Introductory Info

Date introduced: 20 September 2018
House: House of Representatives
Portfolio: Treasury
Commencement: Various dates, as set out in this Digest.

The Bills Digest at a glance

This Digest covers the Treasury Laws Amendment (Making Sure Foreign Investors Pay Their Fair Share of Tax in Australia and Other Measures) Bill 2018 (the Bill), the Income Tax (Managed Investment Trust Withholding Tax) Amendment Bill 2018 (MIT Withholding Bill) and the Income Tax Rates Amendment (Sovereign Entities) Bill 2018 (Sovereign Entities Bill).

The Bill contains five related Schedules.

The main focus of the Bill is to amend the operation of the tax laws so as to limit the ability of foreign investors to convert active business income into more concessionally taxed passive income through the use of stapled structures.[54]

Schedule 1 of the Bill broadly amends the operation of the MIT withholding tax rules so that MIT fund payments to non-residents will attract a non-concessional 30 per cent MIT withholding tax rate to the extent the fund payment is attributable to an amount of:

• MIT CSA income
• MIT trading trust income
• MIT agricultural income or
• MIT residential housing income.

Schedule 1 also contains extensive transitional rules that preserve the concessional withholding tax rates for established projects and arrangements, as well as preserving the concessional tax rate for new and established nationally significant infrastructure projects for up to 15 years.[55]

Schedule 2 of the Bill seeks to improve the integrity of the thin capitalisation rules by modifying the definition of an associate in response to concerns that foreign investors are fragmenting their investments and implementing double gearing arrangements in order to artificially increase the amount of available debt deductions allowed under thin capitalisation rules.[56]

Schedule 3 amends the withholding tax exemption for foreign owned superannuation funds by limiting the withholding tax exemption to circumstances where the superannuation fund:

• receives interest income or dividends
• does not hold a 10 per cent or greater interest in the entity making the payment, and
• is not in a position to influence the decisions, or exert control over, the entity making that payment.[57]

Schedule 4 creates a legislative framework based on an ATO administrative practice that sets out the circumstances in which a sovereign entity will be exempt from income and withholding taxes.[58]

Schedule 5 makes contingent amendments relating to the definition of ‘provide affordable housing’ in the ITAA 1997.[59]

The MIT Withholding Bill makes amendments to the Income Tax (Managed Investment Trust Withholding Tax) Act 2008 to specify that the MIT withholding rate in income attributable to non-concessional MIT income is 30 per cent.[60] These amendments are consequential to the changes made in the Bill.

The Sovereign Entities Bill amends the Income Tax Rates Act 1986 to specify that sovereign entities are liable to income tax on taxable income at a rate of 30 per cent. This is consequential to the changes made in the Bill.

Key Issues

Although the Bill has been generally well supported by stakeholders a number of issues have been raised including:

• A potential drafting issue with the sovereign immunity exemption which may have the effect that certain revenue gains are outside the scope of the exemption, notwithstanding the Explanatory Memorandum expressing an intention for them to be covered.[61]
• The potential for adverse economic impacts as a result of a higher rate of taxation on foreign investors, specifically in relation to infrastructure projects. [62] Concerns were also raised about adverse impacts on the level of foreign investment into the agricultural, build to rent and student accommodation sectors. [63]
• Concerns there may be a concentrated sell-off of agricultural assets just before the transitional rules cease to operate and that this may cause a decrease in the value of agricultural assets, resulting in adverse and unintended consequences for Australian farmers.[64]
• A number of stakeholders expressed concerns around which stapled structures have been deemed acceptable and which have not. In particular, there has been significant criticism by some stakeholders around the decision to exclude commercial residential real estate from the definition of non-concessional MIT residential housing but not certain student accommodation or build to rent property developments. [65] Conversely, the Bill has been criticised for not going far enough and completely removing all concessional tax treatment for all stapled structures.[66]

A further issue not raised by stakeholders is that the Bill may not, in its current drafting, give effect to the Government’s stated intention that all trusts that invest in residential housing primarily for the purpose of deriving rent will be eligible to be a MIT.[67]

These issues are discussed in more detail under the headings ‘Position of major interest groups’ and ‘Key issues and provisions’ below.

Purpose of the Bills

The purpose of the Treasury Laws Amendment (Makings Sure Foreign Investors Pay Their Fair Share of Tax in Australia and Other Measures) Bill 2018 (the Bill) is to amend the tax laws to neutralise tax benefits delivered by stapled structures. The Bill does this by:

• ensuring that certain types of active business income are taxed at the top corporate tax rate, instead of being re-characterised as passive income and therefore taxed at concessional rates
• modifying the thin capitalisation rules to limit the incidence of double gearing structures
• limiting the scope of the withholding tax exemption for superannuation funds with foreign residents and
• creating a legislative framework to exempt sovereign entities from income and withholding taxes on passive investment income.[68] Currently, there is no legislative framework, with the exemption provided through ATO administrative practice.[69]

The Income Tax (Managed Investment Trust Withholding Tax) Amendment Bill 2018 (MIT Withholding Bill) makes amendments to the Income Tax (Managed Investment Trust Withholding Tax) Act 2008 to specify that the MIT withholding rate in income attributable to non-concessional MIT income is 30 per cent.

The Income Tax Rates Amendment (Sovereign Entities) Bill 2018 (Sovereign Entities Bill) amends the Income Tax Rates Act 1986 to specify that sovereign entities are liable to income tax on taxable income at a rate of 30 per cent.

Commencement

The Bill commences as follows:

• sections 1 to 3 commence on Royal Assent
• Schedules  1 to 4 commence on the first 1 January, 1 April, 1 July or 1 October to occur after the day of Royal Assent
• Schedule 5, Part 1 commences on the first 1 January, 1 April, 1 July or 1 October to occur after the day of Royal Assent provided Schedule 3 to the Treasury Laws Amendment (Reducing Pressure on Housing Affordability Measures No. 2) Bill 2018 has commenced on or before that time[70] and
• Schedule 5, Part 2 commences immediately after the commencement of Schedule 3 to the Treasury Laws Amendment (Reducing Pressure on Housing Affordability Measures No. 2) Bill 2018 provided that Bill hasn’t commenced before Schedules 1 to 4 commence.[71]

The MIT Withholding Bill commences at the same time as Schedule 1 to the Bill.

Sections 1 to 3 of the Sovereign Entities Bill commence on Royal Assent. Schedule 1 to the Sovereign Entities Bill commences at the same time as Schedule 4 to the Bill.

Structure of the Bills

The Bill consists of five related Schedules.

• Schedule 1 makes a number of amendments to ensure that trading income from infrastructure assets, agricultural land and residential housing (other than affordable housing) is subject to a 30 per cent withholding tax rate. Schedule 1 also:
  • contains transitional rules that preserve the concessional MIT withholding tax rate for established projects and
  • seeks to encourage nationally significant infrastructure projects by providing the Treasurer discretion to allow infrastructure staples to access the concessional MIT withholding tax rate for a period of up to 15 years.
• Schedule 2 amends the thin capitalisation rules to prevent foreign investors using ‘double gearing’ arrangements to artificially increase the amount of their allowable debt deduction under the thin capitalisation rules.[72]
• Schedule 3 limits the situations in which a superannuation fund with foreign resident members can claim an exemption from withholding taxes on dividends and interest payments to situations where the superannuation fund does not hold a 10 per cent or greater interest in the entity making the payment and is not in a position where it can influence the entity making that payment.  
• Schedule 4 introduces new rules outlining in what situations a sovereign entity will be exempt from income tax and withholding taxes.
• Schedule 5 makes contingent amendments relating to the definition of ‘provide affordable housing’ in the ITAA 1997.

The MIT Withholding Bill and the Sovereign Entities Bill each contain one Schedule.

Background

What is a stapled structure?

Broadly, a stapled structure is a specific type of arrangement where two or more entities that are commonly owned are legally bound together so as they cannot be separately bought or sold.[73] Although the stapled entities are separate legal entities they will generally be regarded as a single integrated business for commercial purposes.[74] Most commonly a stapled structure will consist of:

• a trust (which holds the relevant assets, the ‘asset entity’) and
• a company undertaking the businesses operating activities (the ‘operating entity’).

In a typical stapled structure, the asset entity will lease the asset(s) to the operating entity and may also provide financing – the asset entity will include the lease and interest payments in their assessable income, and the operating entity will claim a tax deduction for those payments, as per the diagram below:

Figure 1: simple stapled structure

Source: Explanatory Memorandum, Treasury Laws Amendment (Making Sure Foreign Investors Pay Their Fair Share of Tax in Australia and Other Measures) Bill 2018, p. 15.

Given the existence of a concessional MIT withholding tax rate, and a 10 per cent interest withholding rate, this can create incentives to implement structures and arrangements to maximise the amount of tax deductions claimed by the operating entity (usually a company taxed at 30 per cent) where the MIT has non-resident members, or the project is heavily reliant on foreign capital. As such, stapled structures are particularly attractive to foreign investors as they provide access to a lower tax rate (15 per cent) as well as a number of commercial advantages (discussed below).

The Australian Treasury (Treasury) has commented that with the exception of a few listed staples in Singapore and Hong Kong, the use of stapled structures outside Australia is uncommon.[75] However, Treasury notes that many comparable jurisdictions provide some form of concessionary income taxation treatment for investment in real property.[76]

How common are stapled structures and why is their use growing?

According to Treasury, as at December 2016, staples accounted for approximately $199 billion or 10 per cent of Australian Stock Exchange (ASX) market capitalisation – this was up from around $149 billion two years earlier.[77]

The Treasury also notes that recently the privatisation of state and territory assets has grown significantly. In 2015-16 almost $60 billion in assets by value were privatised compared to $20 billion in 2014-15.[78] Further, in recent years there has also been an increase in the use of staples in land based industries outside of traditional property and infrastructure,[79] such as:

• student accommodation
• hotels
• aged care facilities
• renewable energy facilities and
• agricultural land.[80]

The ATO estimates the value of stapled assets in these sectors is approximately $5 billion.[81]

Stapled structures first emerged in Australia in the 1980’s and became the choice of investment vehicle for privatised assets in the 1990’s.[82] The popularity of stapled structures is largely due to a 15 per cent concessional MIT withholding tax rate that applies to MIT fund payments made to foreign investors. The ATO has noted that the concessional MIT withholding tax rate coupled with the sovereign immunity exemption and the 10 per cent interest withholding tax rate can enable foreign taxpayers to obtain much more favourable tax outcomes from implementing stapled structures compared to non-stapled structures,[83](compared to, for example, directly owning shares in an Australian resident company that owned the assets and conducted the business operation, where under this arrangement the company and its shareholders would not ordinarily be entitled to the tax concessions available to business conducted through a stapled structure).

