On 4 April 2013, the Government released exposure draft legislation and explanatory materials which propose to implement the third and final element of the Investment Manager Regime (IMR) as announced by the Government on 16 December 2011.
Context of amendments
Notwithstanding the existing IMR rules, a foreign managed fund that invests in Australia would generally be taxed on all income from Australian sources and on capital gains that arise in relation to CGT assets that are ‘taxable Australian property’. This potentially can include gains on non-Australian investments if those investments are managed by an Australian-based fund manager or investment adviser.
As identified in the Johnson Report, particular questions must be answered in order to determine whether a foreign resident is liable to pay tax in Australia. Such questions can include whether the foreign resident has a permanent establishment in Australia, whether the foreign resident’s income is Australian sourced, and whether that income is on capital or revenue account.
In response to the Johnson Report, the Government subsequently announced the implementation of the first two elements of the IMR in the following terms:
- Element 1 would address the ‘FIN48’ issue reported by industry, by amending the law to restrict the Commissioner of Taxation’s ability to raise assessments in respect of certain investment income of a foreign managed fund for the 2010-11 and prior income years; and
- Element 2 would address the tax uncertainty where a widely held foreign managed fund engaged an Australian based financial services intermediary with respect to certain passive (i.e. portfolio) investments. In particular, it would ensure that income from such investments would be exempt from Australian tax if the only reason it was taxable was because the fund engaged the financial services intermediary. This element would apply from the 2010-11 income year and is also known as the ‘conduit income exemption’.
These first two elements were enacted in the Tax Laws Amendment (Investment Manager Regime) Act 2012. This Act received Royal Assent in September 2012.
On 16 December 2011, the Minister for Financial Services and Superannuation responded to the Board’s Report, announcing that the Government would introduce the third and final element of the IMR.
Element 3 extends the IMR so that a broader range of investments are exempt from Australian tax. In effect, element 3 is intended to address the tax uncertainty faced by a widely held fund investing into Australia, whether using an Australian based intermediary or not.
Summary of proposed law
The purpose of element 3 of the IMR is to provide certainty in relation to the Australian income tax treatment of income from certain financial arrangements of qualifying widely held foreign funds. In particular, it seeks to remove the need for such funds to determine whether income from these investments is on capital or revenue account.
To achieve this, whilst at the same time retaining the effect of element 2 of the IMR, these amendments remove the existing requirement that returns or gains from financial arrangements with entities in which an IMR foreign fund holds a portfolio interest would be included in the assessable income of the fund only because the returns or gains are Australian sourced because the fund has a permanent establishment in Australia as the result of engaging an Australian intermediary. As a consequence, returns or gains made by an IMR foreign fund from portfolio investments (i.e. less than 10% interests on an associate-inclusive basis) will broadly be exempt from Australian tax.
In addition, the amendments also extend element 2 of the IMR (the conduit income measure) to financial arrangements with entities in which an IMR foreign fund holds a non-portfolio interest. To ensure that this extension only applies in relation to conduit income (income from investments overseas), the permanent establishment tests under the current law (which no longer applies to portfolio interests) is retained in respect of financial arrangements with entities in which an IMR foreign fund holds a non-portfolio interest. As a consequence, returns or gains made by an IMR foreign fund from non-portfolio overseas investments will be exempt (though not non-portfolio Australian investments).
Access to the IMR is only available for an entity that qualifies as an “IMR foreign fund” in respect of a particular year.
- Element 3 introduces two additional criteria that must be satisfied in order for a fund to be an IMR foreign fund in respect of an income year. These criteria require that the fund:
- at all times during the income year, be a resident of an ‘information exchange country’; and
- submit an information statement to the Commissioner in relation to the income year.
In respect of the existing criteria, the amendments modify:
- the requirement related to an entity carrying on a trading business;
- the widely held test; and
- the concentration test (which is now called the ‘closely held’ test).
The amendments also introduce new rules which apply to the widely held and closely held tests. These changes:
- introduce rules to calculate the members of the fund and their total participation interests in the fund; and
- provide a rule in respect of the ‘start-up phase’ of the fund, consistent with the existing rule in respect of ‘wind-down phases’.
Under the existing rules, an IMR foreign fund cannot be a tax resident of Australia under Australian tax law. This requirement can prove problematic for certain entities, for example, limited partnerships, given the wide definition of residence in the context of limited partnerships. Element 3 does not address this limitation.
A new criteria is also included that requires that a fund provide an information statement to the Commissioner in respect of an income year in order to qualify as an IMR foreign fund for that income year. The statement must be in the approved form, and must be provided to the Commissioner within three months of the end of the relevant income year (being the income year in relation to which the entity was an IMR foreign fund).
The purpose of this rule is to require IMR foreign funds to notify the Commissioner that they have accessed the IMR in respect of an income year. Although funds must also be residents of information exchange countries in order to qualify as IMR foreign funds, the self assessment nature of the IMR means that eligible entities are relieved from the need to lodge a tax return in respect of income or gains to which the IMR applies.
Failure to submit an information statement prevents a fund from being an IMR foreign fund in relation to the relevant income year, any IMR income or IMR gains that would have otherwise been exempt or disregarded, will become taxable (and will therefore require the lodgement of an Australian income tax return).
In addition to providing an information statement to the Commissioner in respect of an income year, a trust or partnership that is an IMR foreign fund, must provide a written notice containing information in respect of its status as an IMR foreign fund for the income year to each of its foreign resident beneficiaries or foreign resident partners. IMR foreign funds must provide the notification no later than the same time that the information statement to the Commissioner is due (that is, within three months of the end of the relevant income year, being the income year in relation to which the entity was an IMR foreign fund). Given the alignment of these periods, a fund may need to provide the information statement to the Commissioner at an earlier date in order for it to have sufficient time to also notify its partners and beneficiaries.
It is important that the status of foreign funds review their status to ensure they qualify as IMR foreign funds and therefore gain access to the benefits of the IMR. Under the draft legislation, pretty much every foreign fund will have a filing obligation; it is just a question of whether that filing obligation consists of the preparation and lodgement of an Australian tax return (with consequential payment of the resultant Australian tax liability) or the annual information statement required to be filed with the Commissioner under IMR 3.