25 May, 2017
New treasury consultation paper proposes the removal of the tax advantages of many stapled arrangements without grandfathering.
Background
While there are several types, the most common stapled structure used in Australia involves a passive asset-owning trust and a related active operating company, whose respective units and shares are stapled together (i.e. the units in the trust and the shares in the operating company cannot be separately traded or otherwise dealt with separately).
Stapled structures became a part of Australia's investment landscape in the late 1980s, largely in response to the introduction in 1985 of Division 6C of Part III of the Income Tax Assessment Act 1936 (ITAA 1936), an anti-avoidance provision concerning the taxation of trusts. In Australia, trusts have traditionally been used as passive investment vehicles for holding and distributing family wealth and generally receive "flow through" taxation treatment, provided that all trust income is distributed to beneficiaries each year.
Division 6C was introduced to counter the perceived growth in the use of trusts as active business vehicles aimed at overcoming the double taxation of company profits under the classical system of company taxation that applied in Australia at that time. Prior to the introduction of dividend imputation in 1987, company profits were taxed once at the company level, and the post-tax profits were then taxed again in full at the shareholder level upon distribution, resulting in full economic double taxation. By carrying on active business activities through a trust rather than a company, only one level of tax was levied on business profits in the hands of the beneficiaries or unit holders.
Broadly, Division 6C applies to tax a "public trading trust" as if it was a company. The introduction of dividend imputation, and the subsequent granting of the right for certain taxpayers (such as individuals and superannuation funds) to claim refunds for unused imputation credits, effectively eliminated the double taxation of company profits inherent in the former classical system and therefore rendered Division 6C largely superfluous. However, this did not prompt the abolition of Division 6C, which is still very much in force today. The continued operation of Division 6C is of most concern to foreign investors who may benefit under the Australian Managed Investment Trust (MIT) regime (see below) if they invest in a trust that retains its "flow through" status and otherwise qualifies under the MIT provisions.
Very broadly, Division 6C will apply to a trust in an income year if the trust is:
- a "public unit trust" (i.e. the units in the trust must be listed or widely held); and
- a "trading trust" (i.e. the business of the trust must not consist wholly of "eligible investment business").
For the purposes of point 2 above, "eligible investment business" is defined to mean investing in land for the purpose, or primarily for the purpose, of deriving rent or investing or trading in certain securities such as secured or unsecured loans, shares and units.
A number of listed stapled structures appeared on the Australian stock exchange in the years soon after the introduction of Division 6C and many more have followed. A typical stapled structure is depicted in the diagram below.
Please click on the image to enlarge.
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Typically, the trust acquires and owns real property and leases it on arm's length terms to the operating company, which carries on the active income-earning business activities. The rent under the lease represents a deductible expense to the operating company and assessable income to the trust. While the operating company is taxed at the company tax rate (currently 30 per cent) on its net profit, the Trust is a "flow through" entity and its beneficiaries may qualify for tax rates that are considerably lower than the corporate tax rate (e.g. if the trust qualifies as a MIT, certain of its foreign resident investors may qualify for a concessionary 15 per cent tax rate on distributions of the trust's net rental income). Flow through status is claimed by the Trust on the basis that it meets the requirement under Division 6C that it must invest in land for the purpose, or primarily for the purpose, of deriving rent.
While stapled structures were for many years used as pooled investment vehicles for commercial property investment (e.g. shopping centres) and infrastructure (e.g. ports, toll-roads, airports) with the ATO's apparent blessing, in recent years a wider range of asset classes and industries (e.g. private infrastructure, agribusiness assets and trading businesses with a significant real property component) have utilised such investment structures.
Tax Alert TA 2017/1
On 31 January 2017, the ATO issued Taxpayer Alert TA 2017/1 (Recharacterisation of income from trading businesses) that signalled its concern with regard to the expanding use of stapled structures for investments outside of the more traditional asset classes. Australian real estate investment trusts deriving all or most of their rental income from unrelated third party tenants and privatisations of land (or land improvement) based businesses were specifically excluded from the Alert.