What are some of the commercial advantages of stapled structures?

In addition to tax advantages, there are also a number of commonly cited commercial advantages associated with stapled structures, including:[84]

• providing investors the ability to recoup their capital and realise cash returns in the early years of an investment while the project is not yet profitable.[85] This is particularly attractive to foreign pension funds that require long-term, inflation-linked cash flows to meet their pension liabilities. As such, stapled infrastructure assets can make it easier to attract investment for infrastructure from other countries[86]
• stapled businesses may attract a lower cost of capital and may have increased levels of investment by lowering the overall tax burden of investors and potentially making it easier to attract greater third party finance (as finance for trust assets may be determined on a pre-tax basis)[87]
• investors may value stapled securities more highly than a similar unstapled structure due to less restrictions on cash flow distributions[88]
• proving security price benefits from a higher market capitalisation[89] and
• preventing the trapping of franking credits.[90]

How is a stapled structure taxed?

Each stapled entity is treated as a separate taxable entity and must calculate its taxable income separately. Therefore, a company will be taxed at the corporate tax rate on its profits and the beneficiaries or unit holders of stapled trusts will be taxed at their marginal tax rate on any trust distributions they receive.

Where a stapled entity is a MIT, the tax outcomes for domestic and foreign investors will differ.

Australian residents

Generally, an Australian resident will include any MIT income they receive or are attributed in their assessable income.[91] This means that an Australian resident superannuation fund will generally be taxed at 15 per cent on MIT fund payments, a company at the relevant company tax rate, and an individual at their marginal tax rate.

Non-residents

The rate of tax imposed on non-residents will depend on whether they are resident in an information exchange country. Where the recipient of MIT income is resident of an information exchange country, the following withholding tax rates apply:[92]

• dividend, interest and royalty payments from the MIT will be subject to the withholding tax rates specified in the relevant DTA[93] and
• MIT fund payments will be subject to a 15 per cent MIT withholding tax.

Where the recipient is resident of a country that is not an information exchange country, the following withholding tax rates apply:

• payments of dividends and royalties will be subject to a 30 per cent withholding tax rate and interest payments a 10 per cent withholding rate[94] and
• MIT fund payments will be subject to a 30 per cent MIT withholding tax.[95]

What tax risks are associated with stapled structures?

Currently stapled structures provide foreign investors the ability to access a concessional 15 per cent MIT withholding tax rate. As explained in a joint press release by then Treasurer Wayne Swan and then Assistant Treasurer Chris Bowen, this concessional rate formed part of a plan to attract greater foreign investment, increase the competitiveness of Australia’s managed funds industry and make Australia the financial services hub of Asia.[96] 

However, as noted by the Treasury and the ATO there has been an increasing incidence of integrated stapled businesses reducing their tax liability by fragmenting their activities and assets with a view to re-characterising trading income into more favourable taxed passive income.[97] The integrity issues arising from stapled structures were summarised by the Treasury as follows:

As a result of the MIT regime, foreign investors in stapled businesses were no longer effectively subject to tax at the corporate tax rate. If the trust side of the staple was a MIT, tax was generally withheld on rental income at 15 per cent.

For traditional staples in the commercial and retail property sectors that earned rental income, the introduction of the MIT regime did not raise significant integrity issues. The trust side of traditional property staples generally held portfolios of property assets that derived passive rental income from independent third party tenants. A lower tax rate on this income was an intended outcome of the MIT regime. Trading activities (for example, commercial and retail property development) were undertaken by the company side of the staple, which continued to pay corporate tax. There was no conversion of active income into passive income.

Over time, the tax rate differential encouraged an increase in the use of stapled structures to convert active business income into passive rental income. For example, a single business would be split between a MIT and an operating company. The land assets necessary for use in the business would be held in a MIT but leased to an operating company. The taxable income of the operating company would be reduced by rental payments to the MIT. The rental payments would obtain access to the 15 per cent MIT withholding tax rate when distributed to foreign investors. In this way, the active income of a trading business was converted into concessionally taxed rental income.

Increasingly, businesses in a broad range of sectors are seeking to access the MIT concession by using stapled structures. In some cases, these arrangements have no clear commercial justification and appear to be solely a tax driven strategy to reduce effective tax rates for foreign investors.[98] (emphasis added)

On 31 January 2017, the ATO released a Taxpayer Alert, TA 2017/1 Re-characterisation of Income from Trading Businesses, outlining its concerns that some taxpayers were implementing stapled structures so as to convert or re-characterise active income into more favourably taxed passive income and achieve more favourable tax outcomes than under transfer pricing or thin capitalisation rules.[99] Following the ATO’s release of Taxpayer Alert 2017/1 on 31 January 2017, the Treasury commenced a consultation process regarding stapled structures, as detailed below.

Background and context of the Bill: increasing uncertainty around acceptable use of stapled structures

Following the release of TA 2017/1 Re-characterisation of Income from Trading Businesses by the ATO, the Treasury released a consultation paper titled, ‘Stapled Structures’ on 25 March 2017. [100]

This consultation paper sought to ‘undertake a holistic examination of the re-characterisation of trading income derived through the use of stapled structures’.[101] Consultation ran from 25 March 2017 to 20 April 2017 and submissions were received from over 50 stakeholders.[102]

A common theme raised during consultation was the increasing uncertainty that existed for investors.

AMP Capital

There is currently uncertainty in the infrastructure sector around which assets the ATO considers are capable of being held in stapled structures and we would welcome legislative reform to increase certainty in this area... and we would welcome this being addressed through the consultation process.[103]

Chartered Accountants Australia and New Zealand

The release of the Consultation Paper follows closely on the heels of the ATO’s Taxpayer Alert TA 2017/1 Re-characterisation of income from trading businesses and the draft Privatisation and Infrastructure – Australian Federal Tax Framework and the uncertainty created for stapled structures, including in relation to real estate and infrastructure, which are heavy users of such structures.[104]

KPMG

Overall, the Taxpayer Alert and Consultation Paper has created considerable uncertainty surrounding the tax outcomes for infrastructure investments. Whilst investors in these assets would like clarification as to the policy settings of the Australian Federal Government in respect of infrastructure assets going forward, such investors also are concerned that a ‘knee jerk’ policy response may give rise to on-going difficulties.[105]

Infrastructure Partnerships Australia

Following the issue of the Australian Tax Office’s (ATO) Taxpayer Alert 2017/1 (“Taxpayer Alert”), the ATO Privatisation and Infrastructure Tax Framework, and the Treasury Consultation Paper on Stapled Structures on 24 March 2017, the infrastructure community (investors, developers, construction companies, advisers and other participants) are uncertain and there is resulting confusion as to which infrastructure assets will in the future be acceptable in stapled structures.[106]

Another theme raised was the potential impact that Taxpayer Alert 2017/1 and the Consultation paper could have on existing projects. For example, Infrastructure Partnerships Australia specifically identified in its submission that the timing of the consultation paper had been unhelpful and caused material uncertainty for a range of recent, current and proposed transactions, including the lease of Endeavour Energy (NSW) and the then forthcoming sale of the ‘WestConnex’ business.[107] Likewise AMP Capital expressed the view that the ATO’s concerns with stapled structures created a level of uncertainty to users of stapled structures and potential FIRB applications.[108]

Government response

On 2 May 2017, the then Treasurer, Scott Morrison issued a media release stating:

Recognising the economic significance of stapled structures in the Australian economy and that this is a complex and sensitive issue, the Government will not be responding to the issue in the Budget. This will allow more time to formulate relevant options that minimise unintended consequences. In this regard, the timeline for the review will be extended to the end of July.[109]

On 27 March 2018, the Treasurer subsequently announced, ‘a package of measures to address the sustainability and tax integrity risks posed by stapled structures and limit the broader concessions for foreign investors’.[110] On 17 May 2018, the first stage of exposure draft legislation was released.

The 2018-19 Budget, released on 8 May 2018, included a measure titled, ‘Stapled structures – tightening concessions for foreign investors’.[111] Following the Budget announcement, Treasury released a further consultation paper on 28 June 2018,[112] with a second stage of exposure draft legislation released on 26 July 2018.[113]

Committee consideration

Senate Standing Committee for the Selection of Bills

The Senate Standing Committee for the Selection of Bills recommended that the Bills be referred to the Economics Legislation Committee for inquiry.[114]

Senate Standing Committee for the Scrutiny of Bills

The Senate Standing Committee for the Scrutiny of Bills raised concerns about the proposed exclusion of the Administrative Decisions (Judicial Review) Act 1977 (ADJR Act), which would mean certain decisions of the Treasurer could be excluded from merit review under that Act. As such, the Committee sought further information from the Minister.[115] After considering the Minister’s response, the Senate Standing Committee for the Scrutiny of Bills noted:

... the committee notes that while... it may be appropriate to exclude decisions relating to the management of the national economy from judicial review... exemptions of this type will be rare. In this regard, it is not apparent to the committee that exemption decisions relating to economic infrastructure facilities are of the same nature as decisions to issue money out of the [Consolidated Revenue Fund] CRF, such as would justify excluding judicial review under the ADJR Act... Further, given that judicial review under the Judiciary Act 1903 (Judiciary Act) remains available for decisions relating to exemptions for economic infrastructure facilities, it is unclear why it is considered appropriate to exclude such decisions from review under the ADJR Act... The committee also reiterates that the ADJR Act is beneficial legislation that overcomes a number of technical and remedial complications that may arise in applications for judicial review under alternative jurisdictional bases (principally, section 39B of the Judiciary Act), and provides for the right to reasons in some circumstances. The committee considers that, from a scrutiny perspective, exclusions from the ADJR Act should be avoided.[116]

Ultimately the Senate Standing Committee for the Scrutiny of Bills left to the Senate as a whole the ‘appropriateness of excluding decisions relating to exemptions for economic infrastructure facilities from judicial review’ under the ADJR Act.[117]

The Committee had no comment on the other two Bills.[118]

Economics Legislation Committee

The Bill was referred to the Economics Legislation Committee (the Committee) for inquiry, with the Committee releasing its report on 9 November 2018. The inquiry received 16 submissions and held a public hearing in Melbourne on 31 October 2018 with 20 witnesses appearing.[119] The Committee recommended that the Bills be passed. [120] The table below summarises the main issues raised by stakeholders:

