1.1 While an IMR may provide exemptions for certain income and gains of foreign managed funds, these amounts should remain taxable in the hands of Australian investors in line with Principle 3. Thus, a well designed IMR should ensure that Australian residents, who would be taxable if particular investments were made directly, remain taxable on those investments where they are made through a foreign managed fund.
1.2 An IMR should also prevent opportunities for Australian residents to gain tax advantages through investing into foreign managed funds which qualify for IMR exemptions. Two main opportunities arise for such tax advantages to arise: (1) deferral of Australian tax; and (2) opportunities for tax evasion.
1.3 In designing measures to ensure the Australian tax base is protected, the design of an IMR should take into account existing integrity rules in the tax law. Additional integrity measures should only be imposed where the existing rules are insufficient to protect the Australian tax base.
1.4 Any IMR integrity measures should not place overly cumbersome eligibility or reporting requirements on foreign managed funds, or unduly increase the regulatory duties of the ATO.
Views in submissions
1.5 While submissions highlighted integrity measures as a key area of concern, they noted that an appropriate level of integrity should be achieved without constraining the IMR’s intended outcomes with high compliance costs. The primary concern for stakeholders regarding round tripping was the accumulation by resident taxpayers of income and deferral of Australian tax, rather than opportunities for tax evasion that could arise from exemptions provided under an IMR.
Whilst measures to deal with round tripping would be required, they should not impose such onerous compliance requirements on the foreign managed fund that they become counterproductive.
The Institute of Chartered Accountants in Australia
1.6 Submissions underlined the scope for application of the Controlled Foreign Company and proposed Foreign Accumulation Fund provisions to safeguard resident taxation. Some submissions recommended that any integrity measures be directed at the underlying Australian investors rather than the foreign funds themselves.
1.7 Some submissions suggested that an appropriate widely held test be included into the IMR. Where such a test is satisfied, the spread of investors and the broad range of tax characteristics would make it difficult for any one particular investor to influence the fund’s affairs, dictate its structure or influence its income distribution policy in order to obtain an inappropriate tax benefit. However, stakeholders also explained that Australian investors could achieve income deferral by investing in a widely held fund which has an explicit accumulation investment policy.
1.8 Submissions generally warned against imposing too onerous ownership tracing requirements.
Ownership tracing is often not practical in widely held funds – for example, because investors are often themselves funds with a wide range of investors. Therefore, there is doubt as to whether the underlying ownership of the fund can be determined with any degree of certainty. In addition, proper tracing, even if practically possible, is often an expensive exercise and therefore an impediment to using the regime.
Law Council of Australia
1.9 Some submissions suggested limiting the level of Australian investment in a foreign managed fund and applying ownership tracing tests to determine that the threshold level of Australian investment is not exceeded (a de minimis test). These submissions also advised against complicated ownership tracing and reporting requirements to prove the composition of Australian investment in the foreign fund.
Any integrity rules relating to foreign funds which might have Australian resident investors should contain a significant Australian resident ownership de minimis test.
Ernst & Young
1.10 A de minimis test allowing a degree of ultimate Australian ownership was generally considered appropriate and consistent with the approach in other jurisdictions (namely, Hong Kong and Singapore). Such a test could be applied in the determination of the aggregate level of Australian resident ownership or the level of ownership of single Australian residents and their associates (which may be easier to determine), or a combination of both. Submissions indicated specific threshold percentages ranging between 10 per cent and 50 per cent, with some indicating that it should not exceed those of competing jurisdictions.
In Hong Kong, the exemption is denied where a single resident person (alone or with its associates) has an interest in 30 per cent or more of the equity in the offshore fund that is seeking access to the IMR. Of importance, it is noted that these tests are based on an associate inclusive investor test, and are not based on whether non-associated residents (on aggregate) meet such thresholds (which is different to that contained at a high level in the Board’s report). These tests do not require a strict tracing of all unit holders and a grouping of all underlying resident unit holders to determine whether a de minimis threshold is satisfied.
