Contributed by Scott Heezen, Partner and Sarah Silk, Senior Associate, King & Wood Mallesons
The Treasurer has released details of an Integrity Package of major reforms that are intended to address concerns with the use of stapled structures. However, as anticipated, the reforms go further than just restricting access to beneficial rates of withholding tax on distributions from stapled structures to significant changes targeting concessions received by foreign pension fund and sovereign investors as well as a tightening of Australia’s thin capitalisation rules.
The proposed changes follow on from the release of a Treasury Consultation Paper last year.
Summary of key elements of the package
The key elements of the Integrity Package are:
- removing the concessional rate of Managed Investment Trust (MIT) withholding tax for distributions sourced from certain cross-staple rental and other payments and subjecting those distributions to withholding at the corporate tax rate (currently 30% for large corporates). Certain permitted stapled arrangements will be excluded from the higher MIT withholding tax, including where the stapled operating entity derives rent from third parties that is merely passed through to the stapled trust. A 15-year exemption for new, government-approved nationally significant infrastructure assets will also be made available
- introducing amendments to the thin capitalisation rules to prevent the use of multiple layers of flow-through entities (eg trusts) to maximise debt gearing (known as “double gearing” arrangements)
- limiting the foreign pension fund withholding tax exemption for interest and unfranked dividends to payments received on portfolio investments only (being interests of less than 10% where there is no influence over key decision-making)
- creating a legislative framework for the existing tax exemption for foreign governments (including sovereign wealth funds) by limiting the exemption to portfolio investments, as well as removing the exemption for distributions of active business income from trusts more generally, and
- excluding agricultural land from being an “eligible investment business” which will prevent trusts with such land from being MITs.
The proposed reforms squarely target foreign investors and should generally leave resident investors into MITs in the same position (with some possible exceptions). They also arguably go further than merely levelling the playing field between domestic and foreign investors. While the Treasurer’s media release notes that “the package will have no direct impact on finance staples or stapled structures in the commercial and retail property sectors to the extent that they generate rent from third parties”, consideration will need to be given to the impact of the reforms for other stapled property arrangements. There is also no specific guidance at this time on what may constitute “nationally significant infrastructure” which will be key for new infrastructure investment.
The changes (except the thin capitalisation changes) are intended to take effect from 1 July 2019, with a seven-year transition period for arrangements in existence as at 27 March 2018. A longer transition period of 15 years is intended to be available in respect of the higher MIT rate for certain economic infrastructure staples that satisfy particular conditions (to be developed in further consultation with industry).
The thin capitalisation changes will take effect across the board from 1 July 2018.
Observations about the proposed Integrity Package
Further detail in respect of the key features of the proposed changes are set out below.
Income derived by most stapled structures to be taxed at 30%
One key benefit of stapled structures has been the ability for foreign investors to access the 15% MIT withholding tax rate. Going forward and save for certain “permitted stapled” arrangements (discussed below), it is proposed that a higher MIT withholding tax rate set at the corporate tax rate (currently 30% for large companies) will apply (the “higher MIT rate”).
The Integrity Package identifies the following as the kinds of fund payments that will attract the higher MIT rate:
- payments derived from cross-staple rental payments
- cross-staple payments made under some financial arrangements (such as total return swaps), and
- distributions received by a MIT from a trading trust.
Exclusions for certain permitted entities
The higher MIT rate will not apply to all fund payments from a stapled MIT. The Integrity Package outlines the following circumstances where the higher MIT rate is not intended to apply:
• rent received from third parties: the Integrity Package notes that the higher MIT rate will not apply “where the stapled operating entity receives rent from third parties that is merely passed through as rent to the trust”.
In our view, this is appropriate given that a cross-staple payment in these circumstances is not re-characterising active business income as passive rent. However, one key question will be what entities will be considered third parties for the purposes of the measures. Also, there is some uncertainty as to what types of payments can constitute rent, so it will be important that this is clarified as part of the drafting process.
• safe harbour exemption: the higher MIT rate will also not apply where “only a small proportion of the gross income of the trust relates to cross staple payments”. There is no guidance in the package as to what proportion of gross income will qualify for this safe harbour exemption.
• nationally significant infrastructure projects: the Integrity Package notes that a concession is intended to be introduced to encourage investment in the construction of “nationally significant infrastructure”. The concession will be time-limited to 15 years and will apply only in respect of infrastructure assets approved by the government.