Table one: Summary of key issues identified by the Committee

Issue	Summary of issue
‘Build to Rent’ property investment	Some stakeholders were concerned that a 30 per cent MIT withholding tax rate would discourage foreign investment in the build-to-rent sector.[121] Conversely, the Housing Industry Australia were generally opposed to concessional tax treatment of ‘Build to Rent’ property investment to the extent it resulted in market distortions.[122]
Purpose built student accommodation	Stakeholders were concerned that raising the effective tax on foreign investors from 15 per cent to 30 per cent could adversely impact on the student accommodation sector and by extension Australian education export services.[123] On this point, PWC submitted that they did not see a clear rationale for treating student accommodation and commercial residential premises differently.[124]
Agricultural investment	The Financial Services Council and Rural Funds Management both opposed increasing the MIT withholding tax rate for MITs that invest in agricultural assets.[125]
Sovereign immunity	PWC contended that the sovereign immunity provisions needed to be redrafted due to a risk that they could be interpreted in such a way that revenue gains would be taxable to sovereign wealth funds. PWC contended that such an outcome would be inconsistent with the policy intention of the Bill.[126]
Threshold for economic infrastructure facility exemption	The Northern Territory Government raised concerns that the $500m project threshold had the potential to impact smaller jurisdictions where infrastructure projects were valued at below the threshold.[127]
Ongoing use of stapled structures	The Tax Justice Network (TJN) expressed concern that the Bill does not go far enough. TJN questioned the need to maintain cross stapled structures, on the basis that it is not clear that a strong case has been made as to their benefit to the general Australian community. TJN called on the Committee to seek further evidence from the Australian Treasury of the benefits derived from allowing for cross staple structures, against the likely government revenue loss they create. [128]
Technical comments on the legislative drafting	Global Infrastructure Partners raised questions about the drafting of provisions relating to the testing of portfolio interests and the influence test.[129] The Financial Services Council raised technical administrative issues relating to non-agricultural primary production businesses.[130]

Source: Economics Legislation Committee webpage

Some of these issues are discussed in more detail below under the heading ‘Key issues and provisions’. Additional details of the inquiry are available at the Senate Standing Committee on Economics webpage.[131]

Policy position of non-government parties/independents

Australian Labor Party

The Bill appears to be broadly supported by the Australian Labor Party. In the Economics Legislation Committee report on the Bill, the Labor Senators stated that they supported the intent of the Bill and its passage but noted the concerns raised by stakeholders (including transitional arrangements for student accommodation). The Labor Senators also stated that:

• the Government should consider changes that accommodate better transitional arrangements for projects where significant investment and project development work had already been well advanced but had not reached the stage of signing construction contracts at the time the legislation was introduced into the Parliament and
• they were concerned about ‘the lack of cogent policy argument to support successive decisions in relation to concessional taxation arrangements for agricultural MIT investment’ and noted that ‘in the absence of clear arguments for reform, at least some stakeholders have concluded that the rationale lies more in politics than good policy’.[132]

Other political parties

Senator Peter Whish-Wilson moved a motion, on behalf of the Australian Greens, that item 11 of Schedule 1 of the Bill be modified to bring forward the end date for the transitional tax treatment of MIT CSA income from 1 July 2026 to 1 July 2022.[133]

Position of major interest groups

As noted above, over fifty stakeholders or groups made submissions to Treasury in relation to the issue of stapled structures. Overall, stakeholders appear to be generally supportive of the Bill’s intention to prevent stapled structures being used to convert active trading income into passive income. A number of the Treasury submissions were re-submitted to the Committee Inquiry.

However, there were a number of reoccurring themes and concerns raised throughout the consultation processes. These are discussed below.

Potential for adverse economic impact

A re-occurring theme raised during the Treasury consultation process and during the Committee Inquiry was that any change to taxation of stapled structures could have broader adverse economic impacts, particularly in relation to the levels of foreign investment and prices paid to state governments in respect of asset recycling and privatisation schemes.[134] The issue of asset recycling and privatisation schemes was not directly addressed in the Final Committee Report.

Impact on Foreign Direct Investment

Foreign direct investment can be broadly broken into two categories – passive income and active income.

There is no specific definition in the tax law as to what is meant by passive and active foreign investment, although the Controlled Foreign Company (CFC) rules contain provisions that do differentiate between passive and active income.[135] Those rules broadly align with the generally accepted meaning of (and differences between) passive and active foreign investment.

Broadly, passive foreign investment is generally taken to refer to investment activities that do not require the foreign investor to actively participate in the management or day-to-day activities of the business. For example, a foreign investor may invest in a toll road project by acquiring interests in a MIT, or purchasing a non-controlling share of a toll-road business. The MIT distributions and dividend payments will generally be characterised as passive income. Other examples of passive income include, rent, royalties, dividends, annuities, capital gains and amounts derived from the assignment of, for example, copyrights.[136]

In contrast, direct foreign investment generally involves a foreign investor actively engaging in the day-to-day trading and business activities of the entity or asset they have invested in. For example, instead of investing in a toll road project through a MIT, the foreign investor may incorporate a company that builds a toll road, or actively manages the day to day operations of the toll road. Income generated from these activities will therefore generally be characterised as ‘active’ income.

As an importer of foreign capital, foreign investment is important to the Australian economy.[137] As such, a concessional MIT withholding tax rate for foreign investors aims to encourage greater foreign investment in Australia, and in particular enhance the ability of Australian property trusts to attract passive foreign investment.[138]

A number of stakeholders have raised concerns that changing the taxation of stapled structures will reduce Australia’s international competitiveness and ability to attract foreign investment. On this point, AMP Capital stated that:

Any changes have the potential to have a significant impact on existing investments for both domestic and foreign investors and Australia’s attractiveness as an investment destination in respect of potential future investments and investment allocations.[139]

King & Wood Mallesons raised similar concerns stating that:

Changing the taxation treatment of stapled structures could be a disincentive for foreign investment in sectors such as agriculture, tourism, renewables, accommodation as well as infrastructure. These sectors have commonly used stapled structures, and the perceived benefits of increased tax collections need to be carefully balanced against the risk of loss of investment to other countries with more attractive or effective investment regimes.[140]

The RIS acknowledges that there may be lower returns for foreign investors in sectors that currently use stapled structures and that this could potentially affect some marginal projects.[141] This is also recognised in the Explanatory Memorandum, which states that, “[a]lthough tax can have a significant impact on investment decisions, tax is only one of many factors that investors consider in their investment decisions.”[142]

Nonetheless, it appears that one of the rationales for the proposed changes to the taxation of stapled structures is that not all businesses are using staples to re-characterise active business income as lower taxed passive income. As noted by Treasury, this means that there is currently an uneven playing field and this may create distortions in resource allocation decision making:

The tax system should not distort decisions about resource allocation across sectors or between firms within sectors. Some organisations that do not re-characterise income will be at a competitive disadvantage compared to those that do. This means that businesses are not competing on a level playing field...[143]

Asset recycling and privatised infrastructure asset prices

Stakeholders, including Infrastructure Partnerships Australia, King & Wood Mallesons and the Northern Territory Government all made submissions to the Committee Inquiry about the potential adverse impact of proposed changes to the taxation of stapled structures on the sale price of state owned infrastructure. Although the Committee Report did not directly address this issue, this was also a significant issue raised by stakeholders as part of the Treasury consultation process in 2017.  

In particular, AustralianSuper contended that changes to the taxation of stapled structures may result in higher costs of capital for investors, decrease the ability to attract foreign capital and as a result increase the cost of building new infrastructure assets in Australia.[144] Similar concerns were raised by Australian Financial Markets Association, Adani,[145] AMP Capital,[146] the Corporate Tax Association,[147] Foreign Institutional Capital (a joint submission by Allens Linklaters, Deloitte, Ernst and Young, King & Wood Mallesons, KPMG and PWC),[148] the Global Listed Infrastructure Organisation,[149] Perpetual Corporate Trust,[150] Property Council of Australia,[151] and Spark Infrastructure amongst others.

In response to these concerns, the Government has included a number of transitional rules for existing staples, including the 15 year exemption for approved economic infrastructure facility projects. As stated in the RIS:

A key concern raised during consultation was that the proposed changes may negatively affect the viability of new nationally significant infrastructure projects. An exception for approved economic infrastructure facilities would mitigate this potential impact for approved projects. Such an exception would focus on new — not existing — facilities. That is, it would only be available if the infrastructure facility has not yet been constructed or for significant upgrades that are not yet committed to. This would ensure that the exception facilitates the construction of infrastructure to improve the productive capacity of the economy and support economic growth.[152]

The potential for increased asset sell-offs and adverse impacts on Australian farmers

PWC expressed concerns that transitional arrangements, specifically those in the agricultural sector, may lead to an increase in the sale of stapled assets prior to the end of the transitional periods, which could reduce the value of such assets.[153] Specifically, PWC was concerned that this could have an adverse impact on Australian farmers who have loan-to-value covenants in their banking requirements, or who are looking to sell around this time as part of their succession planning.[154]

PWC submitted this issue could be addressed by modifying the transitional arrangements so that foreign investors are taxed on any gain, whether realised or unrealised, in the period up to 30 June 2026 at the current rate of 15 per cent, and then all gains accrued after that date are taxed at 30 per cent.[155] The Treasury disagreed with the need for this amendment, stating to the Committee:

I guess a seven-year period is a lot of time for a business to work out what it wants to do with its investment. Does it want to keep it? Does it want to sell it? When does it do it? When can it do it in a market that creates a smooth transition? On balance, the government thought that there wasn't a compelling case for a special cost based reset in this instance.[156]

Tax competition

Tax competition can be described as using low effective tax rates to attract foreign capital and business activity to a particular jurisdiction (in this case, Australia).[157] However, as noted by the OECD, tax competition can be harmful and lead to a ‘race to the bottom’ with respect to income tax between countries.[158]

Infrastructure Partnerships Australia expressed the view in its submission to the Committee that:

Ultimately, the increase in the MIT tax rate means the tax settings for foreign investors are neither globally competitive nor levelled with Australian superannuation funds (which are subject to a maximum 15 per cent tax rate).[159]

A counterview to this position is contained in the RIS, which states that the ability for foreign investors to access preferential tax outcomes (i.e. less than 15 per cent) may lead to domestic investors being disadvantaged.[160]

Transitional provisions

Although the transitional provisions, including the approved infrastructure facility exemption have generally been well supported by stakeholders,[161] some expressed concerns about the length of the proposed transitional periods. For example, King & Wood Mallesons considered the transitional periods to be insufficient compensation for retrospective changes to the law and that they should be for a longer period of time.[162] Conversely, the Tax Justice Network argued that the 15 year infrastructure exemption was too long, noting that Canada has a five year transition period for their specified investment flow legislation.[163]

