MIT reforms a new tax system for property funds

On 9 April 2015, the Government released the long awaited Managed Investment Trusts (MIT) reform exposure draft legislation

2015-04-09

This draft legislation is entitled “Tax Laws Amendment (A New Tax System for Managed Investment Trusts) Bill 2015” (the “ED”).

Broadly, the ED introduces a number of highly anticipated major changes to the tax system for which are expected to come into effect from as early as 1 July 2015. The proposed changes are in addition to the existing MIT measures which include the capital account election and the Fund Payment withholding tax regime. 

The ED introduces the concept of an Attribution Managed Investment Trust (AMIT). If a MIT qualifies to be an AMIT, it will be eligible for the new tax system.

The features of the new tax system for AMITs consist of:

  • Fixed trust treatment
  • Attribution model
  • Unders and overs regime
  • Cost base adjustments

There are also a number of other significant inclusions in the ED, which include

  • debt-like treatment for certain MIT interest;
  • permitting MITs with multiple classes to treat each class as a separate trust;
  • a non-arm’s length income integrity measure;
  • ensuring tax deferred distributions cannot be assessed as ordinary income.

This article will briefly discuss the features of the new tax system, including the changes outlined in the ED and how this will impact AMITs.

Update and recent history

The existing MIT regime is a concessional withholding tax regime that is primarily used by Australian Real Estate Investment Trusts (AREITs) and managed funds.  A key benefit of the MIT regime is the rate of withholding tax on distributions of income and capital which can be as low as 15%.

Since the introduction of the MIT regime there have been some major changes to the MIT withholding rules for payments to non-residents, deemed capital account election and revisions to the MIT definition. However, this latest development is likely to be the most significant tax reforms impacting the AREIT and funds management industry to date.

Why change?

MITs are currently subject to the same generic tax rules that apply to all trust estates.  These rules are relatively archaic having been drafted in a time before the use of trusts as a collective investment vehicle.  As a result, it can be extremely complex to apply these provisions to an MIT and will often create a level of uncertainty which is unacceptable for a growing industry.  The proposed new tax measures addresses the recommendations made back in 2009 and intends to improve the current taxation regime for MITs by increasing certainty, allowing greater flexibility and reducing compliance costs.

Change to the definition of an MIT

In addition to the new tax system for AMITs, the ED broadens the circumstances in which a trust qualifies as an MIT.

Specifically, a change is made to extend the start-up period (from 6 to 12 months) during which a trust does not need to meet the widely held and not closely-held requirements to qualify as an MIT. The ED also modifies the “widely held” requirements of an MIT so that an eligible investor in an MIT now includes:

  • A foreign life insurance company under a foreign law; and
  • a wholly owned subsidiary (directly or indirectly) of an entity that is an eligible investor

The amendments to extend the scope of eligible investors for the purpose of widely held requirements apply from 1 July 2014.

Requirements to be an AMIT

The ED clarifies when a trust will qualify as an AMIT.  A trust will be an attribution MIT if:

  • The trust is an MIT; and
  • The members of the trust have ‘clearly defined interest’ in the trust.

Clearly defined interest

The requirement of members having a ‘clearly defined interest’ in the trust is an integrity measure to ensure that there is fair and reasonable attribution of tax consequences of the trust to its members.
Members of a registered MIT will have clearly defined interest in the trust if:

  • Assuming that the trust is an AMIT, the amount attributable to each member can be worked out on a ‘fair and reasonable basis’ in accordance with the constituent documents of the trust; and
  • The rights of each member of the trust to the income and capital of the trust cannot be materially diminished through the exercise of a power or right.

We note that the above criterion is extended if the MIT is not registered under the Corporations Act.
The ED proposes a number of significant changes to the way the tax law operates in relation to a MIT – the main features of these changes are explained below.

Feature 1: Fixed trust treatment

An AMIT will be treated as a fixed trust for all relevant income tax law purposes. That is, a member of an AMIT for an income year is treated as having a vested and indefeasible interest in a share of the income and capital of the AMIT throughout the year. The fixed trust treatment is especially important to provide MITs with certainty regarding their ability to carry forward tax losses and their ability to distribute franking credits to members.

Feature 2: Attribution model

The introduction of the attribution model is one of the biggest reforms to the taxation of MITs. Currently, MITs are taxed under the general trust provision under Division 6 of the Income Tax Assessment Act 1936. Under these provisions, a beneficiary’s taxable income for a year includes a proportionate share of the net income of the trust where the beneficiary is presently entitled to a share of the income of the trust.

