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Focus: Managed Investment Trusts Withholding Tax – July 2008

Changes to withholding tax rules come into operation

In brief: The Federal Government announced changes in the 2008-09 federal Budget to the withholding tax rules applicable to certain distributions from Australian managed investment trusts. Legislation to implement these changes has now come into operation.¹ Partner Peter Allen (view CV) and Senior Associate Katrina Parkyn report.

• Overview of changes
• Outline of legislation
• Who is required to withhold under the new rules?
• When does a withholding need to be made?
• What is a managed investment trust?
• What is a fund payment?
• Provision of information
• Implications for investors
• Conclusion

Overview of changes

The previous 30 per cent non-final withholding tax rules applying to certain distributions from Australian MITs have been replaced with a final withholding tax regime, with effect from 1 July 2008.

Under the new rules, the rate of withholding tax has also been substantially reduced from 30 per cent to 7.5 per cent (once the new measures are fully implemented).

The reduced withholding tax rate is being phased in over three years. For foreign investors in a country with which Australia has an effective exchange of information (EOI) on tax matters², the new withholding tax rates are:

• a 22.5 per cent non-final withholding tax for distributions of the 2008-09 income year;
• a 15 per cent final withholding tax for distributions of the 2009-10 income year; and
• a 7.5 per cent final withholding tax for distributions of the 2010-11 income year and beyond.

Distributions to investors resident in countries with which Australia does not have an effective EOI on tax matters will not qualify for the reduced withholding rates. Distributions to such investors will instead be subject to a 30 per cent final withholding tax.

Consistent with the previous rules, the new withholding tax regime applies only to distributions of Australian source income (other than distributions of dividends, interest and royalties). Distributions of dividends, interest and royalties continue to be covered by the existing withholding tax rules applicable to these types of income.

Outline of legislation

There are three parts to the new rules introduced by The Tax Laws Amendment (Election Commitments No.1) Act 2008 (Cth):

• the replacement of Subdivision 12-H of Schedule 1 to the Taxation Administration Act 1953 (Cth) dealing with the obligation to withhold amounts;
• the insertion of a new Subdivision 840-M into the Income Tax Assessment Act 1997 (Cth) setting out the circumstances in which a non-resident will be subject to managed investment trust withholding tax and making it clear that such tax is a final withholding tax; and
• various other consequential amendments to the tax legislation.

Who is required to withhold under the new rules?

Under the new rules, an obligation to withhold falls potentially on each of the following persons:

• a trustee of a MIT in relation to an income year that makes a fund payment in relation to that income year;
• a custodian who makes a payment (a later payment), all or some of which is reasonably attributable to an earlier payment received by the custodian that was a fund payment³; and
• another entity (that is not a MIT or custodian) that receives a fund payment, where a foreign resident is, or becomes, entitled to receive an amount reasonably attributable to that fund payment.⁴

The imposition of a withholding obligation on custodians and other entities recognises that a foreign resident may (and often does) invest in a MIT through an interposed entity.

The previous rules imposed withholding obligations on trustees of MITs and custodians only, which resulted in a different treatment for investments made through non-custodians (as opposed to investments made directly or through a custodian). The extension of the rules to non-custodians is designed to ensure that direct and indirect investments all receive the same treatment.

When does a withholding need to be made?

Not all payments made by a trustee of a MIT, a custodian or other entity are subject to withholding.

A trustee of a MIT is required to withhold only where the trustee makes a 'fund payment' to an entity who has an address outside Australia or the place of payment is outside Australia.

This is a change from the previous rules, which required withholding where the recipient was a foreign resident or an entity who the trustee had reasonable grounds to believe was a foreign resident. The change recognises that, in practice, it is often not possible for a trustee to determine the residency of an investor. The new rules are also more in line with the withholding tax rules applicable to other types of payments made to overseas persons.⁵

A custodian is also required to withhold only when it makes a later payment to an entity who has an address outside Australia or the place of payment is outside Australia.

Other entities are required to withhold where a foreign resident is, or becomes entitled to, all or some of the fund payment.

There is no obligation to withhold to the extent that the amount paid or received by the trustee, custodian or other entity (as applicable) is not liable to 'managed investment withholding tax'. This is discussed in more detail below but essentially means that there is no obligation to withhold where payments are made to, or received on behalf of, Australian residents (even where they have an address outside Australia or request payment to be made outside Australia). Similar rules already exist in relation to dividends, interest and royalties.

What is a managed investment trust?

The obligation to withhold (at any level) only applies where the trustee of a 'managed investment trust in relation to an income year' has made a 'fund payment in relation to that income year'.

