Peter Feros
Partner •
Sydney
Australian tax reforms to stapled structures to affect foreign investors
On 27 March 2018 Treasury announced long-awaited tax reforms in its paper, "Stapled Structures Details of Integrity Package". The Reforms aim to address Government concerns regarding the taxation of foreign investors investing in stapled groups and flow-through entities, as well as limiting the tax concessions accessed by sovereign wealth and foreign pension funds.
The Reforms follow significant activity from Treasury and the Australian Taxation Office (ATO) regarding the perceived re-characterisation of trading income derived through the use of stapled structures, particularly:
- the Australian Taxation Office's Taxpayer Alert 2017/1 Re-characterisation of income from trading businesses (TA 2017/1) in January 2017;
- Treasury's consultation paper, "Stapled Structures", in March 2017; and
- the update to the ATO's 2015 document, "Privatisation and Infrastructure - Australian Federal Tax Framework".
The Reforms arguably go further than what was initially proposed in Treasury's consultation paper released in March 2017 and target not only the re-characterisation of trading income derived through the use of stapled structures - by increasing the withholding rate to 30% on fund payments that relate to cross staple rent and payments made under some financial arrangements and distributions received from a trading trust - but purport to level the playing field between domestic and foreign investors through:
- amendments to the definition of an associate entity of a trust for the purposes of the thin capitalisation provisions through lowering the ownership interest test from more than 50% to more than 10%;
- limiting the foreign pension fund withholding tax exemption to those investors which have a less than 10% (portfolio interest);
- limiting the sovereign immunity tax exemption to those investors which have a less than 10% interest; and
- making investments in agricultural land not qualify as "eligible investment business" - this would cause a trust to not qualify as a Managed Investment Fund (MIT) and potentially result in it being taxed like a company.
While the Reforms propose transitional periods for qualifying structures (other than the thin capitalisation amendments) whereby existing tax outcomes are grandfathered for a limited period (7 years or 15 years for existing economic infrastructure staples), restructuring of existing structures is something which may need to be considered. Without the States and Territories providing specific stamp duty concessions (and the Commonwealth providing income tax related rollovers) to facilitate such restructures, restructuring could be a very costly exercise and may mean that restructuring may not be practical.
Preventing active business income from accessing 15% MIT rate
Foreign investors in MITs will be subject to a withholding rate at the prevailing corporate tax rate (currently 30%) on fund payments that relate to amounts derived from cross staple rental payments (i.e., rent paid by the operating entity to the MIT), cross staple payments made under some financial arrangements such as total return swaps, or where the MIT receives a distribution from a trading trust.
The corporate tax rate on withholding will not apply to rent received from third parties or where the amounts are only a small proportion of the gross income of the trust relates to cross staple arrangements (safe harbour).
New investments in economic infrastructure projects approved by the Government that are considered to be "nationally significant", will qualify for be the usual MIT rate (15% for an information exchange country) for cross-staple rental income for 15 years provided they satisfy the other conditions for the exemption. After the 15 years, the corporate tax rate will apply. Further consultation will occur on the requirements for accessing this concession (e.g., stronger integrity measures).
Comment
Of the various measures proposed by Treasury in the Consultation Paper, this is probably the approach which is likely to cause the least disruption to financing arrangements. Concern was expressed that taxing the asset owning trust like a company would cause debt covenants to be breached (among other things).
That said, we query whether the concession period for nationally significant infrastructure will be long enough given that the life of many concessions exceeds 15 years. It will also be useful to understand what immediate impact the measures have on the pricing which State Governments achieve for their assets given the fixed period of the concession.
Arrangements entered into after 27 March 2018
These provisions will commence on 1 July 2019 and apply to all arrangements entered into after 27 March 2018.
Transitional periods
- Arrangements in existence as at 27 March 2018
- The provisions will not apply to arrangements in existence as at 27 March 2018 until 1 July 2026 (7 year transitional period).
- Economic infrastructure staples in existence as at 27 March 2018
The provisions will not apply to economic infrastructure staples in existence as at 27 March 2018 until 1 July 2034 (15 year transitional period)
During the transitional periods, the 15% withholding rate will apply in relation to investments made or committed to as at 27 March 2018.
A key issue relating to the transitional relief for Element A (along with all other Elements qualifying for transitional relief) is what constitutes "an arrangement being in existence" at 27 March 2018. For example, if an existing investment structure is varied in any way, will that post amendment structure constitute the same arrangement for the purposes of this rule.
This rule will need to be defined in a balanced and commercial manner otherwise it will have significant implications for many funds which we consider go beyond what is necessary to provide integrity. For example an existing stapled structure which is part way through an asset acquisition program which is in accordance with a pre-27 March 2018 business plan will be in a very difficult position if the mere carrying out of that acquisition program causes it fall outside the transitional relief because the assets were not owned at 27 March 2018.
Preventing double gearing structures through the thin capitalisation rules
The associate entity test in the thin capitalisation rules will be amended to reduce the ownership interest in a flow through entity from more than 50% to more than 10%.
