Restructures of infrastructure and stapled property groups could be needed if proposals to change the tax treatment of stapled groups are adopted.
Treasury describes its new consultation paper, "Stapled Structures" (the Paper), as "a holistic examination of the re-characterisation of trading income derived through the use of stapled structures".
This follows the Australian Taxation Office's Taxpayer Alert 2017/1 Re-characterisation of income from trading businesses (TA 2017/1) in January as well as an update to the ATO's 2015 document, "Privatisation and Infrastructure ‒ Australian Federal Tax Framework".
While the Paper is intended to provide a basis for consultation, it is fairly clear that Treasury has as its objective some very significant changes which will impact stakeholders differently. The extent of any impacts will become clearer as the consultation process evolves but already, it seems clear that infrastructure and stapled property groups, foreign investors and lenders will need to review and be in a position to respond to the Paper.
The closing date for submissions on the proposed changes to stapled structures is 20 April 2017.
The Paper appears to be a recognition by Treasury that the changes to the taxation of non-residents over the last seven years has led to potential revenue consequences which cannot be fully solved by using current legislation. In many respects the kinds of structures which are causing concern have evolved out of long-established, and accepted, means of structuring investments into passive and active segments.
Ultimately, it all comes down to the rate of tax. In a climate where major economies are looking to reduce corporate tax rates, any suggestion of an increase in the Managed Investment Trust (MIT) rate of withholding would appear to be politically unpalatable and damaging to Australia's credibility as a sound place to invest. Accordingly, increasing the effective rate of tax through other means is a key political imperative.
Who is potentially affected by the proposed changes to stapled structures?
Infrastructure and stapled property groups
The Paper foreshadows potentially significant changes to the taxation of these groups. Traditional A-REITs which derive third party rent and do not have material cross staple transactions are not of significant concern to Treasury and are expected to retain flow through treatment for third party rental income but even those groups will be affected by the proposals, if enacted (for example the introduction of an A-REIT regime and the potential treatment of stapled groups as being consolidated for tax purposes).
A key concern for foreign investors is to what extent any changes will affect the after tax return for investors enjoying an MIT rate of tax or, even more so, those qualifying for sovereign immunity or a withholding tax exemption (eg foreign pension funds).
The Paper creates additional uncertainty for lenders looking to fund significant projects and transactions by potentially burdening borrower "security groups" with tax liabilities which are currently not being modelled.
If significant restructuring for existing groups is an ultimate outcome, it would seem necessary that some form of concessions will need to be given on associated stamp duty costs.
Why is Treasury looking at stapled structures?
The Paper raises two central concerns:
- the taxation of investment income derived by stapled structures where there is a fragmentation of an integrated business into different entities with the same economic owners. The effect of this is is a re-characterisation of trading income into passive income, and therefore a more favourable tax rate for non-residents on fund distributions from MITs and lower tax rates on the payment of interest and royalties (where there is a Double Tax Agreement in place);
- the taxation of income under these fragmented structures goes beyond the original policy intention of Division 6C and the MIT withholding rules which were designed for structures such as A-REIT staples that derive their income as rentals from third party tenants. In particular, where the same economic owners bear the same economic risks and benefits from the fragmented business, the Government is concerned about the predominant driver of the fragmentation.
What aspects of a stapled structure is the consultation paper targeting?
Treasury considers that the use of stapled structures in a fragmented business can give rise to tax advantages that are not otherwise available if the business was in a company structure. These advantages are outlined below.
Flow through structure
Key feature: The trust holds the property or financial assets and the company derives income through conducting operating activities. The company then makes a payment to the trust for the use of the property or financial asset. The trust distributes income to the investors who are taxed at their marginal tax rates or are subject to a lower final withholding tax rate than had the company paid tax and distributed the after tax return as a franked dividend.
Treasury concerns: The investors are able to earn, indirectly, additional income from operating activities while enjoying a lower tax environment, than had the trust undertaken the operating activities itself. That is, the trust would have been taxed as a company and would not be eligible to be taxed as a flow through structure or would lose MIT status.
Deferred tax distributions
Key feature: During the early stages of an infrastructure project a company may not be able to make cash distributions to its investors due to restrictions on the ability to declare dividends under section 254T of the Corporations Act 2001. A trust is not subject to these restrictions. The investors in the trust can receive cash distributions that are not taxable because of the differences that exist in accounting and tax treatments, such as accelerated depreciation and other timing differences. These distributions reduce the cost base of the units.
- For tax residents the receipt of the distribution may result in a permanent difference. The cost base has been reduced and is factored into the capital gain calculation. However a CGT discount may be available to the tax resident that can result in a permanent difference.
