PwC alternatives alert, December 22, 2010

FIN 48 application to Australian investments


The Australian Government is aware that the application of the FIN 48 (now ASC 740-10) accounting standard requires, among other things, "funds to make certain disclosures in their financial accounts in relation to uncertain tax positions, including for prior income years".

In its announcement, the Australian Government acknowledges that "dealing with the requirements (of FIN 48) has underlined to foreign investors the uncertainty of Australia's tax rules".

As a result of this uncertainty, many foreign funds have since invested indirectly using synthetics and some have simply stopped investing in Australia. Consequently, the Australian Government decided to take steps to address this key area of investment uncertainty in order to "improve Australia's standing as a financial services centre."

Government announcement – what’s covered?

Past exposures - for net gains or profits realized until June 30, 2010 (the 2010 income year) - will be closed off. New laws will be introduced to prevent the Australian Taxation Office ("ATO") from issuing assessments for the 2010 and prior income years.

For unrealized gains or profits existing as at June 30, 2010 which may be realized after this date, further consideration will be given by the Australian Government as part of the proposed Investment Manager Regime. While not yet assured, it is hoped that further announcements may be made in the forthcoming Australian Federal Budget in May 2011.

Our experience indicates that past exposure is where the greatest exposure exists. The Australian Government has therefore “acted to improve investor certainty in relation to past transactions, where the impact of FIN 48 is greatest”.

The following summary will help you understand this major development and how it may affect your funds and investors.

Details of the announcement

The Government will consult with industry and the Financial Centre Taskforce to design the necessary legislation, with appropriate integrity measures.

Is the fund a "foreign managed fund"?

The announcements apply to “foreign managed funds”, being a foreign fund that has broadly the following features:
  • not an Australian tax resident;
  • widely held (and not closely held);
  • undertakes passive investment; and
  • does not carry on or control a trading business in Australia.
By way of example, the following will be clarified:
  • the requirements for a foreign managed fund to be "widely held". The widely held concept is used in other parts of the Australian tax legislation (e.g., the Managed Investment Trust regime), but it is unclear whether these similar concepts will apply to this situation;
  • that "passive" is a reference to portfolio investment as opposed to control of an active business or trading as envisaged under the meaning of “eligible investment business” in Division 6C; and
  • whether a foreign fund that meets the requirements for a foreign managed fund will be eligible to qualify for the proposed changes in circumstances where it has a permanent establishment in Australia.

Are the fund’s Australian investments covered?

The announcement covers income and realized gains and losses arising from the following investments by foreign managed funds:
  • portfolio interests in companies (including companies listed on the Australian Securities Exchange), portfolio interests in other entities (including units in a unit trust) and bonds, except to the extent the amount gives rise to a withholding tax liability; and
  • financial arrangements (for example, derivatives) and foreign exchange transactions, except to the extent they are in respect of an underlying interest that is otherwise taxable (such as “taxable Australian property”).
Although "portfolio interest" is not defined in the announcement, other definitions in Australia's existing income tax laws indicate a portfolio interest to be an investment of less than 10%.

As a general rule, the treaties that Australia has entered into contain an Alienation of Property article which grants Australia the right to tax Australian source revenue gains arising in respect of Australian land-rich companies. Clarification is needed to determine whether income derived from trading portfolio interests in Australian companies or other entities that are 'land-rich' (i.e., that hold "taxable Australian property") will be included in this definition.

Has the fund never lodged an Australian income tax return?

The proposed amendments will apply from December 17, 2010 to a foreign managed fund that has not lodged an Australian tax return for the 2009-2010 or prior income tax years.

Under the proposed amendments, the ATO will not be permitted to seek to tax the foreign managed fund in respect of any Australian sourced gains or losses arising to the fund during this period.

Is the fund not under ATO audit or review?

The amendments will not apply to a foreign managed fund to the extent that it has been notified of an audit or review by the ATO. In this case, the foreign managed fund may still have an Australian tax liability where the ATO raises an assessment as part of the audit or review.

Position before and after law is enacted

Once enacted, the foreshadowed law will clarify that gains or profits realized on or before June 30, 2010 should be effectively exempt from Australian income tax. In the meantime, the effect of the announcement is to indicate the government's policy and practice pending possible additional communication from the ATO.

Exposures not covered – what next?

The announcement does not appear to cover unrealized gains or profits existing at June 30, 2010 and realized gains or profits thereafter. As a result, the fund should still consider the need to accrue for unrealized gains and realized gains arising after June 30, 2010.

It is hoped that further changes will be made to extend the exemption. The Government will continue to consult with industry on new rules that may be introduced as part of a new Investment Manager Regime that is now under consideration by the Board of Taxation.

Comments & next steps

This is a very positive step from the Australian Government for foreign managed funds.

As there are still a number of issues to be clarified when the legislation is drafted, care should be taken in reviewing the fund's FIN 48 positions.

It is important to determine the FIN 48 exposure that this announcement addresses and how this will affect the fund's approach to provisioning (or de-provisioning) under FIN 48.

In the meantime, we will continue to assist in the process of enacting the Government’s announcements and the forthcoming developments on this critical issue for foreign funds and investors.

As always, the final outcome depends on analysis of the fund's particular circumstances. Given the significance of the issues at hand, it will be wise to be diligent.

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