Division 6C changes and Superannuation

In one of its first moves since entering Government, the Rudd Labour Government has announced a review of the taxation arrangements relating to managed investment schemes.  The objective of the review is to explore options for introducing a specific tax regime for managed investment schemes which will reduce complexity, increase certainty, minimise compliance costs and enhance the international competiveness of Australian managed funds. The review will be conducted by the Board of Taxation and is expected to be completed by the middle of 2009.

As a part of the review, Treasury has released an industry consultation paper “Potential changes to the eligible investment rules for managed funds, including property trusts” (Consultation Paper).  This article briefly discusses the current taxation arrangements applicable to Complying Superannuation Funds under Division 6C of the Income Tax Assessment Act 1936 (ITAA 36), some of the proposed changes raised in the Consultation Paper and its potential impact on the financial services industry.

Current taxation arrangements

Under the current law, a managed investment scheme that is structured as a trust is generally treated as a flow through entity for tax purposes.  Tax flow through entities enjoy a number of important tax advantages, such as the ability to distribute tax deferred income and CGT discounts, and the ability to stream different types of income to different classes of investors.  

However, if a trust is considered to be a “public trading trust” under Division 6C of the ITAA 36 during an income year, it will lose its flow through status and be treated as a company for tax purposes for that income year.

Broadly, a unit trust is a public trading trust if:

• it is a public unit trust for the relevant income year ie if the unit trust’s units are listed on a stock exchange, offered to the public, held by 50 or more persons, or if 20% or more of the beneficial interests in the trust is held by tax exempt entities and/or complying superannuation funds(section 102P of ITAA 36);
  
  
• it is a trading trust in the relevant income year; and
  
  
• it was either a resident unit trust during the relevant income year or a public trading trust in relation to the income year prior to the relevant income year.

A trading trust is a trust whose trustee carries on a trading business or controls, directly or indirectly, the affairs or operations of another person which carries on a trading business. The term trading business is defined as a business which does not consist wholly of an “eligible investment business” (section 102N of ITAA 36).

An “eligible investment business” is defined to include:

• investing in land for the purpose, or primarily for the purpose, of deriving rent; or
  
  
• investing or trading in a number of investments, including:
  
  
  • secured or unsecured loans (including deposits with a bank or other financial institution);
    
    
  • bonds, debentures, stock or other securities;
    
    
  • shares in a company;
    
    
  • units in a unit trust;
    
    
  • futures contracts;
    
    
  • forward contracts;
    
    
  • interest rate swap contracts;
    
    
  • currency swap contracts;
    
    
  • forward exchange rate contracts;
    
    
  • forward interest rate contracts;
    
    
  • life assurance policies;
    
    
  • a right or option in respect of such a loan, security, share, unit, contract or policy; and
    
    
  • any similar financial instruments.

The narrowness of the “eligible investment business” definition creates a number of issues for the funds management industry.

Firstly, there is uncertainty as to what constitutes “rent”.  In situations in which the amount of rent on a property is dependent substantially on the profits of the business occupying the land (ie hotels) or where income is derived from the operation of an active business utilising the land (ie car parks) it is uncertain whether the trust holding the land carries on an “eligible investment business”.

Secondly, the use of the words “investing in land for the purpose of, or primarily for the purpose of deriving rent”, in section 102M, is unclear as to what other gains a trust is allowed to derive from investment in land (eg the extent to which a non-trading trust may carry on property development activities whilst still being consider to be “investing primarily for the purpose of deriving rent”).

Thirdly, the list of financial instruments and securities in section 102M does not fully reflect the wide range of passive investment opportunities currently available in the market place. For example, the list does not include investments made as a limited partner in a limited liability partnership which is a common investment vehicle in international markets, particularly the United States.

Larger managed investment schemes sometimes use stapled structures to avoid the operation of Division 6C. In a typical stapled property investment structure, a unit trust which derives passive income from land will be stapled to a company deriving trading income from land. Investors in the structure receive both units in the trust and shares in the company. Under this arrangement, the unit trust is able to stream passive income without being tainted by the business income derived by the company.

