Assets; pay a lease premium to the Government for the grant of the lease; and enter into an arrangement with the Operating Trust so that the Operating Trust can use the Land Assets. This is typically given effect through the execution of a sublease of the Land Assets leased from the Government for market value periodic rentals as will be outlined below. A Holding Trust (Operating), whose role it is to hold all of the units in the Operating Trust. A Holding Trust (Asset), whose role it is to hold all the units in Asset Trust. Finance Co whose role it is to raise debt finance for both the Operating Trust and the Asset Trust. Finance Co is a company whose shares may be owned by the consortium, or one of the entities listed above. Generally, the units in the Holding Trust (Asset) and the Holding Trust (Operating) are owned by investors in proportion to their equity contribution. The Asset Trust and the Operating Trust may also either be stapled entities, or there may be some agreement (typically a security holder s agreement and by restrictions in the Operating Trust and Asset Trust deeds), that is in substance the equivalent of stapling The Privatisation The structure of the privatisation is as follows: 1. Finance Co borrows funds from External Financiers. The External Financiers take security over all of the entities and assets in the structure. Asset Trust and Operating Trust would be obligors under the project finance documents. 2. Finance Co lends the money obtained under step 1 to the Asset Trust and the Operating Trust on back-to-back terms. 3. The Holding Trust (Asset) contributes equity to the Asset Trust. 4. The Holding Trust (Operating) contributes equity to the Operating Trust. 5. The Asset Trust and the Government enter into a long-term lease of the Land Assets under which: a. a lease premium is paid; and 46

47 b. as relevant - the Asset Trust has the ability to remove the Land Assets. This ability may arise by virtue of a right the Asset Trust has to remove the asset, conditional on an event such as obsolescence and/or an obligation the Asset Trust has, to replace the asset where necessary for the proper conduct of the facility. At the end of the lease, Asset Trust may or may not receive compensation from the Government for the value of the Land Assets that revert back to the Government. 6. The Asset Trust sub-leases the Land Assets to Operating Trust (the Sub-Lease). The Operating Trust agrees to pay market value periodic rentals to the Asset Trust in exchange. The Operating Trust operates the business, and charges end-user customers for the goods or services of the business, similar to a port usage charge. 7. The Operating Trust purchases or is vested with the Non-Land Assets and liabilities. These assets and contracts, in existence at the end of the sub-lease, typically revert to the Government for no consideration. 8. The Asset Trust uses the lease rentals to repay the borrowing to Finance Co and to fund a return to its unit holders (via the Holding Trust (Asset)). The Operating Trust similarly uses its funds after paying the sub-lease to fund repayments to Finance Co and a return to its unit holders (via the Holding Trust (Operating)). 9. Finance Co uses the funds it receives in step 8 to repay the debt to the external financiers. In this model there are no loans between the Asset Trust and the Operating Trust. A variation that includes such a loan is detailed in

48 48

49 2.3 Tax treatment of the asset-level structure This part will cover the following matters: 1. The staple as a single unified business 2. Purchase Price allocation between the Asset Trust and the Operating Trust 3. Approach to the pricing of the cross-staple lease 4. Levels of gearing 5. Application of Division 6C of the ITAA 1936 to the Asset Trust Rent from land 6. Application of Division 6C to the Operating Trust 7. Tracing for the purposes of Division 6C 8. Holder for the purposes of Division Application of Division 250 to the holder 10. Application of Division 58 to the holder 11. Capital character of lease premium paid to the Government 12. Application of Division Application of Division 57 of Schedule 2D to the ITAA Deductibility of rentals paid by Operating Trust 15. Stamp Duty 16. Part IVA 49

50 2.3.1 The staple as a single unified business In order to understand the ATO s approach to this structure, it is necessary to outline how the ATO characterises the structure from a commercial perspective. Fundamentally, the ATO considers that the activities of the Asset Trust and the Operating Trust constitute a single unified business for the following reasons: the acquisition of the assets by both the Asset Trust and the Operating Trust occurs as part of a single transaction; the expectation is that interests in the Asset Trust and the Operating Trust (or the Holding Trusts) will not be traded separately; the external financiers take security over the entire structure; in the case of businesses subject to regulated returns the relevant regulator will typically view the activities of both entities as a single business for the purposes of determining its regulated return; and the overall business was typically carried on by a single corporation prior to the privatisation. With that context in mind, we set out below how we will approach what we see as being the key tax issues for the transaction Purchase Price allocation between the Asset Trust and the Operating Trust In consideration for the privatisation of the business, the Government receives a Purchase Price that is split into two components, being: a lease premium paid in consideration for the acquisition of the long-term lease of the Land Assets; and other payments which represent consideration for the acquisition of the Non-Land Assets. The Asset Trust will enter into the long-term lease of the Land Assets, and the Operating Trust will likely acquire the Non-Land Assets. Given that these two entities and their investors will likely have very different tax treatments, an appropriate allocation of the Purchase Price is essential to ensure that the Acts the ATO administers are complied with. The ATO acknowledges that Purchase Price allocation is likely to be a difficult process. This is fundamentally due to the co-dependencies that exist between the value of the assets of a privatised business and the value of the right to run that business. The value of both assets would likely be substantially higher when considered as an integrated whole, as opposed to when they are considered on a stand-alone basis. For example, the value of a port to an entity that does not have a 50

51 right to run the port would likely be significantly lower than the value of a port to an entity that does have that right. As such, the ATO considers that a preferable approach is to set out the factors it will consider in determining whether a given Purchase Price allocation would give rise to a low compliance risk. The factors are: the nature of the business being privatised, particularly in light of our comments above about the post-privatisation structure constituting a single unified business; if the business is subject to regulation or supervision on the amount of revenue it can derive the way in which its maximum allowable, or appropriate amount of revenue is calculated by the relevant regulator, and the extent to which that revenue is attributable to the assets of the Asset Trust and the Operating Trust; the total purchase price paid by both entities compared with: o o the privatised businesses pre-privatisation financial statements; and/or if relevant - the value of the privatised businesses assets used by a regulator in determining the entity s maximum allowable or appropriate amount of revenue; if a market valuation of the individual assets is conducted for the purposes of the Purchase Price allocation it is critical that each of tangible and intangible asset should be subject to its own fair and reasonable valuation for tax allocation purposes. A simple example is that a road without a tolling concession would not be worth the same for tax allocation purposes as the same road with a tolling concession. We do not accept that for tax allocation purposes the market value of the road is the value of the road with the tolling concession. This is because that method of valuation would implicitly incorporate the value of an intangible asset when valuing the tangible asset. Rather, we consider that in determining the value of tangible assets as distinct from the value of the intangible assets, the tangible assets intrinsic value should be determined excluding the value of the intangible assets. Accordingly, if the value of the intangibles were excluded from the value of tangible assets there will be a separate amount allocable to the intangible asset; and previous and comparable privatisation transactions. Entities are encouraged to approach the ATO prior to the completion of a privatisation transaction with a view to obtaining a low risk rating for any proposed Purchase Price allocation. Where the ATO becomes aware of a privatisation transaction, it is likely that it will approach prospective bidders to engage in a dialogue about Purchase Price allocation before completion of the transaction. 51

52 2.3.3 Approach to the pricing of the cross-staple lease For various tax purposes, the pricing of transactions between the Asset Trust and the Operating Trust must be based on an arm s length basis, taking into account the single unified nature of the business as outlined above. The Tax Laws Amendment (New Tax System for Managed Investment Trusts) Act 2016 established a new tax system for MITs. One of the changes in this Act was to insert new sections , and into the ITAA 1997 which outlines a non-arm's length income rule (NALIR) relevant to MITs. The NALIR applies to all MITs including attribution managed investment trusts (AMITs). If the Asset trust is an MIT, it will need to apply these rules to determine whether any income it is in receipt of, including rent from a lease, is not non-arm s length income. Law Companion Guideline LCG 2015/15 Managed Investment Trusts: the non-arm's length income rule in sections , and of the Income Tax Assessment Act 1997 describes how the ATO will apply the law as amended by the Tax Laws Amendment (New Tax system for Managed Investment Trusts) Act The part of the Guideline that is relevant for the cross-staple lease is set out in paragraphs 51 to 61E, about integrated business arrangements. This is because: the privatised business will be regulated as a single business, such as the Australian Energy Regulator; the interests held are legally or economically stapled; the Asset Trust and the Operating Trust have the same ultimate underlying owners; the business was purchased together, with contracts for sale/lease executed together; the privatised business has integrated value; the assets of the business, in practice, operate together in a highly integrated manner; the external financiers take security over the entire structure; and it is recognised by key suppliers or customers as a joint business. As a result, the ATO considers it inappropriate for the Operating Trust to be treated as a standard service provider in determining an arm's length reward. In particular, taking into account that the intangible asset is held in the Operating Trust and is not capitalised into the cost of the tangible assets held by the Asset Trust, an appropriate return on capital needs to be made by each entity within the staple. It would be expected that a cross-staple lease would be priced such that the combined net present value of the Asset Trust and the Operating Trust being allocated between the parties in the same proportions as each entity's contribution to the purchase price. 52

53 However, if the pricing of the lease resulted in an allocation of the NPV that was not broadly in the same proportions as outlined above, it will be considered to be at a higher risk of compliance activity. Additionally, the principles mentioned above will equally apply in working out whether or not the cross-staple lease is mispriced, and therefore giving rise to compliance risks around deductibility under section 8-1, the characterisation of the Asset Trust s activities as constituting an investment in land for the purpose of deriving rent, and Part IVA. Note that consistent with the above discussion, this method only applies to privatisations into stapled structures of the type described in this Chapter Levels of gearing The extent to which the two elements of the Purchase Price are financed with debt or equity is a decision for the entities involved, subject to the following two reservations: the Acts the ATO administers (especially, but not limited to the thin capitalisation rules) must be complied with; and the ATO would expect the gearing would be broadly the same for the Asset Trust and the Operating Trust. For example, if the lease premium paid by the Asset Trust is financed by 60% external debt (on-lent by Finance Co) and 40% equity (contributed by Holding Trust (Asset)), then it would be expected that the amount paid by Operating Trust would be similarly financed. To do otherwise would be to disregard the reality, as discussed above, that the activities of the Asset Trust and the Operating Trust constitute a single unified business. On the other hand, an allocation of debt and equity that differed significantly between the Asset Trust and the Operating Trust (particularly, but not limited to, a higher gearing of the Operating Trust relative to the Asset Trust) would be considered to pose a high risk. Compliance resources would be allocated according to this risk rating Application of Division 6C to the Asset Trust Rent from land If Division 6C applies, Asset Trust will be taxed in a similar manner to a company pursuant to sections 102S and 102T of the ITAA The most important implication of this is that the trustee of the Asset Trust will need to pay tax on its taxable income (as opposed to the tax liability generally falling to the trust s unitholders). One of the key questions in Division 6C is whether the Asset Trust is a trading trust (see paragraph 102N(1)(a)). Under that subsection, if the Asset Trust does not carry on a trading business and does not control any other entity that does, then Division 6C will not apply. The classification of the Asset Trust as a trading trust will also be relevant to the question of whether the investors into the Asset Trust will themselves be subject to Division 6C and/or constitute MITs. 53