The ATO indicated that it was concerned about arrangements purporting to fragment integrated trading businesses in a contrived way so as to recharacterise trading income into more favourably taxed passive income. In the ATO's view, such arrangements may erode Australia's corporate tax base, particularly where they are promoted to foreign investors under the managed investment trust (MIT) regime. Typically (but not always), these arrangements use stapled structures.
The ATO also signalled its intention to review the effectiveness of such arrangements under the substantive provisions of the income tax legislation (e.g. Division 6C and the MIT provisions) or the general anti-avoidance provisions (Part IVA of the ITAA 1936).
The ATO intends to engage more closely with taxpayers who propose four categories of arrangements (being finance staples, synthetic equity staples, royalty staples and rental staples) and will subject such taxpayers and their advisers to greater scrutiny. The ATO appears to be particularly concerned where an existing single business is restructured into a rental staple or even where the selected assets and business operations are acquired from a third party and held in such a structure.
Consultation Paper
Hot on the heels of TA 2017/1, the Treasury issued a "Consultation Paper" on 24 March 2017, announcing that the Government is considering measures which remove the tax advantages of stapled arrangements and allow the transition of existing arrangements to the new tax regime within an appropriate time period. The focus of Treasury is not only on contractual stapled arrangements but also potentially on common ownership structural staples.
Some options identified in the Paper for removing these tax advantages are:
- Disallowing certain deductions for cross-staple payments by companies or Division 6C (non "flow-through") trusts (including rentals, interest, royalties and synthetic equity payments) to Division 6 ("flow-through") trusts (potentially treating the income as non-assessable non-exempt for the Division 6 trust);
- Broadly, taxing the recipient of such payments (either the trustee or foreign investors) at the Australian company tax rate; or
- Deeming stapled entities to be consolidated for tax purposes (and therefore taxed at the Australian company tax rate).
Treasury acknowledges that it is consistent with Australia’s tax policy setting for real estate investment trusts (REITs) that derive most of their income as rental from third party tenants to receive "flow-through" taxation treatment. As part of any tax reform of stapled arrangements, the current restrictions around the permitted levels of trading income in trust structures may be loosened so as to ensure Australia’s ability to attract global real estate capital. Currently, Division 6C permits only two per cent of gross income of a publicly listed trust to be non-passive in nature if "flow-through" taxation is to be preserved, which is less concessionary than the equivalent regimes in several comparable jurisdictions such as the USA, Canada and the UK.
Treasury is not inclined to support permanent grandfathering of existing structures as grandfathered structures would be at an advantage when undertaking new investment, assisted by tax advantages not available to new structures.
Instead transitional arrangements could be put in place to bring all stapled arrangements under the new laws over an appropriate period of time (e.g. three to five years), perhaps with some form of restriction on existing structures making new investments during the transitional period.
In the infrastructure space, the Government should tread warily when contemplating either forcing the unwinding of existing arrangements or altering their after-tax yields for investors. Many of these arrangements were established as part of Federal and State privatisation programme where the Government was the direct beneficiary of the increased transaction values they afforded. Depending on the scale of the changes, Australia's reputation as a reliable, predictable and safe international investment location could also be adversely affected.
The Federal Treasurer has announced that the Treasury review of stapled structures will be finalised by the end of July 2017.
Final comments
It now appears inevitable that the Australian income tax legislation will be changed in the near future in a way that will negatively impact many existing and contemplated stapled arrangements (other than qualifying REITs). The proposed changes could affect both traditional asset classes (e.g. property and infrastructure) and the wider range of asset classes that have more recently used such arrangements. Parties currently considering property or infrastructure investments should factor "change of law" risk into their pricing if they are contemplating the use of a stapled arrangement.
Foreign investors who are required to seek upfront approval from FIRB should also expect early engagement with the ATO as it is likely that FIRB will refer such cases to the ATO as part of the approval process. FIRB may also attach tax conditions to the final approval in what they consider to be high-risk cases.
The transition into any new tax regime for existing arrangements will likely be complicated and expensive, potentially involving significant tax and stamp duty costs. Even traditional REITs may need to reorganise in order to benefit from any newly introduced REIT regime, although they may then benefit from increased safe harbours for non-rental income and activities.
For further information, please contact:
Peter McCullough, Partner, Ashurst
peter.mccullough@ashurst.com
