House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Minister for Small Business and Assistant Treasurer, the Hon Kelly O'Dwyer MP)

Chapter 9 - Miscellaneous amendments

Outline of chapter

9.1 This Chapter explains miscellaneous amendments to:

•

exclude superannuation funds and exempt entities that are entitled to a refund of excess imputation credits from the application of the 20 per cent tracing rule for public trading trusts in Division 6C of Part III of the Income Tax Assessment Act 1936 (ITAA 1936);

•

repeal the corporate unit trust rules in Division 6B of Part III of the ITAA 1936; and

•

introduce an arm's length income rule for managed investment trusts.

Context of amendments

Modification to Division 6C

9.2 Division 6C of Part III of the ITAA 1936 operates to tax trusts like companies. Division 6C applies if a trust is both:

•

a trading trust (that is, broadly, a trust that carries on activities other than eligible investment business, such as an active business that does not merely involve passive investment); and

•

a public unit trust.

9.3 Division 6C currently has a look through provision that results in certain non-widely-held trusts becoming public unit trusts that must comply with the eligible investment business rules or be taxed like companies. This occurs when one or more tax exempt entities or complying superannuation entities own 20 per cent or more of the beneficial interests in the trust (the 20 per cent tracing rule).

9.4 The Board of Taxation recommended that membership interests held in a trust by tax exempt entities and complying superannuation entities which are entitled to a refund of franking credits should be disregarded for the purposes of applying the 20 per cent tracing rule.

Repeal of Division 6B

9.5 Division 6B of Part III of the ITAA 1936 applies to certain public unit trusts. If Division 6B applies to a public unit trust, the trust is taxed as a corporate unit trust.

9.6 Division 6B was introduced in 1981 to discourage the reorganisation of companies involving the transfer of assets or businesses into a resident public unit trust in which the shareholders would take equity to avoid continued company tax and shareholder taxation treatment and to attract trust tax treatment instead. The Division was introduced when the then classical system of company taxation applied. Since 1981, the company imputation system and capital gains tax have been introduced.

9.7 The Board of Taxation recommended (Recommendation 42) that Division 6B should be abolished, provided that an arm's length income rules is introduced for managed investment trusts.

Arm's length income rule for managed investment trusts

9.8 In the context of its recommendation to repeal Division 6B, the Board of Taxation recommended the introduction of an arm's length income rule for managed investment trusts (including attribution MITs) to protect the integrity of the corporate tax base (Recommendation 10). Under this rule, the trustee of a managed investment trust will be liable to pay tax on non-arm's length income.

9.9 The arm's length income rule removes the incentive for an attribution MIT to shift profits from an active business of a related party to the attribution MIT by engaging in non-arm's length activity.

Summary of new law

9.10 The amendments will:

•

modify Division 6C of Part III of the ITAA 1936 so that membership interests held in a trust by tax exempt entities and complying superannuation entities which are entitled to a refund of franking credits will be disregarded for the purposes of applying the 20 per cent tracing rule that applies to determine whether a trust is a public trading trust;

•

repeal the corporate unit trust rules in Division 6B of Part III of the ITAA 1936; and

•

introduce an arm's length income rule for managed investment trusts.

Comparison of key features of new law and current law

Detailed explanation of new law

Modification to Division 6C

9.11 Membership interests held in a trust by tax exempt entities and complying superannuation entities which are entitled to a refund of franking credits will be disregarded for the purposes of applying the 20 per cent tracing rule that applies to determine whether a trust is a public unit trust. [Schedule 5, item 1, section 102MD of the ITAA 1936]

9.12 An entity is entitled to a refund of franking credits if:

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the entity is an exempt institution that is eligible for a refund (as defined in the Income Tax Assessment Act 1997 (ITAA 1997)); or

•

the entity is treated as an exempt institution that is eligible for a refund - in this regard, section 84B of the Future Fund Act 2006 specifies that the Future Fund Board is treated as an exempt institution that is eligible for a refund for the purposes of the ITAA 1997.

[Schedule 5, item 1, section 102MD of the ITAA 1936]

9.13 As a result, a trust will not be a public trading trust that is taxed like a company merely because such an entity holds more than 20 per cent of interests in a trust.

