Australian Tax Brief

Capital account safe harbour for Australian Managed Investment Trusts
23 February 2010

Eligible managed investment trusts (MITs) may elect to apply the capital gains tax (CGT) provisions as the primary code for taxing gains and losses on the disposal of eligible assets (namely a share in a company, non-share equity, a unit in a unit trust, land - including an interest in land and a right to acquire or dispose of any of these assets). The election must be made (in the approved form) during the first year that a trust qualifies as a MIT. Where an election is not made in that first year then a deemed revenue treatment applies to certain assets. Accordingly, it is critical to determine when the trust first qualifies as a MIT. The election once made is irrevocable. The Bill [Tax Laws Amendment (2010 Measures No.1) Bill 2010] was introduced to the Australian Parliament on 10 February 2010 and is expected to pass before 31 March 2010 (the close of the autumn sitting).

These reforms were originally announced in May 2009 as part of the 2009-10 Budget. They are an important part of the Australian Government's reform agenda to "enhance the competitiveness of the Australian funds management industry in attracting future foreign investment" to Australia. Specifically, the election should provide certainty for investors, trustees and fund managers in respect of the tax treatment of gains made by a MIT on the disposal of investments, and the distributions made by the MIT to its investors.

Some of the concerns raised during consultation on the previous Exposure Draft legislation have been addressed in the bill, but some issues remain unresolved (including a single definition for a MIT). The Assistant Treasurer (Senator Nick Sherry) has however announced that the definition of a MIT for withholding tax purposes is to be expanded to more closely align the definition in the withholding tax rules with the definition in these capital election rules.

When should the election be made?

The election must be made during the first year that a trust qualifies as a MIT. Where an election is not made in that first year, then a deemed revenue treatment applies to certain assets. Accordingly, it is critical to determine when the trust first qualifies as a MIT. The election once made is also irrevocable.

When did the trust first exist 

The election must be made: 

The election applies:

A trust that was in existence before the 2009-2010 income year

before the latest of:

  • three months after the legislation commences;
  • the last day of the 2009-2010 income year; or
  • a later day if the Commissioner allows.
  • to CGT events that happen on or after the start of the 2008/2009 income year – generally 1 July 2008 - and subsequent years in which the trust qualifies as a MIT.
A trust that came into existence in 2009-2010 or later income year before the day that it lodges its income tax return for the first income year that it qualifies as an eligible MIT.
  • to CGT events that happen on or after the start of the income year in which the trust first qualified as a MIT and subsequent years in which the trust qualifies as a MIT.

Unless a MIT makes an election at this time:

  • it is not eligible to make the election (except with the Commissioner's consent); and
  • any gains on covered assets that are not land or a right or option to acquire or dispose of land will be deemed to be a revenue gain.

Election made in 2008/2009 also provides protection for prior years

Where the election is in force in respect of the 2008/2009 income year, the Commissioner cannot amend an assessment for prior years of a trustee or investor (except in limited circumstances). That is, the Commissioner cannot amend an assessment of the trustee or an investor to treat a capital gain as a revenue gain or vice versa.

The Commissioner may amend an assessment where:

  • the taxpayer gives a written consent to the amendment; or
  • there is evidence of fraud or evasion.

Eligibility Requirements – What is an eligible MIT

A trust will be an eligible MIT if it satisfies either:

  • the existing definition of a MIT (as defined in s.12-400 of the Taxation Administration Act 1953 (TAA) for MIT withholding tax purposes); or
  • the extended definition of a MIT as set out in new Division 275 of the Income Tax Assessment Act 1997 (ITAA 1997).

Broadly, these definitions reflect the different regimes applicable to retail funds and wholesale funds respectively.