The key concepts of the trust provisions (net income, presently entitlement etc.), often causes confusion and high compliance costs in the industry. Under the proposed law, a beneficiary of an AMIT will be taxed under an attribution model which will operate under proposed Division 276 of the Income Tax Assessment Act 1997. Broadly, under the new attribution model, an AMIT will:

  • Determine the overall amounts of particular ‘AMIT characters’ for the trust for an income year; and
  • Attribute amounts with particular AMIT characters to members of the trust with attribution principles for that income year.

AMIT characters

In order to work out how much of an amount of a particular AMIT character flows through to each member for an income year, an AMIT must first determine the ‘trust component’ of each particular ‘AMIT character’. This is done by first, calculating the total of the amounts associated with the various activities of the trust that attract different tax consequences. The total of each amount is referred to as a ‘trust component’ of a particular ‘AMIT character’.

There are four broad categories of AMIT characters:

  • Income AMIT characters – includes items such as discount capital gains, non-discount capital gains, amounts subject to dividend, interest or royalty withholding tax; and ordinary or statutory income from a foreign source.
  • Exempt income AMIT characters
  • Non-assessable non-exempt income AMIT characters
  • Offset AMIT characters – includes items such as franking credits received and foreign income tax paid

Once the various trust components of a particular AMIT character is calculated, a share of the trust component is attributed to each member of the AMIT. The amount attributed to a particular member is based on the member’s clearly defined interest in the AMIT.

As part of the proposed regime AMITs will be required to issue distribution statements, known as AMIT member annual statements (AMMA statements) with the member’s component of the AMIT character no later than 3 months of the end of each income year.

What the attribution model essentially means is that the trustee will be required determine, on a fair and reasonable basis, the components of the income that will be assessed to members.  This is a significant departure from the existing law – which determines the member’s assessable income based on the proportion of the trust income to which a member is ‘presently entitled’. 

Unlike the operation of the existing law, AMIT’s will not be permitted to stream components to different members based on the member’s individual tax profile.  However, the proposed law broadly permits the attribution of different income component to members in three specific circumstances:

  1. net capital gains (from the disposal of AMIT assets) can be streamed to members that are redeeming units;

  2. where an entity becomes a member part way through the year – the attributed amount can be increased or decreased depending on the relative timing of underlying transactions giving rise to economic benefits or detriments;

  3. where an entity becomes a member at a year after an under/ over arises – the adjustment to the income components attributed to that member do not need to take into account the over/ under amount.

Foreign resident members – trustee taxed on foreign resident member’s components

In certain situation a trustee of an MIT is liable to pay income tax on amounts to which a foreign resident beneficiary is presently entitled.  The ED effectively replicates the treatment of the taxation of foreign members of an AMIT. 

Where a foreign member of an AMIT has a taxable member component of an income AMIT character and the component is not covered by a DIR payment or a fund payment, the trustee of the AMIT may be liable to pay income tax.

The ED applies different rates at which the trustee paid tax in relation to foreign members. The rates that apply depend on whether the member is or is not a beneficiary of the taxable member component.

Broadly, if the trustee is liable to pay tax on the taxable member component attributed to a foreign resident, the member may be entitled to a refundable tax offset or a tax deduction.

Feature 3: Unders/overs

Due to the complexity and limited information available at the time that AMITs are required to advise investors of their tax distribution components, AMITs may make errors (unders/overs) in calculating the trust tax distribution components.

Current law requires that if an error is made in calculating the amount of net income, the error should be reconciled in the year to which the error relates. As a result:

  • The trust may be required to reissue distribution statements; and

  • Beneficiaries may need to amend their income tax returns.

In practice, this approach is expensive and time consuming and as a result trustees of MIT’s would rarely reissue distribution statements.  However, the proposed law introduces a statutory mechanism to address the common issue of unders/overs.

Broadly, if an error is made in calculating the trust components a member, the AMIT can:

  • Apply the unders and overs system to attribute the error in the income year that the error is discovered. Essentially, the unders and overs will be carried forward and dealt with in the later income year (usually the next income year in which the error was made) on a character-by-character basis; or

  • Reissue AMMA statements to members to members for the income year to which the variance relates.

The proposed rules allow flexibility for AMITs in how they reconcile their unders/overs.

Uplifts for unders and overs

Where the unders amount in an income year results in a substantial overall shortfall to revenue; the AMIT may need to include an ‘uplift’ factor to the under amount.

An AMIT must uplift income and offset AMIT characters if, in an income year, has a shortfall that exceeds the ‘net error threshold’ for that year.

The ‘net error threshold’ for a year is the greater of:

  • 5% of the total trust components; and

  • 0.4% of the value of net assets in that year.

The amount of each uplift will be the amount of shortfall interest charge payable. Each uplift of an income AMIT character is added to same AMIT character in the next income year.

Similarly, each uplift of an offset AMIT character is subtracted from the trust component of the same offset AMIT character in the next income year.

