New International Tax Measures

1. Re-written interest withholding tax exemption

The Bill proposes amendments to the current exemption from interest withholding tax (“IWT”) for payments to non-residents under certain debt interests.  These changes have been a long time coming.  Indeed, there has already been one false start; this is the second attempt to draft the amendment that Treasury wants to secure.

1.1 Background

Under current law, interest payments to non-residents can enjoy the benefit of an exemption from IWT under section 128F of the Income Tax Assessment Act 1936 if the instrument is offered in a way that meets certain conditions, and either:

• is in the form of a debenture; or
• meets the definition of a “debt interest” under the debt-equity rules. 

The addition of the “debt interest” option was made in 2005 to align the IWT rules with the debt-equity rules already in the legislation.  However, in early 2006, Treasury began discussions on a proposal to wind back the exemption from IWT just to instruments in the form of a “debenture” and to dividends on shares that were re-characterised as debt interests.  In Treasury’s view, the 2005 expansion to permit the possible exemption of interest on any kind of “debt interest” – for example, an interest-bearing account with an Australian financial institution – had been a drafting mistake.

Industry groups made detailed submissions to Treasury recommending modifications and qualifications to the proposal, particularly in relation to syndicated loans and the transitional rule for the new test.  Nevertheless, the Government proceeded to release amendments largely giving effect to the original Treasury proposal in December 2006 in Tax Laws Amendment (2006 Measures No 7) Bill 2006.  The release of the Bill prompted renewed – and ultimately more fruitful – discussions directly with the Government and eventually those provisions were excised from the Bill in March 2007 so that the balance of the Bill could be passed.

1.2 The revised IWT exemption

The Bill contains a second attempt to re-write the test for access to the exemption from IWT.  It re-asserts Treasury’s preferred position that an exemption from IWT is available only if the instrument is a debenture, with only two exceptions: dividends on non-equity shares and interests in certain syndicated loans.

So, under the revised test, in general terms, the benefit of the exemption from IWT will now be available for payments made by resident companies which are:

1. interest paid on debentures, where the issue of the debenture satisfies the public offer test. (This is the familiar IWT exemption that has been in operation, with modifications, since 1971 and remains unaffected by the Bill);
2. dividends paid on shares that are re-classified as debt under the debt equity tests, where the share issue satisfies the public offer test.  (These dividends currently qualify for an IWT exemption and will remain unaffected by the Bill); and
3. interest paid on “syndicated loans” exceeding $100m, where the invitation to participate in the syndicate satisfies an adapted public offer test and other tests. 

A corresponding exemption from IWT is also made available to the trustee of an eligible unit trust and for payments made in similar circumstances by non-resident companies in carrying on business through a branch in Australia.

The Bill also inserts a power for additional debt interests which are not issued in the form of a debenture to be added by regulation.  The power applies to instruments issued by companies or trusts.

1.3 $100m syndicated loans

Much of the Bill involves setting up the conditions for access to an IWT exemption for multi-lender syndicated loans where the total initial commitment available to the borrower is at least $100m.  The Bill requires that there be a written agreement, which is labelled by the parties as a “syndicated loan” or a “syndicated loan facility” and that involves multiple lenders that severally lend to the borrower – it may be established with just one lender, but there will need to be more for the exemption apply.  An arrangement will not usually qualify as a syndicated loan if there are 2 or more borrowers, unless the borrowers are associated.

The Bill adapts the public offer test to make it applicable to syndicated loans.  Under this test, the issuer must either invite at least 10 non-associated financial institutions to participate in the syndicate or else widely advertise the syndicate to financial markets by electronic means.  Either can be done using a broker or underwriter.

1.4 Commencement

The new rules apply to payments under instruments issued on or after 7 December 2006, the date of introduction of the first version of these rules into Parliament.

Where amounts are drawn down after 7 December 2006 under loan facilities that existed at that date, or there is a novation of an existing facility after 7 December, different transitional rules apply.  Current law and ATO practice views each draw down of an amount under an existing credit facility as amounting to a new loan.  Similarly, ATO practice views the purchase of an interest in a syndicated loan as amounting to a new loan.  (This arises principally from the fact that under the terms of syndication agreements the substitution of the purchaser for the original lender is usually effected by novation of the original loan.)  Hence, the draw down after 7 December 2006 of additional funds under an existing credit facility, or the sale after 7 December 2006 of an interest in a syndicated loan, would give rise to a new debt interest, which would not be entitled to the benefit of any existing immunity from IWT and which might not qualify for exemption under the new test in this Bill.  So, where amounts are drawn down after 7 December 2006 under written loan facilities that existed at 21 March 2005, or there is a novation of a written loan facility that existed at 21 March 2005, any payments made under the agreement will still be entitled to keep the benefit of any current IWT exemption to which the non-resident might be entitled.