54 The Asset Trust will not be carrying on a trading business if its only activities consist of investing in land (which is inclusively defined in Division 6C to include an interest in land, fixtures on land, and certain moveable property) for the purpose of deriving rent. There are a number of issues with the investing in land requirement. Is the investment in land genuinely for the purpose of deriving rent? Fundamentally, because a document describes a relationship as an investment in land from which rent is derived, does not mean that this is, in reality, what the substance and effect of the document is, or the purpose of the entities involved. For example, where a document purports to be a lease of land, but the lease rental payments: amount to a substantial component of the profits of the Operating Trust; are excessive such that the Operating Trust derives little by way of taxable income; or do not represent an appropriate return to the Asset Trust as described in 2.3.3; then the ATO would be concerned that the Asset Trust is not merely investing in land for the purpose of deriving rent and therefore will be taken to be high risk from an ATO compliance perspective. This would mean that the Asset Trust may be considered to be a trading trust. The ATO would also consider whether the arrangement would gives rights to Asset Trust that amounts to control. If control does not arise, we would presume it is as a result of contrivance. Additionally, the above discussion does not apply stapled structures that: arise from a transaction other than the privatisation of a Government business; and rely on subsection 102MB(1) in order for a trust that is a stapled entity to not be a trading trust as defined in section 102N. For all other types of staples related to infrastructure, you should refer to Chapter 4 and Taxpayer Alert 2017/1. The issue of what constitutes land and what constitutes rent are beyond the scope of this paper. Note: For Division 6C to apply, a unit trust must be both a public unit trust and a trading trust. The issue of what constitutes a public trust and the issues of tracing through investors in applying those tests is beyond the scope of this paper Application of Division 6C to the Operating Trust The Operating Trust will clearly be a trading trust as its business activities extend beyond eligible investment business pursuant to section 102N. However, whether Division 6C will actually apply will depend upon whether it is a public unit trust (as noted above, a discussion which is beyond the scope of this document). 54

55 As will be discussed in 2.5, the classification of the Operating Trust as being a trading trust may also be relevant to whether the investors into the Operating Trust will themselves be subject to Division 6C and/or constitute MITs Tracing for the purposes of Division 6C As discussed above, Division 6C generally applies to a trust if it is both: a trading trust (see the above discussion); and a public unit trust. The definition of public unit trust, for the purposes of Division 6C, is set out in section 102P. Broadly, a public unit trust is a unit trust whose units are listed on a stock exchange or offered to the public or held by 50 or more persons. A unit trust is not a public unit trust if 20 or fewer persons hold 75% or more of the beneficial interest of the income or the property of the trust. In determining whether a trust is a public unit trust, subsection 102P(10) requires broadly that the beneficial interest in the units of the unit trust be traced through any interposed trusts. Any number of trusts can be traced through in this manner to reach the ultimate beneficiaries. When performing this tracing, it will be relevant to characterise the relationship between the trust and its unitholders to determine whether the requisite beneficial interest is present. In cases where there is a clear and simple trustee-beneficiary relationship, we will not accept arguments that tracing cannot occur which are based on the unitholder not having a beneficial interest in the specific assets of the trust estate. In circumstances where the question of the existence or nature of the trustee-beneficiary relationship is argued to affect the application of the tracing rules, you are encouraged to approach us to discuss the issue. For example, the ATO is aware that this can potentially arise in respect of certain off-shore pension schemes. Additionally, under the previous law, a trust could be treated as a public unit trust when one or more tax exempt entities or complying superannuation entities owned 20% or more of the beneficial interests in the trust (the 20% tracing rule). Under the modifications to Division 6C made by the Tax Laws Amendment (New Tax System for Managed Investment Trusts) Act 2016, super funds and exempt entities that are entitled to a refund of excess franking credits will now be exempt from the 20% tracing rule for public trading trusts. As such, a trust will not be a public unit trust just because such tax exempt entities and/or complying superannuation entities hold more than 20% of interests in the trust Holder for the purposes of Division 40 The table in section identifies the holder of a depreciating asset. Where a lessee enters into a long-term lease over Division 40 assets and becomes the holder, that triggers an acquisition of an asset to which Division 58 has application (see comments on Division 58 below). 55

56 Item 10 of the table in section provides that a taxpayer holds a depreciating asset if they are the owner of the asset, or the legal owner, if there is both a legal and equitable owner. However, there are other items in the table which identify a holder in various other circumstances even though they are not the asset's owner. Item 2 of the table in section provides that if a depreciating asset is fixed to land over which there is (among other things) a lease, and the owner of the right has a right to remove the asset, then the asset is held by the lessor for as long as the right to remove the asset exists. For the purposes of Division 40, this item effectively overcomes the common law presumption that ownership of assets affixed to land rests with the owner of the land. A discussion of when a particular right to remove will be an effective right (i.e. pre-existing rather than contingent) is beyond the scope of this paper. In the above circumstances: the Asset Trust will be a holder of the Land Assets because it holds a lease that carries a right to remove the assets the Operating Trust will not be the holder because the sub-lease granted to it by the Asset Trust will not typically give it a right to remove the asset. Additionally, the Operating Trust would not typically have or inherit a cost for the asset within the definition of Division 40 because all of the payments that would otherwise form part of the cost of the asset are deductible (see below) Application of Division 250 to the holder Division 250 will not apply to the Asset Trust because that Division only applies where: a tax exempt entity uses or controls the use of the asset; and the relevant taxpayer (ie. the Asset Trust) has an insufficient economic interest in the asset. Generally, control or use by a tax exempt end user would not exist where the tax exempt entity s influence is restricted to a regulatory oversight that might typically exist with airports, ports, regulated utilities, etc. Therefore Division 250 is unlikely to apply as the Government entity or connected entities would not use or control the use of the assets. The tests for when an entity lacks a predominant economic interest are set out in section Whether these tests, without additional facts, would apply to the transaction as set out above, is dependent on each transaction Application of Division 58 to the holder Division 58 broadly operates to provide a statutory cap on the availability of capital allowances in the context of depreciating assets that are passing from the ownership of an exempt entity to ownership/holder status of a taxable entity. In these circumstances, the Division 40 cost to the 56

57 new holder is not reset but is calculated by reference to the attributes of the depreciating asset in the hands of the exempt entity. For the standard privatisation, Division 58 will apply to Asset Trust as the new taxable entity and provide the basis upon which it must calculate cost to work out its decline in value of the Land Assets that are depreciating assets that it is taken to hold under section In calculating the Notional Written-Down value of the Land Assets under Division 58, the Asset Trust should apply Division 40 according to its terms, without taking into account any previous notional application of Division 40 under the National Tax Equivalent Regime (NTER). The NTER regime will not be of relevance to the application of the Income Tax Assessment Acts to the private sector acquirer. Accordingly, an application of Division 40 under the NTER that did not happen to accord with the ATO s position (for example with respect to the capitalisation/non-capitalisation of certain expenses) would not restrict or be relevant in considering the ability of Asset Trust to calculate the Notional Written-Down value for Division 58 purposes in a manner consistent with the operation of Division Capital character of lease premium paid to the Government The lease premium paid to the Government entity will not be deductible under section 8-1. Rather, it is a payment of capital or of a capital nature for the enduring benefit of the long-term lease of land. The cost that is relevant in calculating the decline in value of the Land Assets for the purposes of Division 40 is reset by Division 58 as set out above. The lease premium is not relevant to or determinative of the Division 40 cost Application of Division 43 In many privatisations, a Government entity will have undertaken capital expenditure on land which is the subject of the lease to the Asset Trust (eg. the dredging of a port channel). Upon the granting of the lease (of 50 years or more) to the Asset Trust, the Government entity will have elected for CGT event F2 to have happened. Where that election has been validly made, it will cause the lessee (the Asset Trust) to be the owner of the part of the capital works that are the subject of the lease. This may entitle the Asset Trustee to deductions for capital works under Division 43. A requirement to make the CGT event F2 election is that the lease granted by the Government entity to the Asset Trust must be on substantially the same terms as the Government owned the land or leased the land. This means the lease must confer on the Asset Trust the same: usage and access rights over the subject land; and right to the full enjoyment of the land without restriction. Note a description of all the preconditions for a valid CGT event F2 election to have been made is beyond the scope of this paper. 57

58 Application of Division 57 of Schedule 2D to the ITAA 1936 Division 57 of Schedule 2D to the ITAA 1936 deals with the income tax treatment of a taxpayer whose income ceases to be wholly exempt. This may arise where, instead of the assets being transferred and/or leased to the private sector, the entity itself becomes subject to income tax (e.g. the shares in an entity are no longer entirely owned by a State Government, meaning the entity is no longer exempt from income tax under Division 1AB of ITAA 1936). The function of Division 57 is broadly to properly attribute income, outgoings, gains and losses to the periods before and after such a privatisation. Where Division 57 applies, the privatised taxpayer is referred to as a 'transition taxpayer' and the time of the privatisation is the 'transition time' pursuant to section In particular, in calculating a deduction allowable to the transition taxpayer in respect of long service leave or annual leave payments to a person who was an employee of the transition taxpayer before the transition time, the amount of any deduction allowable should broadly reflect only the value of the amount of leave accrued after the transition time (as worked out under section 57-5 and section 8-1) Deductibility of rentals paid by Operating Trust Provided the issue of Purchase Price Allocation and the pricing of cross-staple transactions as outlined above do not represent a compliance risk, and that the lease itself does not represent a distribution of profits from the Operating Trust to the Asset Trust, the rentals would generally be expected to be deductible under section Stamp duty Depending on the type and value of assets leased, the Asset Trust may incur transfer duty in relation to the assets leased that is payable to the relevant state or territory revenue authority. Expenditure for preparing, registering, or stamping a lease is only deductible under section if it has actually been incurred by the taxpayer. Incurred, in this context, requires that the taxpayer have a presently existing liability, and is completely subjected or definitively committed to the loss or outgoing (FCT v James Flood Pty Ltd (1953) 88 CLR 492). Also, the expenditure is only deductible under subsection 25-20(1) if the property has been used or will be used solely for the purpose of producing the lessee s assessable income. In the circumstances outlined above, the amount of a transfer duty payable by the Asset Trust in relation to the stamping of the lease will be deductible to the Asset Trust pursuant to section in the income year in which the expenditure becomes payable by the Asset Trust. 58

59 Where a bid is made to a Government on a stamp duty inclusive basis, and the stamp duty payable appears disproportionately high, we may review the allocation of the bid price as between the stamp duty and other amounts payable to the Government Part IVA Consistent with the ATO s overall approach to the structure, the ATO will review privatisations of land-rich government businesses using stapled structures that have the following features in order to determine whether Part IVA applies: 1. A lease under which rental payments to the Asset Trust are calculated to capture profits of the Operating Trust, or any other instrument that captures profits of the Operating Trust (including, but not limited to cross-staple loans discussed at 2.4.1). 2. The Asset Trust and the Operating Trust having unequal levels of gearing. For example, a transaction we have seen is where the Asset Trust was only 40% geared and the Operating Entity was 99% geared. 3. Purchase price allocation that does not have a reasonable basis. As noted above, a reasonable basis would have regard to: a. the nature of the business being privatised, particularly in light of our comments above around post-privatisation structure constituting a single unified business; b. if applicable - the way in which the maximum or acceptable revenue of the business is calculated by the relevant regulator; c. a comparison between the purchase price and the pre-privatisation value of the assets; d. if a market valuation of the individual assets is conducted for the purposes of the Purchase Price allocation that the valuation for the purposes of tax allocation complies with the ATO s views set out above; e. previous and comparable privatisation transactions. The ATO will typically provide to bidders for a potential privatisation what it considers to be a low risk Purchase Price Allocation. Where a transaction displays any of these features, this would lead to the conclusion that Part IVA would apply to the entire transaction (and not simply to the particular features outlined above). Additionally, as stated above, the ATO will in any event apply compliance resources to privatisations into stapled structures not of the type described at 2.2, and will engage on a transaction-bytransaction basis in relation to potential privatisations. 59

60 2.4 Cross-staple loan variation Sometimes the Operating Trust may borrow funds from the Asset Trust, either to finance its contribution to the overall purchase price, or to fund its ongoing operations. The existence of a cross-staple loan can give rise to a number of issues: 1. Deductibility of the interest payments made by the Operating Trust. 2. The existence of any margin on the cross-staple loan. 3. Unequal levels of gearing caused by the cross-staple loan. 4. The potential for cross-staple control resulting from cross-staple loans. 5. The treatment of the income for interest withholding tax purposes. Deductibility of the interest payments made by the Operating Trust. The ATO may firstly examine cross-staple loans in order to ascertain whether deductions for the interest paid would be denied under section In particular the areas that may be focussed on include whether the cross-staple loan: is a related scheme to the equity interest the investors hold in the Asset Trust under section ; and/or is designed to fund a return on the equity interest in the Asset Trust under section The particular manner in which the loan is funded, as well as the existence of any margin (see below) will be informative in this regard. Additionally, depending upon the principal and interest rate charged on the cross-staple loan, the ATO may also examine whether deductions are available for that interest under section 8-1 and/or Division 230. Margin charged on cross-staple loan Having regard to the unified nature of the business and bank security arrangements, funds on-lent across the staple would be expected to have a small, if any, margin over external debt. Any margin charged on the funds on-lent across the staple would need to be justified with reference to expenses incurred by the Asset Trust in providing that on-loan. Additionally, it would also be expected that any margin would be reflected in the discount rate used for the NPV calculations referred to in above. If a different approach was taken to the pricing of any cross-staple loan, or any cross-staple margin is not also charged by Finance Co, the ATO would see the transaction as posing a high compliance risk. 60

