Treasury has released the first of several tranches of exposure draft legislation to implement the Federal Government's tax integrity package for stapled structures and broader tax concessions currently available to certain foreign investors. The draft legislation sets out the requirements that investors must satisfy to access the concessions and transitional arrangements foreshadowed in the package. However, Treasury has indicated that draft legislation on the agricultural MIT changes, and on the conditions that stapled entities must comply with to access the infrastructure concession and transitional arrangements, will be released in due course. The Exposure Draft is open for public consultation until 31 May 2018. Partner Martin Fry and Senior Associate Igor Golshtein report.
On 18 May 2018, Treasury released the first tranche of the eagerly anticipated Exposure Draft to implement the Government's tax integrity package for stapled structures and broader tax concessions currently available to certain foreign investors. The Exposure Draft covers the first four measures proposed in the package (Elements A, B, C and D)1 to broadly (and subject to certain carve-outs, exceptions and transitional measures) the following effect:
- Fund payments to foreign investors by managed investment trusts (MITs), which consist of, broadly, amounts of rent 'converted' from trading income under a cross-staple arrangement will be subject to withholding tax at the highest corporate tax rate (currently 30 per cent) compared with the concessional rate of 15 per cent;
- The thin capitalisation associate entity test threshold (for the purposes of determining associate entity equity, associate entity debt and the associate entity excess amount) will be lowered from 50 per cent or more to 10 per cent or more for interests in flow-through entities, to limit the ability of investors to use 'double-gearing structures';
- The application of the existing dividend and interest withholding tax exemption available to certain foreign superannuation funds will be limited to those holding 'portfolio-like' investment interests in Australian entities; and
- 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) based on the international law doctrine of sovereign immunity will be codified and limited to those sovereign investors holding 'portfolio-like' investment interests in Australian entities.
Importantly, the Exposure Draft sets out the requirements that must be satisfied in order for investors to access the 15-year concession for 'new approved economic infrastructure assets', or the seven or 15-year transitional arrangements for existing (or sufficiently committed) ordinary business staples or economic infrastructure staples respectively. However, Treasury has indicated that draft legislation on the agricultural MIT changes (Element E from the package) and the conditions stapled entities must comply with to access the new economic infrastructure concession and / or transitional arrangements will be released in due course.
A. Preventing active business income 'converted' to 'rent' from accessing concessional 15 per cent MIT withholding rate
Under the Exposure Draft, from 1 July 2019 but subject to the carve-outs, concessions and transitional arrangements described below, fund payments made by a MIT under a 'cross-staple arrangement' to which it is a party to foreign investors that currently qualify for the 15 per cent concessional withholding rate, will instead be subject to MIT withholding tax at the top corporate tax rate (currently 30 per cent) to the extent the fund payments are attributable to 'non-concessional MIT income'. 'Non-concessional MIT income' is, broadly, an amount of assessable income that is not dividends, interest, royalties, capital gains in relation to a CGT asset that is not taxable Australian property and foreign-sourced income. Accordingly, 'non-concessional MIT income' includes a cross-staple 'rent' payment. A 'cross-staple arrangement' is, broadly, any arrangement between two or more entities – including at least one 'asset entity' and one 'operating entity' – that have common ownership of at least 80 per cent.
However, cross-staple rent will not constitute 'non-concessional MIT income' in the following circumstances:
- Third-party rent: To the extent that the cross-staple payment is attributable to an amount of 'rent' that is derived by a stapled entity from a third party that is not party to the cross-staple arrangement, that payment will not constitute 'non-concessional MIT income'.
It appears from the EM that this carve-out was intended to effectively exempt 'traditional property stapled structures' (such as REITs) from the higher MIT withholding tax rate. Since the touchstone for the application of the carve-out is the derivation of 'rent' from third parties, the carve-out will not apply to stapled structures to the extent they derive income from granting land-use rights to customers that fall short of the legal definition of 'rent' (eg road operators that charge tolls, hotel and student accommodation operators that charge mere licence fees).
Nevertheless, the scope of the carve-out may extend beyond the 'traditional property sector' to cover other businesses to the extent their activities include renting out land to third parties outside the stapled structure.
- De-minimis exception: Broadly, cross-staple rent payments will not constitute 'non-concessional MIT income' where the 'non-concessional MIT income' of the MIT in the previous income year did not exceed 5 per cent of its total assessable income (disregarding any net capital gains) in that previous income year.
- Approved (new) economic infrastructure asset exception: Broadly, cross-staple rent payments relating to certain eligible infrastructure assets will not constitute 'non-concessional MIT income' for 15 years from the time the asset is first put to use. To qualify for the exception, the asset must be covered by an approval of the Treasurer (which approval may be sought by a Federal or State Government agency).