- Depending on the asset held by the trust, the non-resident may not be subject to tax on the capital gain in Australia.
Key features: Regardless of whether a trust or company is used or the type of income generated, a tax resident will be taxed at their marginal tax rate on the distributions received. However a non-resident can qualify for the 15% withholding tax rate on fund distributions from an MIT and access the lower final withholding tax rates on the payment of interest and royalties (if there is a Double Tax Agreement in place).
Treasury concerns: Entities are intentionally fragmenting an integrated business into different entities with the same economic owners in order to re-characterise trading income into passive income with the predominant purpose of enabling non-residents to access the lower final withholding tax rates on MIT fund distributions, interest and royalty payments.
Key feature: Passive income flows structured as a cross-stapled transaction rather than direct offshore transaction.
Treasury concerns: These structures may result in different transfer pricing or thin capitalisation outcomes than if they had been structured directly offshore.
What are the policy options Treasury is considering for stapled structures?
Treasury is considering options to remove the tax advantages associated with the stapled structures so that the tax outcomes are neutral, regardless of whether a stapled structure or company is used to carry out the income earning activities, while maintaining its international competitiveness to attract foreign investment in infrastructure:
- Disallowing deductions for cross-staple payments by companies or Division 6C trusts (including rentals, interest, royalties and synthetic equity payments) to Division 6 trusts;
- Taxing the recipient of such payments at a rate equivalent to the Australian company tax rate; or
- Deeming stapled entities to be consolidated for tax purposes.
Treasury has not yet determined what stapled arrangements will be affected (eg. whether the rules will extend beyond contractual stapled arrangements). If the options extend to apply to other forms of common ownership, then the options to remove the tax advantages would focus on dealings which:
- give rise to interest or royalty income of non-residents;
- facilitate the application of MIT withholding rules; or
- ensure the non-application of Division 6C.
Treasury has indicated that these options will not apply to small businesses or discretionary trust dealings.
Furthermore, the Government is looking into whether there should be a specific regime for A-REITs that are seen to be within the original policy intention of Division 6C and the MIT withholding rules. The commentary here suggests a potentially more generous "trading income" concession for these entities but with significant changes nonetheless.
Other matters Treasury is considering
The Paper also considers:
- whether industry specific concessions should be implemented.
- the impact on tax revenue and investment ‒ the paper overall observes a positive impact on each of these areas though we expect that many stakeholders will vigorously contest some of these assertions.
- grandfathering ‒ the view of Treasury appears to be firmly against grandfathering existing structures due to the competitive distortions which they would introduce to the market (with bolt on acquisitions to legacy structures becoming a dominant form of structuring). The preferred alternative appears to be to introduce transitional arrangements to bring all stapled arrangements under the new laws over an appropriate period of time. The Paper also raises the possibility for tax rollovers and potential State Government stamp duty concessions.
Questions for consultation
A series of questions are raised in the Paper which also provide insight into how Treasury is thinking about approaching solutions to the problems it has identified while also canvassing industry for the potential commercial ramifications of any changes. Key questions ask about:
- the importance of non-tax reasons for using stapled structures;
- specific tax regimes or concession used for infrastructure investments in other countries;
- the importance of tax in determining international competitiveness of Australia;
- the means by which tax advantages of stapled arrangements could be removed;
- the manner in which flow through treatment for A-REITs could be ensured absent the tax advantages of a stapling regime;
- financing arrangements for stapled groups and their terms; and
- grandfathering, transitional arrangements and specific tax relief for restructuring.
What should you do in response to the stapled structures consultation period?
Regardless of the consultation outcome, the property and infrastructure industries will be concerned at the focus on long-established structures which have been the subject of extensive advice and, in many cases, tax rulings.
It will be difficult for industry participants to explain the current position to foreign investors and lenders and the concern will be whether this reduces foreign investment and the prices which participants (including government) obtain for these assets.
Existing groups with concerns should engage with their industry associations and advisers now and participate in the consultation process to help shape any changes to the law. It seems fairly clear that there is a strong desire for change within Treasury but the nature and extent of those changes are still contestable.
For new projects and transactions, it is difficult to future-proof any structure without further guidance from Treasury on what form the law changes will take. Accordingly, these participants should also engage with the consultation process and retain a watching brief over developments. Managing investor and financier expectations over this period of uncertainty will be crucial to the viability of any investment strategies.
It is also important for Treasury to understand the indirect impact of any changes to the law ‒ for instance, potential impacts on asset values (as noted above) and changes to the pricing and serviceability of debt if the law changes.
As stated above, the closing date for submissions is 20 April 2017.