We note that penalties will be imposed if the shortfall that exceeds the net error threshold is as a result of the intentional or reckless disregard of the law. The penalties are consistent with the administrative penalties when an individual taxpayer intentionally or recklessly disregards the law in relation to their income tax affairs.

Feature 4: Cost base adjustment

Current law requires a reduction of the cost base of an investor’s units where tax deferred income is received (e.g. where the cash received exceeds the taxable component of the distribution). Where the cost base is reduced to nil and further tax deferred distributions are received a taxable capital gain (CGT Event E4) would ordinarily arise for the investor.

However, if the cash received by an investor is less than the taxable component of the distribution there will be no corresponding upward adjustment to the cost base – this is even though the investor will pay tax on an amount which is greater than what was actually received. The proposed law intended to address this unfairness by allowing an upward adjustment to the cost base in certain situations.  

Specifically, under the proposed measures an investor can increase their cost base where the amounts included in their assessable income exceed the amount of cash received. This proposed change will restore fairness to many investors as it addresses potential double tax issues that may arise under CGT Event E4. 

CGT Event E10

The rules to downward adjustments of a cost base will remain the same; however in the event that the cost base is reduced to nil, the ED introduces CGT Event E10. CGT Event E10 happens if:

  • A member of an AMIT holds a CGT asset that is their unit or their interest in the trust; and

  • The cost base of the asset is reduced due to tax deferred distributions; and

  • The asset’s cost base in the year the reduction occurs exceeds the cost base of the asset.

Under CGT Event E10, a capital gain equal to the excess of the cost base reduction is made. Currently, CGT Event E4 occurs every time a tax deferred distribution is received. This change will simply mean that the CGT event E10 occurs instead of E4.  

Other significant changes

There are a number of other significant changes in the ED, in summary these include:

  • Permitting MITs with multiple classes to treat each class as a separate trust - For the purposes of the AMIT rules; the ED also grants the power to treat a trust with different classes of rights as a separate trust per class. The power to treat the classes as a separate trust applies if:

      • The interest in the income and capital of an AMIT are divided into classes; and

      • The rights arising from each of those interest in a particular class are the same as the rights arising from every other of those interest in another class; and

      • Each of those interest in a particular class are distinct from those interest in another class; and

      • The trustee of the AMIT has made a choice (by way of method described below) with the ED that applies to the income year

If a choice is made to treat each class of interests as a separate attribution MIT, each class will effectively be treated as a separate trust with a separate trust property. Importantly, once the choice is made to treat each class as a separate AMIT, the choice cannot be revoked.

  • Debt-like AMIT instruments – The ED clarifies that a ‘debt-like’ AMIT instrument issued  in an AMIT is treated as a debt interest for the purposes of:

      • Working our whether a MIT qualified for an AMIT; and
      • Applying the attribution model.

 The ED clarifies what is a ‘debt-like’ instrument for the purposes of the AMIT provisions which broadly requires the interest having following features:

      •  Any distribution relating to the interest is fixed;
      • The interest ranks above other membership interest in the trust in the event that the AMIT ceases to exist or being wound up. 

      • If, in a particular period, the AMIT does not make a distribution relating to the interest then the AMIT is prohibited (via its constituent documents) to make a distribution to any other membership interests.

Under the AMIT rules, any distributions in relation to the debt instrument will be treated as interest for the purposes of interest withholding tax. Further, the interest may be treated as a deduction in working out the trust components of the AMIT.

  • Non-arm’s length income– The trustee of an AMIT may be taxed on amounts related to the AMIT’s non-arm’s length income for an income year.

  • Ensuring tax deferred distributions cannot be assessed as ordinary income – Under the AMIT rules, if a tax deferred distribution is made to a member of an AMIT, the amount of the distribution will not be included in the member’s assessable income. Instead:
      • If the membership interest is held on capital account – the amount of the tax deferred distribution will reduce the cost base of the membership interest;

      • If the membership interest is held on revenue account – the amount of the tax deferred distribution will reduce the cost of the membership interest.

The ED provides statutory confirmation on the treatment of tax deferred distributions to members, which was previously unclear.

What next?

The sweeping nature of these reforms will most likely require modifications to the existing trust tax return that are used by MIT’s.  In this regard, we understand that the Australian Taxation Office is in the process of designing a new form that will accommodate the appropriate disclosures required for an AMITs. The new forms may change your yearly compliance requirements and recommend that you are ready for the new changes.

Treasury has requested comments on the ED which will be required to be submitted by 23 April 2015. ShineWing Australia plans to make a public submission to Treasury regarding the new tax system. If you would like to contribute, please contact us on [email protected].

We highly recommend you be ready for the introduction of the new rules, which could start as early as 1 July 2015, by first familiarising yourself with the changes, your current year end processes and how this may impact your business.