The Northern Territory Government also expressed concerns that the $500 million threshold for the infrastructure exemption is too high, and may have an adverse impact on smaller jurisdictions that do not have infrastructure of that scale and therefore could create a bias towards foreign investment in major cities.[164]

A further issue noted in the ALP’s additional comments in the Senate Committee Report was a view amongst some stakeholders that the transitional arrangements only apply where a project had a construction contract signed on or before 20 September 2018 (the date the Bill was introduced into Parliament). Specifically, the additional comments stated that:

Stakeholders raised concerns that while some projects had not reached a later stage of signing a construction contract, significant commitments such as the purchase of land and project development work had been committed under the assumption of a 15 per cent withholding rate.[165]

Selection of ‘acceptable’ and ‘non-acceptable’ staples

While stakeholders generally agreed with the aims of the Bill, a re-occurring issue raised with Treasury and the Committee was around the selection of sectors subject to the 30 per cent non-concessional MIT withholding tax rate.[166]

For example, Rural Funds Management queried the policy decision to tax foreign investment in agriculture assets at 30 per cent but not the office, retail and industrial property sectors, stating:

There appears to be no clear policy objective of specifically targeting foreign investment in the agricultural sector, whilst not targeting foreign investment in other sectors such as the office, retail and industrial property sectors. The proposed changes would place agricultural A-REITs at a clear disadvantage to A-REITs investing in these other sectors. This would be contrary to any policy objective of levelling the playing field and contrary to the tax reform hallmark of achieving equity for all taxpayers.[167]

On this point, Mr David Bryant, Managing Director of Rural Funds Management expressed the following view to the Committee:

I expect that there is an element in the legislation where government is trying to determine who should invest in Australian agriculture and the circumstances under which they do.[168]

Student accommodation was also a contentious topic, with Treasury providing the following explanation to the Committee as to why it was being treated as non-concessional MIT income:

When you add significant services to accommodation, it starts to look an awful lot less like bare rent and more like running a business of accommodation. It's similar to a hotel rather than a bare rent situation. Commercial activities were not supposed to be accessing the concessional rate in the first place. And then the government announced that it was excluding residential accommodation, so you don't get out of the residential accommodation exclusion, in my view, by arguing that it's commercial.[169] (emphasis added)

However, as noted by the Committee, student accommodation providers rejected this argument on the basis that the configuration of the rooms makes it difficult to re-convert these buildings to offer the units and apartments to the residential market. As explained by Mr Jonathan Gliksten of Iglu Pty Ltd:

Firstly, when it comes to purpose-built student accommodation, we have restrictive covenants placed on the title of our buildings that prevent them being used for anything other than student accommodation. Secondly, the construction form of our buildings is so unsuited to residential. We don't have car parking in our buildings. The floor-to-floor heights of our buildings are unsuited to residential. They are much shallower floor heights. The room sizes are quite compact. They're 13½ square metres. So they don't lend themselves to conversion. And they don't have balconies. They would never pass the test set on us by planning authorities for conversion. It would require absolute demolition of our buildings to then redevelop the sites as residential.[170]

Sovereign Immunity

PWC strongly supported the decision to codify the Sovereign Immunity exception, stating that:

The policy intent on sovereign immunity is very sensible, because it is a part of tax systems worldwide to provide immunity for sovereign governments when they are undertaking activities in another country. It is not an immunity that is provided by every government around the world, but it is a fairly consistent position. Australia has provided that immunity for a long time, but the manner in which that immunity has been provided has been through administrative actions taken by the commissioner, and there was a lack of clarity as to the legislative base for what the commissioner was doing.[171]

However, PWC also expressed the view to the Committee that the Sovereign Immunity provisions may not achieve their desired outcome as currently drafted:

The issue the legislation has is that sovereign immunity should really cover three types of activity: investment activity, consular activity and contracting activity. This legislation covers investment activity but it has gaps in the way it covers investment activity. They are readily obvious gaps and should be fixed in the draft of the legislation. This legislation has no provisions at all to deal with contractual activity that one sovereign government might undertake in another country. That oversight also needs to be fixed. So, we have provisions that deal with consular activity, which is an embassy having a bank account, and that has been readily resolved. The investment provisions deal with the flow of income in regard to investments. But they deal only with capital gains in regard to the disposal of investments. Within the tax law there is a series [of] regimes that tax the disposal of investments other than as capital gains. None of those regimes have been specifically excluded, and they should be. A simple example of that is that if a foreign investor invests in a bond and earns interest income, the interest income will be exempt, but if they make a gain on the sale of the bond, the gain on the sale of the bond will be taxed. That is illogical. We should exclude both the flow and the residual amount. Then, in contractual affairs we need to have an exclusion for contractual affairs, otherwise as a country we will simply embarrass ourselves in dealing with foreign jurisdictions.[172] (emphasis added)

When questioned on this issue by the Committee, Treasury disagreed stating that:

They refer to revenue gains and question whether revenue gains can obtain the benefit of sovereign immunity. We believe they do. The [Explanatory Memorandum] EM makes specific reference to revenue gains in a number of paragraphs, confirming that you can get sovereign immunity in respect of revenue gains. So, we don't think a technical amendment is required on that point.[173]

As discussed below, the Explanatory Memorandum appears to make only one reference to this issue, and adopts different language and terminology to that used in the Bill.[174] This may be problematic because, as noted by the High Court in Re Bolton; Ex Parte Douglas Beane:

...the words of a Minister must not be substituted for the text of the law... the function of the Court is to give effect to the will of Parliament as expressed in the law.[175]

Ongoing use of staples

The Tax Justice Network (TJN) stated that the Bill does not go far enough to address the integrity risks caused by stapled structures. In its submission to the Committee, TJN stated that:

The Bills go some way to addressing the abuse of stapled structures to aggressively avoid paying the corporate income tax rate on certain profits.

Further, it is our understanding that there will remain tax advantages to unit holders of trusts in a stapled structure, which may mean that stapled structures will continue to be an attractive vehicle to set up artificial stapled structures for the purposes of avoiding the taxes that would otherwise be paid...

... TJN-Aus would question the need to maintain cross stapled structures, as it is not clear that a strong case has been made as to their benefit to the general Australian community. The Committee should seek concrete evidence from the Australian Treasury of the benefits derived from allowing for cross staple structures, against the likely government revenue loss they create. It is not enough to simply assert that such tax concessions attract foreign investment. It should be possible to back up such a claim with evidence that can be interrogated.[176]

This view was not shared amongst the majority of submissions made to the Committee Inquiry.

Build to Rent property investment

King & Wood Mallesons, PWC, Property Council of Australia, the Financial Services Council and the Housing Industry Association all made submissions to the Committee regarding the taxation of foreign investors in the Build to Rent sector. However, views differed as to whether the concessional MIT withholding tax rate should extend beyond affordable build to rent housing.[177]

On the one hand, the Property Council of Australia submitted that it should, stating:

...we disagree with the decision to impose a 30 per cent withholding tax rate on investment in build-to-rent housing, which is double the rate of other asset classes where that investment is coming from eligible countries. This will inevitably make these investments less attractive for long-term, patient global capital and result in less build-to-rent housing being created than otherwise would be the case.[178]

Conversely, the Housing Industry Association considered that the concessional tax treatment should be limited to affordable build to rent properties:

The government should be mindful that if it intends to distort the housing market by investing resources into ‘Build to Rent’ projects for the provision of ‘for profit’ rental accommodation, then this is acceptance that the goal of home ownership has been lost in Australia...In encouraging Built to Rent schemes in Australia, the government should consider the impact of such schemes on:

• Existing investors in the housing industry, principally individuals, who use investments in housing as a store of wealth.
• The impact on the changing incentives of home tenure away from ownership to long-term rentals on wealth generation.
• The impact of providing financial incentives on the type of dwellings made available.

The government should also be mindful that if it intends to invest resources into incentivising commercial ‘Build to Rent’ for the provision of ‘for profit’ rental accommodation through the provision on incentives such as tax concessions, then this is acceptance that the goal of home ownership has been further eroded in Australia.[179]

Are the Bills the most suitable policy response?

Division 6C of Part III of the ITAA 1936 deals with the taxation of income from certain public trading trusts. In response to the initial Treasury consultation in March 2017, a number of stakeholders questioned whether a better alternative to addressing the problems identified in the Consultation Paper and Taxpayer Alert 2017/1 would be to reform, enhance and modernise Division 6C of the ITAA 1936, to bring stapled structures and MITs into that regime.

A number of stakeholders made submissions supporting this position, including AMP Capital,[180] Charter Hall,[181] the Corporate Tax Association,[182] Deloitte,[183] King & Wood Mallesons,[184] KPMG,[185] Law Council of Australia,[186] Lend Lease,[187] the Property Council of Australia,[188] PWC,[189] and Transurban. On this point the Law Council of Australia stated that:

The [Law Council] Committees submit that if, contrary to the view above, there is a need for the law to be amended to address a policy shift, it should be either that there is a review and reform of certain aspects of Division 6C (being the activities which constitute eligible investment business and the safe harbours) or a tailored avoidance or similar provision addressing only those specific structures that involve highly structured fragmenting of trading businesses, which "go well beyond the original policy intention".[190]

Financial implications

The Explanatory Memorandum relies on the financial impact contained in the 2018–19 Budget Paper No. 2 and states that as a package the Bills will have a gain of $400 million over the forward estimates.[191]

The stated gain to revenue over the forward estimates is as follows:

2018-19	2019-2020	2020-2021	2021-2022
$30.0m	$80.0m	$125.0m	$165.0m

Source: Explanatory Memorandum, pp. 3–5.

Statement of Compatibility with Human Rights

As required under Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011 (Cth), the Government has assessed the Bills’ compatibility with the human rights and freedoms recognised or declared in the international instruments listed in section 3 of that Act. The Government considers that the Bills are compatible.[192]

Parliamentary Joint Committee on Human Rights

The Parliamentary Joint Committee on Human Rights considered that the Bills do not raise any human rights concerns.[193]

Key issues and provisions

Treasury Laws Amendment (Making Sure Foreign Investors Pay Their Fair Share of Tax in Australia and Other Measures) Bill 2018

Schedule 1 – Non-concessional MIT income

Schedule 1 of the Bill comprises of four Parts.

Part 1 – Main amendments

Part 1 makes a number of technical amendments to the ITAA 1997 and Schedule 1 to the TAA 1953 to ensure that certain income earned, derived or received by a stapled MIT is subject to a 30 per cent withholding tax rate, rather than the concessional 15 per cent withholding tax rate. Part 1 of Schedule 1 to the Bill also contains a number of transitional rules for existing stapled structures.

