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Submission No. 23 Back to full list of submissions
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Review of Business Taxation

Platform for Consultation

Collective Investment Vehicles

Queensland Investment Corporation Submission

March 1999

 

Executive Summary

This submission focuses on the following issues of major significance for large investment trusts:

  • implementation of the decision to allow flow through taxation for widely held collective investment vehicles; and
  • refundability of franking credits to State Governments.

We have summarised our submissions on these matters below along with our recommendations.

Collective Investment Vehicle (CIV) Implementation Issues

The Federal Government’s recognition of the importance of the collective investment vehicles and the benefits they provide in funding the retirement incomes of Australia’s aging population through the decision to retain a flow through taxation approach for CIVs is welcomed. However, great care is needed in the implementation of CIV flow through taxation to ensure the system is workable and does not result in significant unforeseen adverse consequences.

Our detailed comments on CIV flow through taxation policy and implementation issues can be summarised as follows:

  • Flow Through Taxation for CIVs

Implementing a system of flow through taxation for CIVs is a critical aspect of funding the retirement incomes of the Australian population. Without a facility for investors to pool their funds to gain the benefits of economies of scale, diversification and access to professional investment management in a cost effective way, national savings would not be maximised.

Chapter 16 of the Platform for Consultation (PFC) and the recent announcement by the Federal Treasurer have given in principle approval for flow through taxation for CIVs. Whilst this in principle approval is a positive step, the market practice in the portfolio investment activities of CIVs and the development of sophisticated CIV structures designed to maximise investment flexibility must be taken into account in implementing the CIV flow through taxation proposals.

  • Definition of Widely Held CIV

The definition of a widely held CIV should adopt the ultimate ownership principle to ensure flow through taxation is available to all CIVs that are in substance widely held.

The commercial forces affecting most widely held investment trusts have lead to sophisticated trust structures such as those outlined in Attachments 2.1 and 2.2. Accordingly, a practical approach needs to be adopted to the implementation of the ultimate ownership principle to ensure flow through taxation sufficiently caters for these sophisticated structures. Alternative approaches are discussed in Chapter 3.

To ensure the CIV flow through taxation proposals are effective, investment entities owned by widely held CIVs must be covered by the definition of widely held CIV.

  • Tax Free Flow Through of Tax-Preferred Income

An overriding concept of the taxation of CIVs internationally is the maintenance of Investment Neutrality. The Review of Business Taxation’s (RBT) International Perspective Report recognises this fact and therefore supports a direct investment equivalence approach to the taxation of CIVs. This approach requires full flow through taxation in respect of CIV transactions including tax-preferred income. The tax-preferred income of widely held CIVs should not be taxed.

  • Passive Investment vs Active Business Borderline

The requirement to define a borderline between portfolio investment and active business is required both as part of the classification of CIVs as eligible for flow through taxation and to ensure competitive neutrality where full flow through taxation is implemented.

Mechanisms for establishing the portfolio investment vs active business borderline in a practical way that provides certainty are discussed in Attachment 4.1. It is submitted that a test based upon the current Division 6C provisions (with specific modifications) would provide the desired distinction with minimal implementation and compliance issues.

  • Full Distribution of Profits

It is proposed CIVs must fully distribute their profit to be eligible for flow through taxation. The profit that is required to be distributed should be based on the taxable income of the CIV and should exclude tax-preferred amounts.

  • Taxation of Tax-preferred Income Where Flow Through Taxation Denied

Where the tax-preferred income distributions of CIVs are taxed the taxing unfranked inter-entity distributions approach should be implemented. This approach fits better with the nature of CIVs than the Deferred Company Tax (DCT) or Resident Dividend Withholding Tax (RDWT) approaches.

Notwithstanding that the unfranked inter-entity distributions approach represents the best of the proposed entity taxation methods, it would still place investors investing through CIVs at a disadvantage to direct investment. This is not consistent with investment neutrality.

  • Restructure Rollovers

The liquid nature of investment funds means that the RBT proposals could trigger large-scale restructures of pooled investment vehicles. Accordingly, comprehensive tax rollovers should be provided to allow the reorganisation of investment trusts adversely affected by the RBT proposals.

Refundability of Franking Credits for State Governments

The entity taxation proposals have the potential to give rise to significantly adverse tax consequences for State Governments and other tax exempt investors. As a result, State Governments, including their statutory bodies and related corporate entities should be entitled to refunds of additional underlying tax that arises as a result of the implementation of the RBT proposals. The refundability of additional underlying tax should be implemented as a design feature.

Where the refund of DCT/RDWT to State Governments is rejected, the significance of the cost of the entity taxation proposals to the State of Queensland will depend on how the CIV flow through taxation system is implemented. The position of State Governments should be taken into account in the implementation of the CIV proposals. Key issues will include the definition of widely held trust and the taxation of distributions of tax-preferred income.

Recommendations

Our recommendations are as follows:

  • Full flow through taxation should be available for CIVs. The implementation of the CIV tax system should have regard to the portfolio investment activities and investment structures of CIVs.
  • The definition of widely held CIV should adopt the ultimate ownership principle. The adoption of the ultimate ownership principle should be implemented through a "scheduler" approach to the definition of widely held CIV that takes into account the economic substance of a CIV’s owners.
  • Where the definition of widely held CIV is based on the public unit trust definition the "20% superannuation fund/tax exempt ownership" rule should be used and expanded to take into account the economic substance of CIV owners in determining widely held status.
  • The full direct investment equivalence principle should be adopted. The tax-preferred income distributions of CIVs should not be taxed to ensure the tax position of a CIV’s owners is the same as if they had invested directly.
  • If tax-preferred income distributions of CIVs are to be taxed then they should be taxed on a deferred basis through cost base reductions, as is currently the case, and not under the entity taxation regime.
  • The portfolio investment vs active business boundary line for restricting the activities of CIVs should be implemented having regard to the limitations of the existing Division 6C rules.
  • The full distribution of profit requirement should be limited to taxable income. Distribution of tax-preferred income should be at the option of the CIV.
  • Practical issues in respect to investment trust distributions should be considered in the implementation of the profit distribution requirement.
  • Where the tax-preferred distributions of CIVs are to be taxed under the entity taxation system then the taxation of unfranked inter-entity distribution approach should be adopted.
  • As a transitional measure comprehensive tax rollovers should be provided to allow CIVs to vest their assets or restructure as a result of the RBT proposals without triggering unrealised tax liabilities.
  • State Governments and other tax-exempt entities should be entitled to a refund of additional underlying tax caused by the RBT proposals.
  • If State Governments and other tax exempt entities are not granted refunds of additional underlying tax caused by the RBT proposals then special consideration of the effect on State Government and tax exempt investors should be taken into account in implementing the CIV flow through taxation system.

 

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