Tax Brief. 12 August IMR and MIT: A going-away present? 1. Investment Manager Regime

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1 Tax Brief 12 August 2013 IMR and MIT: A going-away present? The centrepiece of business tax policy that the Labor Party carried into the 2007 federal election was to make Australia an Asian funds management hub. The promised final withholding tax for managed investment trusts (MITs) was quickly implemented (though more recently increased from 7.5% to 15%), but despite significant work in the Johnson Report and by the Board of Taxation, several announcements and many Treasury discussion papers, little else has been finalised. Almost the last act of the Treasurer and Assistant Treasurer before the government went into caretaker mode was to release a second exposure draft of legislation for the third instalment of the Investment Manager Regime (IMR) and to make a further announcement in relation to the long-promised and delayed new MIT tax regime. This tax brief briefly reviews these developments in the expectation that, whatever happens in the election, something will happen on these fronts sooner rather than later. 1. Investment Manager Regime Broadly, the IMR regime exempts the investment income of IMR foreign funds derived from or through Australia from being assessable, except in limited cases. In the absence of the IMR regime, such income may be assessable as a result of an Australian manager or intermediary constituting a permanent establishment of the IMR foreign fund or providing the income with an Australian source. The first exposure draft of the third instalment of the IMR regime was the subject of a tax brief earlier this year, see The third instalment proposes to extend the exemption more broadly to IMR foreign funds for portfolio investments while adopting a more restrictive approach for nonportfolio investments. The major areas where changes have been made in the second exposure draft relate to: the start-up and wind-down phases; the widely held and not closely held tests, including a change of name from the not concentrated test for the latter; and the description of IMR income.

2 1.1 Start-up and wind-down Generally, an IMR foreign fund must satisfy certain tests for an entire year of income in order for the IMR regime to apply. In relation to the beginning and end of a foreign fund, the re-drafted rules make clear that in the income year of formation or termination, the fund can satisfy the whole of income year tests for an IMR foreign fund even though it may not be in existence for the whole of that year. More importantly the fund is deemed in that year to satisfy the widely held and not closely held tests which are part of the conditions to qualify as an IMR foreign fund. At some point, however, the fund has to qualify as an IMR foreign fund under the normal rules in order to take advantage of the start-up and wind-down concession. In relation to start-up phase, the deemed satisfaction of the widely held and not closely held tests applies for 12 months from the date of creation of the fund. Where a fund is created part-way through an income year, a foreign fund can rely on the deeming for part of its second income year so long as it satisfies the normal rules for the rest of that year. On termination the deeming is only available for the part of the income year of termination that the fund exists. 1.2 Widely held and not closely held Under the first exposure draft, foreign funds that are: foreign superannuation funds with 50 members; foreign government pension funds; or foreign life insurance companies, were deemed to satisfy the widely held and not closely held tests to overcome compliance and technical issues in tracing through them. The provisions have been maintained with different drafting, referring to them as IMR foreign widely held entities. In addition, foreign sovereign wealth funds (SWFs) will also be deemed to satisfy the widely held test. However, SWFs are not otherwise granted any other concessions in respect of the various IMR foreign fund tests. In particular, an SWF will not qualify as an IMR foreign fund if it is not in an exchange of information country or does not segregate its passive and active business investment portfolios. The new drafting also introduces the concept of an IMR domestic widely held entity which uses concepts from the MIT withholding tax provisions for identifying domestic widely held funds. An IMR widely held entity includes such foreign and domestic widely held entities and simplified tracing rules for such funds apply where they hold interests in an entity seeking the IMR exemption. They are simply deemed to be a number of individual members based on their participation interest in the foreign fund which count directly towards the 25 member test for an IMR foreign fund. Although domestic funds themselves cannot take advantage of the IMR exemptions, they can now effectively be counted through the extension 2 IMR and MIT: A going-away present?

3 of this simplification to domestic funds in determining whether a foreign fund in which they are members meets the widely held and closely held tests. In addition, there are two other significant changes in operation of the widely held and not closely held tests. On the taxpayer s side, there is now some wriggle room if the widely held and not closely held tests are failed for unpreventable circumstances of short duration limited to 30 days during an income year. On the other hand, the not closely held test will now be failed where a manager of the fund, along with its associates, has a participation interest of 20% or more in the fund. For this purpose, there is no looking through the manager or associates to the underlying individual holders as applies for these tests generally. In the start-up and wind-down phases, where the manager and associates are likely to hold larger interests in the fund, the special rules may permit an interest of 20% or greater but otherwise it is now not possible for the manager and associates to have a significant interest in the fund. In view of the breadth of the definition of associates, this change may act as a serious impediment to use of the IMR regime. 1.3 IMR income The broad exemption from Australian taxation of income and gains when the IMR regime applies is retained in the new draft but the special rule that applies where: an IMR foreign fund makes a gain from a financial arrangement; and the IMR foreign fund has a non-portfolio (i.e., 10% or greater) interest in the counterparty to the financial arrangement, has been redrafted again. Where the IMR foreign fund has a non-portfolio interest in the counterparty, income is only exempted by the IMR regime if: the income is only assessable because the IMR foreign fund has a permanent establishment (PE) in Australia as a result of appointing an Australian agent; and the income would not have had an Australian source assuming the foreign fund had itself undertaken the actions performed by the agent. The relevance of the second requirement is explained in the EM as follows: if an IMR foreign fund received a return or gain from a financial arrangement with an Australian resident entity that was listed on the Australian stock exchange (and in which it held a non-portfolio interest), the return or gain would be expected to be Australian sourced income irrespective of whether the IMR foreign fund engaged the Australian intermediary or not. As such, the return or gain would not qualify as IMR income 3 IMR and MIT: A going-away present?

