Financial Services Alert: Funds Management

In brief

• On 7 May 2010, the Federal Government announced that a new tax regime would apply to qualifying Managed Investment Trusts (MITs) from 1 July 2011. The aims of the new regime are to remove investor uncertainty in the interaction of Australian trust law and tax law and to simplify the administration of the managed funds sector.
• The changes are in response to the Board of Taxation’s report into the tax arrangements applying to MITs, which was also released on 7 May. The Government has adopted 38 of the Board’s 48 recommendations.
• Key recommendations of the Board which have been adopted by the Government include:
• a new elective attribution system to replace the present entitlement system, so that investors will be taxed only on the income that the trustee allocates to them on a fair and reasonable basis;
• concessions for “under / over” distributions; and
• the removal of double taxation in certain circumstances by providing for upward adjustment in the cost base of a unit.
• The Government will defer consideration of some of the Board’s recommendations, including clarification of the passive income / public trading trust rules in Division 6C of the Income Tax Assessment Act 1936 (ITAA 1936).
• Fund managers should be considering the impact of these proposed new laws on their products and fund documents, and closely monitoring further developments.

Qualifying MITs and the attribution system

The Board was asked to make recommendations for a specific tax regime for MITs which would reduce complexity, increase certainty and minimise compliance costs. It was asked to develop options for reform with taxation outcomes broadly consistent with five policy principles which included:

(a) the tax treatment for trust beneficiaries who derive income from the trust should largely replicate the tax treatment for taxpayers as if they had derived the income directly; and

 

(b) flow through taxation of income should be limited to trusts undertaking activity that is primarily passive investment.

The principal recommendation of the Board which has been accepted by the Government is that the tax legislation be changed to give a qualifying MIT a right to make an irrevocable election to be taxed under a new attribution system of taxation rather than under the current trust tax provisions in Division 6 of the ITAA 1936, under which beneficiaries are taxed on their proportionate share of trust income.

A MIT will be entitled to elect to be taxed under the new attribution system if it:

(a) meets a ‘widely held’ requirement;

 

(b) complies with eligible investment business (passive income) rules in Division 6C of the ITAA 1936; and

 

(c) meets a requirement that the beneficiary have clearly defined rights to the trust capital and income.

In relation to the widely held test the Board recommended that the definition of a managed investment trust in the tax withholding provisions of Subdivision 12-H of Schedule 1 to the Taxation Administration Act 1953 be used to determine whether a trust would be taken to be ‘widely held’ for the purposes of an MIT regime, rather than the provisions currently in Division 6C of the ITAA 1936.

The Board also recommended that the following trusts be treated as meeting the widely held requirements:

(a) a wholesale trust which has 50 or more members directly or indirectly (say through a trust or superannuation fund) and which trust is subject to a suitable regulatory regime such as a requirement that it is operated or managed by the holder of an Australian Financial Services Licence: and

 

(b) a wholesale trust which is wholly-owned directly or indirectly by another wholesale trust which would qualify under Subdivision 12-H under (a).

In relation to the clearly defined rights requirement, the Board recommended that the beneficiaries’ rights to income, including the character of the income, and capital must be clearly established at all times in the trust’s ‘constituent documents’. The rights should only be able to be changed by a change in the trust’s ‘constituent documents’ and not by the trustee exercising a power given to it under the trust deed.

There is no requirement that the rights in a MIT have to be uniform in order to qualify for the MIT regime. MITs are free to create units carrying special rights to particular kinds of income or gains. IDPSs and other similar ‘bare trust’ arrangements are to be specifically excluded from the MIT regime and there will not be a special tax regime for REITs.

The following principles will apply if a MIT elects to be taxed under the attribution scheme:

(a) a beneficiary will be assessable on the amount of taxable income of the trust that the trustee allocates to the beneficiary;

 

(b) the trustee must allocate the taxable income of the trust between beneficiaries on a fair and reasonable basis consistent with their rights under the trust’s constituent documents and the duties of the trustee; and

 

(c) the trustee will be taxed on any taxable income of the trust which the trustee fails to allocate to beneficiaries within three months of the end of the financial year.

The proposed attribution scheme, and in particular the “fair and reasonable” allocation requirement, raises a host of issues, which will hopefully be addressed in the detail of the exposure draft of the legislation when it is issued. For example, it is not entirely clear whether the present practice of streaming realised capital gains to unit holders who have made large redemptions during the tax year would be permissible under the new system.

Under / over distributions

The legislation will provided that ‘unders’ and ‘overs’ below a minimum level of either 5 per cent of the net income of the trust for a year or a prescribed dollar value per unit will be carried forward into the next income year following identification of the under or over.

Where the under exceeds the minimum amount the trustee may reissue the distribution statement to the beneficiary and make a revised attribution of the income to the beneficiaries within a certain timeframe, and if it does not do so then the trustee will be assessed on the amount of tax shortfall at the top marginal tax rate.

If the over exceeds the minimum, then the trustee must reissue distribution statements to beneficiaries.

Removal of double taxation

To remove the double taxation which can arise where the taxable income of a MIT differs from the amount distributed to beneficiaries (in particular to remove some of the current issues with the taxation treatment of ‘tax deferred distributions’) it is proposed that the CGT cost base/reduced cost base of a beneficiary’s units be adjusted as follows:

(a) where taxable income is attributed to a beneficiary, then the cost base of the beneficiary’s units will be increased by the amount attributed (adjusted upwards for certain CGT amounts that are currently disregarded under CGT event E4 and downwards to reflect the value of certain tax offsets, for example, the franking credit gross up); and

 

(b) where distributions are received, the cost base will be reduced by the amount of the distribution.

MITs will be required to supply beneficiaries with yearly statements of these adjustments.

Passive income / Division 6C

In relation to the passive income requirements the Government has decided to retain the existing definitions of passive income and declined to accept, at this time, the recommendation that a MIT will be treated as carrying on an eligible investment business if at least 90 per cent of its gross revenue is income from passive investments. The Government will further examine the benefits of the recommendation, relative to its costs to revenue.

Income flow through

Consistent with the policy that the tax treatment for trust beneficiaries who derive income from the trust should largely replicate the tax treatment for taxpayers as if they had derived the income the Board recommended that to provide clarity and certainty the principle of character and source flow-through be set out in the legislation. The Government has agreed in the context of developing a new MIT taxation regime, to set out in the legislation the degree to which character and source of income or gains of the MIT flow through to MIT investors.