This article was written by Scott Heezen and Sarah Silk.
The Australian Treasurer released a second draft of the proposed legislation to implement its Integrity Package targeted at stapled structures and foreign investors on 26 July 2018 (the "second stage ED").
The second stage ED not only contains provisions implementing the fifth element of the Integrity Package (preventing agricultural managed investment trusts ("MITs")) but also includes specific provisions to increase the MIT withholding rate on income from residential accommodation.
In this Alert, we summarise the new elements contained in the second stage ED as well as discuss how the second stage ED differs from the initial exposure draft legislation ("first stage ED").
Overview of the new elements contained in the second stage ED
MIT agricultural income
Since the announcement of the Integrity Package there has been considerable uncertainty regarding the scope of the Integrity Package's fifth element: preventing agricultural MITs. The second stage ED clarifies how this measure is proposed to operate.
In particular, under the ED, certain amounts of assessable income of a MIT (MIT agricultural income)that are attributable to an asset (whether or not held by the MIT) that is "Australian agricultural land for rent" will also be treated as non-concessional MIT income and subject to the higher 30% MIT withholding tax rate.
Australian agricultural land for rent is defined to be an asset that is real property situated in Australia if the asset:
(a) is used, or could reasonably be used, for carrying on a primary production business; and
(b) is held primarily for the purpose of deriving or receiving rent.
Under this definition, if the land is used to carry on a primary production business it would not constitute Australian agricultural land for rent (however, such income may be caught by the MIT trading trust income rules). It is not necessary that such income be derived through a stapled arrangement.
MIT agricultural income will also include a capital gain from the disposal of a membership interest that is essentially an indirect interest in Australian agricultural land for rent (determined by applying a principal asset test). As such, gains arising on the sale of an entity whose assets comprise more than 50% agricultural land will be subject to the higher withholding rate, irrespective of the level of investment in that entity.
A 7 year transitional period will apply to investments in Australian agricultural land for rent that were held as at 27 March 2018 (the date of the announcement of the Integrity Package). For such existing investments, the higher 30% MIT withholding tax rate will not apply until 1 July 2026.
On a positive note, in a departure from the original announcement, the provisions have been drafted such that mere holding of agricultural land will not result in a trust ceasing to be a MIT nor will it impact on the trading trust status of such trusts. This will be welcomed by Australian investors that may have been adversely impacted had the provisions deemed such holdings as carrying on of a trading business (as in certain cases this may result in the trust being taxed as a company). From a foreign investor's perspective, it also means that a trust can hold agricultural land and other assets and not automatically lose its MIT status.
MIT residential housing income
The inclusion of the MIT residential housing income measures in the second stage ED was not expected and was not part of the original Integrity Package.
However, the Government had previously indicated that it intended to prevent MITs from investing in residential premises (other than in limited circumstances, such as where the investment was in affordable housing) with draft legislation to this effect being released in 2017.
The original proposal has, thankfully, been modified such that MITs can continue to hold residential property primarily for the purposes of deriving rent without jeopardising their status as MITs. This also ensures that Australian resident investors should continue to be subject to tax on the same basis, with trusts that hold residential property for rent not being deemed to be carrying on a "trading business" as per the original proposals.
However, for non-residents, income from residential investments (such as rent, capital gains and licence fees) will now become subject to the higher 30% MIT withholding tax rate, unless the MIT residential housing income is referable to times when the dwelling was used to provide affordable housing. As such whilst the changes make clear that buy to rent investments will continue to be eligible investments for a MIT, the changes may adversely impact access to foreign capital by significantly reducing the attractiveness of such investments as compared to office or industrial investments which should continue to be eligible for the 15% withholding tax rate.
It is important to note that these measures only relate to Australian real property investments and not to investments that may be held in non-Australian residential property. As for the MIT agricultural provisions, it is not however, necessary that the MIT residential housing income be derived through a stapled arrangement to be subject to the higher withholding rate.
A 10 year transition period will apply to investments in MIT residential housing income that were held as at 14 September 2017. For such existing investments, the higher 30% MIT withholding tax rate will not apply until 1 October 2027.
Overview of the changes to the first stage ED following consultation
This section of our Alert outlines some of the most significant differences between the second stage ED and the first stage ED.
