Proposed Investment Manager Regime changes

Introduction and background

On 15 January 2010, the Australian Financial Centre Forum released its report (Johnson report) on 'Australia as a financial centre', which contained 19 recommendations, including introduction of an 'investment manager regime' (IMR) for investments by foreign residents managed in Australia and a comprehensive regime for the taxation of 'collective investment vehicles' (CIVs). The Government responded on 11 May 2010 with in-principle support for all recommendations and released a consultation paper.

The Board of Taxation (BoT) was asked to review and report on design of an IMR and to review the tax treatment of CIVs. The BoT released its report on 17 December 2010 and the Assistant Treasurer announced on 19 January 2011 that the Government would introduce an exemption for offshore funds engaging domestic investment advisers (referred to as 'conduit income' measures).

As noted in our article about the tax determinations recently issued by the ATO in relation to certain profits on Australian investments derived by foreign private equity funds, the Australian Government announced that it would introduce measures to deal with uncertainties arising in past years for foreign funds in relation to their Australian tax position due to their disclosure requirements under the US accounting standard known as 'FIN 48' and also announced that it would introduce conduit income measures to encourage the use of Australian fund managers by foreign funds in future years.

Exposure draft (ED) legislation was released in August 2011, containing the following 2 measures:

1. The 'FIN 48' measures - to apply for the 2011 and earlier income years (announced on 17 December 2010 and 10 May 2011); and
2. The 'conduit income' measures- to apply for the 2011 and subsequent income years (announced on 19 January 2011).

The proposed measures are the first instalment of the IMR changes and remaining issues raised by the Johnson report are still being considered by the BoT, which is due to release its report to Government (covering both IMR and CIVs) by 31 December 2011.  The proposed changes were described by the Assistant Treasurer as 'an important step towards improving Australia's standing as an international financial services centre'.

FIN 48 measures

These measures¹ provide an exemption (in the 2010-11 and earlier income years, as noted above) from taxation in relation to 'IMR income' (and for an 'IMR loss', 'IMR capital gain' or 'IMR capital loss' to be disregarded) for:

• an 'IMR foreign fund' or trustee of an IMR foreign fund (if the fund would otherwise be taxable on the income);
• a non-resident 'IMR trustee' (if the trustee of an IMR foreign fund would otherwise be taxable on the income); or
• non-Australian resident beneficiaries or partners who are 'ultimately entitled' (directly or through one or more interposed partnerships or trusts) to the income (if the income would otherwise be taxable to the beneficiary or partner rather than to the fund or trustee).

The exemption applies only if:

• the IMR foreign fund (or the beneficiary or partner, if applicable) has not lodged an income tax return in relation to the income year or any previous income year; and
• the Commissioner has not made an assessment of the income of the IMR foreign fund (or beneficiary or partner, if applicable), or notified the IMR foreign fund (or beneficiary or partner) that an audit or compliance review would be undertaken, before 18 December 2010.

The exemption does not apply if the Commissioner is of the opinion that there has been fraud by the IMR foreign fund, beneficiary or partner.

The terms 'IMR foreign fund', 'IMR income', 'IMR loss', 'IMR capital gain' and 'IMR capital loss' are defined in the conduit income provisions (see below).

As noted in our article concerning the 'private equity' tax determinations, the definition of 'IMR income' in the conduit rules does not deal with the issues of Australian source arising from TD 2011/24. It also excludes the type of private equity investments dealt with in the determinations (i.e. non-portfolio investments in Australian companies).

Conduit income measures

These measures² will provide that, in working out the taxable income for an income year of certain 'IMR foreign funds', the 'IMR income' of the fund is non-assessable non-exempt income and any 'IMR loss', 'IMR capital gain' or 'IMR capital loss' of the fund is disregarded.

As noted above, the changes are intended to remove a major impediment to the use of Australian investment managers by foreign funds (namely, causing the fund to have a permanent establishment in Australia that it would otherwise not have) and bring Australian closer into line with other major financial services centres. However, there are a number of limitations and uncertainties with the provisions, as noted below.

Application of the provisions

The proposed provisions will apply (in the 2010-11 and later income years) if:

• the entity is an IMR foreign fund in relation to the income year (or trustee thereof); and
• it does not have a place of business in Australia but is treated as having a permanent establishment in Australia solely as a result of engaging an Australian based investment manager who habitually exercises a general authority to negotiate and conclude contracts on behalf of the entity. That is, the rules will not apply where the fund has an Australian branch or otherwise has a permanent establishment in Australia, except by virtue of engaging the Australian investment manager. The explanatory memorandum (EM) says it is not intended to provide an exemption where the fund has a 'bricks and mortar' permanent establishment or is genuinely carrying on business in Australia and deriving Australian source income.

The EM says that the relief is intended to apply at the fund level (where the entity itself is taxable, e.g. a company or an entity taxed as a company) or at the partner/member level (if the fund is treated as transparent for tax purposes, e.g. a trust) and that it is not intended to apply for an Australian resident partner or member. However, it is not entirely clear that this is achieved in the ED provisions and the EM acknowledges that 'further changes may be necessary to ensure this outcome is achieved'.

IMR foreign fund

The EM says the measures are 'targeted at widely held entities where investors collectively pool their funds to make portfolio investments in foreign sourced assets'.