61 Unequal levels of gearing A cross-staple loan may cause the Asset Trust and the Operating Trust to have broadly unequal levels of gearing. The ATO would have concerns that broadly unequal levels of gearing are primarily tax motivated, and would be therefore regarded as high risk from a compliance perspective. An approach to determining the level of gearing the ATO would not regard as being high risk would be worked out as follows: 1. Work out the extent to which the overall Purchase Price is financed through external finance (being finance provided by third parties to Finance Co) and then work out a gearing ratio. 2. Upon the determination of a reasonable Purchase Price allocation between the Asset Trust and the Operating Trust as outlined above, apply the ratio worked out above to that allocation. 3. The result would be a level of gearing for both the Asset Trust and the Operating Trust that the ATO would consider as not posing a high compliance risk. In doing so, disregard any funds that are borrowed by the Asset Trust and immediately on-lent across the staple. Example A Government business is privatised for $1bn, representing: $700 million paid for land assets in the form of a 99 year lease premium; and the remaining $300 million paid for the other assets of the business. External financiers lend the Asset Trust (via Finance Co) $600 million of this purchase price, with the remaining $400 million financed through equity. The Asset Trust lends $300 million across to the Operating Trust, and the other $300 million is used by the Asset Trust to finance its lease premium. In terms of levels of gearing: the Operating Trust is 100% geared as it has $300 million in assets and $300 million in liabilities; and the Asset Trust is only 42% geared as it has $700 million in assets and $300 million in liabilities (disregarding the $300 million it borrows and immediately on-lends to the Operating Trust). The ATO would be concerned that this unequal level of gearing is primarily tax motivated, and would be regarded as high risk from a compliance perspective. 61

62 A level of gearing that the ATO would not consider as high risk (provided the gearing level itself complied with the other Acts the ATO administers, especially thin capitalisation) would be calculated as follows: 1. The gearing ratio of external finance is 60/ Therefore: a. the Asset Trust would borrow approximately $420 million; and b. the Operating Trust would borrow approximately $180 million. 3. This means that, of the $600 million obtained from external financiers by the Asset Trust: a. $180 million may be on-lent across to the Operating Trust (subject to the provisos outlined above in relation to cross-staple margins) to finance its portion of the purchase price; and b. the remaining $420 million may be used by the Asset Trust to finance its portion of the purchase price. This approach is something that the ATO would not consider as being high risk. Cross-staple loan giving rise to control Division 6C of the ITAA 1936 may apply, and the MIT rules will not apply to the Asset Trust if it controls, or is able to control, an entity that carries on a trading business (section 102M). An example of this is where a cross-staple loan results in the Operating Entity s continuation as a going concern being contingent on Asset Trust deciding not to exercise a right it has to trigger the Operating Entity s insolvency. Interest withholding tax treatment on income from cross-staple on-lending In some cases it may be argued that non-resident holders of interests in the Asset Trust are deemed to be presently entitled to interest income on any cross-staple financing, causing interest withholding tax to apply. The liability to interest withholding tax depends upon the amount to which the non-resident is presently entitled (section 128A(3)), and would therefore be net of expenses. A question arises as to the apportionment of the Asset Trust s expenses between the trust s interest income and its other income (i.e. the income from the cross-staple lease). Any apportionment must be done on a reasonable basis. In order to apportion on a reasonable basis, it is expected that expenses which directly relate to a particular head of income should be deducted 62

63 first against that income. Expenses that relate to more than one head of income are then allocated on a reasonableness basis. An apportionment method will not be reasonable if it spreads the Asset Trust s total expenses in proportion to its income in a way that does not differentiate between the kinds of income the expenses relate to. The reason such a method is unreasonable is because it ignores the reality that the Asset Trust is simply acting as a financing conduit in relation to the cross-staple financing. The Asset Trust s interest expenses are therefore directly relevant to its interest income only. The Asset Trust s other expenses, such as depreciation, should be apportioned to rental income to which the depreciation will be a directly relevant expense. In working out the extent to which an amount that a non-resident holder is presently entitled to is income consisting of interest, it would generally be appropriate for the (gross) interest expenses of the Asset Trust to be first be applied against its (gross) interest income. This is particularly so when the Asset Trust and the Operating Trust are entering into arrangements to fund the amount of the purchase price payable by both entities, and/or the acquisition or significant assets or significant capital expenditure. Where it is appropriate to allocate the (gross) interest expenses first to the (gross) interest income, the result would be that only where the Asset Trust s (gross) interest income exceeds its (gross) interest expenses will the non-resident holders be presently entitled to (net) income consisting of interest. Because the Asset Trust would typically borrow more principal from the Finance Co than it would on-lend across the staple, the interest income of the trust would typically be less than its interest expenses. And as a result, no component of the amount of the income to which a beneficiary may be presently entitled would constitute interest. That being said, where the Asset Trust lends to the Operating Trust at a margin over external debt, the amount of the margin may be considered to be an amount of interest to which a beneficiary may be presently entitled. In calculating the extent to which that margin represents an amount of interest to which a beneficiary is presently entitled, the expenses incurred by the Asset Trust that justify the charging of that margin (as discussed above) must be applied first to that margin in working out the extent to which that margin gives rise to an amount of interest to which a beneficiary is presently entitled. The foregoing discussion in relation to margins applies even in scenarios where it is not appropriate for the (gross) interest expenses of the Asset Trust to be first applied against its (gross) interest income. 63

64 2.5 The upstream/feeder-level structure There can be a variety of investors into privatisations involving stapled structures such as domestic superannuation funds, foreign superannuation funds, companies, other trusts (stapled or otherwise), and foreign government agencies. Typically, the investors that ultimately own interests in the Asset Trust and the Operating Trust through one or more interposed entities will be the same. These entities are referred to as the Ultimate Investors. That is, they own, directly or indirectly, both the Asset Trust and the Operating Trust in proportion to their equity contributions. The particular way in which the investment is structured will depend upon the respective ownership interests of the various Ultimate Investors, and other considerations. However, for the purposes of discussion the following structure will be assumed: 1. There are five Ultimate Investors each holding an indirect 20% interest in the Asset Trust and the Operating Trust: a. an Australian Resident Company b. a Foreign Resident Company c. a Foreign Pension Fund d. a Foreign Government Agency e. an Australian Resident Superannuation Fund. 2. The Australian Resident Company provides direct equity investment into Holding Trust (Asset) and Holding Trust (Operating). 3. The Foreign Resident Company establishes two Australian-resident special purpose vehicle (SPV) trusts with equity. One SPV invests in the Asset side of the structure, and the other invests in the Operating side. The SPVs then invest into Holding Trust (Asset) and Holding Trust (Operating) with equity. 4. The Foreign Pension Fund also establishes two resident SPV trusts with equity one SPV for the asset side and another SPV for the operating side. The SPVs then fund an investment into Holding Trust (Asset) and Holding Trust (Operating). 5. The Foreign Government Agency invests directly into the Holding Trust (Asset) and Holding Trust (Operating). 6. The Australian Superannuation Fund establishes a Australian-resident trust with equity, which in turn invests equity into Holding Trust (Asset) and Holding Trust (Operating). 64

65 7. Holding Trust (Asset) and Holding Trust (Operating) uses the funds it has obtained from the consortium to subscribe for units in the Asset Trust and the Operating Trust (respectively), which, together with the external debt financing, enables the Asset Trust to pay the lease premium and consideration for the Non-Land Assets as described earlier. 65

66 66

67 2.6 Tax treatment of the upstream/feeder-level structure The tax issues arising from the above structure include: 1. Unitholder debt 2. Cost base of equity interests in the Asset Trust and the Operating Trust 3. Control for the purposes of the MIT rules and Division 6C 4. Net income of the trust and tax deferred distributions 5. Non-MIT trustee assessment for trusts with non-resident beneficiaries 6. Availability of credits for tax paid as a trustee assessment 7. MIT status and fund payment withholding The tax treatment of the Asset Trust, the Operating Trust and the holding entities were discussed in Unitholder debt The structure outlined above involves all of the upstream financing taking the form of unitholder equity. The ATO understands that some investors may structure their investment to include an amount of debt, usually by way of the relevant SPV borrowing funds from its parent, and injecting those funds as equity into the relevant Holding Trusts. This is commonly called unitholder debt. The use of unitholder debt to fund an investment in this way potentially could be considered as high risk by the ATO from a compliance perspective. As such, taxpayers adopting a structure which involves unitholder debt should carefully consider the application of the transfer pricing rules in Division 815, the thin capitalisation rules in Division 820, and Part IVA. The ATO will assess whether such unitholder debt does comply with these provisions on a case-bycase basis, and will be issuing compliance guidance in particular on transfer pricing and the application of the arm s length principle in certain situations at some stage in the future Cost base of equity interests in the Asset Trust and the Operating Trust Following on from the observations in in relation to the allocation of the purchase price, the ratio of the total cost base for the purposes of the CGT provisions of the equity interests in the Asset Trust and Operating Trust should be broadly in the same ratio as the Purchase Price allocation. That 67

68 is the amount subscribed for capital in each trust should match the cost base of underlying assets assuming the same gearing level in each trust Control for the purposes of the MIT rules and Division 6C The issue of control is relevant both for the purposes of Division 6C and the MIT rules. Taxpayers should take into account the discussion in Chapter 3 in relation to the concept of control for the purposes of Division 6C. Importantly, in determining whether there is control, there must be reference not only to contractual and other formalised governance arrangements, but also the conduct of the parties in reality and informal understandings. In judging whether there is a compliance risk of particular investors controlling the Operating Trust, the ATO considers the following things to be relevant: the overall nature and significance of any investment into the staple; and whether the investors are composed of members who tend to be passive investors rather than operators of the underlying business. In determining this, taxpayers should take into account the discussion in Chapter 3 on control for the purposes of Division 6C. The ATO is likely to allocate compliance resources to test whether there is control through conduct and/or informal understandings where an investor has a stake of 20% or more. Where an investor has a stake of 30% or more, the ATO will allocate compliance resources to test whether there is control evidenced by conduct or informal understandings Net income of the trust and tax deferred distributions Subject to specific withholding tax rules, where a beneficiary is presently entitled to a share of the income of the Asset Trust or the Operating Trust, then the assessable income of the beneficiary will generally include the beneficiary s share of the net income of the trust (section 95). The net income of the Asset Trust is defined to be, broadly, its taxable income, whereas the income is simply its distributable income for trust law purposes as generally understood or defined by the trust deed. These concepts are contained in Division 6. However, one thing that is likely to occur in the above structure is that, in some income years, the net income of the Asset Trust will be below its distributable income. This will arise where, for example the decline in value of the Land Assets which are subject to Division 40 or Division 43 (as discussed in 2.2) occurs faster for tax purposes than it does for accounting purposes. 68

