A new taxing regime for Funds

The government has released an Exposure Draft (ED) for the taxation of income of qualifying Managed Investment Trusts (MITs).

Many domestic fund managers will be familiar with the rules that allow qualifying MITs the benefit of the capital account election and a capped 15% withholding on distributions to certain of their non-resident unitholders. The breadth and effect of the proposed changes contained in the ED goes well beyond those in terms of funds management reform.
This new regime for qualifying MITs will resolve many unclear tax positions, codify certain administrative concessions and rectify some anomalous outcomes under the existing trust tax rules.
The changes will generally apply from 1 July 2015. Submissions have been sought by 23 April, so there may be further developments prior to the enactment of legislation.
In their current form, the changes will require Funds to review their trust deeds and distribution processes to ensure compliance with the regime so that the Fund and its unitholders can benefit from the new rules.

Headlines

• A new standalone tax regime for a subset of MITs that meet the definition of an ‘Attribution MIT’ or ‘AMIT’.
• A mechanism that attributes or allocates income of the Fund to its unitholders based on their clearly defined interests under the Fund’s trust deed.
• Codification of the current administrative arrangements for unders/overs with a significant penalty regime if errors give rise to a significant loss to the revenue.
• Cost base adjustment rules that operate upward and downward.
• Unitholders in the AMIT will be deemed to hold a fixed interest in the income and capital of the Fund which makes it easier for the Fund to carry forward tax losses and pass franking credits to unitholders.
• MITs that do not qualify for the regime will continue to be subject to the current (cumbersome and archaic) tax rules for Funds with a risk that current administrative practices allowed by the ATO may cease to apply.

Key aspects

MITs that qualify as ‘AMITs’

• In order for a Fund to be an AMIT:
  • The Fund must be a MIT and
  • The unitholders must have ‘clearly defined rights’ under the constituent documents of the Fund.
• The existing law already sets out the requirements for a Fund to qualify as a MIT, for example it must be ‘widely-held’, but not ‘closely-held’. While the key substantive requirements remain unchanged, the ED has made some changes that will make it easier for a Fund to qualify as a MIT.
• A MIT will only qualify as an AMIT if unitholders have ‘clearly defined interests’ in the Fund. This will be the case if:
  • The amount of taxable income of the Fund attributable to each member can be worked out on a ‘fair and reasonable basis’. Broadly, the trustee needs to treat unitholders in a class equally and fairly and
  • The rights of each unitholder to the income and capital of the Fund cannot be materially diminished through the exercise of a power or right.

Most registered retail Funds should be able to meet these tests. Additional requirements need to be met if the Fund is an unregistered wholesale MIS, many of which will need to amend their trust deeds to be able to participate in the new regime.

• The constituent documents of the Fund, in particular the Trust Deed, will need to be reviewed to assess whether the ‘clearly defined rights’ requirement is met. If not, the Fund will continue to be subject to the existing tax regime that taxes Funds and the unitholders based on the ‘present entitlement’ principle. It is likely that the ATO will no longer accept current administrative practices and concessions (for example, for unders and overs) beyond 30 June 2015.

Benefits of the new rules for AMITs

• Relevantly, the main benefits of the regime are that:
  • The Fund is deemed to be a ‘fixed trust’. This has been an area of ongoing uncertainty and risk for Fund managers and responsible entities. While most Funds are held out as ‘fixed trusts’, very few would meet the ATO’s strict interpretation of the fixed trust provisions. The fixed trust treatment now provides certainty regarding the Fund’s ability to carry forward and deduct tax losses and the ability to pass franking credits to unitholders.
  • The Fund’s different classes of taxable income, offsets and credits will be attributed to unitholders based on their ‘clearly defined interests’. This is a departure from the current ‘present entitlement’ basis under which all Funds operate where the Fund’s income is allocated to unitholders based on their proportionate share of the Fund’s income. Practically, many trust deeds will need to be reviewed to ensure they can accommodate this aspect of the rules.
  • The regime codifies the rule that the character of the income received by the Fund retains that character in the hands of the unitholder. Where the trust deed permits, the distribution of certain types of income can be streamed to different classes of unitholders and retain their character in the hands of the unitholder.
  • There will be a statutory mechanism to address errors in distributions (unders/overs) by increasing or decreasing the distribution to reflect the error in the year that the error is discovered. Currently, most Funds do this anyway (rather than issuing amended distribution statements to unitholders), but until these changes are effected, this practice is not supported by law. If the under-statement of income exceeds a threshold, (5% of total Fund income or 0.4% of the value of net assets in that year), an uplift must be applied in the following year to rectify the error
  • The cost base adjustment rules have been reworked and made fairer with the introduction of CGT event E10 that replaces the current E4 event. An upward adjustment is made to the cost base where taxable income is allocated to unitholders (which the unitholder is required to include in their assessable income). A downward adjustment then arises when distributions are made.
• Other implications for AMITs include:
  • AMITs with multiple classes of units will be able to treat each class as a separate trust
  • A new non-arm’s length income rule that applies where an AMIT derives a higher than arm’s length income under an arrangement with another party that is not an AMIT. The trustee will be liable to pay income tax at the top marginal tax rate on the amount that exceeds the arm’s length amount
  • Changes that ensure that ‘tax deferred’ distributions cannot be taxed as ordinary income, but will reduce the cost or cost base of the membership interest and
  • Where certain types of units are issued with debt-like features, those units will be treated as debt interests for tax purposes, so that returns on those units are treated as interest for tax purposes and liable to withholding tax if paid to non-residents.

Other changes proposed

• Amendments will be made to the ‘public trading trust’ rules in Division 6C so that super funds will no longer to be treated as ‘exempt’ unitholders for the purposes of Division 6C. Currently, if super funds own 20% of a Fund that carries on a trading business, the Fund is taxed as if it is a company.