Pitcher Partners Advisors
1.11 Some stakeholders also suggested a maximum Australian exposure test with regard to the investments held by the foreign managed fund.
Taxation of Australian residents
Board’s consideration
1.12 Although an IMR will grant exemptions to a foreign managed fund on income and gains from certain portfolio investments, the design of the IMR should ensure that the exemption does not pass on to Australian residents who may invest into the foreign managed fund.
1.13 Inappropriate outcomes may arise where the foreign managed fund is treated as a flow-through vehicle under Australian tax law. Examples may include the case where the foreign managed fund is a trust, a partnership or a mere contractual arrangement. In these instances, any exemption on gains provided to the foreign managed fund may flow-through to the investors in that fund.
1.14 The Board recommends that, at a minimum, the IMR rules ensure that Australian investors will remain taxable on distributions received from foreign funds (both directly and indirectly) where that distribution includes income that was exempt from income tax under the IMR for foreign managed funds. That is, such investors will not obtain a tax exemption merely by virtue of the IMR.
1.15 One way this could be achieved would be that ordinary or statutory income derived by Australian investors from a foreign managed fund (both directly and indirectly) is not made exempt merely by virtue of the income being treated as exempt for the foreign managed fund under the IMR.
Recommendation 9:
The Board recommends that income derived by Australian investors from a foreign managed fund (both directly and indirectly) is not made exempt merely by virtue of the income being treated as exempt for the foreign managed fund under the IMR.
Measures to deal with deferral of income tax
1.16 Where Australian residents invest into foreign managed funds which qualify for IMR exemptions, this may give rise to deferral of income tax since profits made on investments could be accumulated in the foreign managed fund and would only be taxable when paid to the Australian investor.
Australia’s existing anti-tax-deferral rules
1.17 The operation of Australia’s foreign source income attribution rules was reviewed by the Board in its September 2008 report on its Review of the foreign source income anti-tax-deferral regimes. The Board recommended that Australia’s controlled foreign company (CFC) rules be retained as the primary set of rules designed to counter tax deferral arrangements. It also made a number of recommendations to modernise the CFC rules.
1.18 The CFC rules apply to holdings in foreign companies that are controlled by Australian residents. Given these foreign companies are controlled by Australian residents, those residents may use these companies to accumulate profits and defer Australian taxation. The CFC rules generally apply to prevent resident taxpayers from obtaining a tax deferral benefit on CFC’s passive income and gains by treating those income and gains as assessable income to resident taxpayers on an accruals basis. The CFC rules are currently in the process of being updated and rewritten into the ITAA 1997.
1.19 Prior to 1 July 2010, investments by Australian investors in non-resident funds could have been subject to the foreign investment fund (FIF) rules.
1.20 The FIF rules were repealed as from 1 July 2010 in response to recommendations made by the Board in its Review of the foreign source income anti-tax-deferral regimes. In its report on this review, the Board found that in cases where Australian residents did not control a foreign accumulation fund, only a small risk existed for the deferral of tax, which was to be addressed by a narrowly targeted foreign source income attribution rule. In this respect, exposure draft legislation for a foreign accumulation fund (FAF) rule was released in February 2011.21 This attribution rule, as currently drafted, would seek to target Australian residents holding certain interests in non-resident accumulation funds.
Board’s consideration
1.21 Although the proposed IMR will treat Australian source income made by a foreign managed fund on the disposal of certain portfolio investments as exempt, the Board considers that the risk of tax deferral for an Australian resident investing into the foreign fund in such instances would appear to be similar to the deferral risk which presently exists for Australian residents investing in other offshore vehicles which derive Australian source income.
1.22 The Board considers that the risk of deferral of tax through investments via foreign funds following the introduction of the IMR should be considered and addressed through the application of Australia’s foreign source income attribution rules, in addition to the requirement of foreign managed funds to be widely held.