69 Additionally, an amount to which a beneficiary is presently entitled may be neither income nor net income of the trust where, for example, the amount of the entitlement represents an in-substance return of capital. Where either of these arises, the Ultimate Investors and/or their SPVs receive a tax deferred distribution (TDD). This means they only include in their assessable income the extent to which the distribution they are presently entitled to represents the taxable income of the Holding Trust (Asset). Additionally, in the case of the non-resident Ultimate Investors, neither a trustee assessment nor a MIT withholding obligation would arise in respect of the amount of a distribution that is a TDD. The ATO also does not consider that the distribution would be included in assessable income under section 6-5 unless, in substance, it represents a return in relation to the provision of finance or for services provided to the trust. That said, where a distribution is not fully included in Investors and/or their SPVs assessable income because it is partly or totally a TDD, CGT event E4 will occur: subsection (1). This will have one of two outcomes: it will cause Ultimate Investors and/or their SPVs cost base in the units to be decreased to the extent that the distribution was not taxed; or if the cost base would be less than $0 as a result of the above, the Ultimate Investors and/or their SPVs will make a capital gain to the extent that the cost base would be less than $0. For revenue taxpayers, the amount may also be taken into account on ultimate disposal of the units in determining the net profit. For details on tax deferred distributions and CGT event E4 see the ATO s publication Non-assessable payments from a trust Non-MIT trustee assessment for trusts with non-resident beneficiaries This discussion applies if one of the trusts has a non-resident beneficiary, and the trust is not a MIT as defined in section See the ATO s publication What is a MIT under the new rules for the requirements for a trust to be a MIT. In this case, the trustee of the trusts will generally be taxed in relation to the beneficiaries. The trustee is taxed to assist in the collection of Australian tax on relevant income. Specifically, under section 98 of the ITAA 1936, the trustee of the trust will generally be liable to pay tax on the non-resident s share of the net income of those trusts see for a discussion of this. The applicable tax rate will depend upon the type of entities that are the beneficiaries of those trusts, and range from 30% to 46.5%. Generally, the MIT withholding rate will be 15% for beneficiaries that are residents of tax information exchange countries. Details of the tax rates that apply to particular types of 69

70 beneficiaries and types of investments are set out in the ATO s publication Withholding tax arrangements for managed investment trust fund payments. The 15% rate is applied to the net income of the trust, and will not, for example, apply to the component of any distribution which is a TDD. However, one of the key issues regarding whether the SPVs will be MITs relates to the requirement that the these trusts not control, or not be able to control a trading business. This issue is covered in Chapter 3. Where withholding taxes are not payable, the tax that was assessed to the trustee as outlined above in relation to a non-resident beneficiary is generally not a final tax. If the trustee is assessed in respect of an individual or company beneficiary, those beneficiaries are assessed under subsection 98A(1) and allowed a credit under subsection 98A(2) for tax paid by the trustee. If the trustee is assessed in respect of a trustee beneficiary, the trustee beneficiary and any later trustee in the chain of trusts is not assessed again on that amount under section 98, 99 or 99A. However, an amount may be taxed to an ultimate individual or company beneficiary under subsection 97, 98A(3) or 100 and allowed a credit under section 98B. See the ATO s publication Taxation of trust net income non-resident beneficiaries MIT status and fund payment withholding If a trust is a MIT, then a special MIT withholding rate will apply (to the extent that interest, dividends or royalty withholding tax is not payable); and the trustee assessment and crediting process mentioned above will not occur. In determining whether a trust qualifies as a MIT, and/or are entitled to the MIT withholding rate of 15%, particular care should be taken to ensure that: the trust is a managed investment scheme (within the meaning of section 9 of the Corporations Act 2001) a requirement that may be difficult to satisfy where there is a single beneficiary of that trust; a substantial proportion of the investment management activities are in substance carried out in relation to the trust in respect of the assets of the trust are carried out in Australia. The ATO will be undertaking compliance resources in order to ascertain whether purported MITs or withholding MITs do actually satisfy these requirements. 70

71 2.7 Restructuring and exiting of an investment This part covers a number of topics regarding restructuring and exiting of the investment by the Ultimate Investors. The topics are: 1. Capital gains tax and Division Attribution of sale proceeds upon exit 3. Pre-sale restructuring 4. Potential revenue account treatment of sale Capital gains tax and Division 855 Generally, if an investor were to exit their investment by way of a sale, any gain or loss made on the sale would be a capital gain or loss, and subject to the CGT rules, unless the sale is on revenue account (see below). However, a capital gain or capital loss made by a non-resident from a CGT event is disregarded under subsection (1) if the CGT event happens in relation to a CGT asset that is not 'taxable Australian property'. Relevantly, one type of taxable Australian property is an 'indirect Australian real property interest'. Subsection (1) provides that a membership interest is an 'indirect Australian real property interest' when a CGT event happens in relation to the membership interest if the interest passes: the non-portfolio interest test at that time or throughout a 12 month period beginning no earlier than 24 months before the CGT event happened and ending no later than that time; and the principal asset test in section at that time. The principal asset test generally will be passed where 50% or more of an entity s underlying value is derived from real property situated in Australia (including a lease of land, if the land is situated in Australia), as well as other types of rights not relevant for present purposes. This means that: if a non-resident Ultimate Investor sold their interest in either one of the SPVs that hold interests in the Holding Trust (Operating), or the Holding Trust (Operating) itself; if the assets of the Operating Trust that constitute land or a lease of land situated in Australia are less than 50% of the assets of the Operating Trust (which is typically the case in privatisations where the Operating Trust s interest in real property is a lease under which it pays market rentals); and 71

72 there are no other assets held by any other entity interposed between the Ultimate Investor and the Operating Trust, other than membership interests in the interposed entities, then any capital gain or capital loss made by the non-resident Ultimate Investor would be disregarded under Division 855. Note, if taxpayers purported to treat a particular asset as being not real property for the purposes of Division 855, but land for the purposes of Division 6C, the ATO would regard this treatment as high risk from a compliance perspective and apply compliance resources accordingly Attribution of sale proceeds on exit Because the interests the Ultimate Investors hold in the Asset Trust or the Operating Trust are legally or economically stapled, it is likely that any sale of these interests would be a single unified transaction, and also with a single sale price. That notwithstanding, an attribution of the sale price between the interests held in these two entities will be required for tax purposes. This is because, as noted above, a capital gain resulting from the sale of: the SPVs that hold interests in the Holding Trust (Operating), or the sale of the Holding Trust (Operating) itself will likely be disregarded under Division 855; but the SPVs that hold interests in the Holding Trust (Asset), or the sale of the Holding Trust (Asset) itself will likely not be disregarded under Division 855. An appropriate allocation of sale proceeds is essential to ensure that the capital gains tax provisions are complied with, and Part IVA does not apply. Consistent with the pricing of the cost base of the interests, an appropriate allocation of sale proceeds should be worked out particularly having regard to: the nature of the business at the time it is being sold, particularly if the business at the time of sale is a single unified business; if the business is subject to regulation or supervision on the amount of revenue it can derive at the time of sale - the way in which its maximum allowable, or appropriate amount of revenue is calculated by the relevant regulator, and the extent to which that revenue is attributable to the assets of the Asset Trust and the Operating Trust; the total sale price paid for both entities compared with: o o the stapled structure s pre-sale financial statements; and/or the value of the businesses assets at the time of sale used by a regulator in determining the an entity s maximum allowable or appropriate amount of revenue; 72

73 if a market valuation of the individual assets is conducted for the purposes of the Purchase sale price, it is critical that each of tangible and intangible asset should be subject to its own fair and reasonable valuation for tax allocation purposes. A simple example is that a road without a tolling concession would not be worth the same for tax allocations purposes as the same road with a tolling concession. We do not accept that for tax allocation purposes the market value of the road is the value of the road with the tolling concession. This is because that method of valuation would implicitly incorporate the value of an intangible asset when valuing the tangible asset. Rather, we consider that in determining the value of tangible assets as distinct from the value of the intangible assets, the tangible assets intrinsic value should be determined excluding the value of the intangible assets. Accordingly if the value of the intangibles were excluded from the value of tangible assets there will be a separate amount allocable to the intangible asset; and consistency, to the extent reasonable, with the way in which the cost base of the interests were calculated Pre-sale restructuring As has been outlined above, the tax treatment of the returns on different types of investment, as well as the tax treatment of gains made on the sale of the investment, can be significantly different. For example, there will generally be a preferential tax treatment of the returns paid on loans while the investment is on foot as opposed to the returns paid on an equity investment. By way of another example, where the equity investment is made into a land rich entity like the Asset Trust, then flow-through taxation and/or MIT withholding tax treatment will be more likely. This will generally constitute a preferential treatment over the investment into the Operating Trust especially where it is a public unit trust. However, at the time of sale, the Operating Trust will generally receive a preferential treatment under capital gains tax due to the disregarding of capital gains under Division 855. The Asset Trust, on the other hand, would generally be expected to not have its capital gain disregarded under Division 855, provided it is land rich. Given the different set of tax arrangements that apply while the investment is on foot as against when it is sold, taxpayers may be faced with an incentive to restructure their investment prior to exit (e.g. creating more value in Operating trust prior to the sale). Where this occurs, and a tax benefit is obtained (such as the omission of a capital gain), the ATO considers that there is a risk that Part IVA will apply, and will allocate compliance resources accordingly. 73

74 2.7.4 Potential revenue account treatment of sale As noted above, when a non-resident investor sells their direct (or indirect) interest in the Hold Trust (Asset), Division 855 may potentially apply to disregard any capital gain or loss arising from that sale. This part is about the treatment of any gain or profit from the sale which is on revenue account and treated as ordinary income under section 6 5. In working out the amount of ordinary income, consistent with our administrative approach in relation to TDDs, the amount of any TDD should be taken into account. The fact that there is an amount of ordinary income does not automatically mean that the gain is taxable in Australia; it will depend on the source of the income and the application of any applicable tax treaty. Residents in non-treaty countries Because the investor is a non-resident, any income from the sale will only be taxable in Australia to the extent that the income is from an Australian source. In determining whether the income from the sale is from an Australian source, the question is not dependent solely on where the purchase and sale contracts are executed in respect of the sale of the interests. While issued in the context of the sale of the shares by a private equity fund, TD 2011/24 outlines some of the factors we will consider when determining the source of the income from the sale of the units. Residents in treaty countries Where the investor is a resident of a country with which Australia has a tax treaty, the treaty will determine whether Australia has taxing rights in respect of any profit or gain from the sale. If Australia does have taxing rights, the treaty will deem the relevant profit or gain to arise from an Australian source. Generally the profit or gain will only be taxable in Australia if: the value of the units sold is principally (50% or more) derived from Australian real property (including where the real property is held directly or indirectly through a chain of interposed entities). The definition of real property will be found in the relevant treaty and will generally include a lease of land; or the units form part of the business property of an Australian permanent establishment; or the profit is attributable to an Australian permanent establishment. Therefore, provided the investors do not have an Australian permanent establishment (within the meaning of the relevant treaty), they will generally only be subject to tax on any gain from the sale of their units in the SPVs if the value of the units is principally derived from Australian real property. 74

75 If the SPV trusts in the above example have an Australian permanent establishment, the enterprise carried on by the trustee of the SPV is deemed to be a business carried on by the foreign investors. As a result the investors would generally be subject to tax on any profit or gain made by the trustee of the SPVs on the sale of units in the Holding Trusts. TD 2010/20 outlines the ATO s view on treating shopping. As set out in paragraph 17 of that TD, Australia s tax treaties are subject to the operation of Part IVA by virtue of Section 4 of the International Tax Agreements Act Accordingly, it will be necessary to examine the circumstances of each individual taxpayer claiming treaty benefits. 75

76 3. Other infrastructure-related issues This Chapter sets out how the income tax law applies to infrastructure-related issues not covered in Chapters 1, 2 or 4. This Chapter is structured as follows: 1. Customer cash contributions / reimbursements 2. Government grants 3. Gifted assets 4. Capitalised labour 5. Undergrounding power lines 6. Control for the purposes of Division 6C. 3.1 Customer cash contributions / reimbursements Infrastructure network providers will often receive payments from customers or third parties in exchange for adding to, extending or modifying their network. For example, where a customer requires an electricity connection for a new property, the customer may pay the network provider a sum to extend the network. Similarly, where a third party requires the partial relocation of network assets (to allow the construction of a mine, for example) it would generally pay the network provider to carry out the required work. From the perspective of the network provider, such customer contributions will usually constitute assessable income at the time of invoice under section 6-5 of the ITAA1997. This is because the receipt of cash in exchange for constructing such assets is an ordinary incident of the business activities of the taxpayer. It does not matter that the funds may be used by the provider to construct or improve what might be a capital asset. Some infrastructure providers may receive payments that are grossed up in excess of construction costs and/or a margin which are designed to compensate for the tax payable upon receipt of the cash contribution. Such additional amounts would usually be included in the assessable income of the provider under section

