A package of tax measures that seek to address the Federal Government's perceived sustainability and tax integrity risks posed by 'stapled structures' has been announced. It also limits certain broader tax concessions currently available to foreign investors, so that the potential reach of the measures is not limited to investments made by, or in, stapled structures. Partner Martin Fry and Senior Associate Igor Golshtein report.
On 27 March 2018, Treasury announced a package of tax measures that seek to address the Government's perceived sustainability and tax integrity risks posed by 'stapled structures', which the package describes as 'an arrangement where two or more entities that are commonly owned (at least one of which is a trust) are bound together such that they cannot be bought or sold separately'. In addition, the package limits some broader tax concessions available to foreign investors.
Broadly, the measures propose to limit tax rate reductions and exemptions currently available to:
- foreign investors in Managed Investment Trusts (MITs) who receive distributions of passive rental income 'converted' from trading income;
- investors in structures using multiple layers of flow-through entities to 'convert' trading income into favourably taxed interest income;
- foreign pension funds;
- foreign governments (including sovereign wealth funds); and
- foreign investors in Australian agricultural land.
The measures will apply variously from 1 July 2018 and 1 July 2019, with transitional relief, including from the application of Part IVA, available to certain qualifying arrangements in existence at the date of the announcement.
According to the announcement, the package will have no direct impact on finance staples or stapled structures in the commercial and retail property sectors (eg REITs) to the extent they generate rent from third parties. However, some of the abovementioned foreign investors into these structures (eg foreign pension funds) may be affected by the changes to the broader concessions.
Treasury's announcement is the product of more than a year of consultation with stakeholders, and aims to balance the global competitiveness of Australia's tax settings, the sustainability of Australia's tax base, and competitive neutrality between domestic and foreign investors, and also to increase certainty for businesses and investors. While the long-awaited announcement provides a welcome injection of certainty for affected investors whose investments have been marred by significant regulatory uncertainty over the last few years, key issues arising out of the proposed measures are still to be resolved. While the package states that it seeks to limit the tax outcomes presently accessible by affected investors without requiring them to restructure their existing arrangements, the effect the proposed measures will have on foreign investment in Australia and associated structuring remains to be seen, and may depend on the precise terms of the legislation through which these measures are to be implemented
(A) Preventing active business income 'converted' to rental income from accessing the 15 per cent MIT rate
- The higher MIT withholding tax rate (30 per cent) will apply to MIT fund payments derived from cross-staple rental payments, cross staple payments made under some financial arrangements (eg return swaps), or where the MIT receives a distribution from a trading trust.
- The higher rate will not apply where the operating vehicle of the staple receives rent from third parties and merely passes it on to the MIT, or where only a small proportion (not defined in the measure) of the gross income of the MIT relates to cross staple payments.
- The Government will introduce a 15-year exemption from the higher MIT withholding rate for new investments in nationally significant economic infrastructure assets approved by the Government to be held in stapled structures, at the expiry of which the MIT withholding rate will increase to align with the prevailing corporate tax rate. Treasury proposes to consult separately on the conditions that stapled entities must comply with to access the exemption.
(B) Preventing double gearing structures through the thin capitalisation rules
- It is proposed to amend the thin capitalisation rules to limit the ability of investors to use 'double-gearing structures', whereby multiple layers of flow-through entities (eg trusts, partnerships) each issue debt against the same underlying assets, while being able to avoid the application of existing 'associate entity' grouping rules (requiring eg a 50 per cent of greater ownership interest for grouping to occur) intended to prevent such 'double gearing'.
- The proposed measure will lower the thin capitalisation associate entity test (for the purposes of determining associate entity equity and associate entity debt) from 50 per cent or more to 10 per cent or more for interests in flow-through entities. Also, to safeguard against adverse behavioural responses, the thin capitalisation arm's length debt test will be clarified to require consideration of gearing against the underlying assets for interests in any entity.
