On 3 May 2016, Treasurer Scott Morrison announced the Australian federal budget. Among the tax measures announced was the announcement that two new types of fund vehicle are to be created – a corporate collective investment vehicle (CIV) and a limited partnership CIV. These new legal forms are intended to increase the international competitiveness of the Australian asset management industry. But is it enough?
The announcement of the new CIVs in the Australian budget can be indirectly traced back to the Johnson Report which was published in November 2009 1 and provided the foundation for three subsequent reports on the taxation aspects of the Australian asset management industry and included an entire report dedicated to the taxation of collective investment vehicles and specifically addressed the need for legislative change in this regard. 2
The Johnson Report acknowledged that a fund vehicle needs to be a conduit for tax purposes with limited investor liability otherwise it simply doesn't work as a vehicle for collective investments. 3 Unit trusts are the only vehicles which can be established in Australia matching these requirements. General and tax law partnerships are conduits but carry unlimited liability for investors. Limited partnerships are generally taxed as companies in Australia and the specific concession applying to Venture Capital Limited Partnerships (VCLPs), which are tax transparent, remains tightly controlled under the legislation,4 leaving the unit trust as the only option where an Australian collective vehicle is required.
The Johnson Report noted that unit trusts are not a commonly used vehicle for international investing, particularly given the understandable lack of familiarity with a 'trust' by investors from civil law jurisdictions. Unit trusts are very common – and work very well – for funds offered to Australian investors. These plug into the existing structures of superannuation and insurance company investors, and for property funds there is often no better suited structure.
Subsequent to the Johnson Report, the Board of Taxation concluded that, in order to increase its international competitiveness as an asset management hub, Australia needed a new type of CIV which offering tax transparency and investor protection.5 The Board of Taxation report refers to the corporate CIV and the partnership CIV separately although functionally they are clearly intended to meet the same requirements.
The VCLP regime
It is worth noting that Australia has tried to introduce unique conduit vehicles before. The VCLP regime was introduced in 2002 and was designed to offer the very taxation conduit function that the partnership CIV and the corporate CIV will provide. The introduction of this regime required both Federal legislation amendments to the Australian Income Tax acts and amendments to State and Territory partnership law in order to realise this unique entity.6
The adoption rate for the VCLP regime, and the genus of limited partnerships which this encompasses, has been disappointing. This may be partially due to the strict approval criteria and the ongoing regulatory requirements which must be met to comply with the regime.7 Perhaps, more fundamentally, it could be argued that this regime was designed around a problem facing the Australian funds industry that was more theoretical than real. It is still not clear in what way a VCLP based structure is a superior vehicle for Australian venture capital investing than the combination of an offshore limited partnership and corporate subfunds in tax treaty jurisdictions. Given that non-residents are only subject to Australian CGT on gains made in relation to taxable Australian real property, it may not even be necessary to structure transactions through a treaty jurisdiction.8
Funds management hub vs funds domicile
It is important to be specific when describing the desire for a jurisdiction to become a hub for the asset management industry. Is the objective to increase fund formations in that jurisdiction using its local law or is the intention to attract the funds management function? The economic spin offs are quite different. The asset management function is typically seen as the higher value added function, with the greater potential to utilise other parts of the domestic financial services sector. This is compared to the fund administration and ongoing compliance functions which are more typically undertaken in a domiciled fund jurisdiction.
Clearly the two don't need to go together. For many years now, the Cayman Islands exempted limited partnerships have been a commonly used venture capital or private equity fund vehicle. These are almost a default choice for US managers, and are often distributed to US based investors by managers who do not have any operational presence in the Cayman Islands. Similarly Irish and Luxembourg funds are very common structures for both traditional and alternative funds. These can easily be managed by a UK fund manager without a presence in continental Europe.
The analysis of the Australian funds regime needs to specifically identify what Australia is seeking to attract. If, indeed, it is the fund management function, then arguably the greater emphasis of the legislature should be upon the Australian taxation of offshore funds and the regulatory and tax considerations of managers wishing to establish an Australian presence.
Personal taxation matters
A very important part of attracting fund managers to a particular jurisdiction is the personal taxation of the investment professionals themselves. If Australia has any aspiration of becoming a funds management hub, this should be a key consideration.