Proposed amendments in the Consultation Paper

The Consultation Paper states that the rationale behind flow through taxation of trusts is to ensure that where the investments of a collective investment vehicle is similar to that of an individual passive investor, the tax treatment ought to be similar to that of an individual investor and not an active business or trading activity.  If  managed investment schemes are able to invest in active businesses, it would have a tax advantage over companies resulting in greater usage of trusts as a structure for trading business and erosion of the corporate tax base.

In light of the comments above, the proposed reforms in the Consultation Paper are intended to clarify current laws on the taxation of managed investment schemes rather than overhaul them.

Safe harbour rule for income from land not attributed to rent
In order to clarify what is meant by investment in land “primarily” for the purposes of deriving rent, the Consultation Paper proposes the introduction of a safe harbour rule for non-rental income derived from land.  Under the proposed safe harbour rule, up to 25 percent of the managed investment scheme’s gross income from investment in land can be non-rental income.  However, a number of qualifications apply:

• it is proposed that rent is to be defined in the legislation to include only passive income from land rather than trading income from conducting businesses on land (ie hotels and car parks);
  
  
• any capital gains from the disposal of investment in land that had been held in each year would be disregarded for the purposes of the safe harbour rule. This would prevent scheme operators abusing the safe harbour during income years in which it derives a large capital gain; and
  
  
• the safe harbour rule will apply to gross income from each individual  investment in land rather than all investments in land by the managed investment scheme as a whole. This prevents scheme operators from utilising excess safe harbour amounts from one investment to cover excess non-rental income derived from another investment.
  
  

Redefinition of rent
As discussed above, the Consultation Paper also proposes to redefine rent to exclude all forms of income derived from operating active trading businesses on real property.

Expanding scope of investment in other financial securities and instruments
The Consultation Paper recognises that the existing list of financial securities and instruments in section 102M does not reflect the wide range of commercially available passive investments.  To address this, the Consultation Paper proposes to expand the list in section 102M to include all financial arrangements which are subject to the taxation of financial arrangements regime (the enabling legislation for which was prorogued as a result of the 2007 elections). 

Stapled structures
It is expected that the Board of Taxation will also consider whether, and on what terms, managed funds should be able to establish themselves as controllers of companies with active business trading activities without the need for stapling.

Impact on industry

The Consultation Paper indicates that any reform would adhere to the underlying policy that managed investment schemes should only receive tax flow through status if they invest in passive investments. Industry should not expect the reform to apply so as to allow managed investment schemes to carry out previously prohibited activities such as property development.

Moreover, the ability of managed investment schemes to derive income from trading businesses is limited under the safe harbour rule. Under the proposed safe harbour rule, each and every investment in land held by the scheme must satisfy the safe harbour rule, otherwise the entire scheme will be taxed as a company under Division 6C. The operation of the safe harbour rule also imposes administrative burdens on scheme operators by requiring annual assessment of the safe harbour amount on a property by property basis.

Given the restrictive nature of the safe harbour rule, larger managed investment schemes may still prefer to use a stapled structure which is not restricted in its ability to derive trading income from investments in property, provided that the income is derived through a company.

Furthermore, whilst the reforms are welcomed by the funds management industry, there are a number of issues with Division 6C which have not been addressed by the Consultation Paper, including:

• the extent to which the definition of “eligible investments” in Division 6C is flexible enough to accommodate commonly used and future passive investments undertaken by managed investment scheme such as limited liability partnership and carbon rights;
  
  
• increased compliance costs arising from continuous monitoring of the eligible and non-eligible investment activities mix conducted by a managed investment scheme; and
  
  
• the extent to which the same trustee can act for both passive trusts and trading trusts, which are independent of each other, without causing the passive trust to become a trading trust under section 102N of the ITAA 36.

Further enquiries