9.14 Consequential amendments are made to:

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preserve the current effect of provisions that include superannuation contributions and other payments in the assessable income of a complying superannuation entity; and

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ensure that subsection 102P(10) of the ITAA 1936, which deems units in a unit trust that are held by the trustee of another trust to be held by the beneficiaries of that other trust in certain circumstances, does not apply to a trustee of a complying superannuation entity.

[Schedule 5, item 2, section 295-173; Schedule 6, item 12, subsection 102P(10A) of the ITAA 1936]

Repeal of Division 6B

9.15 The corporate unit trust rules in Division 6B of Part III of the ITAA 1936 are repealed. [Schedule 5, item 3]

9.16 Numerous consequential amendments are made to:

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remove references in the income tax law to Division 6B of Part III of the ITAA 1936; and

•

ensure that the operation of other provisions in the income tax law that refer to the definition of public unit trust in Division 6B, or to a trust that is taxed under Division 6B, remain effective following the repeal of Division 6B.

[Schedule 5, items 4 to 74; Schedule 6, items 10, 11 and 14, subsection 102AAF(2) and 102NA(2) and the definition of 'public unit trust' in subsection 128FA(8) of the ITAA 1936]

Transitional rules for trusts that cease to be corporate unit trusts or public trading trusts

9.17 If Division 6B or Division 6C applies to a trust, the trust is effectively taxed as a corporate tax entity. As a result, the trust is required to keep a franking account and can distribute franking credits to its members.

9.18 As a result of the amendments to repeal Division 6B and modify Division 6C, some trusts will cease to be taxed as corporate tax entities. If a trust that ceases to be taxed as a corporate tax entity has a surplus in its franking account, a significant disadvantage may arise as the trust will no longer be able to pass franking credits on to its members.

9.19 To overcome this problem transitional rules will apply if, as a result of these amendments:

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a trust ceases to be taxed as a corporate unit trust - that is section 102K of the ITAA 1936 ceases to apply to the trust; or

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a trust ceases to be taxed as a public trading trust - that is section 102S of the ITAA 1936 ceases to apply to the trust.

[Schedule 5, subitem 75(1)]

9.20 The first transitional rule applies if:

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an event happens in respect of the trust that causes a franking credit or franking debit to arise in the trust's franking account between the cessation time and 1 July 2018; and

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the event is:

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the trust paying income tax for an income year starting before 1 July 2016;

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the trust paying a PAYG instalment in respect of income tax for an income year starting before 1 July 2016;

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the trust receiving a refund of income tax for an income year starting before 1 July 2016; or

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the trust franking a distribution.

[Schedule 5, subitem 75(2)]

9.21 In these circumstances, for the purposes of determining whether a franking credit or franking debit arise in the trust's franking account in respect of the event:

•

the trust is taken to be a corporate tax entity at the time the event happens; and

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the trust is taken to have satisfied the residency requirement in section 202-25 for the income year in which the event happens.

[Schedule 5, subitem 75(3)]

9.22 The second transitional rule applies if:

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the trust makes a distribution on or after the time it ceases to be taxed as a corporate unit trust or public trading trust and before 1 July 2018; and

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the trust's franking account is in surplus just before it makes the distribution.

[Schedule 5, subitem 75(4)]

9.23 In these circumstances, for the purposes of determining whether the trust franks the distribution as a result of the event:

•

the trust will be taken to be a corporate tax entity at the time it makes the distribution; and

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the trust will be taken to have satisfied the residency requirement in section 202-20 at the time it makes the distribution.

[Schedule 5, subitem 75(5)]

9.24 Therefore, as a result of these transitional rules, a trust that ceases to be taxed as a corporate tax entity as a result of these amendments will have until 30 June 2018 to utilise any surplus in its franking account provided that the trust meets the requirements in Part 3-6 of the ITAA 1997 and any other imputation system integrity rules. For these purposes, a franking credit will arise in the trust's franking account for any tax paid before 1 July 2018 in respect of an income year starting before 1 July 2016.