(C) Limiting the foreign pension fund withholding tax exemptions
- Foreign pension funds in receipt of interest and dividends from Australian-resident companies that are tax-exempt in their country of residence are currently exempt from Australian interest and dividend withholding tax, regardless of their ownership interest in the paying entity.
- It is proposed that this exemption be limited to income associated with 'portfolio-like interests', described in the announcement as where the foreign pension fund holds an ownership interest of less than 10 per cent and does not have 'influence' over the entity’s 'key' decision-making.
(D) Limiting the sovereign immunity tax exemption
- An exemption from interest and dividend withholding taxes, capital gains tax and tax on trust distributions currently (and based on long-standing practice) provided by the ATO as an administrative concession to certain foreign government investors (including sovereign wealth funds) on the basis of the international law doctrine of sovereign immunity will be codified into legislation (the SIE), with limitations.
- Presently, the ATO provides the SIE to foreign sovereign investors on income in Australian 'non-commercial' investments and who cannot influence the decision-making of the holding entity. Depending on the particular governance arrangement for an investment, the SIE may be provided to investors having a 10 per cent or greater interest in the holding entity.
- Similarly to the abovementioned measure regarding foreign pension funds, the proposed legislation will limit the application of the SIE to situations where the sovereign investor holds an ownership interest of less than 10 per cent and does not have influence over the entity's key decision-making. The exemption will also not extend to distributions of active business income from trusts (including where the active income has been converted to rent through cross-staple payments).
(E) Preventing agricultural MITs
- To neutralise competition as between foreign and domestic investors in Australian agricultural land, a measure will be introduced to prevent rent from agricultural land qualifying as eligible investment business income for MIT qualification purposes. This follows a recent announcement from the Treasurer on the tightening of requirements for foreign investors seeking FIRB approval to acquire agricultural land.
- The measures referred to in items A, C, D and E will commence on 1 July 2019, but qualifying 'arrangements' in existence at the date of the announcement will have access to transitional relief for a period of seven years (or 15 years for existing economic infrastructure staples in relation to item A). Item B (the thin capitalisation measure) will apply to income years commencing on or after 1 July 2018 (with no transitional relief for existing arrangements).
- During the transition periods, foreign investors can still access the MIT concessional withholding tax rates on 'converted' business income, the foreign pension fund exemption and the SIE but, it seems from the announcement, only for investments made (or, in the case of item A, committed to) at the date of the announcement. However, Treasury has indicated that it will consult separately on the conditions that stapled entities must comply with to access the transitional arrangements under item A (foreshadowing that stronger integrity measures may be needed to protect against aggressive cross-staple pricing).
- Sovereign investors that have a ruling from the ATO on the SIE for a particular investment period extending beyond the transition period will be able to access the transition period on that investment until the expiry of the ruling.
- Furthermore, it is proposed that Part IVA will not apply to the choice of a stapled structure to obtain a deduction on cross-staple rent payments during the transition period (although it may continue to be applied to other 'egregious tax-driven arrangements such as royalty staples' consistent with TA 2017/1).
- Investors need to be aware that the benefits of the transitional arrangements for infrastructure are limited to those structures that comply with foreshadowed integrity rules. The integrity rules are not specified and will be developed in separate consultations with Treasury.
- After such a long period of consultation, it is remarkable that some of the fundamental issues arising from Taxpayer Alert TA 2017/1 remain. Eg the announcement identifies staples with underlying third party rent income as 'good staples', but experience shows that finding acceptance of a 'good staple' outside of the traditional REIT structure is problematic and, it seems, will continue to be so.
- As often occurs in tax reform, there are significant interaction issues. Eg while a stapled structure might involve underlying third party rent and might therefore be considered a 'good staple', if the underlying rent is for agricultural land, it would seem to be precluded from the protection otherwise available to 'good staples'. Another example might be the curtailment of benefits for sovereign wealth and foreign pension funds, as the announcement leaves open the question of whether the measures directed to those entities are necessarily limited to investments in stapled structures.