77 3.2 Government grants Government grants made in relation to infrastructure assets will usually be assessable income under section 6-5, or, alternatively, under Where a government grant is received by an entity that immediately prior to the grant is merely a holding company, that grant will be assessable income under section 6-5, or alternatively, under Additionally, a grant for the construction of an infrastructure asset that is received before or during the construction phase of that asset will be assessable under section 6-5, or alternatively, under The timing of the recognition of the income: if section 6-5 applies generally at the time the grant is invoiced or received whichever is earlier; and if section applies, when it is received. 77

78 3.3 Gifted assets This part is about the tax treatment of gifted assets from the perspective of: 1. the transferee; and 2. the transferor. A gifted asset is an asset provided to the transferee in a manner that an interest in that asset passes to the transferee. An asset will not be treated as a gifted asset where the Government makes a contribution to an asset not owned by the Taxpayer. For example if the State Government agrees to pay for part of a toll road, provided no property in that road passes to the private sector operator, the Government contribution will not be treated as a gifted asset Tax treatment of the transferee The tax treatment of the transferee is governed by a number of provisions, including section 21A of the ITAA 1936, section 6-5 and Division 40. Section 21A of the ITAA 1936 operates to give a value for the gifted asset for the transferee, and section 6-5 operates to include that amount in assessable income if it is income according to ordinary concepts that is derived by the transferee. Division 40 then operates to allow for capital allowances (in some cases) to be available for the amount of the gifted asset. As such, this part will be structured as follows: 1. The application of section 21A of the ITAA The application of section Entitlement to deductions under Division The provision of examples. 1. Section 21A There are two issues in determining the value of the gifted asset under section 21A of the ITAA1936: 1. What is the arm s length value of the gifted asset (see subsection 21A(5))? 2. What is the amount of the recipient s contribution (which will reduce the amount included in assessable income as a result of the gift see paragraph 21A(2)(b))? Arm s length value of the gifted asset Subsection 21A(5) defines the arm s length value of a gifted asset to be: 78

79 (a) the amount that the recipient could reasonably be expected to have been required to pay to obtain the benefit from the provider under a transaction where the parties to the transaction are dealing with each other at arm's length in relation to the transaction; or (b) if such an amount cannot be practically determined--such amount as the Commissioner considers reasonable. The Commissioner considers the following methods will apply in determining the amount referred to above: where the asset is immediately gifted and derived as ordinary income under section 6-5 (see the below discussion on derivation) to the transferee post-completion: o o the transferor s construction costs; or a reasonable estimate of the transferor s construction costs undertaken by the transferee (had construction occurred at the time of derivation); in any other case the asset s replacement cost at the time of derivation. Amount of the recipient s contribution The value of the gifted asset under section 21A of the ITAA 1936 is reduced by the amount of the recipient s contribution. In the case of gifted assets, this would mean the amount of any consideration paid by the transferee to the transferor in respect of the gifted asset. Subsection 21A(6) further specifies that this consideration must be in money. This would not include, for example, the market value of encumbrance or similar obligation the transferee must comply with after it is gifted the asset by the transferor (although such encumbrances or obligations may affect whether the gift constitutes income that is derived and the timing of that derivation). 2. Implications under section 6-5 A gift will only be included in assessable income under section 6-5 if, taking into account section 21A of the ITAA 1936 and the discussion above, the gift is income according to ordinary concepts that the entity receiving the gift derived. In general, where an infrastructure asset is gifted to a transferee, and: at the time of the gift, there is an obligation to provide that asset to the transferor at some later stage; and there are encumbrances or similar obligations that prevent the transferee from benefiting from its (temporary) ownership of the asset; 79

80 then the transferee will not be expected to derive the gift. However, where the transferee: is gifted the asset absolutely; is not under an obligation to provide the asset to the transferor; or may, while it owns that asset, benefit from its ownership of that asset; then the transferee would generally be expected to derive income consisting of that gifted asset. The timing of the derivation of that income will in turn depend upon the circumstances of the gift. In the situation where the asset is: gifted absolutely, or not subject to an obligation to provide the asset to the transferor at a later date (except for the situation outlined immediately below) the income will be derived upon receipt of the gifted asset; or gifted subject to an encumbrance or similar obligation that (temporarily) prevents the transferee from benefiting from its ownership of the asset the income will be derived when that encumbrance or similar obligation comes to an end. 3. Implications under Division 40 Section provides that Division 40 will apply to taxpayers that start to hold a depreciating asset gifted to them as though the taxpayer paid to start to hold that depreciating asset for the greater of: the amount included in assessable income under section 6-5 taking into account the effect of section 21A of the ITAA 1936, ignoring the value of anything the taxpayer gave that reduced the amount actually included in assessable income; or other amounts set out in the table in subsection (1) that are not relevant to the current discussion. 4. Examples This part sets out examples of: a gift of a wharf; and a gift of an expanded network. 80

81 Example 1 Gift of a wharf A lessee leases freehold land owned by a lessor on which it constructs a wharf. That wharf, due to the doctrine of fixtures as it applies in the relevant jurisdiction, becomes a fixture to the leased land, and also the property of the lessor. However, pursuant to either the lease itself or another related agreement such as a licence, the lessor must provide the lessee exclusive and unfettered access to the wharf for a period. In this example, the lessee does not have a right to remove the wharf, during the lease or at expiry of the lease. As an illustration, if: a port lessee constructs a new wharf; the port lessor obtains ownership of the wharf under the doctrine of fixtures as it applies in the relevant jurisdiction for no consideration; under the lease, the port lessor must provide exclusive and unfettered access to the wharf to the lessee; and at the end of the lease, the replacement cost of the wharf is $2 billion; then: there is a gift of an asset, being the wharf to the port lessor; the amount of that gift will be the $2 billion replacement cost of the wharf at the time it is derived (see below); the market value of the port lessor s obligation under the lease (to give exclusive possession) will not constitute a recipient s contribution under subsection 21A(5) of the ITAA 1936 because of subsection 21A(6); the amount included in the lessor s assessable income under section 6-5 because of the effect of section 21A of the ITAA 1936 will be $2 billion; and that $2 billion will be derived at the time that the port lessor s obligation under the lease comes to an end. Example 2 Gift of an expanded network An entity owns an infrastructure network under which it receives income that is subject to regulation by a regulator. A third party incurs expenditure to expand the infrastructure network into areas not previously covered. 81

82 The entity that owns the network is gifted the expansion by the third party under legislation that provides that the expansion of the network is the property of the owner of the network, and not the entity that constructed the expansion or the entity on whose land the expansion is situated. The entity pays no consideration for the expansion, and nor does it grant any other entity any licence or any other benefit in relation to the network. Under this scenario: there is gift of the expansion of the infrastructure network to the entity; the amount of the gift will be the amount of the expenditure incurred by the third party in constructing the expansion, because the gift was derived immediately after the expansion occurred (see below); there is no recipient s contribution; the amount included in the entity s assessable income under section 6-5 because of the effect of section 21A of the ITAA 1936 is the amount of expenditure incurred by the third party; and the amount is derived immediately after the expansion of the network occurred Tax treatment of the transferor The gift of an asset would generally be not deductible under section 8-1 because the loss or outgoing arising from the gift would be of capital, or of a capital nature. Similarly, expenditure incurred in constructing the gifted asset would also be capital, or of a capital nature, as that expenditure would typically secure for the donor a right to access the infrastructure asset being constructed (such as a lease agreement for a port or a connection agreement for electricity infrastructure). That said, deductions may be available in accordance with: 1. Section 8-1 if it can be demonstrated that the loss or outgoing is not of capital, nor of a capital nature. A potential situation where this may arise is where expenditure is incurred by a developer in respect of the construction of a gifted asset that directly relates to the construction of a particular development e.g. expenditure incurred by a developer to construct residential electricity connections for a housing development. 2. Section if, for example, the expenditure is mining capital expenditure or transport capital expenditure, or the amount is paid to create or upgrade community infrastructure for a community associated with a project (subject to the rest of the requirements for Subdivision 40-I being satisfied). 82

83 3. Section if the expenditure constitutes black hole expenditure. That being said, it would generally be expected that a deduction would be precluded under this section as it is likely that the expenditure would be included in the cost base of a CGT asset. 83

84 3.4 Capitalised Labour Some taxpayers are actively involved in the self-construction or upgrade of depreciating assets that are used in their business. Expenditure on: salary and wages, and associated labour on-costs; and certain other costs to the extent that the relevant employees are engaged in the selfconstruction or upgrade of depreciating assets, or the other costs directly relate to that activity, are not an allowable deduction under section 8-1. The salary and wages may be of employees directly engaged in the physical construction of the asset, or those engaged in the design, planning, and other associated activities directed at the construction of those assets. These types of expenditure are regarded as being capital in nature and will normally form part of the cost of the self-constructed assets (e.g. the depreciating assets cost under Subdivision 40-C where relevant): ATO IDs 2011/42, 2011/43 and 2011/44. In circumstances where employees undertake a variety of work (e.g. operational repairs and asset construction), the taxpayer would be expected to identify the time spent by an employee in carrying out activities that relate to the construction and upgrade of depreciating assets and capitalise those costs accordingly: ATO IDs 2011/42 and 2011/43. Other relevant costs, such as the running costs of vehicles used in the construction of depreciating assets undertaken by a taxpayer, will not be deductible under section 8-1. Instead, the portion of vehicle running costs incurred for such use will generally form part of the cost base of the relevant depreciating assets: ATO ID 2011/44. Where expenditure of the type described above forms part of the cost base of the asset in accordance with: the accounting standards as defined in the Corporations Act 2001; or if there are no accounting standards applicable to the matter, authoritative pronouncements of the Australian Accounting Standards Board that apply to the preparation of financial statements. then that expenditure would generally be regarded as being capital in nature, and, for example, form part of the cost of those depreciating assets under Subdivision 40-C. Where a taxpayer has lodged returns other than on this basis, the ATO will apply compliance resources to test the position taken by the taxpayer. 3.5 Undergrounding power lines Taxpayers conducting electricity transmission and distribution businesses may enter into agreements with governments under which: 84

85 works are to be undertaken that will result in the replacement of power lines in bushfire prone areas which would otherwise not have been replaced with insulated underground power lines (known as undergrounding ); and consideration will be paid to the taxpayer in the form of a fee. The question that arises is whether the costs incurred by the taxpayer in undertaking the undergrounding are deductible under section Section provides: (1) You can deduct expenditure you incur for repairs to premises (or part of premises) or a * depreciating asset that you held or used solely for the * purpose of producing assessable income. Property held or used partly for that purpose (2) If you held or used the property only partly for that purpose, you can deduct so much of the expenditure as is reasonable in the circumstances. No deduction for capital expenditure (3) You cannot deduct capital expenditure under this section. The undergrounding is not considered to be a repair to premises or a depreciating asset because the works are not undertaken to remedy defects arising from wear and tear or deterioration due to the passage of time. The power lines are capable of functioning properly in their current condition. This is so even if the age of the power lines may be part of the reason why the Government entered into the above agreement. No part of the purpose of the works is to restore something lost or damaged. For these reasons, the works are not a repair for the purposes of section The works would also be expected to be an outgoing of capital, or of a capital nature, and therefore for this reason are also not deductible under either sections or