An entity (regardless of its legal form)³ will be an IMR foreign fund in relation to an income year if:

• the entity is not (at any time during the income year) a resident of Australia;
• the entity is (at all times during the year) recognised under a foreign law as being used for collective investment by means of pooling the contributions of its members as consideration to acquire rights to benefits produced by the entity. The EM says that an entity that is designed to pool funds of a number of investors and has a common purpose of investing should satisfy this requirement - however, as noted below, the concept is not entirely clear;
• the entity's members do not (at any time during the year) have day to day control over the operation of the entity;
• the entity does not (at any time during the year) carry on a 'trading business' in Australia within the meaning of s 102M of the 1936 Act⁴ - that is, it does not carry on any activity other than 'eligible investment business' (i.e. investing in land for the purpose of deriving rental income or investing or trading in shares, securities and various other financial products - essentially passive investment);
• the entity is (at all times during the year, except during a winding-down phase):
• 'widely held'; and
• not 'closely held'.

'Widely held' and 'closely held' are defined as in the definition of a 'managed investment trust' (MIT) for the purpose of the MIT non-resident withholding provisions in Schedule 1 to the Taxation Administration Act 1953 (Cth), subject to necessary modifications (to enable them to apply to non-resident entities of various legal forms).

The 'widely held' test essentially requires that either the fund's interests are listed or the fund has at least 50 members (or certain types of entities have interests totalling more than 25% and no other single entity has an interest of 60% or more). While the definitions allow for tracing through certain types of entities and chains of entities, difficulties and anomalies can arise, for example, where the fund's members are 'feeder funds', which may prevent the fund from being treated as widely held even where, as a matter of substance, it is.

The requirement that the fund is recognised under foreign law as a collective investment vehicle and its members do not have day to day control is similar (but not identical) to a provision in the non-resident withholding rules for MITs allowing for tracing through such a vehicle in determining whether the widely held test is met for those provisions. The scope of the test is not clear and it has been the subject of various private rulings requests and ATO Interpretive Decisions.

IMR income etc.

'IMR income' is the amount of what would otherwise be the fund's assessable income for the year to the extent that:

• the income is attributable to a relevant financial arrangement (see below); and
• the amounts are included in the assessable income arises only because of one of the following 3 reasons:

1. They are deemed to have an Australian source pursuant to a double tax agreement (DTA) ‑ i.e. because the amounts are attributable to a permanent establishment of the entity in Australia (which, due to the definition of an 'IMR foreign fund' as discussed above, will only be where the fund has a permanent establishment because it uses an Australian investment manager); or
2. The Commissioner makes a determination that the amounts have an Australian source under s 136AE (in the transfer pricing provisions) of the 1936 Act; or
3. The financial arrangement is a CGT asset that is 'taxable Australian property' by virtue of being an asset used in carrying on business through a permanent establishment in Australia or an option or right to acquire such an asset (again, this will only be relevant where the permanent establishment arises only from use of an Australian fund manager). Note that the IMR income (or IMR loss) will only include revenue gains or losses on such CGT assets, as capital gains and losses are dealt with separately).

Because IMR income is defined by reference to amounts that would otherwise be assessable income, it does not cover amounts that are subject to the withholding tax regime (or would be but for an exemption). The EM says these amounts will continue to be dealt with as they are currently.

A relevant financial arrangement for the purpose of the definition is a 'financial arrangement' within the meaning of the 'TOFA' provisions in Division 230 of the 1997 Act (e.g. debt and equity interests, derivatives, foreign exchange transactions) other than any of the following:

1. A debt or equity interest issued by an entity, or a derivative financial arrangement that relates to such a debt or equity interest, where the fund has a non-portfolio interest in the entity (i.e. a 'total participation interest' of 10% or more);
2. A derivative financial arrangement that relates to a CGT asset that is either taxable Australian real property or an indirect Australian real property interest (and therefore subject to Australian CGT); or
3. A financial arrangement whose terms allow the fund to vote at a meeting of the board of directors or other governing body of the issuing entity, participate in decision-making in respect of the issuer or deal with the assets of the issuer (other than where such rights arise only where the issuer breaches the terms of the financial arrangement).

An 'IMR loss' is the amount of the fund's deductions for the year to the extent they are attributable to its IMR income - that is, a net loss, provided that the deductions were incurred with the intention of gaining or producing IMR income.

An 'IMR capital gain'and 'IMR capital loss' is a net capital gain or loss from a CGT asset referred to above that is attributable to a relevant financial arrangement.

Conclusion

The measures in the ED are very limited, dealing only with certain types of income and gains derived by a widely held foreign investment fund where the fund is deemed to have a permanent establishment in Australia solely by reason of using an Australian funds manager.

The measures do not address other issues identified in the Johnson report as 'the main areas of concern regarding the clarity and scope of the Australian tax system as it applies across the financial sector', namely:

• the general source rules;
• the capital/revenue distinction; and
• residence issues.

Presumably, these matters will be addressed (for later income years) following the BoT's report due by the end of this year.⁵ However, as noted above, the FIN 48 measures in the ED for previous years do not deal with the uncertainties arising for foreign investment funds in relation to these issues (particularly in light of the Commissioner's tax determinations dealing with foreign private equity funds).

There are a number of issues in the ED measures, including in relation to the definition of 'widely held' and what constitutes and entity that is 'recognised under a foreign law as being used for collective investment'. Specific rules may also be needed to ensure that the benefits of the conduit income exemption flow through to the ultimate investors where the fund is transparent for tax purposes

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