Table 1 – The existing MIT definition – s.12-400 Taxation Administration Act

 

Eligibility Requirement

Requirements to be an eligible MIT 

Test Time for requirement to be satisfied 

1 Residency
  • a trustee of the trust is an Australian resident, or
  • the trust is centrally managed and controlled in Australia
  • at all times during the income year
Licence requirement
the trust is a managed investment scheme and is operated by a financial services licensee (as defined by s.761A of the Corporations Act 2001) whose licence covers operating such a managed investment scheme.
  • the time of the first fund payment in relation to the income year
3 Widely held membership
  • units in the trust are listed on the ASX; 
  • the trust has at least 50 members (ignoring objects of a trust);
  • one of the following is a member of the trust:
    • a life insurance company
    • a complying superannuation fund (being a fund that has at least 50 members)
    • a complying approved deposit fund (being a fund that has at least 50 members)
    • a foreign superannuation fund (being a fund that has at least 50 members)
    • a trust which meets the requirements in items 1 and 2 of section 12-400 of the TAA and which is listed or has 50 members (ignoring objects of the trust) an entity recognised under a foreign law relating to corporate regulation as an entity with similar status to a managed investment scheme and that has at least 50 members
    • a trust where all the interests are owned directly or indirectly by the entities in (a) (b) (c) or (d) and where the trust and each interposed trust meets the requirements in items 1 and 2 of section 12-400 of the TAA
  • the time of the first fund payment in relation to the income year

Making comparisons between the Australian regulatory regime and foreign jurisdictions may not be easy. Accordingly further administrative guidance may be required to confidently apply paragraph 3(f) above.

Table 2 – The extended MIT definition – new Division 275 of the ITAA 1997

 

Eligibility Requirement

 Requirements to be an eligible MIT

Test Time for requirement to be satisfied 

Residency
  • a trustee of the trust is an Australian resident, or
  • the trust is centrally managed and controlled in Australia
  • at all times during the income year
2 Licence requirement

the trust is operated or managed by:

  • a financial services licensee (as defined by s.761A of the Corporations Act 2001) who holds an Australian Financial Services Licence which covers providing financial services to wholesale clients; or
  • an authorised representative licensee (as defined by s.761A of the Corporations Act 2001) of such a financial services licensee
  • the time of the first fund payment in relation to the income year, or
  • if no fund payment is made, at both the start and end of the income year
3a Widely held membership because every member is qualifying – in accordance with section 275-5(2)

every member of the trust must be one or more of the following:

  • a MIT;
  • a life insurance company;
  • a complying superannuation fund (being a fund that has at least 50 members);
  • a complying approved deposit fund (being a fund that has at least 50 members);
  • a foreign superannuation fund (being a fund that has at least 50 members)
  • the time of the first fund payment in relation to the income year, or
  • if no fund payment is made, at both the start and end of the income year
3b Widely held membership because 75% of the membership is held by qualifying members – in accordance with section 275-5(3)

75% of the membership rights are held by members which are:

  • a life insurance company;
  • a complying superannuation fund (being a fund that has at least 50 members);
  • a complying approved deposit fund (being a fund that has at least 50 members);
  • a foreign superannuation fund (being a fund that has at least 50 members);
  • a trust which meets the requirements in items 1 and 2 of section 12-400 of the TAA and which is listed or has 50 members (ignoring objects of the trust);
  • an entity recognised under a foreign law relating to corporate regulation as an entity with similar status to a managed investment scheme and that has at least 50 members; or
  • a trust where all the interests are owned directly or indirectly by the entities in (a) (b) (c) or (d) and where each interposed trust meets the requirements in items 1 and 2 of section 12-400 of the TAA.
 
3c Widely held membership because there are 50 or more individual sophisticated or professional investors in accordance with section 275-5(4) The trust has directly or indirectly at least 50 members - determined by applying specific rules including tracing and aggregation rules and where individual investors must be qualifying 'sophisticated' or 'professional investors' (refer below).
  •  the time of the first fund payment in relation to the income year, or
  • if no fund payment is made, at both the start and end of the income year

Applying the 50 member test

The rules for determining if there are 50 members of the trust are as follows:

  • if an entity that is not a trust holds an interest in the trust indirectly through a chain of trusts, treat the entity as a member of the trust (and do not treat a trust in that chain as a member);
  • treat the following entities as together being one member of the trust:

    1. an individual; and
    2. each of his or her relatives; and
    3. each entity that holds as a nominee of the individual mentioned in (a) or (b).
  • treat the following entities as together being one member of the trust:

    1. a member of the trust that is not an individual; and
    2. each entity that holds as a nominee of the member mentioned in (a).
  • do not treat an object of the trust as a member
  • do not treat an individual as a member of the trust unless the individual became a member because a financial product or financial service was provided to, or acquired by the individual as a wholesale client (as defined by section 761G of the Corporations Act 2001)