86 3.6 Control for the purposes of Division 6C As outlined in Chapters 1 and 2, the concept of control for the purposes of Division 6C of the ITAA 1936 can be relevant as to whether Division 6C and/or the MIT rules apply in relation to a particular trust. This part will: 1. Discuss the ATO s approach to the concept of control in Division 6C 2. Set out the types of clauses that may be more likely than others to give rise to control for the purposes of Division 6C 3. Provide examples ATO s approach to the concept of control in Division 6C Paragraph 102N(1)(b) provides that: [f]or the purposes of this Division, a unit trust is a trading trust in relation to a year of income if, at any time during the year of income, the trustee: [ ] b) controlled, or was able to control, directly or indirectly, the affairs or operations of another person in respect of the carrying on by that other person of a trading business. There are three components to paragraph 102N(1)(b): 1. Controlled, or was able to control, directly or indirectly; 2. The affairs or operations of another person; and 3. In respect of the carrying on by that other person of a trading business. Controlled or was able to control, directly or indirectly Section 102N will apply in relation to a year of income if at any time during the year the trustee controlled, or was able to control a trading business. There are three elements to this: 1. The meaning of control. 2. Where control rights are not exercised. 3. Control arising indirectly. Meaning of control The ATO considers that the context and wording of section 102N indicates that the phrase controlled, or was able to control should not be determined solely by reference to legally binding or enforceable agreements. The phrase requires all surrounding facts and circumstances to be taken into account, including informal understandings and practices. 86

87 One of the consequences of this is that control can arise not simply where an investor has majority ownership of the investment. Another consequence is that control will arise where there is a circumstance such that an entity has the power of veto to prevent or block a decision being made by the operating entity that goes towards the carrying on of a trading business. A proposition has been put to the ATO that the above conclusions are incorrect based on the following passage from Mendes v Commissioner of Probate Duties (Vic) [1967] 122 CLR 152 (Mendes): 2 for the purposes of the revenue laws, a member of a company who holds enough shares to give a majority of votes at a general meeting has control of the company. That is the general rule. Control in that sense means the capacity to carry an ordinary resolution at a general meeting. It is important to note however that Mendes is not authority for any general proposition that control can only arise where an entity has the majority of votes in a company. Indeed, Bowen CJ in Re The News Corporation Ltd (1987) 15 FCR 227, with whom Lockhart J agreed, said (at FCR 242-3): It was argued that a power of veto does not constitute control in the relevant sense. Control, it was said, exists only where there is a power to get one s own will. I do not agree that the concept of control is so limited. The Oxford English Dictionary defines control as to exercise restraint or direction. A power to veto is a power to restrain, and hence control. In News Corporation, Beaumont J summed up the various authorities as such: 3.for the purposes of the revenue laws a member of a company who holds enough shares to give a majority of votes at a general meeting has "control" of the company. "That is the general rule. Control in that sense means the capacity to carry an ordinary resolution at a general meeting." See also Kolotex Hosiery (Australia) Pty. Ltd. v. The Commissioner of Taxation of the Commonwealth of Australia (1973) 130 CLR 64 per Mason J. at pp 77-8; (1975) 132 CLR 535 per Gibbs J. at pp On the other hand, in The Commissioner of Taxation of the Commonwealth of Australia v. Commonwealth Aluminium Corporation Limited (1980) 143 CLR 646, the meaning of "control" of a business by nonresidents for the purposes of s.136(a) of the Income Tax Assessment Act 1936 was seen to be different. Stephen, Mason and Wilson JJ. said (at pp ) that shareholders, through their power to control the company in general meeting and perhaps through their power to elect directors, may be said to "control" the company, "but as a general rule they do not exercise de facto control of the company's business." Authorities such as Mendes were distinguished as being concerned with the different question of control of the company rather than its business (at p.660). Therefore, an interpretation that limits the meaning of control, or able to control in the context of Division 6C to 50 per cent of voting rights is not consistent with case law, and would unjustifiably restrict the natural meaning of the word as used in section 102N. Additionally, in the context of stapled structures including but not limited to the structure outlined in Chapter 2, where the transactions between Asset Trust and the Operating Trust are such that the 2 Windeyer J in Mendes at Re The News Corporation Ltd (1987) 15 FCR 227 at

88 Operating Trust s continuation as a going concern is contingent on Asset Trust deciding not to exercise a right it has to trigger the Operating Entity s insolvency, this will give rise to control for the purposes of Division 6C. Control arises even if not exercised Additionally, control will also arise where an entity: a) demonstrates control; or b) has the ability to control despite not having exercised it. As illustrated by example 1 in Examples, the ATO does consider that in order to give Division 6C its intended effect, control should not be limited to instances where the entity actually exercises control over the affairs or operations of a person, who is carrying on a trading business. Relationships through interposed entities Lastly, the reference to directly or indirectly recognises that the ability to control can exist through an interest in a subsidiary or a relationship with an interposed entity. The affairs or operations of another person The phrase affairs or operations is not defined in the ITAA On ordinary concepts, the phrase affairs or operations of a person includes their business and internal affairs or operations. 4 Indeed, as Winn J stated in R v Board of Trade, ex parte St Martin Preserving Co Ltd: 5 the phrase affairs of the company comprises all its business affairs, interests or transactions, all its investment or other property interests, all its profits and losses, and its goodwill. As such the ATO considers the phrase affairs or operations to be sufficiently wide enough to encompass any thing done by the relevant entity. In respect of the carrying on of a trading business The ATO considers the phrase in respect of the carrying on by that other person of a trading business as limiting the type of matters which would be sufficient to establish control for Division 6C purposes. Those matters which may give rise to control for the purposes of Division 6C are outlined in the table below. Relevantly, there is a distinction between those matters that go to the capital structure and distribution policy of an entity and those matters which are in respect of the carrying on of a trading business. Where the control rights are in the nature of protective minority interest holder rights, then the presumption would be that such rights do not go to the carrying on of a trading business. 4 Re National Foods Ltd (Nos 1 and 2) (2005) 54 ACSR 80 at [55] 5 R v Board of Trade, ex parte St Martin Preserving Co Ltd [1964] 2 All ER 561 at

89 As a general principal, where the control rights relate to matters that are commonly in the domain of management, then those control rights will relate to the carrying on of a trading business. This will still be the case, notwithstanding that a control right may only be able to, or be expected to be, exercised infrequently. Control is not singular If two or more investors each have the power to veto decisions that go the affairs or operations of the trading business, then each of those investors will individually and separately have the power to restrain and hence control Examples of clauses that may give rise to control for the purposes of Division 6C Some clauses either require that certain decisions be approved by a supermajority of the board of the directors or require a special resolution by a supermajority of shareholders. Whether a specific clause requires board or shareholder approval varies from case to case. Clause type Management Arrangements Description of activity in relation to which a veto right exists Appointment and removal of the CEO and/or CFO of the Company. The appointment or termination of any entity with a material influence over decisions made in respect of the business carried on by the entity. Any other agreement or understanding that results in an entity, or gives an entity the ability to control the entities mentioned above. Does control arise? Yes Management Business Plan / Annual Budgets Entry into business contracts Any approval or amendment of strategic and annual operating plans or budgets. Entry into, amendment or termination of any arrangement, contract or transaction (other than those arrangements, contracts or transactions of the type categorised below as not giving rise to control for the purposes of Division 6C). Yes Yes New investments and Divestments Capital expenditure Entering into or exiting any project or transaction, including any variation to any existing project or transaction. Approval for capital expenditure projects. Yes Yes 89

90 Entry into Lease Entry into a lease (or other similar arrangements). Yes Tax New indebtedness Changes to Constitution Filing of any return or tax report for any group entities. The making, variation or revoking of any material tax election by any group entities. Entry into any indebtedness of any kind, redemption or early payment of loan capital, unless it goes only to the debt/equity mix. For the avoidance of doubt, control relating to altering the total amount of capital on issue (including both debt and equity) will give rise to control for the purposes of Division 6C. Any amendment to the constituent documents of the Company unless those amendments go to the matters described as giving rise to control for the purposes of Division 6C. Yes Yes No Termination or changes of Security holders Agreement Decision to terminate or change Security holders Agreement unless such terminations or changes go to the matters described as giving rise to control for the purposes of Division 6C. No Material change in business A decision to terminate the existing trading business or a decision to start a completely new trading business. No Distributions Policy Capital structure The establishment of or any change to the distribution policy of the Company. This is because decisions regarding the allocation of profits are separate to that of the carrying on of a trading business, and would therefore generally not be relevant for establishing negative control. Any change in capital structure, including any issue of a new class of securities, reclassification of existing securities, buyback, redemption, purchase or cancellation of any securities or reduction of share capital in the Company other than on a pro rata basis to all existing Security holders. No No Variation of security rights Changes in the rights attached to any securities issued in the Company. No Initial Public Offering A decision to proceed with investigating and preparing for an initial public offer of Securities, or a listing of the business, on No 90

91 Transfer of securities Creation of new Group Entity a recognised stock exchange, and the ultimate decision to proceed with the IPO. Any decision by the parent company to transfer any or all securities in a Subsidiary. The formation of any subsidiary, branch, office or agency. No No Pension / Superannuation Winding up of the Entity Third Party advisors Annual Accounts Establishment or material amendment to any pension scheme. A decision to wind up the company, or any other entity. Appointment or removal of third party accounting, auditing and tax advisors. Approval of the annual accounts. Any change to the financial year of the Company. No No No No Registered Office Any changes to the registered office of any group entities. No Litigation Matters Name of group Entities Commencing, defending or resolving any legal proceedings or dispute, depending on the nexus between those proceedings or disputes and the trading business. Any change to the name of any group entities. No No Additionally, depending on the particular facts and circumstances, other types of clauses may give rise to control for the purposes of Division 6C. These are outlined below. + Clause type Board members Guarantees Related party contracts Description of activity in relation to which a veto right exists Appointment and removal of Board Members (including the independent Chairperson) Depends on the composition of the Board, and the voting procedures for the Board. Changes to the size of the Board, remuneration to members of the Board, and professional liability insurance. Giving any guarantee or indemnity to any person depending on the nexus between that transaction and the trading business. Entry into a contract with a related party depending on the nexus between that contract and the trading business. 91

92 Entry into any transaction with any security holder, or members of the security holders group or any director or officer holder of the security holder group. Where related party contacts are infrequent and immaterial, and the purpose of control rights exist as a matter of good governance to prevent or manage conflict of interests. Where the related party contract is a substantial part of the trading business, then such control right would give rise to control for Division 6C purposes Examples The following examples address the application of paragraph 102N(1)(b) of the ITAA Example 1: Appointment and Removal of Directors 1. Investors A, B, C, D and E intend to invest in an Infrastructure Asset in Australia. 2. Each Investor establishes a resident holding trust and company, to act as trustee, to acquire their respective unit holding in the Infrastructure Asset. 3. Pursuant to the Investment Agreement, each Investor is entitled to appoint (and remove at will) the following number of directors: a. Investor A: 1 b. Investor B: 1 c. Investor C: 1 d. Investor D: 1 e. Investor E: 3 4. The quorum for Board of Director meetings is The Board of Directors has control over the affairs or operations over the trading business. 6. All Board decisions require 80% or more of Board votes to be passed. 7. Investor E chooses not to appoint any nominee directors to the Board. At the point in time when Investor E makes the decision to not appoint any nominee directors to the Board, Investors A, B, C, D and E all have control of the trading business for Division 6C purposes. Investors A, B, C and D, by virtue of their ability to appoint a single nominee director, will have control, or the ability to control, directly or indirectly, the affairs or operations of the Infrastructure Unit Trust in respect of it carrying on a trading business. This is because, Investors A, B, C and D each 92

93 have the ability to veto decisions of the Board which go towards the carrying on of the trading business. Investor E, by virtue of their ability to appoint multiple nominee directors, irrespective of the fact that they have not exercised their right to appoint nominee directors, will have the ability to control, directly or indirectly, the affairs or operations of the Infrastructure Unit Trust in respect of it carrying on a trading business. This is because, at any point in time Investor E has the ability to appoint nominee directors and in turn veto decisions of the Board which go towards the carrying on of the trading business. At the point in time, when Investor E decides to exercise its power of appointment, Investor E alone by virtue of their ability to appoint three nominee directors, will have control, or the ability to control, directly or indirectly, the affairs or operations of the Infrastructure Unit Trust in respect of it carrying on a trading business. Consequently, Investors A, B, C and D will not have control, or the ability to control, directly or indirectly, the affairs or operations of the Infrastructure Unit Trust in respect of it carrying on a trading business. Facts for examples 2 to 5: 1. Investors A, B, C, D, E, and F intend to invest in an Infrastructure Asset in Australia that will be held through an Infrastructure Unit Trust which has XYZ Pty Ltd as its corporate trustee. 2. Each Investor establishes a resident holding trust, and company to act as trustee, to acquire their respective unit holding in the Infrastructure Unit Trust. 3. Each Investor acquires the following percentage of units on offer: a. Investor A: 20% b. Investor B: 10% c. Investor C: 10% d. Investor D: 15% e. Investor E: 5% f. Investor F: 40% 4. The Investor Agreement provides for the following in relation to the Board of Directors of XYZ Pty Ltd: a. the Board will comprise of up to a maximum of 10 directors; b. all Board decisions require 81% or more of board votes to be passed; and 93