Items 6 and 7 of Schedule 1 amend the MIT withholding tax rates in Schedule 1 to the TAA 1953 by applying a 30 per cent MIT withholding rate to fund payments to the extent they are attributable to non-concessional MIT income. Where the fund payment is not attributable to non-concessional MIT income the following withholding rates apply:

• a general 15 per cent MIT withholding rate and
• a 10 per cent MIT withholding rate where the fund payment is attributable to a clean building MIT.[194]

Non-concessional MIT income is defined in proposed section 12-435 of Schedule 1 to the TAA 1953 (item 11 of Schedule 1 to the Bill) as any of the following:

• MIT CSA income
• MIT trading trust income
• MIT agricultural income and
• MIT residential housing income.

Each of these concepts is explored in more detail below.

What is cross staple arrangement income?

Proposed section 12-437 of Schedule 1 to the TAA 1953 define cross staple arrangement income as:

• an amount of income derived, received or made by a stapled asset entity
• from a cross staple arrangement
• entered into with a stapled operating entity.

Proposed subsections 12-436(2) to (8) of the TAA 1953 define a cross stapled arrangement (CSA) as one where:

• an arrangement is entered into by two or more entities
• the arrangement involves an operating entity and an asset entity and
• one or more other entities have a combined total participation interest of 80 per cent or more in each of the stapled entities.[195]

However, proposed section 12-437 of Schedule 1 to the TAA 1953 excludes various amounts from the definition of CSA income (meaning this amount of income will be treated as concessional MIT income).[196] These are discussed below. Without these exemptions, CSA income will be subject to a 30% MIT withholding tax rate rather than the concessional 15% rate.

Exception: certain rental income

Rental income from a land investment that is derived, received, or made by a stapled entity in relation to a cross staple arrangement from an entity that is not stapled is exempted from the definition of CSA income.[197]

This appears to have the effect of preserving the concessional MIT withholding tax rate for rental income that a stapled operating entity receives from a third party (that is an entity not stapled to the MIT or its related entities) and passes on to the asset entity.[198] The reasons for this are explained in the RIS as follows:

There are circumstances when cross staple payments do not convert trading income. For example, there may be commercial arrangements where the operating entity receives rent from third parties and this is merely ‘passed through’ to the trust. This is most common in the traditional property sector. Requiring these staples to restructure in order for the trust to receive these third party rents would create compliance costs, without raising revenue.[199]

Exception: rental income from approved economic infrastructure

Rent income from a land investment that is:

• attributable to a facility, or improvement to a facility that
• is covered by the approved economic infrastructure exception

is exempted from the definition of CSA income. Proposed subsections 12-439(1) and (2) of Schedule 1 to the TAA 1953 (at item 11 of Schedule 1 to the Bill) state that income will not be CSA income, for a period of up to 15 years, if it is derived or received in respect of an asset that the Treasurer has approved to be classified as an economic infrastructure facility.[200] Proposed subsection 12-439(4) provides that the Treasurer may issue such an approval where the facility or improvement:

• relates to transport, energy, communications or water infrastructure[201]
• the facility is yet to be constructed[202]
• will have an estimated capital expenditure of $500 million or more and
• will significantly enhance the long-term productive capacity of the economy and issuing such an approval is in the national interest.

De minimis exception

Broadly speaking, CSA income satisfies the de minimis exception where:

• for the most recent income year the MIT CSA income of an asset entity does not exceed five per cent of that asset entity’s net income or
• if the asset entity is an AMIT, the MIT CSA income does not exceed five per cent of the AMIT’s total assessable income.[203]

Proposed subsection 12-438(4) of Schedule 1 to the TAA 1953 makes it clear that any net capital gains are to be excluded from the income of an asset entity for the purposes of the de minimis exception.

Exception: certain capital gains

Capital gains referable to the stapled asset entity transferring or selling an asset to the stapled operating entity are exempted from the definition of CSA income.[204] Although the Explanatory Memorandum to the Bill does not explain the reason for exempting these capital gains from the definition of CSA income, it should be noted that the transfer of an asset from an asset entity to an operating entity is unlikely to create opportunities to convert active income into passive income – which the Bill is designed to prevent. In fact, without the exemption, such transfers would be CSA income, resulting in the imposition of a higher tax rate on these capital gains. In turn, that may act as a disincentive to undertake such transfers. This would be an undesirable outcome as the higher MIT withholding tax rate may discourage  the unwinding of stapled arrangements – meaning there may be strong after-tax incentives to not unwind stapled arrangements (particularly where that income is continued to be taxed concessionally).

Transitional rules

Proposed section 12-440 Schedule 1 to the TAA 1953 creates complex transitional rules that have the effect of preserving the concessional MIT withholding tax rate for CSA income in relation to existing stapled arrangements.  Broadly, the application of the transitional rules for MIT CSA income can be broken down into the following categories:

• where an Australian government entity approves the acquisition, creation or lease of a facility and a CSA was entered into in relation to that facility[205] or
• where a non-government entity either owns or enters into a contract to acquire, create or lease a facility and enters into a CSA in relation to that facility.[206]

These are summarised below.

Australian Government agencies

Transitional rules apply where before 27 March 2018 an Australian government agency:

• approved the acquisition, creation or lease of a facility
• publicly announced that decision and
• took steps to implement this decision and either:
  • a CSA was entered into in relation to the facility before 27 March 2018 or
  • it was reasonable on 27 March 2018 to conclude a CSA would be entered into in relation to the facility and
• all the stapled entities to the arrangement already existed before 27 March 2018 and
• before 30 June 2019 (or another time allowed by the Commissioner) each stapled entity elected to apply the transition rules.[207]

Non-government entities

Transitional rules apply where before 27 March 2018 an entity:

• either:
  • owned or was the lessee of a facility or
  • entered into a contract for the acquisition, creation or lease of a facility and
• either:
  • a CSA was entered into in relation to the facility before 27 March 2018 or
  • it was reasonable on 27 March 2018 to conclude a CSA would be entered into in relation to the facility and
• all the stapled entities to the arrangement already existed before 27 March 2018 and
• before 30 June 2019 (or another time allowed by the Commissioner) each stapled entity elected to apply the transition rules.[208]

Date of application and effect

As noted above, the transitional rules relating to MIT CSA income are complex. Readers are referred to pages 32 to 42 of the Explanatory Memorandum, which provides a detailed explanation of the operation of the transitional rules and illustrative examples.

The effect of these transitional rules is that these amounts of income will be able to be taxed concessionally during the transition period. This ensures that foreign investors who invested in infrastructure facilities before the changes to taxation of stapled arrangements were announced will continue to access the tax conditions that existed at the time of making their investment decision for the duration of the transitional period.

What is MIT trading trust income?

Proposed section 12-446 of Schedule 1 to the TAA 1953 (at item 11 of Schedule 1 to the Bill) defines MIT trading trust income as:

• an amount included in the assessable income of a MIT
• that is attributable to an amount received, derived or made
• from another partnership or trust (other than a public trading trust) that the MIT has a participation interest greater than nil in.[209]

MIT trading income specifically excludes amounts that are:

• dividends, interest, or royalties
• capital gains or losses in relation to a CGT asset that is not taxable Australian property
• amounts that are not from an Australian source[210] and
• amounts that are attributable to capital gains made from CGT Events E4 and E10.[211]

This means that those amounts may attract concessional withholding tax rates, instead of the 30 per cent withholding tax rate applied to MIT trading trust income.[212]

Proposed section 12-447 of Schedule 1 to the TAA 1953 creates a transitional rule allowing MIT trading trust income to continue to be concessionally taxed where the amount of MIT trading trust income is derived, received or made by a MIT before 1 July 2026, and the MIT had a participation interest of greater than nil in the other entity immediately before 27 March 2018. Where a MIT acquires new participation interests in the second entity on or after 27 March 2018, the MIT trading trust income transitional rules apply so that a part of the relevant amount is taken not to be MIT trading trust income and will continue to be eligible for the concessional 15 per cent MIT withholding rate for the specified period (the relevant amount able to access the concessional rate is calculated by dividing the pre-27 March 2018 ownership interests by the post-27 March 2018 ownership interests).[213]

What is MIT agricultural income?

Proposed section 12-448 of Schedule 1 to the TAA 1953 defines MIT agricultural income as an amount included in the income of a MIT to the extent that is attributable to an asset that is Australian agricultural land for rent (regardless of whether the MIT directly or indirectly held the Australian agricultural land).[214]

Proposed subsection 12-448(3) of Schedule 1 to the TAA 1953 defines Australian agricultural land for rent as Division 6C land situated in Australia that is used, or could reasonably be used, for carrying on a primary production business and is primarily held for the purposes of deriving or receiving rent.[215] Proposed sub-section 12-448(4) of Schedule 1 to the TAA 1953 clarifies that where an economic infrastructure facility is located on Australian agricultural land they are to be treated separately.

It should also be noted that proposed paragraph 12-448(1)(b) of Schedule 1 to the TAA 1953 clarifies that agricultural MIT income does not include:

• dividends, interest, or royalties and
• capital gains or losses in relation to a CGT asset that is not taxable Australian property and
• amounts that are not from an Australian source.[216]

This means that those amounts may attract concessional withholding tax rates, instead of the 30 per cent withholding tax rate applied to MIT agricultural income.[217]

Proposed section 12-449 of Schedule 1 to the TAA 1953 contains a set of transitional rules that largely mirror proposed section 12-447 of Schedule 1 to the TAA 1953 and preserve the concessional MIT withholding tax rate until 30 June 2026 in respect of MIT agricultural income from assets held, acquired or leased before 27 March 2018.

What is MIT residential housing income?

Proposed section 12-450 of Schedule 1 to the TAA 1953 defines MIT residential housing income as an amount included in the assessable income of a MIT to the extent that is attributable to a residential dwelling asset (regardless of whether that asset is directly held by the MIT). Proposed section 12-452 of Schedule 1 to the TAA 1953 states that a residential dwelling asset is a dwelling that is Australian taxable real property and either a residential premises (other than a commercial residential premises) or premises primarily used to provide accommodation for students (other than in connection with a school).

Proposed sub-section 12-450(3) of Schedule 1 to the TAA 1953 also clarifies that an amount is not MIT residential housing income to the extent it is referrable to the use of a residential dwelling asset to provide affordable housing.  As such, this means that income from commercial residential premises will continue to be taxed at the concessional MIT withholding tax rate; but income from student accommodation and build to rent (to the extent it is not affordable housing) will not.

