Thin capitalisation: eroding asset values and increasing debt ... - PwC

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TaxTalk – Electronic Bulletin of Australian Tax Developments 1. the tax treatment of beneficiaries should largely replicate the tax treatment applying if the beneficiary had derived the trust income directly 2. ‘flow though’ tax treatment should only apply to trusts undertaking activity that is primarily passive investment 3. beneficiaries should be assessable on their share of the net income of the trust whether it is paid or applied for their benefit 4. the trustee should be assessable on trust income that is not assessable to beneficiaries in a particular year, and 5. trust losses should generally be trapped in the trust subject to special rules for utilisation. Having regard to these terms of reference, the discussion paper outlines the following three options for determining tax liabilities of MITs and beneficiaries (as alternatives for the current reliance on the concept of present entitlement for allocating liability between the trust and its beneficial owners) and requests ‘stakeholder’ submissions with respect to these options and any other options that might be appropriate: • Option 1 – the trustee is assessed on the net income after allowing a deduction for certain distributions made to beneficiaries (the ‘trustee assessment and deduction model’). Under this option, the liability of beneficiaries depends on the extent of distributions made and, where the MIT has accrued income which is included in assessable income, the MIT may need to borrow to make distributions to beneficiaries to avoid tax being assessed on undistributed income. • Option 2 – the trustee is exempt from tax and instead, tax on the trust’s net income is always assessable to beneficiaries irrespective of distributions made to them (the ‘trustee exemption model’). The discussion paper notes that this provides a high degree of certainty about where the tax liability will fall, since there is no requirement for any distributions to be made for the beneficiaries to be assessed. • Option 3 – tax on the trust’s net income is always assessable to beneficiaries, provided a substantial minimum level of annual distributions (for example 90 per cent) is attained. The discussion paper notes that this option reduces the extent to which beneficiaries are liable to tax on amounts not received, but there may be some additional compliance costs for trustees, who must ensure that the minimum levels of distributions are attained to ensure that the trustee is not taxed. If the minimum level of distributions is not made, the Board suggests that the trust could fall out of the MIT regime entirely with the income being subject to tax under the existing trust provisions (Division 6 of the Income Tax Assessment act 1936). Alternatively, the Commissioner could be given discretion to permit the trust to continue to be taxed as an MIT, or the trustee could be assessed on the undistributed amount possibly at penal rates. The further option raised by the Board is to retain the existing Division 6 structure and simply redefine key terms such as ‘present entitlement’, ‘income of the trust’ and ‘share’ of that income. This approach would no doubt remove existing uncertainty with respect to matters such as the treatment of capital gains, and the debate as to whether the ‘proportionate approach’ or the ‘quantum approach’ for allocation of net income is used. Defining the term ‘distribution’ The Board notes that under Option 1 (and potentially Option 3), it would be essential for the term ‘distribution’ to be defined, and in that context, the Board is seeking stakeholder comment on a definition that would provide clarity and ensure appropriate tax outcomes. Tax rate for undistributed/ unallocated income The Board raises the issue as to what tax rate should apply to undistributed income under Option 1 and is seeking stakeholder input. After noting that the existing tax rate of 46.5 per cent was originally designed to remove the cost to the revenue of trusts accumulating income, the Board states in the context of MITs, that the tax rate to apply should reflect an appropriate balance between equity and integrity. When is tax liability determined? The Board notes that under current law, a beneficiary’s tax liability arises in the same year that the income is derived by the trust, even though an amount of income may not be distributed to the beneficiary until the following year. This position would apply under Option 2, however under Option 1, the paper outlines the following two approaches that could be adopted: • The trustee could be given say three months after the end of the income year to make distributions for that year. The paper notes that a period of three months aligns with the period allowed for withholding by MITs from distributions to foreign residents. PricewaterhouseCoopers :
TaxTalk – Electronic Bulletin of Australian Tax Developments • Taxable distributions could be assessable in the income year that they are actually received by beneficiaries (with the trustee claiming a deduction in the prior year in certain cases). The discussion paper acknowledges that this approach will lead to a deferral of tax revenue, and states that such cost to revenue would need to be balanced against the simplicity of resident beneficiaries being taxed on a distribution receipts basis. The Board notes that a further approach suggested by some stakeholders would be to change the tax year for all MITs to 31 March to allow more time for the preparation of distribution statements before 30 June. Treatment of ‘unders’ and ‘overs’ The Board in its paper considers options for addressing the under-reporting and over-reporting of net income by MITs. These options are: • a ’carry forward’ approach, allowing ‘unders’ or ‘overs’ to carry forward into the following income year, or • a ‘credit/deduction’ approach, whereby MITs would pay tax and be subject to the general interest charge on an ‘under’ and attach a tax credit to the after-tax distribution. MITs would claim a deduction for an ‘over’ in the following income year. The Board is seeking input from stakeholders on the appropriate treatment of ‘unders’ and ‘overs’. This includes views as to whether, under either approach, there should be a de minimus rule of up to (say) 2 per cent of the net income, and if so, what the consequences should be for breaching this rule. International considerations The Board outlines the current international tax treatment of MITs and highlights the tax benefits afforded in other countries to certain collective investment vehicles (CIVs) that are treated as companies for tax purposes, even though they are not generally subject to tax. The Board notes the advantages available to these corporate CIVs (with ‘flow through’ tax treatment) when compared to an MIT, including for example the availability of tax treaty benefits to a CIV in its own right. This is in contrast to an MIT, where treaty benefits generally cannot be claimed by the MIT but by each beneficiary, based on the resident status of the beneficiary. In light of the above observations made in the paper, the Board is seeking input from stakeholders as to: • the issues they are currently experiencing under Australian domestic law and tax treaties with respect to the operation of international rules for MITs • suggestions for dealing with these issues, and • whether there would be advantages in having a deemed corporate ‘flowthrough’ CIV regime in Australia for international reasons. Dealing with distributions that are greater than or less than net income The Board notes that distributions of a MIT will not equal the trust’s net income for a number of reasons, including for what are referred to in the MIT industry as ‘timing’ and ‘permanent’ differences. The Board further notes that the existing mechanism creates tax distortions and, in some cases, can result in the same amount being taxed twice. Under this mechanism, amounts in excess of net income either reduce the recipient beneficiary’s capital gains tax (CGT) cost base, or in some cases are assessed as ordinary income. In view of the existing problems, the Board raises a number of options for change. In the case of ‘tax deferred distributions’, an option would be to assess the beneficiary (after adjustment for the extent that the beneficiary would not be taxable in full on the gain), rather than adjusting the CGT cost base of the beneficiary’s interest. Adjustments would then need to be made at the trust level to ensure the distribution was not included in subsequently-calculated gains of the MIT. Where distributions are less than the net income, there would be a corresponding uplift in cost base of the units held by beneficiaries to avoid double tax. Character retention and flow‐through The Board identifies the following issues that arise under the current approach of allowing the character of amounts in the hands of the trustee to flow through to the beneficiaries of the trust: • uncertainty about how the general deductions of the trust should be allocated when calculating the separate components of the trust’s net income • uncertainty in determining amounts that are ‘attributable to’ or ‘taken into account in working out amounts’, included in the beneficiaries’ assessable income under specific mechanisms existing in the income tax law, and PricewaterhouseCoopers :
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Thin capitalisation: eroding asset values and increasing debt ... - PwC

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