Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello MP)Chapter 4 - Regulation impact statement
Background
4.1 This bill is a further instalment of reforms announced by the Government following the review of international taxation arrangements. Earlier instalments include the New International Tax Arrangements Bill 2003 and the New International Tax Arrangements (Participation Exemption and Other Measures) Bill 2004, both of which are currently before the Parliament.
4.2 This bill also includes a minor amendment to the interest withholding tax exemption provisions, which was not part of the review of international taxation arrangements. Due to its minor nature, a regulation impact statement is not required for this amendment.
Policy objective
4.3 The reforms in this bill will more closely align the tax treatment of foreign residents that invest in Australian fixed trusts (which then invest in assets) on the one hand, and the treatment of foreign residents that invest directly in the assets, on the other.
4.4 This is intended to remove tax barriers to foreign residents investing in assets through Australian fixed trusts, such as managed funds. In turn, this should improve the international competitiveness of Australia's managed funds industry, enabling the industry to attract more offshore funds for investment in Australian and foreign assets.
Implementation
4.5 The measures in this bill amend aspects of Australia's tax rules that make it unattractive for foreign residents to invest in Australian fixed trusts that derive foreign source income or invest in assets that do not have the necessary connection with Australia. This is because foreign residents that invest in these trusts are currently taxed on a broader range of income and gains than if they had invested directly in the assets.
4.6 The measures in this bill:
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- exempt from tax foreign resident beneficiaries of Australian fixed trusts that are presently entitled to capital gains from assets that do not have the necessary connection with Australia;
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- amend the deemed source rules in Australia's tax treaties so that foreign source income derived by Australian managed funds, to which foreign resident beneficiaries are presently entitled, is not taken to have an Australian source;
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- disregard capital gains and losses made by foreign residents in respect of interests in Australian fixed trusts where the trust's underlying assets do not have the necessary connection with Australia; and
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- provide an exception to CGT event E4 for distributions of foreign source income to foreign resident beneficiaries of Australian trusts.
4.7 The measures addressed in this regulation impact statement arise directly from the recommendations made by the Board of Taxation as part of the review of international taxation arrangements. The implementation options for these measures can be found in the Board of Taxation's report, International Taxation - A Report to the Treasurer (the Board's Report) and the Treasury's consultation paper, Review of International Taxation Arrangements (Consultation Paper).
4.8 Table 4.1 shows where the measures, and principles underlying them, are discussed in the Board's Report and the Consultation Paper.
| Measure | The Board's Report | Consultation Paper |
|---|---|---|
| Exempt from tax foreign resident beneficiaries in Australian fixed trusts that are presently entitled to capital gains on assets that do not have the necessary connection with Australia. | Recommendation 4.6(1), pages 122 to 129 | Option 4.6, pages 66 to 68 |
| Amend the deemed source rules in Australia's tax treaties so that foreign source income derived by Australian managed funds, to which foreign resident beneficiaries are presently entitled, is not taken to have an Australian source. | Recommendation 4.6(2), pages 122 to 129 | Not applicable |
| Disregard capital gains and losses made by foreign resident beneficiaries in Australian fixed trusts (in respect of an interest in the trust) where the trust's underlying assets do not have the necessary connection with Australia. | Recommendation 4.7, pages 122 to 129 | Option 4.7, pages 66 to 68 |
| Provide an exception to CGT event E4 when foreign resident beneficiaries in Australian trusts receive distributions of income and gains that are attributable to foreign sources. | Recommendation 4.8, pages 122 to 129 | Option 4.8, pages 66 to 68 |
4.9 Where the Board's Report and the Consultation Paper do not address details in this bill, the implementation options are set out in Table 4.2. The table also sets out options endorsed by the Board of Taxation that were not adopted by the Government in this bill.
| Measure | Implementation options |
|---|---|
| Exempt from tax foreign resident beneficiaries in Australian fixed trusts that are presently entitled to capital gains from assets that do not have the necessary connection with Australia. | Managed funds typically achieve exposure to investment markets by investing in wholesale funds which pool these funds with other wholesale investors and invest in real markets. These managed funds may realise gains on their underlying investments by selling their interests in the wholesale funds (as opposed to the wholesale funds selling the real assets and distributing the gains).
To ensure that this measure applies appropriately to this investment structure, the exemption will also apply to capital gains in respect of an interest in a fixed trust where the trust's assets do not have the necessary connection with Australia. |
| Amend the deemed source rules in Australia's tax treaties so that foreign source income derived by Australian managed funds, to which foreign resident beneficiaries are presently entitled, is not taken to have an Australian source. | The Board of Taxation recommended that this measure be implemented by amending the law so that foreign resident investors in Australian managed funds are not taken to be carrying on a business in Australia. However, this option was not pursued as there are circumstances in which foreign resident investors in Australian managed funds are carrying on a business by holding units in the managed fund.
Instead, the measure will be implemented by amending the law to ensure that foreign source income derived by Australian managed funds, to which foreign resident beneficiaries are presently entitled, is not deemed to have an Australian source. This will achieve the purpose of the measure (i.e. conduit treatment for foreign resident investors in managed funds) without the unintended effects of deeming all investors in a managed fund not to be carrying on a business. |
| Disregard capital gains and losses made by foreign resident beneficiaries in an Australian fixed trust (in respect of an interest in the trust) where the trust's underlying assets do not have the necessary connection with Australia. | This measure was initially to apply only to 'managed funds', but it will now potentially apply to foreign resident beneficiaries in all fixed trusts. This change is due to:
Also, the measure was initially to disregard capital gains and losses from disposals of interests in managed funds. This has been extended to cover capital gains and losses from all CGT events. This will ensure that the measure is simple to apply, and also that it has integrity because it cannot be avoided where a foreign resident beneficiary has a capital loss. |
Assessment of impacts
4.10 The potential compliance, administrative and economic impacts of the measures in this bill have been carefully considered, by the Board of Taxation and the Government, in consultation with the business community.