Arm's length income rule for managed investment trusts

9.25 The Board of Taxation recommended the introduction of an arm's length income rule for managed investment trusts (including attribution MITs) to protect the integrity of the corporate tax base (Recommendation 10). The arm's length income rule removes the incentive for an attribution MIT to shift profits from an active business of a related party by engaging in non-arm's length activities.

What is non-arm's length income?

9.26 An amount of ordinary income or statutory income is non-arm's length income of a managed investment trust if:

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the amount is derived from the non-arm's length scheme; and

•

the amount is more than the amount that the managed investment trust might have been expected to receive if those parties had been dealing with each other at arm's length in relation to the scheme.

[Schedule 4, item 5, paragraphs 275-610(1)(a) and (b); Schedule 9, item 11, definition of 'non-arm's length income' in subsection 995-1(1)]

9.27 However, certain amounts that are derived by a managed investment trust are specifically excluded from being non-arm's length income.

9.28 First, a distribution to a managed investment trust from a corporate tax entity is not non-arm's length income of the trust. [Schedule 4, item 5, subparagraph 275-610(1)(c)(i)]

9.29 Second, a distribution to a managed investment trust from a trust that is not a party to the non-arm's length scheme is not non-arm's length income of the managed investment trust. [Schedule 4, item 5, subparagraph 275-610(1)(c)(ii)]

9.30 Third, a return to a managed investment trust that an entity pays or provides on a debt interest is not non-arm's length income of the trust if the rate (expressed on an annual basis) of the return does not exceed the greater of:

•

the benchmark rate of return for the debt interest (as defined in section 974-145); and

•

the base interest rate for the day on which the return is paid or provided, plus three percentage points - that is, a rate of return equal to the rate of the shortfall interest charge.

[Schedule 4, item 5, subparagraph 275-610(1)(c)(iii) and subsection 275-610(2)]

9.31 If an interest in a managed investment trust is a debt interest, the non-arm's length income rule focuses on the return from that debt interest rather than, for example, the principal of the loan. In this regard, as a safe harbour rule, the return on a debt interest is not non-arm's length income if the rate (expressed on an annual basis) of the return does not exceed the benchmark rate of return for the debt interest or the rate of the shortfall interest charge.

9.32 The benchmark rate of return for an interest (the test interest) in an entity is defined in section 974-145 to mean, broadly, the annually compounded internal rate of return on an ordinary debt interest that:

•

is issued, immediately before the test interest, by the entity, or an equivalent entity, to an entity that is not a connected entity;

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has a comparable maturity date;

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is in the same currency;

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is issued in the same market;

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has the same credit status; and

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has the same degree of subordination to debts owed to the ordinary creditors of the issuer.

9.33 The fact that the return on a debt interest exceeds the safe harbour rate of return is not conclusive evidence that the return is non-arm's length income - rather this will be determined based on the circumstances of each particular case.

9.34 Fourth, if a managed investment trust receives a distribution from, or is entitled to a share of the net income of, another trust (the underlying trust) that is a party to the non-arm's length scheme, the distribution will be non-arm's length income of the managed investment trust only to the extent that it would be non-arm's length income of the underlying trust (on the assumption that the underlying trust were a managed investment trust). [Schedule 4, item 5, subsections 275-610(3) and (4)]

9.35 This will ensure that a distribution to a managed investment trust from the underlying trust is not non-arm's length income unless it reflects non-arm's length income of that underlying trust.

9.36 Finally, if a managed investment trust receives a distribution from another trust, some or all of the distribution will be not be non-arm's length income of the managed investment trust. This exception applies where:

•

an amount (the first amount) of ordinary income or statutory income of the managed investment trust that would be non-arm's length income (disregarding subsection 275-610(6)) is a distribution from, or a share of the net income of, a trust (the first trust) that is a party to the non-arm's length scheme;

•

another amount (the second amount) of ordinary income or statutory income of the managed investment trust is a distribution from, or a share of the net income of, another trust (the second trust), whether or not that second trust is a party to the non-arm's length scheme); and

•

it is reasonable to conclude that the second amount would have been higher but for the first amount.