2. New PAYG withholding regime for managed fund distributions to foreign residents

2.1 Background

The Bill proposes a new PAYG withholding regime for collecting amounts from distributions of certain types of Australian source income paid by managed funds to foreign residents.  This measure will be very significant to the managed funds industry, principally listed property trusts, although wholesale funds and funds in sectors other than property will need to monitor their exposure.

Under current collection provisions (modified by the provisions next discussed), a trustee is assessable and must pay tax on a beneficiary’s share of the net income of the trust if the beneficiary is a foreign resident at the end of the income year.  The rate of tax payable by the trustee depends on whether the foreign resident is a company (30%), individual (29% - 45%) or trustee (currently nil).  The same rules apply to private trusts as to managed funds.

The amendments will change the collection process by substituting a PAYG withholding regime at the corporate tax rate (currently 30%) on various components of payments made by certain types of trust to certain classes of recipient.  This withholding will replace the tax currently assessed on the trustee.

In practice, many trust distributions are paid by fund managers to Australian intermediaries (rather than directly to the non-resident investor) and difficult questions can arise about the nature of the relationships between the fund manager, foreign investors and any Australian intermediary, and their impact upon the trustee’s obligations.  Under the new regime the liability to withhold can be shifted by the managed investment fund onto an intermediary if the intermediary meets certain conditions and the managed investment fund gives a notice to the intermediary of its decision to do so.

The operation of the new withholding depends on three key definitions:

1. the paying entity is a “managed investment trust” or in some cases, an “intermediary;”
2. withholding only needs to be made from a “fund payment;” and
3. withholding only need be made from payments made to certain kinds of recipient.

2.2 Payers – Managed investment trust

The liability to withhold is imposed on the trustee of a “managed investment trust.” 

Broadly, a trust is a managed investment trust in relation to an income year if at the time the first fund payment for the year is paid:

• the trustee is an Australian resident or the trust was managed in Australia;
• the trust is a “managed investment scheme” and is operated by a “financial services licensee” as defined in the Corporations Act 2001;  and
• the trust must satisfy one of three membership tests:
  • the trust is listed on an approved stock exchange;
  • the trust has more than 50 members; or
  • units in the trust are owned by a life insurance company, a complying superannuation fund with more than 50 members, another managed investment trust or a foreign entity which resembles a managed scheme under its law.

The test is applied on only one day during the year – the day on which the first fund payment for a year is made – so a trust would not become a managed investment trust just because a superannuation fund acquired units, if that happened after the first distribution.  Further, the test is a year-by-year test, so it is quite conceivable that a trust could be a managed investment trust one year and not the next – for example, if a superannuation fund sold its units during the year.  Being a “managed investment scheme” is not enough to trigger exposure under these rules – the MIS must be listed, or have the right number or kinds of members.

The requirements that the trust be listed or widely held may create the mistaken impression that the withholding regime will be limited to retail trusts, and that trusts operating in a wholesale market need not be concerned.  A trust may be a managed investment trust if it has a single complying superannuation fund with more than 50 members or insurance company as a unitholder.  A wholesale fund could easily have a handful of large complying superannuation funds as members and so be subject to these rules.  Once it qualifies as a managed investment trust, it will then be exposed to liability to withhold from payments to any non-resident unitholders.

2.3 Payers – Intermediaries

The PAYG withholding regime can operate differently where fund payments are made by the trustee of the managed investment trust to a resident intermediary, which then pays an amount to the foreign resident.  In this situation, the managed investment fund can eliminate any exposure to withhold. 

To qualify as an intermediary in respect of a payment, the entity must, at the time of receipt of the payment:

• be an Australian entity;
• be carrying on business which consists predominantly of providing custodial or depository services pursuant to an Australian financial services licence; and
• have received a notice (from the trustee of the managed investment trust) in relation to the payment.

The status as an “intermediary” is confined to only those entities which are licensed in Australia to provide custodial or depository services.  Trading banks or other collection agents will not ordinarily qualify.

A decision whether an entity qualifies as an intermediary must be made on each occasion that a fund payment for a year is made. 

The notice to the intermediary should set out information that would enable the intermediary to calculate the amount it will need to withhold when it on-pays the amount received to a foreign resident.  It will also specify the income year of the paying managed investment to which the relevant fund payment relates.

