The Federal Government has released a second exposure draft of the foreign accumulation fund (FAF) rules.
These revised accruals taxation reforms will open up significant opportunities for offshore fund managers to offer their products directly to Australian investors, or through Australian feeder funds. The investments may be offered without the need for the fund manager to undertake bed and breakfasting arrangements, or to enter into complex derivative arrangements.
These rules are an integrity measure following the repeal of the foreign investment fund (FIF) rules (from 30 June 2010) and are designed to prevent offshore accumulation of profits and gains by Australian resident entities. While there is no statement on timing, it would be expected these rules are implemented effective from 1 July 2010.
This second exposure draft addresses concerns previously raised on the first exposure draft surrounding the scope of the proposed FAF provisions by replacing previously proposed concepts of low risk investments and distributing funds with quantitative thresholds.
Changes to the draft FAF rules
Broadly, the proposed rules will subject Australian resident investors in FAFs to accruals taxation. Importantly, the concept of a FAF has now been clarified.
Foreign funds that will constitute FAFs
The exposure draft defines a FAF as a foreign company or fixed trust which satisfies both of the following requirements:
- the market value of debt interests held by the entity comprises 80% or more of the market value of all assets held by the entity (Investment Requirement); and
- the entity does not distribute more than 80% of the realised profits and gains derived by it or its controlled entities by the date that is three months after the end of its accounting period (Accumulation Requirement).
Foreign funds that will not constitute FAFs
A foreign fund that does not satisfy either of the Investment Requirement or the Accumulation Requirement will not constitute a FAF and accordingly Australian resident investors will not be subject to accruals taxation on realised gains of the fund.
Practically, these requirements may allow funds managers to design portfolios in accumulating funds that are not subject to the FAF attribution rules, provided that there is a prescribed minimum exposure to investments other than debt.
Alternatively, a fund that does hold an extensive debt portfolio may, subject to any future regulations, effectively accumulate up to 20% of any realised gains or profits of an entity (and its controlled entities) offshore, without any attribution to Australian investors.
Australian investors in offshore collective investment vehicles that are not FAFs will be subject to Australian income tax on either distribution from the foreign fund or on realisation of the investment (that is, there will not be any Australian income tax on an accruals basis).
The exposure draft does not include detailed rules dealing with:
- calculating attribution of income where a FAF exists, although it suggests that a market value method will be adopted; and
- exemptions for particular entities. The exposure draft suggests that lightly taxed entities, being complying superannuation funds and certain activities of life insurance companies (including situations where the lightly taxed entities are members of interposed trusts or partnerships), will be exempted from attribution. This is consistent with the former FIF rules.
The draft rules are open to submissions until 18 March 2011. There remain some areas requiring further clarification including how losses incurred by a FAF are treated in determining whether the Accumulation Requirement is satisfied and in relation to the proposed but as yet undrafted provisions mentioned above.
The additional certainty in relation to the scope and application of the proposed integrity measures is welcome. Assuming enactment of the law in exposure draft form, Australian and offshore fund managers may offer offshore investment funds either directly or through Australian Managed Investment Trusts without having to manage either complex derivative arrangements, or costly bed and breakfasting arrangements.
While these reforms should simplify the tax management of offshore investments, fund managers offering these products should consider the income tax consequences for their Australian investors in realising their investments in the offshore funds.