[Schedule 4, item 5, subsection 275-610(5)]

9.37 In these circumstances, the first amount is not non-arm's length income of the managed investment trust to the extent that the second amount would have been higher. [Schedule 4, item 5, subsections 275-610(6)]

9.38 Subsections 275-610(5) and (6) can apply where the second amount (referred to in paragraph 275-610(5)(b)) is nil in circumstances where the second trust has no net income or has a tax loss because of the transactions with the first trust.

Example 9.1

MIT Trust is a managed investment trust that holds investments in both Trust 1 and Trust 2.

MIT Trust, Trust 1 and Trust 2 are all parties to a non-arm's length scheme.

Trust 1 derives $500 in an income year and makes a distribution to Trust 2 of $100. If Trust 2 was a managed investment trust, that distribution would be non-arm's length income.

Trust 2 distributes the whole amount to MIT Trust. Under subsections 275-610(3) and (4), this distribution is taken to be non-arm's length income of MIT Trust.

Trust 1 distributes the whole of its income ($400) to MIT Trust. However, this distribution would have been higher if Trust 1 had not made the distribution to Trust 2 - that is, the distribution by Trust 1 to MIT Trust would have been $500.

As a result, subsections 275-610(5) and (6) apply to reduce the non-arm's length income of MIT Trust by $100.

As a result, MIT Trust has no non arm's length income.

Commissioner may make a determination to apply the arm's length income rule

9.39 The arm's length income rule is an integrity rule that will apply only if the Commissioner of Taxation makes a determination under section 275-615 that specifies an amount of non-arm's length income in relation to a managed investment trust in relation to a specified income year. [Schedule 4, item 5, subsection 275-605(1)]

9.40 The Commissioner can make a determination in writing that specifies an amount of non-arm's length income in relation to a managed investment trust in relation to a specified income year if the Commissioner is satisfied that:

•

the amount of non-arm's length income for the managed investment trust is reflected in:

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if the trust is an attribution MIT - one of more of the attribution MIT's trust components for the income year; or

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otherwise - the trust's net income for the income year;

•

the managed investment trust is a party to a scheme (which is defined in subsection 995-1(1) to mean, any arrangement, scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise), where the parties to the scheme are not dealing with each other at arm's length (the non-arm's length scheme); and

•

at least one of the parties to the non-arm's length scheme is not a managed investment trust for the income year.

[Schedule 4, item 5, subsection 275-615(1)]

9.41 The determination does not form part of an assessment. [Schedule 4, item 5, subsection 275-615(2)]

9.42 If the Commissioner makes a determination, the Commissioner must give a copy of the determination to the managed investment trust concerned. The notice may be included in a notice of assessment. [Schedule 4, item 5, subsection 275-615(3)]

9.43 The production of a notice of a determination, or a document signed by the Commissioner, a Second Commissioner or a Deputy Commissioner purporting to be a copy of a notice of a determination, is:

•

conclusive evidence of the due making of the determination; and

•

conclusive evidence that the determination is correct (except in proceedings under Part IVC of the Taxation Administration Act 1953 (TAA 1953) on an appeal or review of the determination).

[Schedule 4, item 5, subsection 275-615(4)]

9.44 If a taxpayer to whom a determination relates is dissatisfied with the determination, the taxpayer may object against it in a manner set out in Part IVC of the TAA 1953. [Schedule 4, item 5, subsection 275-615(5)]

Consequences of a determination

9.45 If the Commissioner makes a determination in relation to a managed investment trust, the trustee is liable to tax on the amount of non-arm's length income to the extent that it exceeds the amount of deductions that:

•

are reflected in:

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if the trust is an attribution MIT - the amounts of the attribution MIT's trust components for the income year; or

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otherwise - the trust's net income for the income year; and

•

are attributable only to the amount of the non-arm's length income.