It is not mandatory for the managed investment trust to give a notice to an intermediary.  Failure to provide a notice to an intermediary will mean that the withholding obligation would not apply to the intermediary when it on-pays the payment or credits it to the account of the non-resident investor.  (Any liability to withhold would remain with the managed investment trust, but since, in many cases, the managed investment trust is paying a resident, it may not have an obligation to withhold.)

How this system will work out in practice is not entirely clear.  While the regime appears to leave the matter in the hands of the trustee of the managed investment trust, it is likely that custodians would insist on managed funds preparing the notice and paying amounts to them free of withholding.  Alternatively, fund managers may decide to prepare periodic distribution statements in a way which routinely provides all of the relevant information (and consequently attempts to absolve the trustee from any liability it might have to withhold).

2.4 Fund payment

Despite the impression that may have been conveyed so far, the withholding regime is likely to have the highest impact in the property sector.  In so far as non-property trusts are caught up in the withholding net, withholding would be imposed on a relatively small portion of each cash distribution or reinvested amount.

The trustee does not simply withhold an amount at the stipulated rate from the gross cash payment or re-invested amount.  Rather, in general terms, the trustee must withhold from a payment to the extent that it represents a share of the net income of the trust, is attributable to Australian sources or is a capital gain made on taxable Australian property, and is not already subject to the existing withholding tax regime for dividends, interest and royalties.

Limiting the withholding just to a share of the “net income” of the trust means that cash amounts distributed or reinvested in excess of the net income of the trust estate are not subject to withholding.  In other words, no amount need be withheld from cash distributions attributable to tax deferred amounts earned by the trust.

Secondly, the trustee need not withhold under this regime to the extent that the payment represents trust income that is dividends, interest and royalties.  These payments are excluded from this new withholding regime presumably because existing withholding rules already require the trustee to withhold from these amounts and at different rates.  (It is this exclusion which will remove many share trusts and cash management trusts from the new regime.)

Thirdly, foreign source income, and capital gains made on assets that are not taxable Australian property, are also not liable to withholding.  But, where a payment includes an Australian capital gain which is liable to withholding, the withholding must be made on the undiscounted amount of the gain.

Notice finally that there is an important timing dimension to the definition.  An amount will be a fund payment provided it is made no later than 3 months after the end of an income year.  So, interim distributions made during the income will be “fund payments,” as will a final distribution, but only if the final distribution is made by 30 September (for a trust with a 30 June year end).  A final payment made 5 months after the end of income year is not a “fund payment” and so is not liable to withholding!  While this might seem odd, the consequence is that the trustee is made liable to pay tax by assessment at 46.5% on the undistributed share of net income.  (There appears to be no similar time requirement where a managed investment trust pays an amount free of withholding to an intermediary; the intermediary only needs to withhold if and when it pays an amount to the investor.)

This regime will force managed investment trusts to make a full distribution of net income within 3 months after the end of its income year.  This will be especially significant for trusts that currently retain some net income, where there is some delay in determining the net income of the trust, or where there are subsequent amendments to the accounts which disclose further net income after the 3 month period.  It is worth mentioning that the Commissioner does have a discretion to extend the 3 month period and these might be appropriate circumstances to exercise the discretion.

The new system will also require some careful judgments and accurate predictions to be made in determining the amount to be withheld by trustees of managed investment trusts.  First, the amount that must be withheld is based on a share of the “net” income.  This means that expenses must be calculated and attributed to various classes of income.  The definition says that deductions “relating to” dividends, interest and royalties are to be disregarded in determining the amount of fund income.

Secondly, if interim distributions are made during the income year, the trustee must predict the future.  The regime will, in effect, require the trustee to estimate at the time of the first payment the total net income of the trust estate for the entire year, and the composition of that net income, and to predict what other fund payments will be made by the trust during the year.

Thirdly, where additional interim distributions are made during the income year, the trustee apparently has to revisit its prior computations and continually re-assess what needs to happen for this payment, in light of what has happened for past distributions. 

2.5 Payment recipient

The requirement to withhold will be triggered where:

• the managed investment trust makes a payment to a recipient and at that time the recipient is a foreign resident;
• the managed investment fund makes a payment to the recipient and has reasonable grounds to believe that the recipient is a foreign resident; or
• the managed investment fund makes a payment to the recipient, it has no reasonable grounds to believe the recipient is an Australian resident, and either
  • the recipient’s address is outside Australia, or
  • the payer is authorised to make the payment outside Australia.