1.23 If an Australian resident sets up artificial arrangements offshore to accumulate investment income which involved a foreign managed fund, these arrangements would likely only be effective where that resident had control (whether directly or together with associates) over the foreign accumulation vehicle. In this case the Board considers the CFC rules are sufficient to address any deferral of taxation arising from such an arrangement.
1.24 Where an Australian resident invests in a foreign entity but is unable to control decisions of that foreign entity to accumulate or distribute income, the Board understands that the proposed FAF rules are aimed to address the key areas where there is a heightened risk of tax deferral.
1.25 The Board therefore considers it desirable not to create a further set of integrity rules to address deferral of taxation under the proposed IMR for foreign managed funds. Any such additional integrity rules would only add further complexity to the tax law given the existence of the foreign source attribution rules and their further development.
1.26 As part of the further development of the foreign source income attribution rules, the Board recommends that the Government consider whether any unique tax deferral opportunities arise from the design of the IMR for foreign managed funds, and take this into account in the final design of the attribution rules to ensure that any potential for such deferral is adequately addressed prior to the finalisation of those rules.
1.27 In this context, the Board notes that unlike Australian investors in a MIT which are to be subject to an attribution method of taxation, Australian investors in a foreign managed fund under the IMR would only be taxable when they derive income from the foreign managed fund. Whether or not this would constitute a heightened risk of tax deferral, including through a possible shift in investments by Australian investors from MITs to IMR foreign managed funds, is an area that may warrant further consideration by the Government.
1.28 The Board also recommends that the Government should undertake a post-implementation review of the operation of the foreign source income attribution rules and the IMR for foreign managed funds following their introduction into law to ensure that inappropriate deferrals of tax are not being carried out through the IMR rules.
Recommendation 10:
The Board recommends that:
- integrity rules should not be introduced into the IMR for foreign managed funds to address deferral of taxation that would operate in addition to Australia’s foreign source income attribution rules;
- the Government consider whether any unique tax deferral opportunities arise from the design of the IMR for foreign managed funds, and take this into account in the final design of the foreign source income attribution rules to ensure that any potential for such deferral is adequately addressed prior to the finalisation of those rules; and
- the Government should undertake a post-implementation review of the operation of the foreign source income attribution rules and the IMR for foreign managed funds following their introduction into law to ensure that inappropriate deferrals of tax are not being carried out through the IMR rules.
Measures to deal with evasion of tax
1.29 Where Australian residents invest into offshore assets, the basic risk arises that those residents may not report the income made on those offshore assets (the evasion of tax). This same basic risk arises where Australian residents invest into a foreign managed fund.
1.30 To assist in addressing this risk of tax evasion, a number of initiatives are being developed internationally, especially in the area of round tripping. These initiatives seek to provide tax authorities and revenue collection agencies with information on offshore investments made by their residents. The initiatives also seek to provide information on whether offshore investors into their jurisdiction are beneficially owned by domestic investors (that is, cases of round tripping by domestic investors), to ensure that any potential tax evasion can be addressed.
1.31 Some tax jurisdictions impose requirements on foreign funds investing into their jurisdiction to disclose information on any residents who invest into their fund. There are varying levels of information disclosure which are imposed on such funds, including disclosure of the residence of direct investors only to the disclosure of the residence of ultimate beneficial owners.
Existing projects for the tracing and identification of resident investors
1.32 A variety of approaches are being developed to address informational asymmetries which exist between market participants and revenue collection agencies. The United States (US) is currently implementing the Foreign Account Tax Compliance Act (FATCA) to address various issues relating to round tripping. Under the new laws:
- Foreign banks and other financial institutions operating in the US must reach an agreement with the Internal Revenue Service (IRS) and identify US accounts or they could subject their owners to a 30 per cent withholding tax.
- The definition of affected foreign financial institutions is broad and wide-ranging, and includes entities that manage investments, including alternative investment entities and insurance companies.