The Bill also specifically excludes from the definition of MIT residential housing income:

• capital gains in respect of residential dwelling assets used to provide affordable housing where the entity disposing of that asset held it for 3,650 days from 1 July 2017[218] and
• MIT income from dividends, interest, royalties, capital gains or losses in relation to a CGT asset that is not taxable Australian property and amounts that are not from an Australian source.[219] 

This means that those amounts may attract concessional withholding tax rates, instead of the 30 per cent withholding tax rate applied to MIT residential housing income.[220]

Proposed section 12-451 of Schedule 1 to the TAA 1953 contains a set of transitional rules that have the effect preserving the concessional MIT withholding tax rate until 1 October 2027 in respect of MIT residential housing income from residential dwellings held, acquired or leased before 4.30 pm 14 September 2017, and student accommodation held, acquired or leased before 20 September 2018.[221] The operation of the transitional rules is discussed in more detail at paragraphs 1.238 to 1.251 of the Explanatory Memorandum.

Capital Gains Tax – MIT agricultural income and residential housing income

When an investor invests in a MIT, they will have an ownership interest, which amongst other things entitles them to a share of the MIT income. For tax purposes, this interest is referred to as a membership interest. [222] As a MIT membership interest is an asset for capital gains tax purposes,[223] there may be certain events that occur in relation to the interest that result in a capital gain or loss. For example, where an investor sells their membership interest in a MIT for a higher value than they paid to acquire that interest they will have a capital gains event,[224] and be subject to capital gains tax.

Proposed section 12-453 of Schedule 1 to the TAA 1953 contains specific rules dealing with the situation where a capital gain is attributable to a CGT event occurring in respect of a membership interest in a MIT that has MIT agricultural income or residential housing income.

Broadly, proposed sub-section 12-453(2) of Schedule 1 to the TAA 1953 will treat capital gains from the disposal of a membership interest in a MIT, as MIT agricultural or MIT residential dwelling income where:

• more than 50 per cent of the MIT’s asset holdings are taxable Australian real property[225] and
• the MIT also has direct or indirect ownership of one or more assets that are Australian agricultural land for rent or residential dwellings, and
• one of the following conditions is satisfied:
  • the MIT directly or indirectly only held Australian agricultural land for rent
  • the MIT directly or indirectly only held residential dwelling assets
  • the market value of the membership interest attributable to the Australian agricultural land for rent exceeds the market value of the membership interest attributable to  the residential dwelling assets or
  • the market value of the membership interest attributable to the Australian agricultural land is less than the market value of the membership interest attributable to the residential dwelling assets.

Therefore, under proposed sub-section 12-453(2) of Schedule 1 to the TAA 1953 where a capital gain occurs in relation to a membership interest in a MIT that primarily holds agricultural land for rent, or residential dwelling assets, then that capital gain will be deemed to be MIT agricultural income or MIT residential dwelling income and subject to a 30% MIT withholding tax rate.[226]

The effect of this is to ensure consistent taxation outcomes for the sale of a direct or indirect interest in agricultural land for rent or residential dwelling assets (by selling a relevant MIT membership interest) and the direct sale of the agricultural land for rent.[227]

Integrity rules

Proposed sections 12-441 to 12-445 of the Schedule 1 to the TAA 1953 contain two integrity rules designed to prevent entities from manipulating the excepted MIT CSA income rules by:

• capping the amount of excepted MIT CSA rental income to approximately 80% of income earned from a stapled entity for a project[228] - this seeks to prevent entities employing aggressive cross stapled arrangements that defeat the intended operation of the changes to the taxation of stapled structures[229] and
• requiring a stapled entity to first allocate its deductions to amounts of rental income that can access the concessional 15% MIT rate.[230] This will prevent expenses being allocated in a way that defeats the intended operation of the changes to the taxation of stapled structures (for example, by allocating deductions to rental income taxed at non-concessional tax rates, which would have the effect of lowering the entity’s effective tax rate more than if they were allocated to concessionally taxed income first).

These are discussed in more detail below.

Calculating the CSA rent cap

The first integrity rule applies where a MIT derives, receives or makes MIT CSA income that is attributable to rent from land that is eligible for the economic infrastructure exemption (this income is referred to in the Bill as excepted MIT CSA income).[231] Under this proposed rule, the amount of excepted MIT income eligible for the concessional MIT withholding tax rate is limited to the concessional cross staple rent cap amount. This means that any MIT CSA income that exceeds the cap amount will be treated as non-concessional MIT income and subject to a 30 per cent MIT withholding tax rate.[232]

The amount of the cap differs depending on whether there was a lease entered into before 27 March 2018.

• Where a lease was entered into before 27 March 2018, proposed subsections 12-443(1) and (2) of Schedule 1 to the TAA 1953 stipulate that the cap is the amount of rent specified in the lease.
• Where a lease was not entered into before 27 March 2018, proposed section 12-444 of Schedule 1 to the TAA 1953 contains a complex formula to determine the cap amount. The formula can generally be summarised as follows:
  • Step one: calculate a reasonable estimate of the net income of the asset entity, disregarding previous years’ tax losses[233]
  • Step two: calculate a reasonable estimate of the net income of the operating entity, disregarding previous years’ tax losses[234]
  • Step three: add the amounts from steps two and three and multiply by 0.8[235]
  • Step four:  subtract the step one amount from the step three amount and[236]
  • Step five: add the amount of excepted MIT CSA income to the step four amount.[237]

This calculation effectively caps the amount of excepted MIT CSA rental income to approximately 80% of income earned from a stapled entity for a project – meaning any amounts of excepted MIT rental income outside of this cap will be subject to a 30% MIT withholding tax rate. This prevents entities from inflating rental payments in order to increase the amounts of excepted MIT CSA income to take advantage of the concessional 15% MIT withholding tax rate.  

Integrity measure: allocating deductions to concessionally taxed income first

Proposed section 12-445 of Schedule 1 to the TAA 1953 contains a second integrity rule, which requires an asset entity to first allocate deductions against MIT income that is not cross staple arrangement income.[238] The purpose of this rule is to ensure that expenses cannot be first allocated to non-concessional MIT income in an attempt to reduce the amount of MIT withholding tax payable. For example, an asset entity that has deductions of $10 million, and that has $20 million of exempted MIT CSA income and $10 million of MIT CSA income will be prevented from allocating those expenses against the MIT CSA income.

Are MITs eligible to hold build to rent property?

The Explanatory Memorandum to the Bill explains that the Government intends for MITs to be able to invest in residential housing that is held primarily for the purpose of deriving rent.[239] However, as explained in more detail below, it does not appear that the Bill actually gives effect to this intention. The Explanatory Memorandum states:

In the 2017-18 Budget package, the Government announced that MITs would be prevented from investing in residential premises unless they are commercial residential premises or affordable housing.

Following consultation, the announced approach has been refined to adopt an approach that is more consistent with the stapled structures measures that were subsequently developed.

As a result, MITs will be able to invest in residential housing that is held primarily for the purpose of deriving rent. However, distributions that are attributable to investments in residential housing that are not used to provide affordable housing will be non-concessional MIT income that is subject to a final MIT withholding tax at a rate of 30 per cent.[240]

It is important that the Government clarifies this issue, as there was considerable uncertainty about whether a trust holding build to rent property could be eligible to be a MIT. There is significant uncertainty about the eligibility rules for trusts being MITs if investments are made in dwellings that are residential premises. This is because there is a view that investment in residential property is not made for a primary purpose of earning rental income. It is instead for delivering capital gains from increased property values, and therefore not eligible for the MIT tax concessions. [241]

It should be noted that the Exposure Draft Materials for the Treasury Laws Amendment (Reducing Pressure on Housing Affordability No. 2) Bill 2017 and the Income Tax (Managed Investment Trust Withholding) Amendment Bill 2017 (the Affordable Housing Bills 2017) sought to clarify that a MIT can carry on or control an active trading business of providing affordable housing. [242] However, the relevant provisions (discussed below) clarifying this were removed from the two Affordable Housing Bills presented to Parliament[243] in order to ensure that the affordable housing measures were consistent with the stapled structures 2018-19 Budget announcement.[244]

The Exposure Draft Materials for the Affordable Housing Bills sought to clarify that a MIT could hold residential property by modifying paragraph 275-10(3)(b) of the ITAA 1997 and inserting proposed subsection 275-10(4C) of the ITAA 1997 which amongst other things provided a trust could be a managed investment trust where it invested in residential dwelling premises (but not commercial residential purposes).[245] This would have had the effect of explicitly clarifying that a trust that invested in residential housing that was held primarily for the purpose of deriving rent would be eligible to be a MIT. [246]

As noted above, the Bill does not modify section 275-10 of the ITAA 1997. Rather, it inserts proposed section 12-450 of Schedule 1 to the TAA 1953, which defines MIT residential housing income as an amount included in the assessable income of a MIT to the extent that is attributable to a residential dwelling asset (regardless of whether that asset is directly held by the MIT).

Proposed sub-section 12-452 of Schedule 1 to the TAA 1953 states that a residential dwelling asset is a dwelling that is Australian taxable real property and either a residential premises (other than a commercial residential premises) or premises primarily used to provide accommodation for students (other than in connection with a school).

Therefore, the Bill does not actually clarify whether a MIT can hold residential property – meaning that where a trust is carrying on or controlling an active trading business in relation to residential property it may be precluded from being a MIT, regardless of the existence of proposed section 12-450 of Schedule 1 to the TAA 1953. As such, the uncertainty noted in the Exposure Draft Explanatory Material for the Affordable Housing Bills, is likely to continue to exist.[247]

Other amendments

Item 2 of Schedule 1 to the Bill inserts proposed section 25-115 in the ITAA 1997 which broadly allows an operating entity to make an irrevocable election to claim a deduction for amounts paid to a stapled asset entity in respect of rent from land investments where the stapled arrangement was entered into after 27 March 2018 and the rent relates to approved economic infrastructure. Where the arrangement was entered into before 27 March 2018, proposed section 25-120 of the ITAA 1997 creates a transitional rule mirroring proposed section 25-115 of the ITAA 1997.

This effectively allows a stapled asset entity to make an election to preserve, for the duration of the transitional period, the tax treatment that applied at the time they entered into the stapled arrangement. The Explanatory Memorandum does not provide a policy reason for this. However, this may be in response to concerns along the lines of those raised by Infrastructure Partnerships Australia, namely that changes to the taxation of stapled structures (including the deductibility of expenses) may cause material uncertainty for large privatisations and infrastructure projects.[248] For example, an investor may have determined the purchase price with reference to their expected tax liability and if the investor knew that their tax liability would be higher due to changes to the tax law, they may have paid a lower price.