The Treasurer may approve the asset if satisfied that the following criteria are met:
- The asset is an economic infrastructure asset, defined as transport, energy, communications or water infrastructure for public purposes (which will include certain roads, ports and electricity generation, transmission or distribution facilities for public purposes);
- The estimated capital expenditure on the asset is $500 million or more;
- The asset is yet to be constructed, or the asset is an existing asset that will be substantially improved;
- The asset will significantly enhance the long-term productive capacity of the economy (which may involve consideration of whether the economic benefits resulting from the asset, or the substantial improvement, will outweigh the economic costs and the opinion of Infrastructure Australia on the national significance of the asset); and
- Approving the asset is in the national interest.
A MIT will also have 'non-concessional MIT income' to which the higher MIT withholding tax rate will apply where the MIT receives distributions (directly or indirectly) from a Division 6C 'trading trust' (ie if the MIT has a non-controlling interest in, and cannot otherwise control, that trading trust). None of the abovementioned exceptions apply to 'non-concessional MIT income' arising in these circumstances.
Subject to the transitional rules described below, the amendments to modify the MIT withholding tax to payments attributable to 'non-concessional MIT income' will apply from 1 July 2019.
The transitional rules in relation to these amendments are quite complex, require the making of a written choice (by 30 June 2020) and with the period of grandfathering depending on the particular asset held (or to be held) by the stapled structure. The effect of a transitional rule applying to these amendments is that cross-staple rent payments that would be treated as 'non-concessional MIT income' are not treated as such and remain eligible for the concessional withholding tax rate for the relevant grandfathering period.
In this regard, the transitional rules will apply, very broadly, to both existing assets the subject of cross-staple arrangements and assets to be acquired / constructed for which there has been the requisite level of commitment, as follows:
- For existing assets that are already in use and currently producing income, the transitional rules apply to an amount that is derived before:
- 1 July 2034 (for economic infrastructure assets); and
- 1 July 2026 (for other assets).
- For assets currently being constructed, or whose construction has not yet commenced, the transitional rules will apply to an amount that is derived after the time that the asset is first put to use and starts producing income and before the earlier of:
- 1 July 2039 and 15 years after the asset is first used for the purpose of producing assessable income (for economic infrastructure assets); and
- 1 July 2031 and seven years after the asset is first used for the purpose of producing assessable income (for other assets).
Careful assessment will need to be made as to whether capital improvements will constitute new assets or enhancements to existing assets, as this may, depending on the circumstances and timing, affect eligibility for the application of the transitional rule.
A separate transitional rule applies for MITs that have 'non-concessional MIT income' by virtue of receiving distributions (directly or indirectly) from a Division 6C 'trading trust'. In these circumstances, that portion of the MIT's total participation interest in the trading trust that was acquired before 27 March 2018 will be treated as not constituting 'non-concessional MIT income' until 1 July 2026.
As foreshadowed in the package, the Exposure Draft also contains provisions that seek to ensure that the general anti-avoidance rule in Part IVA will not apply to the choice of a stapled structure to obtain a deduction for cross-staple rent during the relevant transition period.
Under the Exposure Draft, for income years commencing on or after 1 July 2018, the thin capitalisation rules will apply to limit the ability of investors to use 'double-gearing structures', which may otherwise allow foreign investors to provide a greater proportion of their capital as potentially more favourably-taxed interest income and to gear higher than the intended thin capitalisation limits. Broadly, 'double-gearing' occurs 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 amendments will lower the thin capitalisation associate entity test threshold (for the purposes of determining associate entity equity, associate entity debt and the associate entity excess amount) from 50 per cent or more to 10 per cent or more for interests in flow-through entities.
Also, to safeguard against investors attempting to effectively circumvent the effect of the new rule by relying on the calculation of the 'arm's length debt amount', the determination of the 'arm's length debt amount' will require factoring in the debt-to-equity ratios of any entities in which the tested entity has a direct or indirect interest, to determine the ability of the relevant investments of the entity to act as security to support the entity's debt.
No transitional rules will apply to these measures.
C. Limiting the interest and dividend withholding tax exemption for foreign superfunds to portfolio-like interests
Currently, a foreign resident superannuation fund for foreign residents that is exempt from income tax in the country in which it resides is exempt from Australian withholding tax on payments of interest, dividends and non-share dividends from Australia, irrespective of the foreign superfund's stake in, and ability to influence the decision-making of, the Australian entity in which it has invested and from which it receives the payment.
Under the Exposure Draft, from 1 July 2019 (but subject to the transitional arrangements described below) the withholding tax exemption will no longer apply to interest, dividend and non-share dividend income derived by the foreign superfund if its total (direct or indirect) participation interest in the entity from which the superfund derived that income is 10 per cent or more at the time the payment was made and throughout any 12-month period in the 24-month period preceding the payment.