This would generally exclude an individual investor unless:

  • the amount invested by the investor in the trust equals or exceeds $500,000;
  • the investor has made the investment in connection with a business that is not a small business (ie the investor employs 20 or more people, or 100 or more if a manufacturing business);
  • the investment is not made in connection with a business and the investor provides the provider with a certificate (given within the preceding 6 months by a qualified accountant) that states that the person has:

    • net assets of at least $2.5 million; and
    • gross income for the last two years of at least $250,000.
  • the person is a professional investor;
  • the trustee is satisfied that the individual is a sophisticated investor within the meaning of section 761GA of the Corporations Act 2001 and has signed a written acknowledgement before or at the time when the product or service is provided that:

    • the licensee has not given the client a Product Disclosure Statement;
    • the licensee has not given the client any other document that would be required to be given under Chapter 7 to a retail client; and
    • the licensee does not have any other obligation to the client under Chapter 7 of the Corporations Act that would apply to a retail client.

Start up and End years

The widely held requirement does not need to be satisfied:

  • in the start up year; or
  • in the year of cessation where the trust was a MIT in the previous year.

The 'value' of this 'start up' year concession appears limited given the closely held requirement continues to apply (see below).

Crown or Sovereign Funds and other unlicensed entities

Crown entities and entities that are not required under the Corporations Act 2001 to be operated by a financial service licensee because of an instrument issued by the Australian Securities and Investment Commission may also qualify as eligible MITs.

Corporate unit trust and trading trusts are not eligible MITs

A public unit trust that is carrying on a trading business (other than an eligible investment business) or a corporate unit trust is not eligible to make the safe harbour capital election.

Closely held trusts are not eligible MITs

Closely held trusts are not eligible to be MITs. Where at any time in the income year twenty (20) or fewer individuals (being natural persons) hold or have the right to acquire (either directly or indirectly) 75% or more of the beneficial interests in the income or property of the trust, then the trust is not eligible to be a MIT. This requires the MIT to trace back through interposed entities (such as companies, unit trusts, partnerships and superannuation funds) and identify if 20 or fewer individuals control 75% or more of the rights to income and property. Practically, this may require interposed entities to confirm their membership numbers since the tracing exercise requires the MIT to trace back to natural persons unless any interposed company, complying superannuation fund, complying approved deposit fund or superannuation fund for foreign residents itself has 50 or more members. Where one of these MIT members has more than 50 members then the MIT will not be closely held.

MIT may also be eligible if it is fair and reasonable

Where, apart from a particular circumstance, a trust would be an eligible MIT, it may still qualify as an eligible MIT where the circumstance is temporary, outside the control of the trustee, and it is fair and reasonable to treat the trust as an eligible MIT taking into account:

  • the nature of the circumstance;
  • actions taken by the trustee to address or remove the circumstance, and the speed with which those actions are taken;
  • the tax impact of whether the trust is a MIT or not; and
  • other relevant matters.

This concession appears to be a fallback to ensure the eligibility requirements do not cause unnecessary hardship for a trust and its investors. The example in the Explanatory Memorandum suggests that the concession should be available provided the trust is actively seeking to remedy any temporary defect (such as falling below a membership threshold).

Given the consequences of not making a valid election in the first year, this concession would not be relied upon in a first year without a binding ruling from the ATO.

What assets does the election apply to?

A deemed capital account safe harbour applies to the following assets (provided they are not a debt interest or a Division 230 financial arrangement):

  1. a share in a company
  2. a non-share equity interest in a company
  3. a unit in a unit trust
  4. land (including an interest in land)
  5. a right to acquire or dispose of an asset mentioned in (a), (b) (c) or (d).

Since not all assets of the trust are eligible assets there may be potential character mismatching. For example, capital losses on the eligible assets noted above, would not be available to shelter revenue gains on related or other financial arrangements.

A Division 230 asset would generally include equity interests including non-share equity (refer section 230-50 and 230-530 of the ITAA 1997). However, Division 230 will only apply to tax gains made on equity interests where the taxpayer has elected the fair value method, or the method of relying upon financial reports, and in limited circumstances the tax hedge method. Division 230 does not apply to tax gains made on equity interests under the realisation or accruals method (refer 230-45(4)(e) of ITAA 1997). Similarly, interests in a unit trust are excluded from the definition of a Division 230 arrangement (refer 230-460(3) of the ITAA 1997).