Part 2 of Schedule 1 of the Bill makes a number of consequential amendments to the Dictionary at subsection 995-1(1) of the ITAA 1997 to insert a number of defined terms.

Exclusion of review under the ADJR Act

Part 3 of Schedule 1 of the Bill makes consequential amendments to the Administrative Decisions (Judicial Review) Act 1977  (ADJR Act) and subsection 6(1) of the ITAA 1936. Proposed paragraph (gaaa) of Schedule 1 of the ADJR Act 1997 will exclude any decision made by the Treasurer with respect to whether a facility, or improvement to a facility, is an approved economic infrastructure facility from review under the ADJR Act. It should be noted however, that the Treasurers’ decision will still be subject to judicial review under section 39B of the Judiciary Act 1903.[249]

As noted above, the Senate Standing Committee for the Scrutiny of Bills raised concerns about the proposed exclusion of ADJR Act.[250] In response to these concerns, Stuart Robert (Assistant Treasurer) stated:

The decisions are not suitable for judicial review under the ADJR Act because key factors that must be taken into account when making a decision include whether:

• the facility will significantly enhance the long-term productive capacity of the economy; and
• approving the facility is in the national interest.

Consideration of these factors involves complex questions of government policy that can have broad ranging implications for persons other than those immediately affected by the [sic] For example, when making a decision, the Treasurer must take into account a broad range of factors, including the national interest, the long-term productive capacity of the economy, Australian Government policies (including tax), impacts on the economy and the community.

In addition, the decisions relate to the management of the national economy, which do not directly affect the interests of individuals. In my view, it is appropriate that decisions with high political content in relation to the management of the national economy should not be subjected to merits review or judicial review under the Administrative Decision (Judicial Review) Act 1977 (ADJR Act).

I note that in the Federal Judicial Review in Australia (the Review) by the Administrative Review Council (the Council), the Council considered that excluding decisions by the Finance Minister to issue money out of the Consolidated Revenue Fund from the ADJR Act was justified. This was on the basis that the decisions relate to the management of the national economy, do not directly affect the interests of individuals, and are likely to be most appropriately resolved in the High Court.

It is therefore not appropriate for decisions that have such high political content in relation to the management of the economy to be subject to merits review or judicial review under the ADJR Act. These decisions would likely be more appropriately resolved by the High Court. This is consistent with the principle stated in the Review. [251]

After considering the Minister’s response, the Committee concluded:

... the committee notes that while... it may be appropriate to exclude decisions relating to the management of the national economy from judicial review... exemptions of this type will be rare. In this regard, it is not apparent to the committee that exemption decisions relating to economic infrastructure facilities are of the same nature as decisions to issue money out of the CRF, such as would justify excluding judicial review under the ADJR Act... Further, given that judicial review under the Judiciary Act 1903 (Judiciary Act) remains available for decisions relating to exemptions for economic infrastructure facilities, it is unclear why it is considered appropriate to exclude such decisions from review under the ADJR Act... The committee also reiterates that the ADJR Act is beneficial legislation that overcomes a number of technical and remedial complications that may arise in applications for judicial review under alternative jurisdictional bases (principally, section 39B of the Judiciary Act), and provides for the right to reasons in some circumstances. The committee considers that, from a scrutiny perspective, exclusions from the ADJR Act should be avoided.[252]

Application

Subitem 16(1) of Schedule 1 to the Bill states that the amendments made by Schedule 1 apply to a fund payment made by a MIT if the fund payment is made on or after 1 July 2019 and that payment is made in relation to the 2019-20 income year or a later income year. This means that the new rules relating to the taxation of MIT fund payments that are referable to income from stapled structures (including transitional provisions) will apply to MIT fund payments made after 1 July 2019.

Proposed section 25-115 of the ITAA 1997 (at item 2 of Schedule 1 to the Bill) applies to an amount of rent from land investment derived or received in relation to the 2019-20 income year.[253] Proposed section 25-120 of the ITAA 1997 applies in relation to an amount of rent from land investment that is derived or received on or after 27 March 2018.  This means that from the 2019-20 income year an operating entity that pays an amount to a stapled asset entity in respect of rent from land investments will be able to claim a tax deduction for that payment provided the stapled arrangement was entered into before 27 March 2018. Similarly, from the 2019-20 income year, an operating entity may elect to claim a tax deduction for payments to an asset entity for rent from a land investment (where it is also an approved economic infrastructure asset).

Schedule 2 – Thin capitalisation

Broadly, the thin capitalisation rules apply to foreign controlled Australian entities, Australian entities that operate internationally and foreign entities that operate in Australia that have debt deductions of greater than $2 million in an income year.[254]

The thin capitalisation rules limit the total amount of debt deductions (for example, interest or loan establishment fees) an entity can claim to an amount that does not exceed one of three prescribed legislative ratios. [255] The three ratios are:

• the safe-harbour amount: broadly this allows an entity to claim a debt deduction in respect of an amount of debt, where that debt represents no more than 60 per cent of an entity’s total asset holdings. For example, if an entity holds $300 million of assets and has $200 million of debt, it can only claim a tax deduction for debt deductions against $180 million of debt (meaning 10 per cent of its debt deductions will be disallowed)[256]
• the arm’s length test: this allows an entity to claim debt deductions against an amount of debt that represents the amount that would reasonably be expected to have been the minimum arm’s length capital funding of the Australian business for the year[257] and
• the worldwide gearing limit: this allows an entity to claim debt deductions against an amount of debt that is in line with the gearing ratio of the worldwide group to which the entity belongs.[258]

An important feature of the thin capitalisation rules is that in determining the amount of allowable debt deductions that an entity can claim, the entity must have regard to the financial position of their associated entities. Section 820-905 of the ITAA 1997 defines an associated entity as an entity in which another entity holds an associate interest of 50 per cent or more.

In the context of the safe harbour rule the amount of allowable debt is calculated with reference to not only the assets of the test entity, but also any associate entity debt, equity and non-debt liabilities.[259] The rationale for this is explained as follows in the Explanatory Memorandum to the New Business Tax System (Thin Capitalisation) Act 2001:

Where an entity borrows funds and on-lends those funds to its associate, the same pool of debt could be tested in both entities when in economic terms there is really only one loan transaction. The associate entity debt rule eliminates the debt in the interposed lending entity so that the same pool of debt is not tested twice...

...Where the debt is raised by the joint venturers and on-lent to the joint venture entity in these circumstances, it will be ignored for thin capitalisation purposes in the hands of the joint venturers.[260]

What is the problem and how is it being addressed?

The Explanatory Memorandum to the Bill explains that it is possible for businesses to fragment their interests in an entity in order to get around the 50 per cent associate test. This means that some entities will no longer be treated as associated entities, and as a result an asset can effectively be geared against an amount of debt greater than 60 per cent of the asset’s value but still satisfy the safe harbour debt test.[261] This practice is explained in the Explanatory Memorandum to the Bill as follows:

It is common in some sectors for consortiums to provide funding through a combination of equity and debt. These investors typically have controlling interests of 20 per cent to 40 per cent and therefore fall below the 50 per cent threshold. Consequently, these investors are able to minimise tax through double gearing. [262]

Item 3 of Schedule 2 to the Bill specifically seeks to address this concern by reducing the associated entity threshold for interests in trusts and partnerships from 50 per cent to 10 per cent or more.[263]

Further, the Bill insets proposed paragraphs 820-105(3)(g) and 820-315(3)(g) into the ITAA 1997, so as to safeguard against investors who may attempt to implement similar double gearing structures under the arm’s length debt test. This is achieved by creating a requirement that in determining an arm’s length debt amount, regard must also be had to the debt to equity ratios of any entities in which the test entity has a direct or indirect interest.[264] As noted by the Explanatory Memorandum to the Bill this prevents an asset being double geared because as a result of this amendment:

...the ability of relevant investments of the entity to act as security (or asset backing) to support the entity's debt is determined taking into account the burden of any debt claims the investments already have against their underlying assets (whether held directly or indirectly through further interposed entities). [265]

Application

Item 4 of Schedule 2 to the Bill states that the amendments made by Schedule 2 apply to income years starting on or after 1 July 2018, meaning the amendments will apply retrospectively. This is consistent with the announcement in the 2018-19 Budget, that the thin capitalisation double gearing changes would apply from 1 July 2018.[266]

Schedule 3 – Superannuation funds for foreign residents withholding tax exemption

What is the foreign superannuation funds withholding tax exemption?

Section 128B of the ITAA 1936 imposes withholding tax obligations on an Australian resident making a payment to a non-resident that relates to a royalty, dividends or interest payment.

However, paragraph 128B(3)(jb) of the ITAA 1936 creates a general exemption from withholding tax on interest and dividend payments where:

• the recipient of the payment is a member of a superannuation fund for foreign residents and
• that superannuation fund is exempt from income tax in their country of tax residence.[267]

What is the problem and how is it being addressed?

As noted by the Explanatory Memorandum to the Bill, the absence of withholding tax can create an incentive for foreign superannuation funds to heavily gear their Australian investments with debt.[268] This means the investment entity can reduce their Australian tax liability due to higher interest deductions while little or no tax is paid in respect of the interest payments made by the Australian entity as these payments will generally be exempted from withholding tax and may not be taxed in the foreign jurisdiction. The Explanatory Memorandum to the Bill states that:

Combined with a stapled structure, this exemption can result in these superannuation funds paying little Australian tax on Australian business activities. In addition, the broad exemption from dividend and interest withholding tax puts these superannuation funds in a better financial position than other investors. For example:

• foreign corporate entities typically pay 10 per cent interest withholding tax on interest income; and
• Australian investors pay tax on interest income at their marginal tax rates.[269]

Schedule 3 seeks to reduce this incentive by inserting proposed subsections 128B(3CA) to (CE) in the ITAA 1936. Broadly, the proposed subsections limit the availability of the withholding tax exemption for foreign superannuation funds to situations where the foreign superannuation fund:

• does not hold a 10 per cent or greater interest in the entity making the payment[270] and
• is not in a position where it can influence a person who individually or collectively can make or control decisions of the entity making the payment.[271]

As such, this limits the exemption to situations where the superannuation fund is a passive investor with little control or influence over the investment entity.