The definition of 'managed investment trust' is broadly consistent with the previous rules (although there are some differences, which are discussed below).

Also consistent with the previous rules, the time for testing whether a trust is a 'managed investment trust in relation to an income year' is at the time the trustee makes the first 'fund payment' in relation to that income year. If the test is satisfied at that time, the trust is a MIT for the whole of that income year. Conversely, a trust that fails the test at the time of making the first fund payment will fail the test for the entire year (regardless of whether it satisfies the test later in the income year).

In order for a trust to be a MIT, there are three requirements that must be satisfied:

• A trustee of the trust must be an Australian resident or central management and control of the trust must be in Australia (the residency requirement). The residency requirement must be satisfied either at the time the first fund payment is made, or at an earlier time, in that income year. Where there are multiple trustees, the residency requirement will be satisfied if any of the trustees is an Australian resident. This is a change from the previous rules.
• The trust must be a 'managed investment scheme' operated by a 'financial services licensee' (as defined in the Corporations Act) (the Corporations Act requirement).
• The trust must satisfy one or more of the following requirements (the widely held requirement):

1. units in the trust are listed for quotation in the official list of an approved stock exchange in Australia (eg the Australian Securities Exchange, Bendigo Stock Exchange or National Stock Exchange);
2. the trust has at least 50 members (ignoring objects of a trust); or
   1. one of the following entities is a member of the trust:
   2. a life insurance company;
   3. a complying superannuation fund, a complying approved deposit fund, or a foreign superannuation fund, being a fund that has at least 50 members;
   4. a trust that satisfies the residency requirement and Corporations Act requirement and which satisfies either (a) or (b) above (ie is either listed or has at least 50 members);
   5. an entity that is recognised, under a foreign law relating to corporate regulation, as an entity with a similar status to a managed investment scheme and that has at least 50 members;
   6. a trust that satisfies the residency requirement and the Corporations Act requirement and:
      1. the interests in which are owned directly by an entity covered by any of paragraphs (i) to (iv); or
      2. the interests in which are held indirectly by an entity covered by any of paragraphs (i) to (iv) through a chain of trusts (in which case, the residency requirement and Corporations Act requirement must also be satisfied for each trust in the chain).⁶

There are special rules dealing with trusts that are created or cease to exist during an income year.

What is a fund payment?

There is no obligation to withhold unless there is an initial 'fund payment' in relation to an income year.

In general terms, a fund payment is that part of any payment made by the trustee of a MIT that is, in effect, a distribution of Australian source net income of the trust⁷, disregarding dividends, interest and royalties.

Non-Australian source income is excluded on the basis that such amounts would generally not be assessable to a foreign resident. The exclusion of dividends, interest and royalties recognises that these types of income are already covered by existing final withholding tax arrangements. In practice, this means that the new rules are likely to be of most significance in the property trust sector.

To the extent that the net income of the trust being distributed includes capital gains from taxable Australian property, withholding is based on the gross gain (ie ignoring any CGT discount).

Since withholding is only imposed on distribution of net income, cash distributions in excess of net income (the tax deferred component) are not subject to withholding.

An important point to note is that a distribution is not a 'fund payment' unless it is paid during the income year or within three months after the end of the income year. A distribution made outside this time frame is not subject to withholding but is, instead, subject to the rules in Division 6 of the Income Tax Assessment Act 1936 (Cth) governing the treatment of distributions to non-resident beneficiaries, which would likely result in the relevant income being taxed at considerably higher rates.

Provision of information

An important aspect of the new rules are the requirements that are imposed on various entities to give notice or make certain information available.

Broadly speaking, the trustee of a MIT or a custodian that makes a payment which is not subject to withholding but from which an amount would have been withheld had the payment been made to an entity with an address outside Australia, or the place of payment had been outside Australia, is required to give the recipient a written notice providing certain details regarding the payment (such as how much of the payment would have been subject to withholding and the income year to which the payment relates).

An entity that is not a MIT or custodian that receives a fund payment in circumstances where another entity is, or becomes, entitled to receive an amount reasonably attributable to that fund payment is also required to provide certain information to that recipient, if the entity would have been required to withhold if the recipient had been a foreign resident.

The purpose of these obligations is to provide each recipient in the chain with sufficient information to allow it to discharge its own obligations (ie when it on-pays the distribution).

As an alternative to providing a written notice, the trustee, custodian or other entity (as applicable) may make these details available on a website in such a way that the details are readily accessible to the recipient for at least five continuous years. The ability to discharge this obligation by publishing the information on a website is a change from the previous rules.