4.11 The measures in this bill will affect foreign resident beneficiaries in Australian fixed trusts, many of which are widely held managed funds. The legal duties of trustees to their beneficiaries, as well as the nature of the funds management industry, mean that trustees and fund managers will also be affected.
4.12 Currently, there are around 2,500 Australian trusts that have one or more non-resident beneficiaries. There is no reliable estimate of how many foreign resident beneficiaries in Australian trusts exist in total. It is expected that the number of foreign resident beneficiaries in Australian trusts will grow once the measures in this bill are operative.
Exempt from tax foreign resident beneficiaries in Australian fixed trusts that are presently entitled to capital gains from assets that do not have the necessary connection with Australia
4.13 This measure will create for fixed trusts a new category of capital gain, and is expected to impose some additional compliance costs on trustees (and fund managers). These additional compliance costs may include making changes to computer systems - to track and classify the new category of capital gain - and modifying distribution statements provided to investors.
4.14 Although the tracking/classifying obligation is an ongoing one, it is not expected to have a significant impact on fund managers' compliance costs. For example, the Investment and Financial Services Association (IFSA), the peak industry body representing fund managers, said the following in its submission to the Board of Taxation:
"Th[is] option ... can be implemented by fund managers with very little change to existing systems - IFSA members tend to have sophisticated accounting systems, so tracking and classifying the underlying fund assets is a simple exercise."
Amend the deemed source rules in Australia's tax treaties so that foreign source income derived by Australian managed funds, to which foreign resident beneficiaries are presently entitled, is not taken to have an Australian source
4.15 This measure will reduce compliance costs for foreign resident investors in Australian managed funds as they will no longer be subject to Australian tax in respect of the foreign source income of managed funds. The measure will also reduce compliance costs for trustees (and fund managers) as they will no longer be required to withhold tax in respect of the foreign source income.
Disregard capital gains and losses made by foreign resident beneficiaries in Australian fixed trusts (in respect of an interest in the trust) where the trust's underlying assets do not have the necessary connection with Australia
4.16 This measure disregards a capital gain or loss a foreign resident makes in respect of an interest in an Australian fixed trust where the underlying assets of the trust do not have the necessary connection with Australia. This will require trustees (or fund managers) to track the fund's underlying assets. However, as noted above, this is not a complex or costly exercise for most fund managers.
Provide an exception to CGT event E4 when foreign resident beneficiaries in Australian trusts receive distributions of income and gains that are not attributable to foreign sources
4.17 This measure will reduce compliance costs for foreign resident beneficiaries in Australian trusts, in respect of foreign source income, as these taxpayers will no longer be required to undertake cost base reductions and perform other complex calculations required by CGT event E4.
4.18 The Australian Taxation Office (ATO) may incur, as a result of these measures, some initial costs in making changes to its publications and other communication materials and educating its staff about the measures. It may also incur costs in providing advice to taxpayers by public and private rulings. However, none of these costs is likely to be significant.
4.19 The revenue cost of the tax exemption for foreign resident beneficiaries on capital gains from assets that do not have the necessary connection with Australia is insignificant and has been rounded down to nil for each year from 2004-2005 to 2007-2008.
4.20 The nature of the other three measures in this bill is such that a reliable revenue estimate cannot be provided. However, none of these measures is expected to have a discernible effect on revenue.
4.21 The reforms in this bill are aimed at removing tax impediments that discourage foreign residents from investing in Australian trusts, including managed funds. This is expected to make Australia's managed funds industry more internationally competitive, enhancing the ability of Australian funds to attract foreign investment. If, as expected, this results in an increased flow of funds into Australian funds it will increase scale and efficiencies in the Australian managed funds industry. This will put downward pressure on the cost of managed fund services which will benefit all investors in Australian managed funds.
Consultation
4.22 As discussed in paragraph 4.7 , the measures contained in this bill arise directly from the recommendations of the Board of Taxation. Those recommendations were the subject of extensive consultation, which began with the release of the Consultation Paper in August 2002. The Board of Taxation consulted widely with the business community (in relation to the options contained in the Consultation Paper) and presented its recommendations to the Government in February 2003.
4.23 Since it announced its response to the Board of Taxation's recommendations in May 2003, the Government has worked closely with industry representatives, tax practitioners and the ATO to develop the measures contained in this bill. This has involved the establishment of an advisory group constituted by members of industry and professional bodies to assist in designing the legislation. The more technical issues and the details of the measures were referred to a particular sub-group including representatives of the managed fund industry, wider business community and practitioners. In addition, direct discussions with taxpayers affected by these measures were undertaken as necessary.
4.24 The ATO and external representatives have had a substantial input on the CGT measures contained in this bill. During the consultation process, it became clear that it is common practice for fund managers to pool their funds and invest in wholesale trusts, which then invest in real assets. This led to the Government making changes to the design of the exemptions to ensure that this industry structure is adequately accommodated.
Conclusion
4.25 The measures in this bill are a further instalment of reforms to implement the Government's response to the review of international tax arrangements. The measures are consistent with the Government's policy objectives of enhancing the competitiveness of Australian based managed funds and removing barriers to Australia's development as a global financial services centre.
4.26 While the measures in this bill may impose some additional compliance and administration costs, the costs are not significant when compared with the expected benefits provided by the measures.
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