[Schedule 4, item 5, subsections 275-605(2) and (5)]

9.46 The rate of tax that is payable in relation to the non-arm's length income is the standard corporate tax rate of 30 per cent. [Schedule 4, item 5, subsection 275-605(2)]

9.47 The Income Tax Act 1986 imposes tax that a trustee must pay under subsection 275-605(2). The Income Tax Rates Act 1986 specifies the rate of the tax to be 30 per cent. [Income Tax Rates Amendment (Managed Investment Trusts) Bill 2015, Schedule 1, item 11, subsection 12(10) of the Income Tax Rates Act 1986]

9.48 To prevent double taxation, the trustee of a managed investment trust that is an attribution MIT is liable to pay tax on an amount of non-arm's length income in relation to a specified income year:

•

if the attribution MIT does not have an over for the specified income year in the income year in which the determination is made - the attribution MIT is taken to have an over (with a character relating to ordinary income or statutory income from an Australian source) in the income year in which the determination is made for the specified income year equal to the amount that is subject to trustee taxation; and

•

if the attribution MIT does have an over with the character of ordinary income or statutory income from an Australian source for the specified income year in the income year in which the determination is made - the amount of that over is increased by the amount that is subject to trustee taxation.

[Schedule 4, item 5, subsection 275-605(3)]

9.49 If the trustee of a managed investment trust that is not an attribution MIT is liable to pay tax on an amount of non-arm's length income in relation to a specified income year the trust's net income for the income year is reduced by the amount that is subject to trustee taxation. [Schedule 4, item 5, subsection 275-605(4)]

9.50 The fact that the Commissioner has made a determination that part of the income of a managed investment trust does not of itself lead to the conclusion that the trust is engaged in a business that does not consist wholly of eligible investment business for the purposes Division 6C of Part III of the ITAA 1936. Therefore, the making of the determination trust does not of itself lead to the conclusion that the trust is a trading trust within the meaning of that Division.

Trustee can be subject to an administrative penalty

9.51 Subdivision 284-C of Schedule 1 to the TAA 1953 operates to impose an administrative penalty on taxpayers who enter into a scheme to reduce their tax liabilities. The amendments extend the scope of Subdivision 284-C so that it also applies when the trustee of a managed investment trust enters into a scheme to derive non-arm's length income.

9.52 Therefore, the trustee of a managed investment trust will be liable to an administrative penalty if:

•

to give effect to the non-arm's length income rules in Subdivision 275-L of the ITAA 1997 (the adjustment provision) in relation to a scheme, the Commissioner amends an assessment issued to the trustee for the income year; and

•

as a result, the trustee is liable to pay an additional amount of income tax.

[Schedule 4, item 7, subsection 284-145(2C) of Schedule 1 to the TAA 1953]

9.53 If the trustee of a managed investment trust is liable to an administrative penalty, then the base penalty amount is generally:

•

50 per cent of the scheme shortfall amount; or

•

25 per cent of the scheme shortfall amount if it is reasonably arguable that the adjustment provision does not apply.

[Schedule 4, item 9, subsection 284-160(1) of Schedule 1 to the TAA 1953]

9.54 The scheme shortfall amount for a scheme to which subsection 284-145(2C) applies is the total additional income tax that the attribution MIT is liable to pay because the Commissioner has made a determination that the managed investment trust has an amount of non-arm's length income. [Schedule 4, item 8, subsection 284-150(6) of Schedule 1 to the TAA 1953]

9.55 However, if subsection 284-145(1) applies to a scheme, the scheme shortfall amount for that scheme is disregarded to the extent that it is attributable to additional tax that is, or is part of, a scheme shortfall amount for a scheme to which subsection 284-145(2C) applies. [Schedule 4, item 8, subsection 284-150(7) of Schedule 1 to the TAA 1953]

9.56 In some circumstances, the amount of the penalty will be reduced due to the operation of section 284-224.

Transitional rules

9.57 A transitional rule will apply if:

•

a managed investment trust became a party to a scheme before the date that the Bill is introduced into the House of Representatives; and

•

the parties to the scheme are not dealing with each other at arm's length.

[Schedule 8, item 2, subsection 275-605T(1) of the Income Tax (Transitional Provisions) Act 1997]

9.58 In these circumstances, any income derived by the managed investment trust before the start of the 2018-19 income year will not be taxed as non-arm's length income. [Schedule 8, item 2, paragraph 275-605T(1)(c) and subsection 275-605T(2) of the Income Tax (Transitional Provisions) Act 1997]