There are administrative penalties for not providing the required notices (with the amount of the penalty being equal to the amount that would have been withheld from the payment had the notice or information requirements been complied with).

Implications for investors

As part of the changes, a new Subdivision 840 has been inserted into the Income Tax Assessment Act 1997.

Broadly, the new Subdivision 840 imposes a liability for 'managed investment trust withholding tax' on foreign residents who receive or, in some cases, are entitled to receive amounts that are represented by or reasonably attributable to fund payments of a MIT.

In practice, a liability to managed investment trust withholding tax will generally be satisfied by another entity withholding under the rules discussed above.

Consistent with withholding under the new rules being a 'final' withholding, income on which managed investment trust withholding tax is payable is non-assessable, non-exempt income of an entity. This means that expenses relating to the derivation of that income are not deductible (as there is no nexus with assessable income). It also means that in the case of a non-resident whose only Australian income is derived from a MIT, there is no obligation to file an Australian tax return. Under the previous non-final withholding tax regime, non-resident investors were still technically required to lodge an Australian tax return, although, in practice, many did not.

Conclusion

The new rules are expected to significantly enhance the competitiveness of the Australian funds management industry and to increase their ability to attract foreign investment.

The reduction in the headline rate of withholding is obviously a key feature of the changes (and is more favourable than the 15 per cent rate that was announced by the Federal Government as part of its 2007 federal election campaign).⁸ It is, however, important to note that the reduced withholding is not available to all foreign investors, only those resident in a country with which Australian has an effective EOI on tax matters. The Government seems hopeful that this may create incentives for other countries to enter into EOI arrangements with Australia (so that investors in those countries may be able to take advantage of the new rules).
For investors, one advantage of the new rules is that, as a final tax on the relevant distributions, foreign resident investors will be relieved of the compliance burden of filing Australian tax returns in respect of those distributions.

Footnotes

1. The Tax Laws Amendment (Election Commitments No. 1) Act 2008 (Cth).
2. The Taxation Administration Amendment Regulations 2009 (No.2) sets out the 37 countries with which Australia has an effective EOI on tax matters. The relevant countries are: Argentina, Bermuda, Canada, China, Czech Republic, Denmark, Fiji, Finland, France, Germany, Hungary, India, Indonesia, Ireland, Italy, Japan, Kiribati, Malta, Mexico, Netherlands, Netherlands Antilles, New Zealand, Norway, Papua New Guinea, Poland, Romania, Russia, Slovakia, South Africa, Spain, Sri Lanka, Sweden, Taipei, Thailand, United Kingdom, United States of America and Vietnam.
3. A custodian is an entity that carries on a business that consists predominantly of providing a custodial or depositary service (as defined by section 766E of the Corporations Act 2001 (Cth)) under an Australian financial services licence: s12-390(9) of the Taxation Administration Act.
4. This includes the situation where the foreign resident is entitled to have the entity credit the amount to the foreign resident, or otherwise deal with the amount on behalf of the foreign resident or as the foreign resident directs.
5. See, for example, Subdivision 12-F of Schedule 1 to the Taxation Administration Act in relation to dividend, interest and royalty payments.
6. If the above requirements are satisfied, a trust will still not be a MIT if, at the time a distribution is made, one foreign resident individual, directly or indirectly:
   • held, or had the right to acquire, interests representing 10 per cent or more of the value of the interests in the trust;
   • had the control of, or the ability to control, 10 per cent or more of the rights attaching to membership interests in the trust; or
   • had the right to receive 10 per cent or more of any distribution of income that the trustee may make.
7. The Australian source net income of the trust includes any capital gains attributable to taxable Australian property.
8. It is, however, worth bearing in mind that the Government itself has noted that 'for some foreign investors this benefit [the reduced withholding rate] would be offset by the denial of Australian deductions for expenses associated with their investment [in the managed investment trust], which could result in a higher overall tax liability than under the current system'. See paragraph 1.280 of the Explanatory Memorandum to The Tax Laws Amendment (Election Commitments No. 1) Bill 2008.

For further information, please contact:

• Peter AllenPartner, Brisbane
  Ph: +61 7 3334 3350
  Peter.Allen@aar.com.au
• Michael PerezPartner, Melbourne
  Ph: +61 3 9613 8500
  Michael.Perez@aar.com.au
• Tony SheehanPartner, Sydney
  Ph: +61 2 9230 4781
  Tony.Sheehan@aar.com.au
• Katrina ParkynSenior Associate, Brisbane
  Ph: +61 7 3334 3323
  Katrina.Parkyn@aar.com.au

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