- Non-financial foreign entities (NFFEs) will be required to disclose whether they have any 10 per cent US owners. NFFEs that fail to document the existence or non-existence of US owners may be subject to the 30 per cent withholding tax regime.
1.33 The OECD has created the new Treaty Relief and Compliance Enhancement (TRACE) Group to deal with a broad range of issues relating to cross border taxation of capital flows, including the issue of round tripping. The objectives of its work are two-fold: (i) to develop treaty relief systems that are as efficient as possible, in order to minimise administrative costs and allocate the costs to the appropriate parties; and (ii) to identify solutions that enhance countries’ abilities to ensure proper compliance with tax obligations, from the perspective of both source and residence countries.
1.34 One of the issues being considered by TRACE is the identification of beneficial ownership in foreign entities which may be used by resident investors for round tripping. Resident investors may invest in multiple tiers of offshore vehicles before investment is directed back on-shore. In these instances, ownership needs to be traced through potentially a number of vehicles and a number of tax jurisdictions.
1.35 Another measure that could be used to assist tax authorities to obtain information on investments made by resident investors in their jurisdiction is to rely on the network of countries with which the jurisdiction has exchange of information arrangements in place (information exchange countries). An example is Australia’s MIT regime which provides a concessional withholding tax rate on fund payments only if those payments are made to investors who are resident in an information exchange country.
Measures to deal with compliance in other jurisdictions
1.36 Apart from measures which aim to provide tax authorities with relevant information on the investments made by investors resident in their tax jurisdiction, a number of jurisdictions have incorporated alternative measures to reduce the risk of tax evasion by residents through round tripping. These measures may incorporate a combination of elements including reporting obligations on foreign funds as well as restrictions on the degree of ownership by resident investors in foreign funds seeking to access exemptions.
1.37 As an example, the Singapore tax law will provide tax exemptions on certain investments made by foreign funds into Singapore, but only for qualifying investors in the foreign fund. Non-qualifying investors are required to pay tax broadly based on the profits of the fund multiplied by their percentage holding in the fund. Foreign funds are required to identify and disclose to the Singapore tax authority the identities of any non-qualifying investors in the fund each year.
1.38 The definition of qualifying and non-qualifying investors under the Singapore tax regime only requires the identification of the direct investors into the foreign fund. The Singapore tax rules incorporate a de minimis test where Singaporean companies are entitled to tax exemptions if they own not more than 30 per cent of the foreign fund (or not more than 50 per cent if the fund has over 10 or more investors).
1.39 The Hong Kong tax law provides for a similar de minimis test where Hong Kong residents are entitled to exemption only if they own a beneficial interest of not more than 30 per cent in the foreign fund.
Board’s consideration
1.40 The Board recommends that foreign managed funds should be required to be resident in an information exchange country (as defined in the MIT withholding tax rules22) as a prerequisite for accessing the IMR. This requirement will assist the Commissioner of Taxation to seek relevant information on the residence of investors in foreign managed funds with a view to identifying tax evasion by Australian resident investors.
1.41 This requirement will also align the residence requirements of foreign managed funds in the IMR with the MIT regime, fits into the broader policy context of information exchange and would support Australia’s effort to address cross border tax non-compliance.
1.42 The definition of whether an entity is resident in an information exchange country in the MIT withholding tax rules specifically takes into account the circumstance where that entity may not strictly be a resident of any country. In this case, the MIT withholding tax rules will deem an entity to be resident in an information exchange country if ‘;the entity is incorporated or formed in that country and is carrying on a business in that country’.23
1.43 However, the Board notes there may be circumstances where a foreign managed fund may not be considered to be an “entity”, such as the case of common contractual arrangements, and thus may not be taken to be resident of any country. The Board considers that these types of CIV arrangements should be able to qualify for the IMR, and thus a residence deeming provision may be required such that, provided information is available as if the CIV were an entity resident in an information exchange country, it is deemed to be a resident of such a country for the purpose of the IMR. This will need to be taken into account in implementing the Board’s recommendation.