The amendments aim to target those structures that use "double gearing" in order to:
- gear a structure in excess of what was intended under the thin capitalisation regime;
- access the lower 10% withholding rate; and
- decrease the overall effective tax rate.
Double gearing is the use of a chain of entities that are flow-through for tax purposes (trusts and partnerships) which issue debt against the same underlying asset.
These debts are not currently captured under the thin capitalisation regime because the flow through entities are not considered to be associate entities as the ownership interest the foreign investor has in each entity is less than 50%.
In addition, the arm's length debt test will require consideration of gearing against underlying assets, to ensure that taxpayers do not seek to rely on this alternative method of testing for thin capitalisation compliance.
Comment
These amendments could best be described as plugging a gap in the legislation. Investors will need to take steps to amend their financing arrangements to ensure that deductions are not denied. Given the lack of a transitional period, urgent action is required to give effect to these changes.
These provisions will apply from 1 July 2018 with no transitional period.
Limiting the foreign pension fund withholding tax exemptions
The exemption from interest and dividend withholding tax that applies to foreign pension funds will be limited to those who have an interest of less than 10% and do not have an influence over the entity's key decision-making.
Comment
This is a mainstay of many foreign investment structures into infrastructure projects. How this affects asset pricing will be a key issue, given that so much infrastructure investment is sourced from foreign pension funds
Arrangements entered into after 27 March 2018
These provisions will commence on 1 July 2019 and apply to all arrangements entered into after 27 March 2018.
Transitional period
The provisions will not apply to arrangements in existence as at 27 March 2018 until 1 July 2026 (7 year transitional period).
During the transitional period, the exemption from dividend and interest withholding tax will still apply to pension funds in relation to investments made as at 27 March 2018.
Limiting the sovereign immunity tax exemption
The administrative concession provided by the ATO to exempt sovereign wealth funds from tax on income derived from 'non-commercial' investments:
- will be limited to those who have an interest of less than 10% and do not have an influence over the entity's key decision-making; and
- will not extend to distributions of active business income from trusts (including where the active income has been converted to rent through cross stapled payments).
Comment
To a large extent, this is consistent with existing ATO practice on sovereign immunity and so is among the least controversial of the measures.
Arrangements entered into after 27 March 2018
These provisions will commence on 1 July 2019 and apply to all arrangements entered into after 27 March 2018.
Transitional period
The provisions will not apply to arrangements in existence as at 27 March 2018 until 1 July 2026 (7 year transitional period).
During the transitional periods, the sovereign immunity exemption will continue to apply in relation to investments made as at 27 March 2018.
Sovereign investors who have a ruling from the ATO on sovereign immunity for a particular investment extending beyond the transitional period will be able to continue to rely on the ruling until its expires.
Preventing agricultural MITs
Investment in agricultural land will no longer be taken to qualify as eligible investment business, meaning that such a trust cannot qualify as a MIT and, if that trust is a "public trust" under Division 6C of the Income Tax Assessment Act 1936 (1936 Act), will be taxed in a manner similar to a company and will therefore lose pass through status (affecting not only foreign investors, but also domestic investors).
Comment
The implications for agricultural fund structuring are significant. At best, these structures will lose their MIT status and at worst, will be taxed as companies. The impact on financing covenants needs to be carefully considered for these entities and given the potential for these entities to be taxed like companies, inadvertently falling outside the transitional relief will be a very significant issue (particularly for public trusts under the 1936 Act).
Arrangements entered into after 27 March 2018
These provisions will commence on 1 July 2019 and apply to all arrangements entered into after 27 March 2018.
Transitional period
The provisions will not apply to arrangements in existence as at 27 March 2018 until 1 July 2026 (7 year transitional period).
During the transitional period, the rent derived from investments in agricultural land made as at 27 March 2018 will continue to qualify for the 15% withholding rate.
Application of TA 2017/1
In TA 2017/1 the ATO advised that Part IVA may apply to some stapled transactions. Following implementation of the Reforms, Part IVA will not apply to transactions that relate to cross staple rental payments during the transitional period. However, the ATO will apply Part IVA to "egregious tax-driven arrangements such as royalty staples".
What should investors and funds do next?
For those investors and funds which are affected by the new rules it will be important to:
- conduct a due diligence on their existing structure in light of the Reforms to determine what short-term and long-term impact the Reforms have on their respective tax positions - in particular, does the structure qualify for transitional relief and is any action contemplated which might inadvertently cause the fund to fall outside of transitional relief;
- understand the impact of the new rules on transactions or restructures which might be partially completed as at 27 March 2018 - will these have an adverse impact on the availability of transitional relief;
- understand the impact on financing - is there anything in the proposals which could affect the continued availability of financing? For instance, will the relevant entity become immediately taxable (eg. in relation to agricultural investments); and
- engage with the consultation process. Treasury needs to understand how the detail of these new rules is likely to impact existing structures in the real world. While extensive consultation has occurred to date, the extent of the Reforms has only just become public and there may still be an opportunity to influence outcomes on some of the more detailed aspects, particularly the availability of transitional relief.
Disclaimer
Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.