The Federal Government’s response to the Board of Taxation Report into the tax arrangements applying to managed investment trusts (MIT) has accepted most of the recommendations with a majority of the changes being beneficial for eligible MIT.

The Government has flagged that the next step is to undertake consultation on the details of the proposed regime and legislation, and McCullough Robertson will be involved in making submissions.

The key issue for MIT potentially eligible for the new tax regime is to decide what action needs to be undertaken between now and the start date of 1 July 2011.

The changes announced and accepted

There are four key changes that can be taken from the Government’s response being:

Change 1

The introduction of an elective attribution system for the taxation of distributions made by a ‘qualifying MIT’ to replace the present entitlement system that operates under the trust tax rules. The new attribution system will operate so that investors are taxed on the taxable income that the trustee allocates to them on a fair and reasonable basis. This will need to be consistent with, and able to be determined under, the terms of the trust deed or trust constituent documents.

Action items for fund managers - confirm whether the trust (fund) satisfies the definition of a qualifying MIT (see definition below) and review the trust constitution to ensure compatibility with the new tax regime.

Change 2

Establishing a system to allow qualifying MIT to deal with ‘under or over’ distributions within a capped level, so the trustee is not required to re-issue statements and investors are not effectively required to revisit their tax returns. The new rules will remove the perceived double taxation that arises as a result of the amount of taxable income differing from the amount actually distributed to the beneficiaries (often referred to as tax preferred distributions). The regime proposes that there will be up and down adjustments in relation to the difference between the taxable income allocated to a beneficiary and the actual distribution received.

Action items for fund managers - obtain advice on how the new tax regime will operate administratively and its impact on the trust’s operations, and decide what amendments to the trust’s constitution may be necessary.

Change 3

New amendments - removal of Division 6B, but retention of the current Division 6C subject to further analysis.

Action item for fund managers - the retention of Division 6C means the activities of trusts will still need to be monitored to ensure that the company tax rules are not triggered. For example if the MIT is classified as a trading trust, the trust may be taxed as a company with distributions franked or unfranked.

Change 4

Other changes include deeming qualifying MIT to be fixed trusts for tax purposes as well as confirming that the character of the income in the hands of the trustee is retained in the hands of the beneficiary. It is necessary to be a fixed trust:

• for franking credits to flow through to unitholders
• to access the fixed trust CGT rollover, and
• for trust losses to be more easily carried forward for recoupment. It has been the position that constitutions that allow for the issue and redemption at other than market value are not fixed trusts.

Action item for fund managers - consider whether the certainty of being a fixed trust and of having the income character flow through is sufficient incentive to ensure the necessary steps are taken to be a qualifying MIT.

What is a MIT?

Previously a MIT was defined as a trust operated by a financial services licensee which:

• was a listed trust or had at least 50 members, or
• had as a member:
• a life insurance company
• a complying superannuation fund or foreign superannuation with at least 50 members
• a holding trust that satisfied the above conditions, or
• an entity with at least 50 members recognised under a foreign law with similar status to a managed investment scheme.

The definition of an MIT will also include:

• widely held wholesale trust whether registered or not. A widely held wholesale trust is a trust that has at least 25 ‘wholesale members’
• expanded list of entities considered to be widely held including foreign government pension plans, sovereign wealth funds and certain government agencies, and
• an 18 month start up period during which a trust may be treated as a MIT despite not being widely held.

The expanded definition permits a wider range of MIT structures to qualify for the MIT reforms. While applying from 1 July 2010, there are transitional rules up to the 2014/2015 income year in respect of withholding tax obligations, but the capital gains election can be applied earlier.

What is a qualifying MIT?

To be a qualifying MIT for the new tax regime, there will be a requirement that, under the constituent documents of the trust, the beneficiaries have clearly defined entitlements. Importantly, there will be no requirement that rights are uniform, meaning different unit classes will be acceptable. It is not clear yet whether the ‘constituent documents’ are limited to just the trust constitution, but we expect that this will be the most important document.

MIT and capital gains election

The Australian Taxation Office (ATO) was proposing to treat gains on the disposal of assets in certain circumstances as being income rather than capital gains. To address the uncertainty, the Government announced that it would introduce measures to allow an MIT to choose for gains to be subject to the CGT rules only.

The relevant legislation was passed into law on
3 June 2010, providing final confirmation of the form of the rules that allow eligible MIT to make an irrevocable choice to apply the CGT rules as the primary code for taxing gains and losses on disposal of assets being shares, units and real property. In effect, if that capital account treatment is in force for the 2008/2009 income year, the ATO is not able to amend prior year assessments.

All MIT should consider making the election now that the rules have been finalised.

For trusts that became a MIT prior to the 2009/2010 income year the choice must be made by 3 September 2010 (three months from the 3 June 2010 commencement date of the new law) and it will then be in force from the 2008/2009 income year. Otherwise, the choice must be made by the MIT by the due date for lodgement of the MIT’s income tax return for the year when it commenced to be a MIT.

If the MIT is eligible to make the choice, a failure to do so will mean that gains are treated on revenue account.

What are the risks of doing nothing?

If a trust is a MIT and it fails to make the capital gains election, all gains that the trust makes will be treated on revenue account, meaning the 50% general CGT discount is lost.

If the trust does not take the necessary steps to become a qualifying MIT then it will not be able to access the announced beneficial changes including:

• the attribution system which provides beneficiaries with significant improved tax certainty as well as favourable cost base adjustments
• access to the formalised ‘unders’ and ‘overs’ treatment for tax changes, and
• the certainty of being a fixed trust and having the income derived by the trust retain its character in the hands of the beneficiaries.

Collective investment vehicles review by Board of Taxation

The Board of Taxation has been asked to further examine and report on the tax treatment of collective investment vehicles, including managed investment schemes, having regard to the proposed new MIT tax regime and including whether a broader range of tax flow-through collective investment vehicles (such as companies and limited partnerships) should be permitted.

The specific terms of reference include that the review have regard to the following:

• collective investment vehicles in the context of the review are widely held investment vehicles (with typically long term portfolio investors) that undertake primarily passive investment activities, consistent with the eligible investment rules in Division 6C of the Income Tax Assessment Act 1936
• the tax treatment of a collective investment vehicle should be determined by the nature of its investment activities rather than the structure of the entity through which the funds are pooled, and
• the tax outcomes for investors in a collective investment vehicle should be broadly consistent with the tax outcomes of direct investment, other than flow through of losses (subject to limited special rules for their utilisation).

As part of the review, the Board of Taxation has been asked to examine the effectiveness of the special tax treatment accorded under the Venture Capital Limited Partnership regime in a way that recognises its policy objectives.

The Board of Taxation is asked to report to the Assistant Treasurer by 31 December 2011.

Further information

For further assistance or enquiries, please contact:

Tax Group contacts

Mark West on 07 3233 8871
David Marschke on 07 3233 8883

Financial Services Group contacts

Sean Robertson on 07 3233 8860
Tim Wiedman on 07 3233 8716.