PwC alternatives alert, August 18, 2011

Update on Investment Manager Regime reforms in Australia

Following key recommendations in the Johnson Report, the Australian Government is developing an Investment Manager Regime (“IMR”), to remove tax impediments and uncertainty while providing incentives, to improve Australia's prospects of becoming a financial services hub. In 2010 the Government commissioned the Board of Taxation to prepare a report with recommendations for the IMR, which is due by September 30, 2011. In the meantime, two interim measures have been announced by the Government.

The first of these, announced on December 17, 2010, addressed concerns raised in applying the US reporting requirements for uncertain tax liabilities (widely known as “FIN 48”) for foreign funds, on profits made on Australian equities. The lack of certainty was seen as harming Australia's reputation as an investment market, thereby discouraging investment in to Australia. This is known as the FIN 48 measure.

The second measure, announced on January 19, 2011, confirmed that foreign funds having a permanent establishment in Australia, by reason of using an Australian intermediary, would not be subject to tax on profits made on foreign assets. This issue historically discouraged foreign funds from engaging the services of an Australian based intermediary. This is known as the conduit income measure.

On August 16, 2011 the Government released exposure draft legislation for comment on these two interim measures. The exposure draft is discussed below.

Interim IMR measures – framework

Broadly speaking, the central themes of the interim IMR measures are classifying the foreign funds that are eligible for relief and the income and gains covered by the measures.

Foreign funds and investors covered

Considerable thought has been given to the foreign funds to be covered by these measures. These funds (defined as “IMR foreign funds”) include many entities and collective arrangements and will extend to underlying non-resident investors of transparent entities in the case of partnerships and trusts. Broadly speaking, an entity is an IMR foreign fund where:

  • It is not an Australian tax resident;
  • Under a foreign law it is a collective investment vehicle being broadly, an entity designed to pool the funds of a number of investors and has a common purpose of investing;
  • The members of the entity do not control the day-to-day operation of the foreign fund;
  • It does not carry on a trading business in Australia. That is, the entity only undertakes passive activities such as investing in land for the purpose of deriving rent*, investing or trading in securities such as shares, bonds, loans, units in a trust, derivatives or any other similar financial arrangements;
  • The fund is widely held;
  • The fund is not closely held.

(* Gains on land [including derivatives over land] will not be exempt.)

These tests refer to existing tests elsewhere in Australia‟s tax legislation and require careful examination.

Income and gains covered

The draft legislation currently covers “IMR income” and “IMR capital gains”, being income and gains from portfolio investments in financial arrangements that are taxable in Australia solely due to tax rules that deem the income to be Australian sourced because the foreign fund has a PE in Australia.

The proposed legislation will not cover circumstances where the income or gains are subject to withholding tax, nor income that has an Australian source for reasons other than because it is attributable to a PE in Australia.

FIN 48 measure

The Exposure Draft clarifies the treatment of past realized gains and losses from certain Australian investments by foreign funds and “provide certainty of tax treatment for funds that have invested in Australia”. This is most relevant for foreign funds in non-treaty countries where gains on Australian securities are considered to be Australian sourced revenue gains‟ for Australian income tax purposes.

The Australian Taxation Office (“ATO”) will be unable to assess Australian tax in respect of IMR income derived by IMR foreign funds. This will extend to non-resident investors in transparent vehicles being partners or beneficiaries of the IMR foreign fund.

We will clarify during consultation that the income and gains covered under this measure include income that is taxable because it is Australian sourced, i.e. to include circumstances where no permanent establishment (“PE”) exists in Australia.

This measure will apply to income and gains realized before July 1, 2011.

Circumstances not covered

The proposed legislation will not cover circumstances where:

  • A fund has been notified of an audit or review by the ATO before December 18, 2010;
  • The Commissioner is of the opinion that there has been fraud by the “IMR foreign fund”;
  • A fund has lodged a tax return in respect of the 2010-11 income year or previous income year;
  • A fund has unrealized gains that are realized after June 30, 2011;
  • The income or gains are subject to withholding tax.

Conduit foreign source income measure

This measure is designed to encourage foreign funds to appoint an Australian based manager, but who have not previously done so due to the risk of creating a PE in Australia.

IMR foreign funds will not be taxed on income or gains from portfolio investments in financial arrangements which are currently taxable solely because the fund retains an Australian based investment manager or intermediary who is deemed to create a PE in Australia for the fund. Importantly, this measure is directed at foreign source income and does not address Australian sourced income. As Australian sourced income has only been addressed in the FIN 48 measure for realized gains up to June 30, 2011, the outcome of the final IMR will be keenly followed.

Observations on the draft legislation

The draft legislation has been designed on common principles for both measures with regard to IMR foreign funds and IMR income. This has made the drafting process challenging because:

  • The FIN 48 measure is a broad exemption, whereas the conduit income measure is a narrow exemption;
  • The FIN 48 measure applies to realized positions up to June 30, 2011, whereas the conduit income measure applies for the 2011 and later income years;
  • The FIN 48 measure applies to Australian sourced income, whereas the conduit income measure is restricted to foreign sourced income;
  • The FIN 48 measures covers income and gains regardless of whether a PE exists or not, whereas the conduit income measure applies to income and gains that are taxable solely because the foreign fund has an Australian PE due to using an Australian intermediary.

A further challenge has been how to define the foreign funds eligible to qualify for the interim measures. Considerable effort has been made to accommodate collective arrangements where the legal entity status is unclear and to include non-resident investors in transparent arrangements such as partners and beneficiaries.

What the interim measures do not cover

It is important to be clear on what the interim IMR measures do not cover, being:

  1. The recommendations of the Board of Tax (due September 30, 2011), and the Government's response, on the proposed final IMR. This includes the extent of any exemption to be provided to foreign investors on investments in Australian assets.
  2. The extent of any IMR in respect of broader financial services.

Comment & next steps

This is a very positive step from the Australian Government for foreign managed funds. Comments are due on the Exposure Drafts by August 30, 2011. As always, the final outcome depends on analysis of your particular circumstances. Given the significance of the issues at hand, it will be wise to be diligent.