The Government is urgently looking to address uncertainty around the Australian tax treatment of passive investments into Australia by widely-held foreign funds. This tax uncertainty was identified in the Australian Financial Centre Forum’s report: Australia as a Financial Centre − Building on our Strengths (the Johnson Report)1 and has led to some foreign funds being required to disclose potential tax liabilities under ‘FIN 48’ in US accounting standards.
As part of a longer term solution, the Government is consulting with industry to develop a new regime to provide relief for foreign funds investing into Australia. This is likely to be introduced as part of a new Investment Manager Regime (IMR), which is under consideration by the Board of Taxation. The design and development of an IMR is a key focus of the Board of Taxation’s discussion paper on ‘Collective Investment Vehicles’, which was released for public consultation on 17 December 2010. Following extensive submissions, the Board of taxation is expected to release its report by 31 December 2011.
Concerns with fin 48
Under the US Financial Accounting Standards Board Interpretation No. 48 − Accounting for Uncertainty in Income Taxes (FIN 48), certain foreign funds which have adopted US accounting standards may be required to make disclosures/provisions in their financial accounts in relation to uncertain tax positions, including for prior years. The FIN 48 disclosure requirements are very strict, and can require foreign funds to book a provision even where there is a theoretical exposure to tax.
This has led to considerable concerns that foreign funds may be required to make FIN 48 disclosures in respect of possible Australian tax liabilities as a result of the uncertainty surrounding the Australian tax treatment of their investments in Australia. These tax uncertainties, which were identified by the Johnson Report as key constraints to the growth of the Australian funds management industry, include:
- The risk that, as a result of using a local Australian investment adviser or fund manager, a foreign fund will be deemed to have a permanent establishment in Australia and therefore be subject to Australian tax on Australian sourced income attributable to that permanent establishment
- The lack of certainty as to whether income derived by the fund will be considered to have an Australian source and therefore be taxable in Australia
- The possibility that the fund could be considered an Australian tax resident (and therefore subject to Australian tax on its worldwide income) by virtue of key decisions being made in Australia and the fund’s central management and control being situated in Australia, and
- Uncertainty as to whether gains on the disposal of Australian investments are on capital or revenue account, and therefore whether the capital gains tax exemption will be available to foreign investors.
On 17 December 2010 the Assistant Treasurer, Bill Shorten, announced that the Government will amend the tax laws to provide certainty around the FIN 48 issue for foreign funds investing into Australia.
In relation to prior years, the Government announced that where a foreign managed fund has not lodged a tax return for the 2009-10 or prior income years in respect of certain investment income of the fund, the Australian Taxation Office (ATO) will not be permitted to raise an assessment in respect of that income, except where the fund lodges a tax return disclosing such income. This means that prior year positions will not be called into question. As part of its Budget announcement on 10 May 2011, the Government extended this concession to the 2010-11 income year pending finalisation of the IMR.
For foreign managed funds which are subject to FIN 48, these announcements should ensure that it is not necessary to disclose an uncertain tax position in respect of the fund’s Australian investments for 2011 or prior years. However, this relief will only apply to funds which are considered to be ‘foreign managed funds’ and will only cover certain types of investment income of the fund.
While the specific definition will be developed in consultation with industry, a ‘foreign managed fund’ is broadly intended to cover a widely-held (and not closely-held) foreign fund which undertakes passive investment and does not carry on or control a trading business in Australia. The fund must also not be an Australian tax resident. In relation to the investment income of the fund, the relief will be provided in respect of income, gains and losses arising from the following types of investments by foreign managed funds:
- Portfolio interests in companies (including companies listed on the ASX), portfolio interests in other entities (including units in a unit trust) and bonds, except to the extent the amount gives rise to a withholding tax liability, and
- Financial arrangements (for example, derivatives) and foreign exchange transactions, except to the extent they are in respect of an underlying interest that is otherwise taxable (such as taxable Australian property).
A new regime ahead
A key focus for the Board of Taxation is the design of an IMR for investments by foreign residents managed in Australia. One of the options considered by the Board of Taxation is an exemption style IMR, which would be applicable to portfolio income of ‘foreign managed funds’.
An exemption style IMR could potentially provide:
• an exemption from Australian tax (other than withholding tax) for foreign managed funds in respect of eligible investments (generally, portfolio investments other than Australian land), and
• if an Australian based intermediary is used by the foreign fund, the intermediary would be subject to tax only on the arm’s length fees for their services.
The IMR is intended to apply to ‘foreign managed funds’ which have the following features:
- the fund is not an Australian resident
- the fund is widely held
- the fund undertakes passive, typically portfolio investment, and
- the fund does not carry on or control a trading business in Australia (except to the extent that its dealings in securities may amount to trading).
The Board of Taxation notes that the IMR could include hedge funds or other foreign collective investment vehicles regardless of their legal form, to the extent that they have the above features.
IMR’s application wide but not all encompassing
The Johnson Report recommended that the IMR have wide application, and apply more broadly than to foreign managed funds. While the Board of Taxation is consulting on the scope and application of the IMR to other areas of financial services beyond funds management, it is noted that private equity and venture capital funds are unlikely to be eligible for inclusion in the IMR. This is because private equity and venture capital funds typically undertake active investment activities which control their target. The Board considers that this control should exclude private equity funds from this exemption.
Time for action
Despite the general and high-level nature of the Board’s discussion paper, the development of an IMR in consultation with industry is a welcome step forward towards improving certainty for Australian fund managers and foreign managed funds investing into Australia. Industry has been lobbying for this for some time.
However, the industry continues to be faced with long term uncertainty and seeks the detail of the Government’s proposals as an urgent priority. The funds management industry is growing quickly in this region and unless the Government can deliver its promised reforms, fund managers will look to other jurisdictions. Unfortunately, these investment decisions cannot be made on the promise of reforms and concrete measures are needed.
1 The Australian Financial Centre Forum Report, ‘Australia as a Financial Centre: Building on our Strength’ released on 15 January 2010.
2 Now Accounting Standards Code 740-10.