Importantly, the new rules treat the superfund as having the requisite 10 per cent participation interest (even if it is in fact lower) if, at the relevant time(s):
- it holds a membership, debt or non-share equity interest in the paying entity; and
- that interest confers (or those interests confer) a right on the superfund to:
- vote at a meeting of the board of directors (or other governing body) of the entity;
- participate in making financial, operating and policy decisions regarding the entity; or
- to deal with the assets of the entity.
The explanatory materials state that the foreign superfund must test the size of its interest and influence over the abovementioned decision-making at the first level of its investment into Australia.
The explanatory materials also state that the superfund will be taken to have influence over that decision-making 'if it has any of the specified rights, however obtained', and that this means that rights arising from side letters and ancillary agreements must be taken into account when considering this criterion. Notwithstanding the seemingly broad scope of the rights in question (eg 'participate in making … decisions' rather than, say, controlling decision-making), it is not clear that the actual terms of the Exposure Draft go quite as far as the explanatory materials suggest. In particular, the relevant provision in the Exposure Draft clearly requires that it is the membership, debt or non-share equity interests that must confer the requisite rights on the superfund.
The amendments under this measure will apply from 1 July 2019. However, a seven-year transitional rule applies to investment assets held by foreign superfunds on or before 27 March 2018. In these circumstances, the amendments will apply to payments of interest, dividends or non-share dividends received from such investment assets from 1 July 2026.
It is critical to appreciate that these rules apply to any relevant investments by the foreign superfund – they are not limited to investments in stapled structures.
Presently, the ATO provides an exemption based on the international law doctrine of 'sovereign immunity' from interest and dividend withholding taxes, capital gains tax and tax on trust distributions to foreign sovereign investors (including sovereign wealth funds) in Australian 'non-commercial' investments where the investor cannot influence the decision-making of the holding entity. Depending on the particular governance arrangement for an investment, the exemption may be provided to investors having a 10 per cent or greater interest in the holding entity.
Under the Exposure Draft, this sovereign immunity exemption will be codified into Division 880 of the Income Tax Assessment Act 1997 (Cth). As with the withholding tax exemption for foreign superfunds, this exemption will apply only to 'portfolio-like' investments. However, under the sovereign immunity exemption, in determining whether a sovereign entity holds a 10 per cent or greater interest in the paying entity, the sovereign entity's interest is aggregated with that of any other sovereign entity of the same foreign country as the sovereign entity. This rule is an integrity rule designed to prevent sovereign investors investing through multiple entities each holding a less than a 10 per cent interest, to circumvent the policy objective of limiting the exemption to portfolio-like investments.
In addition to the '10 per cent or more' rule, the exemption will only apply if, broadly:
- the amount of income is derived from a trust or company;
- if the paying entity is a trust, it is a MIT;
- the sovereign entity did not acquire any interest in the paying entity in the course of carrying on a trading business within the meaning of Division 6C; and
- the amount of income is not attributable to a fund payment made by a MIT that is attributable to 'non-concessional MIT income'.
The amendments under this measure apply from 1 July 2019, subject to the following transitional rules:
- If a sovereign entity acquired its investment asset on or before 27 March 2018, and on or before that date the Commissioner gave it a private ruling to the effect that the asset qualifies for sovereign immunity and the ruling applied to it on 27 March 2018, then it will continue to be eligible for the exemption until the later of 1 July 2026 or the day before the private ruling ceases to apply.
- A transitional rule also applies to reset the tax costs of assets held by a sovereign entity that currently qualifies for sovereign immunity. If a sovereign entity holds an asset (other than money) on 1 July 2026 and on or before 27 March 2018, the Commissioner gave it a private ruling to the effect that the asset qualifies for sovereign immunity, then the sovereign entity is taken to have sold and repurchased the asset, for consideration equal to its market value, on the day that is the later of 1 July 2026 and the day before the private ruling ceases to apply.
The Exposure Draft contains important details that were not in the package released in March, particularly those concerning the requirements that must be satisfied for investors to access transitional relief regarding the amendments to the MIT withholding regime, as well as the limits to be placed on exemptions for foreign superfunds and sovereign wealth funds.
Potentially affected investors will need to consider the impact of the Exposure Draft (if enacted in its present terms) on their current or prospective investments, whether transitional relief may be accessed and any impact on the internal rate of return. For existing investments, consideration will also need to be given to the ongoing viability of the investment and whether a partial or full divestment of the asset might be appropriate in the future. Regarding the changes to the MIT withholding regime, this analysis might be further affected by the draft legislation yet to be released on the conditions that stapled entities must comply with to access the transitional arrangements.
Furthermore, since the thin capitalisation amendments regarding 'double-gearing' structures will apply to income years starting on or after 1 July 2018, with no transitional relief available to any taxpayers, investors holding their investments through the affected structures should consider the impact of the amendments on their cost of finance and return on investment as soon as possible.