94 c. each Investor is entitled to appoint one director for each 10% equity interest holding. 5. Nine directors are appointed, with each Investor appointing the following number of directors: a. Investor A: 2 b. Investor B: 1 c. Investor C: 1 d. Investor D: 1 e. Investor E: 0 f. Investor F: 4 6. An investor that is able to appoint two directors will have the ability to veto all board decisions. Example 2: Fragmentation of control If Investor A, instead of holding a 20% equity interest via a single resident trust, were to establish two resident trusts each acquiring a 10% equity interest, the ATO will regard the transaction as high risk and allocate compliance resources accordingly. Despite the fact that neither trust can appoint two directors, the ATO will examine whether the facts and circumstances establish that each of Investor A s resident trusts (through their trustee), directly or indirectly, controls or is able to control the affairs of XYZ Pty Ltd carrying on a trading business, and whether the arrangement is a scheme to avoid the operation of Division 6C. Example 3: Acting in concert by virtue of agreement Investor B enters into a separate agreement with Investor C. The agreement entitles Investor B to use Investor C s voting interests to appoint a director to XYZ Pty Ltd. The ATO will regard the transaction as high risk and allocate compliance resources accordingly. The ATO will examine whether the facts and circumstance establish that Investor B s resident trust (through the trustee), directly or indirectly controls, or is able to control the affairs, of XYZ Pty Ltd carrying on the trading business, and whether the arrangement is a scheme to avoid the operation of Division 6C. 94

95 Example 4: Acting in concert by virtue of an investment management agreement A Fund Manager, who is also Investor E, has an investment management agreement with Investor B and Investor C. The investment management agreement provides that Investor B and Investor C will instruct their nominee director to vote under the instruction of the Funds Manager. The ATO will examine whether the facts and circumstance establish that Investor E s resident trust (through the trustee), directly or indirectly controls, or is able to control the affairs, of XYZ Pty Ltd carrying on the trading business, and whether the arrangement is a scheme to avoid the operation of Division 6C. The ATO will examine whether the facts and circumstance establish that Investor E s corporate trustee controls, or is able to control, the affairs of another person carrying on the trading business, and whether the arrangement is a scheme to avoid the operation of Division 6C. Example 5: Unrelated investors A Fund Manager, who is also Investor E, has an investment management agreement with Investor C and Investor D. Under the terms of the investment management agreement, the Fund Manager must act solely in the best interest of each investor. Investor C and Investor D are unrelated and have no ongoing relationship outside of their interests in the Infrastructure Asset. Neither the investment management agreement nor any arrangement, understanding or practice, either formal or informal, has the legal, practical or commercial effect that: the respective units in the Infrastructure Asset Trust will be voted jointly; or Investor C or D would instruct their nominee director of XYZ Pty Ltd to vote jointly, or otherwise, under the instruction of the Fund Manager. The above arrangement would not attract compliance resources to test whether any of Investors C, D and E s corporate trustees control, or are able to control, the affairs of XYZ Pty Ltd carrying on the trading business. Example 6 Unitholder Reserve Matters 1. Investors A, B, C, D and E intend to invest in an Infrastructure Asset in Australia that will be held through an Infrastructure Unit Trust which has ABC Pty Ltd as its corporate trustee. 2. Each Investor establishes a resident holding trust, and company to act as trustee, to acquire their respective unit holding in the Infrastructure Unit Trust. 95

96 3. Each Investor acquires the following percentage of units on offer: a. Investor A: 45% b. Investor B: 35% c. Investor C: 10% d. Investor D: 5% e. Investor E: 5% 4. The Constituent document (i.e. Trust Deed) of the Infrastructure Asset Trust provides for various Unitholder Reserved Matters of which a two-third majority of unitholder votes is needed for approval with the voting based on the percentage of unit interests held. 5. Unitholder Reserved Matters include, but are not limited to: a. approval or amendment of strategic and annual operating plans and budgets; b. changes in the rights attached to any securities issued in the Company; c. Related Party Contracts; d. approval for capital expenditure projects; and e. changes to the size of the Board. 6. Absent any arrangement similar to that of examples 2 to 4, the ATO will not examine whether the facts and circumstance establish that a trustee of Investor C, D or E controls, or is able to control, the affairs of the Infrastructure Unit Trust carrying on the trading business. 7. Investor A and Investor B, by virtue of their unit holding, will have the ability to veto any Unitholder Reserved Matter. 8. In the event that the Unit Holder Reserve Matters consisted only of: a. approval or amendment of strategic and annual operating plans and budgets Investor A and Investor B, by virtue of their unit holding, will have control, or the ability to control, directly or indirectly, the affairs or operations of the Infrastructure Unit Trust in respect of it carrying on a trading business. This is because, Investor A and B each have the ability to veto the single Unitholder Reserved Matter, and this single matter does go to the affairs or operations of the Infrastructure Unit Trust in respect of it carrying on the trading business; 96

97 b. changes in the rights attached to any securities issued in the Company - Investor A and Investor B, by virtue of their unit holding, will not have control, or the ability to control, directly or indirectly, the affairs or operations of the Infrastructure Unit Trust in respect of it carrying on a trading business. This is because, although Investor A and B each have the ability to veto the single Unitholder Reserved Matter, this single matter does not go to the affairs or operations of the Infrastructure Unit Trust in respect of it carrying on the trading business; c. Related Party Contracts, approval for capital expenditure projects and changes to the size of the Board Investor A and Investor B, by virtue of their unit holding, will have control, or the ability to control, directly or indirectly, the affairs or operations of the Infrastructure Unit Trust in respect of it carrying on a trading business. This is because Investor A and B each have the ability to veto the combined three Unitholder Reserved Matters, and this combination of matters goes to the affairs or operations of the Infrastructure Unit Trust in respect of it carrying on the trading business. 97

98 4. Areas of ATO compliance focus This chapter outlines certain infrastructure related issues with which the ATO has concerns. These are rated as high risk from a compliance perspective and will be the subject of focus by ATO compliance teams. Specifically the ATO is concerned about: 1. Abuse of PPP structures 2. Illegitimate uses of stapled structures 3. Overshoot of land-rich privatisations into stapled structures 4. Fracturing of control interests 5. Satisfaction of MIT requirements 6. Interposition of a Finance Co owned by a Charitable Trust. We discourage taxpayers from entering into arrangements of the type described in this Chapter. If you are planning to enter or have entered into arrangements of these types we recommend you seek independent professional advice, review your arrangements and discuss your situation with us by ing PGIAdvice@ato.gov.au Given the nature of the arrangements, any entity involved in the promotion of such arrangements may be considered a promoter of a tax exploitation scheme for the purposes of Division 290 of Schedule 1 to the Taxation Administration Act We will be allocating compliance resources to consider the effectiveness of the arrangements and the potential application of Division 290. Lastly, while this Chapter describes some of the arrangements with which the ATO has concerns, it is not possible to cover every potential variation arrangement the ATO may have an issue with. The absence of the arrangement from this Chapter or a variation of an arrangement does not mean that we accept or endorse the arrangement or variation, or the underlying tax consequences. 98

99 4.1 Abuse of PPP structures A summary of the standard-form PPP structure is set out in Chapter 1. The ATO is comfortable with the exact structure as set out in that Chapter. If taxpayers adopt the structure set out in Chapter 1, taking into account the discussion in this Chapter, it would represent a low compliance risk in relation to the tax outcomes described in Chapter 1. This includes the discussion under the heading Part IVA in that Chapter. However, the ATO has seen a number of variations on this structure that it regards as high risk. These variations fall into three broad categories: 1. Arrangements attempting to bring forward deductions and/or defer income 2. Arrangements attempting to disguise capital outgoings as deductible payments 3. Arrangements which attempt to fragment integrated trading businesses in order to recharacterise trading income into more favourably taxed passive income. As such, the ATO discourages taxpayers from entering into structures or transactions that depart from the type set out in Chapter 1. That said, the ATO acknowledges that there may be other variations that do represent a low compliance risk. If such variations are to be proposed, the ATO would want to understand the nature and rationale for this, and expect that you would approach us to discuss your proposal. 99

100 4.1.1 Arrangements attempting to bring forward deductions or defer income The ATO understands that one of the main benefits from the PPP model outlined in Chapter 1 is that it enables the Project Trust to obtain deductions for a large component of capital improvements over the licence term. It is the Licence Fees that enable this deduction to occur. This is different to what might occur under a more traditional Build-Own-Operate-Transfer model where the Project Trust would only obtain deductions under Division 43 for capital works while the Project Trust was the owner of the capital improvements. Those Division 43 deductions would typically be spread over 40 years. If the term of the Build-Own- Operate-Transfer agreement was 40 years, a PPP model that gives deductions over 40 years for the Licence Fees carries no significant tax benefit. If the term is 30 years, the consequence is an extra ten years worth of deductions. The ATO is concerned about variations on the PPP structure set out in Chapter 1 which attempt to bring forward deductions or defer income. There are three arrangements where we are concerned this could occur: 1. Where the term of the Licence and therefore the period over which deductions for the Licence Payments are spread is less than 20 years. 2. Where the amount of the Licence Payments is front-loaded such that effectively most of the deductions are spread over a period of less than 20 years 3. Where the Availability Payments are back-loaded such that most of the Project Trust s taxable income is deferred into the later stages of the licence. For these transactions, the ATO is concerned that: the Licence Payments may not be deductible under section 8-1 on the basis that they are capital, or a capital nature. Division 230 may apply to the Project Trust where there is back-loading of the Availability Payments on the basis that the Project Trust should aggregate the Licence Payment and the Availability Payment in the definition of arrangement under subsection (4) and disregard the licence and other significant non-cash settlable rights and/or obligations in the identification of that arrangement under subsection (4). The ATO would also be concerned to ascertain whether on a proper application of section 6-5 and/or Division 16E of the ITAA 1936, the income from the Availability Payment should be brought to account on an accruals basis. the bringing forward of deductions for the Licence Payments or the deferral of income from the Availability Payments may result in the application of Part IVA. 100

101 4.1.2 Arrangements attempting to disguise capital outgoings as deductible payments The ATO is concerned about arrangements which attempt to disguise capital outgoings as deductible payments. Under a standard-form PPP, the Finance Co raises external debt, and any remaining financing is provided in the form of equity into the Project Trust. This typically results in the investors making a capital loss equal to the remaining cost base in the Project Trust when the Licence comes to an end. Under these arrangements however the capital loss the investors would typically make at the end of the Licence is purportedly replaced with the deductible Licence Payments incurred by the Project Trust. There are two types of arrangements where we have seen this occur: 1. Fabricated PPPs 2. Capital stripping PPPs. These arrangements are detailed below. 101

102 Fabricated PPPs A fabricated PPP typically displays all of most of the following features: The structure is similar to the standard-form PPP set out in Chapter 1. However, instead of constructing social infrastructure, the investors are bidding to the Government for the right to run a monopoly business. Additionally, the Receivables Purchase Payment paid by the Finance Co to the Government is not subsequently paid as the Construction Payment to the Project Trust. The Receivables Purchase Payment instead is paid to and retained by the Government as part of the consideration for the grant of the right to run the monopoly business. The diagram below shows a simplified example of a fabricated PPP. We are concerned that because the Licence Fees are in reality paid for the granting of a right to run a monopoly business, they would not be deductible under section 8-1 on the basis that they are an outgoing of capital, or of a capital nature. Additionally, even if the fees were found to be deductible, the unnecessary complexity and contrivance of a structure which is implemented to pay a purchase price for a licence to run a business would point towards Part IVA applying. 102