Consequences of making a choice – deemed capital treatment

Where a capital account safe harbour election is made by an eligible MIT:

  • the CGT provisions will be the primary code for taxing those CGT assets covered by the election (see above) in the income year when the disposal or realisation of that asset occurred;
  • resident investors are therefore eligible for a CGT discount (50% for individuals and 33 1/3% for complying superannuation funds) if the asset has been held for at least 12 months;
  • non-resident investors should not be taxed on capital gains distributed by the eligible MIT unless it arises from a non-portfolio interest (10% or more) in a 'land rich' entity;
  • generally those provisions regarding income and deductions will no longer apply to the assets covered by the election as they will not be treated on revenue account;
  • the election once made is irrevocable (i.e. it applies in the year the election is made and to all subsequent income years);
  • assets cannot be acquired or held as trading stock if a deemed capital account election has been made and modifications to these trading stock rules apply to ensure the tax outcome is consistent with the safe harbour capital treatment.

Consequences of not making a choice – deemed revenue treatment

Where a MIT is eligible to make the capital account election but does not choose to do so, gains or losses from the disposal, realisation or cessation of ownership of eligible assets (excluding certain land assets - see below) will be taxed as revenue gains.

This deemed revenue treatment does not generally extend to land, an interest in land, or a right or option to acquire or dispose of land (and ordinary principles would apply). Gains and losses made on the disposal of land will receive revenue treatment if:

  • the gain would otherwise be ordinary income because it is held as trading stock or as part of a profit making undertaking or plan; or
  • the MIT:

    • acquired the asset in an income year that preceded the choice;
    • the asset was treated as trading stock in the financial report for the income year immediately preceding the choice;
    • the asset was treated as trading stock in the income year immediately preceding the choice;
    • the asset was treated as trading stock in the financial report for the income year immediately preceding the CGT event; and
    • the asset was treated as trading stock in the income year immediately preceding the CGT event.

Carried interest entitlements in MITs

Distributions and gains made in respect of 'carried interest entitlements' in a MIT will be assessable in full and will be deemed to have an Australian source. These amounts will also not be eligible for the concessional MIT withholding rates. The bill does not deem the amount received on an asset that has a carried interest entitlement to be a revenue gain but simply denies the CGT discount concessions in respect of any distribution or any CGT event that arises in relation to the asset. These gains may continue to be revenue or capital gains but in either case will be taxable in full.

Where a trust does not qualify as a MIT then ordinary capital and revenue distinctions (and ambiguities) apply. In this case however, the MIT tax treatment for carried interest entitlements would also not apply.

What is a carried interest entitlement asset?

Any CGT asset that carries an entitlement to a distribution from a MIT that is contingent on the attainment of profits by the MIT, and that is acquired because of services provided to the MIT by the holder or its associate, is a carried interest entitlement. The services are those of a manager or employee (or associate) of a manager of the MIT.

There is a positive requirement for the carried interest holder to include the amount of the distribution or gain on the CGT event in assessable income.

For resident taxpayers, this should result in the carried interest being taxable in full since no CGT discount is available where the amount is taxed under Division 275 or as statutory income (under Division 6).

For non-resident taxpayers, the distribution of the carried interest entitlement is taken to be from an Australian source and the payment is excluded from the MIT withholding tax regime that applies to other fund payments. Thus it appears to override Australia's policy on taxing non residents on capital gains by ensuring the 'distribution' and not the capital gain is the relevant amount included in the assessable income of the non-resident investor.

Timeframe

These amendments broadly apply to eligible CGT events that happen on or after the start of the 2008-2009 income year.

The amendment, which provides that the acquisition of trading stock will be treated on capital account when an election is in force, applies to acquisitions on or after the start of the 2008-09 income year.

The amendments, which deem certain assets to be on revenue account when an election is not made, apply to disposals of assets, cessations of ownership of assets and other realisations of assets which take place on or after Royal Assent.

The amendments, concerning 'carried interests' in MITs, apply to entitlements to distributions that arise on or after Royal Assent, or to disposals of assets that happen on or after Royal Assent.