4 This means that IMR foreign funds will still need to address the difficult issues of source under general law where they transact with Australian entities in which they hold a non-portfolio interest. The draft like its predecessor maintains the policy position that the IMR exemption does not extend to the final international withholding taxes (dividends etc) but does not deal with the interaction of that policy with the exemption of PE income is it intended that withholding tax or the exemption apply where there is a PE? In sum not a great deal has changed and several of the problems identified in our previous tax brief remain. In particular the requirements to report to the ATO and members that have to be fulfilled to be an IMR foreign fund are maintained in the revised draft, with the result that many foreign funds are likely to consider that the Australian IMR regime is not worth the compliance effort. 2. Managed Investment Trust Regime The government s response to the Board of Taxation s MIT Report was released in May 2010 followed by a Discussion Paper in late Since then there have been protracted consultations seeking to bridge differences between industry and policymakers. The Assistant Treasurer s Press Release indicates the outcome of these consultations on three issues. 2.1 Unders and overs One important issue has been what happens when an MIT does not meet the de minimis allowance for unders and overs in the calculation of the MIT s net income. Originally, it had been proposed that where income was understated by more than the de minimis amount, the shortfall would be taxed at the highest marginal rate. Industry had noted that if income had been reported correctly it would likely have been taxed at much lower rates (e.g., non-resident withholding tax and income tax on complying superannuation funds at 15%). Under the announcement if the trustee does not cause an under intentionally, the MIT may choose to issue a revised distribution statement or carry forward the under with an uplift to maintain its value for the government to the next income year where the MIT has net income. An over may be subject to revised distribution statements or carry-forward without uplift. In either case the trustee may be subject to administrative penalties if the under or over arose carelessly or recklessly (though not intentionally). If an under or over arises intentionally, revised distribution statements are mandatory and higher penalties will apply. 2.2 Arm s length test In relation to the arm s length test that will apply to dealings between the MIT and its associates to prevent artificial shifting of income out of a corporate tax environment into the more beneficial pass-through treatment of MITs, exceptions are proposed for certain services provided to an MIT at a price between cost and 4 IMR and MIT: A going-away present?

5 market value, where the services could be performed by the MIT for itself without breaching the eligible investment business rules or services that have to be provided by the RE and cannot be provided by a MIT for itself because of corporate law requirements. In the unders and overs case industry has obtained most of what it wanted while with the arm s length test the compromise will remove a lot of transfer pricing type compliance that would otherwise have been imposed on MITs for routine transactions. One issue which is still ongoing is the need for investors to have clearly defined rights, or rather what that requirement may mean. 2.3 Trust s adjusted net income exceeds distribution The Press Release also indicates that the MIT withholding regime will be amended to address the circumstance where a trust s adjusted net income for MIT purposes exceeds the amount actually distributed by the MIT. The original policy intent had been for the appropriate rate of MIT withholding tax to apply to the higher adjusted net income amount and it is intended that the provisions will be amended to give effect to this intention. 5 IMR and MIT: A going-away present?

6 For further information, please contact Sydney Chris Colley phone Andrew Mills andrew.mills@gf.com.au phone Andrew White andrew.white@gf.com.au phone Melbourne Perth Toby Eggleston toby.eggleston@gf.com.au phone Nick Heggart nick.heggart@gf.com.au phone G&F document ID _3.docx These notes are in summary form designed to alert clients to tax developments of general interest. They are not comprehensive, they are not offered as advice and should not be used to formulate business or other fiscal decisions. Liability limited by a scheme approved under Professional Standards Legislation Greenwoods & Freehills Pty Limited (ABN ) Sydney Level 39 MLC Centre Martin Place Sydney NSW 2000 Australia Ph , Fax Melbourne 101 Collins Street, Melbourne VIC 3000, Australia Ph Fax Perth QV.1 Building, 250 St Georges Terrace, Perth WA 6000, Australia Ph Fax IMR and MIT: A going-away present?