Australian Tax Brief

Capital account safe harbour for Australian Managed Investment Trusts
17 December 2009

On 10 December 2009 exposure draft legislation was released allowing eligible managed investment trusts (MITs) to make an irrevocable election to apply capital gains tax (CGT) provisions as the primary code for taxing gains and losses on the disposal of certain assets - primarily shares, units and land. The draft legislation requires fine tuning but provides much needed certainty for investors and fund managers alike in the Australian financial services industry. Consultations close on 24 December 2009.

Under the existing law, a complying superannuation fund and a unit trust wholly owned by complying superannuation funds can apply the CGT provisions as the primary code for gains and losses on the sale of assets (subject to some specific exceptions). The exposure draft legislation will similarly allow eligible MITs to treat gains and losses on the sale of qualifying assets on capital account. This provides certainty for investors, trustees and fund managers in respect of the tax treatment for distributions made by the trust.

The safe harbour capital election can first apply to CGT events that happen on or after the start of the 2008/2009 income year – generally 1 July 2008.

An eligible MIT that came into existence in the 2009 – 2010 (or later) income year must make an election before the day that it lodges its income tax return for the first year that it qualifies as an eligible MIT. All other eligible MITs must make the election 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.

Unless the 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 assets that are not land or a right or option to acquire or dispose of land will be deemed to be a revenue gain.

The choice once made cannot be revoked.

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

Where the election is made in the 2008/2009 income year, the Commissioner cannot amend an assessment for prior years of a trustee or investor. 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 in certain circumstances including where:

  • the taxpayer gives a written consent to the amendment

  • there is evidence of fraud or evasion.

Eligible MITs - requirements for deemed capital treatment

A unit trust will be an eligible MIT if it satisfies the existing MIT requirements or the new modified and extended definition of a MIT. The modified rules (below) remove many of the technical difficulties that arise from the current definition of a MIT. Australian wholesale funds may now qualify where every member of the trust is a MIT or where the fund has 50 members. The 50 member requirement as drafted appears to be based on the number of members on the unit register rather than on the number of members ultimately (that is, members traced through interposed entities). This is expected to be raised as an issue during the consultation process since it may restrict the wholesale funds that can access the safe harbour and does not mirror the tests that determine if a MIT is a closely held trust (refer below).

Table 1 – eligible MIT requirements

  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
2 Licence requirement the trust has to be operated by a financial services licensee (761A of the Corporations Act 2001)

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 because every member is qualifying; or

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

  • a MIT
  • a life insurance company
  • a complying superannuation fund
  • a complying approved deposit fund
  • a foreign superannuation fund (being a fund that has at least 50 members
    or
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 the trust must have at least 50 members (ignoring objects of a trust and individuals).

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



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.

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

Corporate unit trust and trading trusts are not eligible MITs

A 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

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. This requires the MIT to trace back through interposed entities (such as companies, unit trusts, partnerships and superannuation funds) to 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. How this requirement is intended to operate in a start up year will need to be clarified through the consultation process.

MIT should not be ineligible if 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.

What assets?

A deemed capital account safe harbour applies to the following assets:

  1. a share in a company

  2. a unit in a unit trust

  3. land (including an interest in land)

  4. a right to acquire or dispose of an asset mentioned in (1), (2) or (3).

An eligible MIT that has not made an election is deemed to make revenue gains. The deemed revenue does not apply to land, an interest in land or a right or option to acquire or dispose of land. The disposal of land assets will receive revenue treatment if under ordinary principles of law, the land asset is a revenue asset of the MIT.

Consequences of making a choice - capital

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 apply to ensure the tax outcome is consistent with the safe harbour capital treatment.

Consequences of not making a choice - revenue

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. Gains made on the disposal of land or leasehold assets will not be deemed revenue gains. However, the disposal of land assets will receive revenue treatment if under ordinary principles of law, the land asset is a revenue asset of the MIT.

Carried interest entitlements are taxable in full

The exposure draft legislation also makes clear that a 'carried interest entitlement' held in an eligible MIT (for example a private equity fund) is taxable in full and no CGT discount is available for a distribution or any CGT Event that arises in relation to the asset that has the 'carried interest entitlement'. The legislation does not deem the amount to be a revenue gain but simply denies the CGT discount for those entitlements. These gains may continue to be revenue or capital gains but in either case will be taxable in full.

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 are 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.

  • For non-resident taxpayers it is unclear if the CGT exemption for non-residents (under the taxable Australian property requirements) is intended to override the requirement noted above.

Australian MIT withholding would not seem to apply where the carried interest entitlement is held by a non-resident and is a capital gain. This suggests that there is no intention to amend Australia's policy and tax position on non residents and capital gains but hopefully this will be clarified through the consultation process.

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.