Treasury will consult separately on the parameters of the infrastructure concession and it will be important for interested parties to take part in that process to ensure the access to the concession is appropriately structured. While there is no specific guidance in the paper, the term “nationally significant infrastructure” has previously been used in the Infrastructure Act 2008 to include transport, energy, communications and water infrastructure in which investment will materially improve national productivity. It seems that the government has not sought to link the concession to the concept of critical infrastructure more recently used in the Security of Critical Infrastructure Bill as part of reforms targeting national security risks to infrastructure.
Thin capitalisation changes to prevent “double gearing” structures
New integrity measures are intended to be introduced into the thin capitalisation regime, with effect from 1 July 2018, to target structures which use a chain of flow-through entities which each issue debt against the same underlying asset (so-called “double gearing” structures).
This will be achieved by lowering the thin capitalisation associate entity test from 50% or more to 10% or more for flow-through entities.
Amendments will also be made to the existing arm’s length debt test which can allow for a permitted level of gearing above the safe harbour level provided certain criteria is satisfied. In applying this test under the current rules, the relevant considerations were largely limited to the specific vehicle being funded. Going forward, the rules will require consideration of gearing against the underlying assets for interests in any entity.
This reform will apply broadly to structures using flow-through entities and is not limited only to investments into MITs.
Changes to foreign pension fund withholding tax
It is proposed that the withholding tax exemptions that apply in respect of payments of interest or unfranked dividends to foreign pension funds will be limited. From 1 July 2019, the exemptions are proposed to apply only where the foreign pension fund holds a portfolio-like interest (broadly an interest of less than 10% where there is no influence over the entity’s key decision-making). Grandfathered arrangements will not be subject to these rules until 1 July 2026.
Modification of the sovereign immunity exemption
The Integrity Package also proposes that the ATO’s administrative concession for sovereign investors will be legislated and limited to situations where the sovereign investor has a portfolio-like interest (again being an interest of less than 10% with no influence over the entity’s key decision-making). Going forward, sovereign investors will also be taxed on active business income derived by them through a trust (even if it is not a MIT).
For many sovereign investors, the combined effect of these two measures could result in a significant increase in the tax rate on their Australian investments.
Apart from the common grandfathering (discussed below), a further concession is being made available to sovereign investors who have an existing ruling from the ATO on a particular investment where that ruling extends beyond the standard seven-year period.
As an aside, it is interesting that the government has now reopened this area given that proposed reforms as recently as 2011 were subsequently parked by it.
Transitional arrangements for existing stapled structures
Limited transitional arrangements are proposed for stapled entities in existence as at 27 March 2018 (being the date of announcement of the Integrity Package), namely:
- a transition period of seven years for all measures other than the thin capitalisation integrity change, and
- for existing “economic infrastructure staples”, a transition period of 15 years for the higher MIT rate. Treasury intends to consult separately on the conditions stapled entities must comply with in order to access this longer transition period.
The thin capitalisation changes will apply to income years commencing 1 July 2018 with no transitional relief.
The government is proposing to take significant action to protect what it sees as key tax integrity risks. The reforms, if enacted, will have a significant impact across a wide range of asset classes and their valuations and will require significant effort by participants to assess the costs of the reforms on existing and new investments and projects.
One of the more disappointing (although not unsurprising) aspects of the announcement is the failure to provide more extensive grandfathering for existing stapled structures. This is particularly so given the importance of Australia’s international reputation as a predictable and safe market for investment, as well as the wide use of staples as part of the states’ privatisation processes.
There is also a significant amount of work to be done in actually drafting the new rules with new concepts being required to be developed including what types of arrangements will constitute “stapled structures”, which entities would be considered to be “third parties” for the purposes of the rental concession and what will constitute “influence over key decision making” by pension fund and sovereign investors.
The criteria to access the significant infrastructure concession will need to be developed and there is reference to the possibility of stronger integrity rules being required for such staples to protect against aggressive cross-staple pricing. This is something we expect that the ATO will be keen on given their recent approach to this in reviews of existing arrangements as well as the privatisation process.
The reference in the paper to the higher MIT rate applying to distributions received by a MIT from a trading trust does not specifically appear to be limited solely to stapled MITs. If this is the intention, it will adversely impact MIT payments sourced from other trusts which are not controlled by a MIT but which carry on a trading business. Currently, such payments are eligible for the 15% MIT rate and are common in many consortium and certain private equity style investments.