Non-concessional MIT Income
Under the second stage ED, non-concessional MIT income that will be taxed at the higher 30% MIT withholding tax rate is defined to mean each of the following four categories: (i) MIT cross staple arrangement income; (ii) MIT trading trust income; (iii) MIT agricultural income; and (iv) MIT residential housing income.
Several of the concerns that were expressed in submissions, including our own, regarding the non-concessional MIT income rules have been addressed in the second stage ED. In particular:
- Treatment of capital gains on sale of properties as non-concessional MIT income: the second stage ED makes clear that capital gains made by an asset entity on a sale to a non-asset entity are not to be treated as non-concessional MIT income.
- Concept of economic infrastructure facility: the concept of economic infrastructure asset has been replaced with economic infrastructure facility, which refers to groups of assets that are connected and together perform a particular function
Further refinements to the economic infrastructure facility concession include that:
- the definition of economic infrastructure facility no longer contains the "public purpose" element;
- the Treasurer's approval may apply to a new facility or to the substantial improvement of an existing facility; and
- the concession will also cover future expansions and enhancements where assets are added to an existing facility to improve or extend its functionality.
There are also some other changes including modifications to the exclusion for de minimis cross staple arrangements and the application of the transitional rules.
Residual concerns that have not been addressed in the second stage ED include:
- provisions relating to the interaction between the general anti avoidance provisions in Part IVA to transitioned and non-transitioned stapled arrangements; and
- the need to define the concept of "rent" for the purposes of providing clarity as to whether payments are eligible to fall outside the definition of non-concessional MIT income.
Superannuation funds for foreign residents
The first stage ED introduced measures to exclude the current exemption for foreign superannuation funds. This applies where foreign superannuation funds hold an interest of 10% or more in the relevant paying entity, or due to the existence of certain rights, are deemed to hold a 10% or greater interest. The second stage ED has modified the provisions regarding the circumstances in which a foreign superannuation fund may be deemed to hold a 10% or greater interest in an investment. In particular, for the purposes of the portfolio interest test:
- a debt interest which confers certain rights (such as voting) is no longer treated as a membership interest in the entity; and
- a substance test is to apply for the purposes of determining whether or not the fund has relevant "influence" over the entity.
Unfortunately, the new "influence" test is still not particularly clear and it will require full consideration of the rights of particular investors including any involvement in advisory bodies. For example, the explanatory materials to the second stage ED provide that the rights to appoint a person on an advisory board will give rise to the necessary level of "influence" where the board of a relevant company cannot make certain decisions with that advisory body's approval. Furthermore, the testing of the influence is still undertaken at the first level of investment into Australia. This may mean that investors with interests in Australian funds of greater than 10% will not be eligible for the exemption even if they have an underlying indirect interest of less than 10% in the relevant portfolio entities that issue the shares or securities which generate the interest or dividend payments.
Modification of the sovereign immunity exemption
There have been some modifications also to the sovereign immunity provisions. It is pleasing to see the second stage ED no longer combines all sovereigns from the same country for the purposes of determining the level of participation interest. Rather, the concept of a "sovereign entity group" is introduced for these purposes. While sovereign entities of the same foreign government will be combined for the purposes of determining the participation interest, sovereign entities from the same country, but a different government, will not.
Further, similar changes to those discussed above in respect of the foreign superannuation fund measures, have also been included in the sovereign immunity measures in relation to the deemed 10% interest tests. Again this raises the same concerns as to the testing of "influence" and the fact that such testing is undertaken at the first level of investment into Australia.
The second stage ED has also made some modifications to the 7 year transitional relief provisions, including extending the transition rules to sovereigns that obtain a private ruling before 1 July 2026 provided that such ruling had been applied for prior to 27 March 2018. Under the previous draft, the ruling had to have been provided to a sovereign on or before 27 March 2018.
Our summary of the first stage ED, as well as a copy of our submission to Treasury as part of the first stage consultation process, can be found at the following link.
A link to the Exposure Draft Treasury Laws Amendment (Making Sure Foreign Investors Pay Their Fair Share of Tax and Other Measures) Bill 2018 and to the explanatory materials can be found here.