103 1. Capital stripping PPPs A capital stripping PPP typically displays all of most of the following features: The structure is similar to the standard-form PPP set out in Chapter 1. However, there is only nominal equity injected into the Project Trust. Instead, the Project Trust is almost entirely financed by the Construction Payment being received from the Government. Additionally, almost all of its income is paid to the Government in the form of the Licence Payments. The Government in turn finances that Construction Payment in one of the following three ways: o o o it obtains funds by from a trust (the Finance Trust) that is owned by the same investors as the Project Trust; or a trust that is a holding trust (the Hold Trust) for the Project Trust; or a Finance Co which in turn obtains subordinated high-interest debt funding from a trust (the Finance Trust) that is in turn owned by the investors into the Project Trust. These other trusts are collectively referred to as the related trusts. The Licence Payments that represent most of the income of the Project Trust is paid via the Government to the related trust or, via both the Government and the Finance Co to the related trust. The diagrams below show a simplified example of these capital stripping PPPs. 103

104 104

105 We are concerned that the transactions described above are being used to replace what would typically have been a capital loss the investors would have made at the end of the PPP with purportedly deductible Licence Payments being incurred by the Project Trust. As a result, the ATO will examine whether the Licence Payments are deductible under section 8-1 on the basis that they are an outgoing of capital, or of a capital nature. Additionally, even if the payments were found to be deductible, the ATO is concerned that these arrangements are being entered into or carried out for the dominant purpose of obtaining a tax benefit. This might attract the operation of the anti-avoidance rule in Part IVA of the ITAA

106 4.1.3 Using securitisations to re-characterise income from trading businesses The ATO is concerned about arrangements which attempt to fragment integrated trading PPPs in order to re-characterise trading income into more favourably taxed passive income. Our concern arises where a single PPP is divided in a contrived way into separate businesses. The income that might be expected to be subject to company tax is artificially diverted into a related trust where, on distribution from the related trust, that income is ultimately subject to no tax or a lesser rate than the corporate rate of tax. These arrangements have the potential to erode the corporate tax base, particularly where they are promoted to overseas investors as a way to acquire tax advantages in Australia. The ATO s concerns with these structures are in addition to its concerns with stapled structures set out in Taxpayer Alert 2017/1. PPPs are one mechanism being used in these arrangements, but our concerns are not limited to arrangements involving PPPs The PPPs where we have seen this occur were all covered above at In addition to converting a capital loss into a deductible payment, taxpayers entering into these PPPs have also argued that: the difference between the Securitised Licence Payments and the Receivables Purchase Payment may constitute interest for the purposes of interest withholding tax, resulting in distributions to non-resident investors from the related trust being ultimately subject to taxation at a rate of between 0-10%; that same difference should constitute income from an eligible investment business on the basis that the securitisation is a financial arrangement as defined in sections to of the ITAA 1997, resulting in the related trust arguing that it is a MIT, and that distributions to non-resident investors being ultimately subject to taxation at a rate of 15%; interest on the high-interest subordinated debt (in the third example of Capital stripping) paid to the non-resident investors also being subject to taxation at a rate of between 0-10%. The ATO is concerned that these arrangements are being used to fragment integrated trading PPP businesses in order to re-characterise trading income into more favourably taxed interest income, or income of an MIT. As such, the ATO will examine: whether the characterisation of the difference between the Securitised Licence Payments and the Receivables Purchase Payment as constituting interest for the purposes of interest withholding tax is correct; whether section may deny deductions due to the application of sections or ; whether the Project Trust is entitled to deductions under section 8-1 where the Licence Payment provides an equity-like payment profile (commonly known as an equity 106

107 securitisation) this is in addition to the concerns outlined at in relation to the characterisation of the payment as capital, or of a capital nature; whether the related trust controls, or is able to control, the Project Trust for the purpose of Division 6C of Part III of the ITAA 1936; where applicable, whether related trust and the Investors satisfy the definition of a MIT, including the validity of any capital treatment choice under Subdivision 275-B of the ITAA 1997; where applicable, whether the income of the related trust may be taxed as non-arm s length income under Subdivision 275-L of the ITAA 1997 on the basis that the transactions entered into would not be ones that parties dealing with each other at arm s length in relation to the transactions would have entered into; where applicable the application of the transfer pricing and thin capitalisation provisions; and whether these arrangements are being entered into or carried out for the dominant purpose of obtaining a tax benefit. This might attract the operation of the anti-avoidance rule in Part IVA of the ITAA

108 4.2 Illegitimate use of stapled structures A stapled structure involves two (or more) entities being set up in a way such that the membership interests that investors hold in them (such as shares or units) cannot be sold or otherwise dealt with separately. Chapter 2 discussed a particular kind of stapled structure where a government business is privatised by way of a long-term lease. Under that structure, the business was sold into a combination of a private-sector held asset-holding trust ( the Asset Trust ) and a related operating company or trust ( the Operating Entity ). However, that Chapter does not apply to, and the ATO will apply compliance resources to, privatisations into stapled structures not of the type described above. The ATO will however engage on a transaction-by-transaction basis in relation to potential privatisations. For all other types of stapled structures, you should refer to Taxpayer Alert 2017/1. For the avoidance of doubt, the discussion at paragraph 51 to 61A of LCG 2015/15 about the pricing of transactions between entities involved in integrated business only applies where the transactions that would have been entered into by parties dealing with each other at arm's length. If the transactions are not of the type that entities dealing with each other at arm s length would have entered into (such as the stapled structures outlined in Taxpayer Alert 2017/1) because entities dealing with each other at arm s length would not have entered into the transaction, then the amount of non-arm s length income for the purposes of section would generally be expected to be the difference between the amount derived by the entity, and the amount that would have been derived had the transaction not been entered into. 108

109 4.3 Overshoot of land-rich privatisations into stapled structures Chapter 2 outlined that where there is a privatisation of a land-rich government business which complies with the structure and tax treatment outlined in that Chapter, that the ATO would not apply compliance resources. However, where the structure and/or tax treatment outlined in that Chapter is not adopted by the taxpayer, the ATO will apply compliance resources, including to whether the stapled structure itself is one to which Part IVA of the ITAA 1936 may apply to. 109

110 4.4 Fracturing of control interests As discussed in Chapter 3, the level of one investor s stake in another entity is relevant to the question of control for Division 6C and the MIT rules, as well as the associate entity test in section Consequently, there may be an incentive for investors to hold their stake in another entity not through one investment vehicle, but multiple investment vehicles. For example, instead of an investor holding a 40% stake through a single resident trust, it might seek to hold that stake through two interposed trusts, each having a 20% stake. The investor may do this in order to ensure: each trust is not subject to Division 6C because it does not control an entity carrying on a trading business; each trust can avail itself of MIT status because similarly it does not control an entity that carries on a trading business; and each trust is not an associate entity of the entity the investor wants to invest in. This might be done to enable the two trusts to gear up without having to take into account any investments they might hold in associates. This may effectively enable the entire structure to be double geared once at the entity level and then again at the level of the two trusts. The ATO however considers that the fracturing of control interests in the manner described above will give rise to a high compliance risk. Firstly, the fracturing of control would not alter the conclusion that the two interposed trusts would be associates of the entity carrying on the trading business. Secondly, consistent with the discussion in Chapter 3, the two interposed trusts may in fact control the entity carrying on the trading business, and/or give rise to a scheme to which Part IVA may apply. Other types of fracturing of control interests which we have similar concerns include where: different types of control and/or veto rights are artificially placed in different entities within an investor s structure. An example of this would be where relatively minor rights might be vested in a unit trust which has a large stake in an investment, but more significant rights are vested in the 100% unitholder of that unit trust. The ATO s concern here is that this artificial fracturing might be used to suggest that the unit trust does not control the entity that owns the investment; and different governance arrangements are put in place with the effect that an Operating Entity effectively controls the Asset Trust, but the immediate holders of interests in the Asset Trust themselves are said to not control the Asset Trust. This is despite the holders of interests in the Asset Trust and the Operating Entity having the same underlying owners. The ATO would have concerns that while the overall effect is to give control over the entire business to the investors, only the entities in the Operating side of the structure would actually be said to control any of the entities they invest in. This would, in turn, enable non-eligible investment 110

111 business income-producing assets to be placed in the Asset Trust, and be taxed on a flowthrough basis. The ATO would consider both of these types of fracturing of control interests to pose a high compliance risk of the relevant entities controlling the investment, or the fracturing being a scheme to which Part IVA may apply. 111

112 4.5 Satisfaction of MIT requirements Many types of infrastructure investments involve foreign residents investing into Australian infrastructure through resident holding trusts. For example a foreign resident investor may invest into a single trust that holds the infrastructure that is not subject to Division 6C because it is not a public unit trust; the Project Trust of a PPP using a resident holding trust; and the Asset Trust that is part of a stapled structure of the type outlined in Chapter 2. Each of these investments may be held through an Australian resident holding trust. The object of the interposition of this Australian resident holding trust is to facilitate withholding MIT treatment of the distributions made to the foreign resident investors. Without the resident holding trust, distributions from the trust that holds the infrastructure asset would be subject to tax at 30% as a non-resident beneficiary trustee assessment. The result of interposing the resident holding trust is that a final MIT withholding tax rate of 15% is purported to occur. In addition to taking note of the discussion earlier in this Framework in relation to control, in determining whether a particular trust qualifies as a MIT, and/or are entitled to the MIT withholding rate of 15%, particular care should be taken to ensure that: the trust is a managed investment scheme (within the meaning of section 9 of the Corporations Act 2001) a requirement that may be difficult to satisfy where there is a single beneficiary of that trust; and a substantial proportion of the investment management activities are in substance carried out in relation to the trust in respect of the assets of the trust are carried out in Australia. The ATO will be undertaking compliance resources in order to ascertain whether purported MITs or withholding MITs do actually satisfy these requirements. 112

113 4.6 Interposition of a Finance Co owned by a Charitable Trust Section 128F of the ITAA 1936 is intended to provide a concessional 0% interest withholding tax rate for publicly offered company debentures or debt interests. The concessional rate will not apply, however, where the company debenture or debt interest is offered, or issued to foreign resident associate as defined in section 318 of the issuer. The ATO is concerned about arrangements which attempt obscure the connection between an otherwise associated issuer and lender by interposing a Finance Company that is owned by a charitable trust between the issuer and the lender. In this way, it is purported that section 128F treatment is available, even though the issuer and lender should be associates. These structures typically display all or most of the following features: A Foreign Investor invests in an Operating Entity. The Operating Entity is also capitalised with debt it receives from a Finance Co. The Finance Co is owned directly or indirectly, through one or more interposed entities, by a charitable trust or a trust with a beneficiary that is a charity. The Finance Co obtains the funds to finance the loan to the Operating Entity by receiving a loan from a Related Foreign Bank. The Foreign Investor and the Related Foreign Bank, through one or more interposed entities, is owned by the same Ultimate Common Parent. The diagram below shows a simplified example of this structure. 113

114 Without this structure, the Related Foreign Bank would be an associate of the Operating Entity due to its Common Ultimate Parent, with the result that section 128F would not apply to debts issued by the Operating Entity to the Related Foreign Bank. The same would apply if the Finance Co instead issued the debts, and it was owned either by the Operating Entity or the Foreign Investor. However, the effect of this structure, it is argued, is that section 128F may apply even though the debt is being issued to a related party. This is achieved by having a purportedly independent entity being the Australian Charity owning the Finance Co, rather than the Operating Entity owning it, or the Operating Entity simply issuing the debt directly to the Related Foreign Bank. The ATO is therefore concerned that the use of the Finance Co which is owned by the Charitable Trust is fundamentally designed to both change the withholding tax rate applying to the related party financing expenses of the business, and the taxpayer deriving that income. That is, there is no reason for the interposition of the Australian Charity owned Finance Co, other than to shield the entities from the application of the associate definition in section 318. This would point towards Part IVA applying to the Finance Co, the Asset Trust, the Operating Co, the Related Foreign Bank or a combination of two or more of these entities. 114