Application

The proposed amendment will apply to income that is derived by a foreign superannuation fund on or after 1 July 2019.[272] Where the income relates to an asset acquired by a foreign superannuation fund before 27 March 2018, a seven year transitional rule applies – meaning that the interest and dividend exemption will continue to apply until 30 June 2026, even if the foreign superannuation fund holds more than a 10% interest.[273]

The Explanatory Memorandum to the Bill states the transitional rules:

ensure that there is no immediate adverse impact on superannuation funds for foreign residents for investments held at the time the changes were announced.[274]

Schedule 4 – Sovereign immunity

Schedule 4 of the Bill codifies the ATO’s administrative practice to exempt the income and gains of foreign governments or foreign sovereign wealth funds. Schedule 4 of the Bill creates a legislative framework that is broadly based on the ATO’s administrative practice but has a more limited application. Notably, the Bill limits the application of the sovereign immunity exemption to situations where the sovereign entity is:

• not in receipt of non-concessional MIT income
• has less than a 10% interest in the relevant MIT and
• cannot influence the decision making or control of that MIT.[275]

That is, the sovereign entity is a genuine passive investor. The purpose of codifying the sovereign immunity exemption is to provide greater certainty over its operation as well as limit the ability of sovereign investors to utilise stapled structures in order to re-characterise active business income as passive income as the exemption does not cover non-concessional MIT income.[276]

Why is there a sovereign immunity exemption?

The ATO currently provides an administrative concession to sovereign investors on income from non-commercial investments. This exemption is a longstanding ATO practice.[277] The basis of the sovereign immunity exemption is explained in the Explanatory Memorandum to the Bill as follows:

The exemption is based on the international law doctrine of sovereign immunity (see I Congreso del Partido (1981) 2 All ER 1064). This international law doctrine is unclear in its application and different countries take different approaches to how the immunity is implemented in practice.  

In ATO ID 2002/45, the Commissioner states that:

Certain income derived from within Australia by foreign governments is exempt from Australian tax under the international law doctrine of sovereign immunity. In accordance with that doctrine, Australia accepts that any income derived by a foreign government from the performance of governmental functions within Australia is exempt from Australian tax. An activity undertaken by a foreign Government Agency will generally be accepted as the performance of governmental functions provided that it is functions of government, provided that the agency is owned and controlled by the government and does not engage in commercial activities.

In practice, the Commissioner exempts investment income and gains derived by foreign governments and foreign government agencies from tax where:

• the monies invested are and will remain government monies; and
• the income is derived from a non-commercial activity.[278]

Key provisions

Item 6 of Schedule 4 of the Bill inserts proposed Division 880 – Sovereign entities and activities into the ITAA 1997. A sovereign entity is defined in proposed section 880-15 of the ITAA 1997 as a body politic of a foreign country (or part of a foreign country), a foreign government agency, or a non-resident entity in which a foreign country or foreign government agency holds a 100 per cent participation interest.

Proposed section 880-55 of the ITAA 1997 creates the general rule that a sovereign entity will be liable to pay tax in Australia. The Income Tax Rates Amendment (Sovereign Entities) Bill 2018 makes consequential amendments to the Income Tax Rates Act 1986 to specify that sovereign entities are liable to income tax on taxable income at a rate of 30 per cent.

Proposed subdivision 880-C of the ITAA 1997 then creates the exemptions to that general rule. Broadly, proposed section 880-105 of the ITAA 1997 provides that a sovereign entity will not be taxed on an amount of income where:

• the amount of income is attributable to a membership interest, debt interest or non-share equity interest the sovereign entity holds in another entity (known as the test entity)[279]
• if the amount of income is a fund payment, it is not attributable to non-concessional MIT income[280]
• the test entity is an Australian resident company or MIT[281]
• the sovereign entity is part of a sovereign entity group that holds less than 10 per cent interest in the test entity[282] and
• the sovereign entity group satisfies the influence test – the influence test will not be satisfied where broadly the sovereign group can identify at least one person who individually or collectively can make decisions in respect of the test entity, and that person is accustomed or obliged to act, or might reasonably be expected to act, in accordance with the directions of a member of the sovereign entity group.[283]

Proposed subsection 880-105(3) of the ITAA 1997 ensures that stapled structures are taxed the same for sovereign entities and other foreign investors by clarifying that the sovereign immunity exemption does not apply to a fund payment to the extent that it is attributable to non-concessional MIT income.

Proposed section 880-110 of the ITAA 1997 introduces a rule that only allows covered sovereign entities (CSEs) to claim a deduction for a loss in respect of a membership interest, debt interest or non-share equity interest in an Australian company or MIT.[284]

Three further exemptions are inserted by Schedule 4 including:

• proposed section 880-115 of the ITAA 1997 exempts CSEs from CGT in respect of a membership interest, debt interest or non-share equity interest held in an Australian company or MIT
• proposed section 880-120 of the ITAA 1997 disregards capital losses in respect of such interests and
• proposed subsection 880-205 of the ITAA 1997 creates a tax exemption for income of an entity that arises from its consular functions.

Does the sovereign immunity exemption achieve its purpose?

PWC contends that as a result of the current drafting there is a risk that the sovereign immunity exemption may not apply to exempt revenue gains in respect of membership interests, non-share equity interests or debt interests. PWC’s concern centres around the phrase ‘the amount is a return’ in proposed sub-paragraph 880-105(1)(b) of the ITAA 1997, with PWC submitting that the following words should be inserted at the end of proposed section 880-105 of the ITAA 1997:

for the purposes of this Division, a return includes a gain made on disposal or otherwise on realisation of the asset. [285]

PWC explained its concerns as follows:

The Sovereign Immunity provisions in the Bill provide a CGT exemption for gains made by qualifying foreign government investors on certain Australian ‘membership interests’, ‘non-share equity interest’ and ‘debt interests’. The provisions also treats ‘returns on’ such interests as non-assessable. It appears from the above that the intention is to exempt from Australian tax income from qualifying investments and gains made on realisation of those investments. Notwithstanding this apparent intention, the drafting creates significant uncertainty for foreign government investors on the tax outcomes on gains made on disposing of or otherwise realising their investments where those gains are not taxed under the CGT provisions but would instead be taxed as revenue gains. This is because:

• there are specific tax deeming rules that treat gains on ‘debt instruments’ as being on revenue, rather than capital account; and
• for equity investments, the size and sophistication of these investors and the level of turnover in their investment portfolios is likely to mean those assets are revenue assets.

Given this, the CGT exemption may be somewhat redundant in many cases. Notwithstanding this, it is possible that a revenue gain realised by the investor (say on a disposal) would be non-assessable if the gain is a ‘return on’ the investment. While such an interpretation may be possible, this could be inconsistent with the meaning of that phrase in other part of the existing tax law. For example, there is longstanding precedent under the debt / equity rules contained in Division 974 of the ITAA 1997 which specifically deals with ‘returns on’ debt and equity instruments, which would suggest a ‘return on’ an instrument could be read narrowly to only cover distributions or payments (such as dividends, non-share dividends and interest payments) made by the issuer.[286]

The Committee raised this issue directly with Treasury on 31 October 2018. In response to concerns that there may be a drafting error, Treasury stated:

They refer to revenue gains and question whether revenue gains can obtain the benefit of sovereign immunity. We believe they do. The EM makes specific reference to revenue gains in a number of paragraphs, confirming that you can get sovereign immunity in respect of revenue gains. So, we don't think a technical amendment is required on that point.[287]

The phrase ‘revenue gain’ appears only twice in the Explanatory Memorandum, and only once with reference to proposed subsection 880-105 of the ITAA 1997,[288] with paragraph 4.37 of the Explanatory Memorandum stating:

Broadly, the following amounts derived, received or made by a covered sovereign entity may be [non-assessable non-exempt] NANE income (or disregarded in calculating statutory income)...net capital gains and revenue gains made on the disposal of an interest in the test entity – including gains that pass through a MIT.[289]

Although the Explanatory Memorandum states that revenue gains on the disposal of an interest in the test entity may be NANE, this is broader than the wording contained in proposed subsection 880-105 of the ITAA 1997. This is because proposed paragraph 880-105(1)(b) only exempts the revenue gain where it is a return on an interest, and as noted by PWC, the phrase ‘a return’ may be read more narrowly than the phrase ‘gain on investment’. [290]

Therefore, the amendment proposed by PWC may be appropriate in order to avoid uncertainty.

Transitional rules

Item 7 of Schedule 4 to the Bill creates a number of transitional rules that broadly have the effect of allowing a sovereign entity to seek an ATO private ruling conferring the ATO sovereign immunity exemption where:

• it relates to a return on an investment acquired prior to 27 March 2018
• the ruling application was made on or before 27 March 2018 and
• the ATO issued the ruling prior to 1 July 2026.[291]

Where the above conditions are satisfied the ATO ruling will continue to be effective until the end of the 2025-26 income year.[292]

Application

Proposed Division 880 of the ITAA 1997 will apply to the 2019-20 income year and later years.[293]

Schedule 5 – Contingent amendments relating to definition of provide affordable housing

Schedule 5 makes contingent amendments relating to the definition of ‘provide affordable housing’ in the ITAA 1997.

As discussed above, proposed subsection 12-450(3) of Schedule 1 to the TAA 1953 (at item 11 of Schedule 1 to the Bill) preserves the concessional MIT withholding tax rate for income earned from providing affordable housing. The Treasury Laws Amendment (Reducing Pressure on Housing Affordability Measures No. 2) Bill 2018 contains a set of provisions defining what is meant by affordable housing – however, it has not yet been passed by the Parliament.[294] Therefore, Schedule 5 replicates the relevant parts of that Bill to ensure proposed subsection 12-450(3) of Schedule 1 to the TAA 1953 achieves its purpose, even if the other Bill does not pass Parliament.

The need for these amendments is explained further in paragraphs 1.229 and 1.230 of the Explanatory Memorandum:

Schedule 5 to this Bill contains contingent amendments that apply if the Treasury Laws Amendment (Reducing Pressure on Housing Affordability Measures No. 2) Act 2018 has not commenced at or prior to the commencement of Schedules 1 to 4 to this Bill. This ensures that the provisions in this Schedule apply to identify the meaning of providing affordable housing. [Schedule 5, items 1 to 6]

Schedule 5 includes the same meaning of providing affordable housing as Treasury Laws Amendment (Reducing Pressure on Housing Affordability Measures No. 2) Bill 2018.[295]

Concluding comments

The Bill is a result of a range of consultation processes and appears to have wide in-principle support from most stakeholders. Notwithstanding this, a number of stakeholders have expressed concerns over the decision to not extend concessional MIT withholding tax rates to build to rent properties and student accommodation.

If enacted, it is expected that the reforms are likely to result in increased tax revenue being raised, however the long-term impact on asset privatisations and asset recycling schemes is unclear.

It is also unclear whether further amendments will be made to the sovereign immunity exemption or whether further clarification will be provided as to when a MIT can hold residential property. It is expected that further information on these matters would be welcomed by most stakeholders.