1.44 The Board also notes that most jurisdictions where foreign managed funds are currently based are listed as information exchange countries24. A list of Australia’s 51 current information exchange countries is contained in Appendix C. The scope of the IMR will increase as Australia enters into exchange of information agreements with more jurisdictions.
1.45 The requirement that foreign managed funds be resident in an information exchange country will also provide greater information to the Commissioner of Taxation in order to administer the CFC and proposed FAF rules to safeguard Australian resident taxation.
1.46 The Board also considered imposing reporting requirements on foreign managed funds under an IMR. In considering different reporting options, the Board agreed with stakeholders that any options should not place overly burdensome or impractical reporting obligations on foreign managed funds as this could act to deter investment through the IMR.
1.47 The Board came to the view that while, in principle, reporting obligations that require the tracing of ultimate beneficial ownership of funds would assist in integrity, such a requirement was considered to be too onerous. It would also go beyond the level of compliance required by foreign managed funds investing in most other tax jurisdictions.
1.48 After considering different options, the Board came to the view that foreign managed funds should be required to lodge an annual information return to the Australian Taxation Office to indicate that it was claiming IMR exemptions. The Board considers this would be important to enable the ATO to identify which foreign managed funds were claiming exemptions under the IMR.
1.49 The Board recommends that the information return should be lodged within six months of the end of the foreign managed fund’s accounting year, and that failure to do so would make the fund ineligible for the IMR for that year. The Board also recommends that the Commissioner of Taxation be given a power to exercise discretion in extending the time in which the foreign managed fund can lodge its information return.
1.50 The Board recommends that information required to be disclosed on the annual information return should be further developed by the ATO and Treasury. The Board recommends that the required content of the information return be set out in regulations to the tax law, so that changes can be made expeditiously where required.
1.51 The Board also recommends that in developing the required content for the information returns, the ATO and Treasury should take into account the following principles:
- the information should assist the ATO in identifying whether the foreign managed fund complies with the IMR eligibility requirements;
- the information should be readily obtainable by the foreign managed fund; and
- the information should not place overly burdensome or impractical reporting obligations on foreign managed funds.
1.52 Examples of the type of information which could be required in the annual information return include:
- the name and address of the foreign managed fund;
- accounting year for the foreign managed fund;
- confirmation that, at both the start and end of the year, the foreign managed fund is widely held, does not carry on or control a trading business in Australia, and is resident in an information exchange country;
- the information exchange country in which the fund is resident;
- the amount of profits made by the fund on portfolio investments, non-portfolio investments and other investments (such as derivatives and bonds); and
- contact details of representatives of the fund.
1.53 The Board considers that its recommended information return requirement is reasonable for foreign managed funds to comply with, and would provide the ATO with the information necessary to monitor compliance with the IMR.
1.54 In addition, the Board notes that if FATCA or TRACE are eventually integrated into the business systems of foreign managed funds, then Australia could consider adopting additional reporting rules consistent with these programs.
Recommendation 11:
The Board recommends that:
- as an integrity measure, foreign managed funds should be required to be resident of an information exchange country as a prerequisite for accessing the IMR;
- foreign managed funds should lodge an annual information return with the ATO within six months of the end of the fund’s accounting year, and that failure to do so would make the fund ineligible for the IMR for that income year;
- the Commissioner of Taxation should be given a power to exercise discretion in extending the time in which the foreign managed fund can lodge its information return;
- the information required to be disclosed on the annual information return should be further developed by the ATO and Treasury;
- the required content of the information return be set out in regulations to the tax law, so that changes can be made expeditiously where required; and
- in developing the required content for the information returns, the ATO and Treasury should take into account the following principles:
- the information should assist the ATO in identifying whether the foreign managed fund complies with the IMR eligibility requirements;
- the information should be readily obtainable by the foreign managed fund; and
- the information should not place overly burdensome or impractical reporting obligations on foreign managed funds.