The UK has been hugely successful in attracting highly remunerated foreign investment professionals with features of their tax system such as the remittance basis of taxation for so-called 'resident non-doms'. This, combined with a settled position on the treatment of carried interest, meant that there were tried and tested ways to tax efficiently structure the remuneration and returns of an investment professional based in the UK. Although the possible structuring options have recently been reduced in the wake of changes announced during 2015. Despite this legislative incursion, carried interest will still only be taxable at the CGT rate of 28%, and not at the higher marginal tax rates which apply to employment income in the UK.
Like the UK, the US has for a long time had a settled position on the treatment of carried interest as long term capital gains which significantly reduces the effective rate of taxation on this slice of an investment professional's compensation. For how much longer this lasts is anyone's guess. The most recent attempt to address this 'loophole' are the proposals announced by President Obama in February of this year. For other jurisdictions, it is not the special treatment of carried interest but the fundamentals of the tax system which have inherent appeal. The rate of income tax payable in Hong Kong is 15% while the maximum rate of tax in Singapore for an individual is 22%. Neither of these jurisdictions have clarified the taxation of carried interest and there is currently a range of approaches which are adopted. This includes the use of traditional offshore structures at one end of the spectrum and the payment of performance bonuses which pass through as employment income at the other.
The position of Australian tax resident investment professionals is comparatively grim. The carried interest entitlement of an investment manager in a VCLP is treated as a capital gain and thus eligible for the CGT discount of 50%. Given the way that the VCLP rules have been shaped, and the limited number of VCLPs which have actually been formed, this outcome is not commonplace. Offshore carry structures can be used but once a distribution is made back to Australia, full rates of individual taxation applies. Decanting the funds arising from an offshore carry structure into a separate controlled offshore vehicle gives rise to a host of attribution consequences with the result that it is generally not a viable option.
Advantages of the corporate CIV and the partnership CIV
If we are to have two new entity types dotting the Australian funds landscape, then hopefully these will offer the best-in-class features as compared to other jurisdictions. Many traditional domiciled fund jurisdictions enable the creation of companies with segregated cells, in which assets can be internally separated within a single fund entity. This structure, in theory, avoids the need for separate fund SPVs for each investment which is particularly common in Private Equity funds. The UK has the open-ended investment company and there are equivalent vehicles available in Mauritius and Luxembourg. A similar vehicle is under consideration for Singapore and Hong Kong.
Perhaps a trickier ask for any corporate CIV is that is it able to benefit from Australia's network of double tax treaties. The ability of CIVs to obtain treaty benefits is now part of the BEPs debate on limitation of benefits, and it remains to be seen how sustainable it is for some jurisdictions to continue to offer treaty benefits for resident corporate funds which are themselves not subject to tax. The ability of a corporate CIV to claim treaty benefits was mentioned in passing by the Board of Taxation in their report9 but it is now potentially more contentious.
While treaty benefits would be a nice to have for a corporate CIV, this is more aligned with the aspiration for Australian domiciled funds to be used as a regional platform than the reality of Australia as an investee jurisdiction. At the moment, investors simply don't pool into Australian funds and it would seem bold to assert that a new fund vehicle is going to change that. Even for countries such as Singapore, which has been successful in attracting managers to manage offshore funds and certain resident funds, the adoption rate for master pooling vehicles established in Singapore (such as the Singapore limited partnership) is comparatively low. Investor familiarity is a key consideration as this avoids fund raising being more complicated than it has to be. A manager needs to demonstrate a very compelling reason to depart from tried and tested structures. This is particularly so for vehicles established in jurisdictions where the applicable law has not been subjected to the scrutiny of the legislature.
Arguably the most useful application of a corporate CIV which is able to access Australia's tax treaty network is to act as a subfund sitting underneath a more traditional master pooling vehicle. It is highly desirable for the implementing legislation to recognise this, rather than automatically assuming that investor funds will pool directly into a corporate CIV or partnership CIV.
The pending introduction of a corporate CIV and partnership CIV in Australia is worth noting, though there is reason to approach this with guarded optimism at best. A real game changer for the Australian funds offering would be a clearly articulated concession for the taxation of carried interest or something else to entice investment managers to use Australia as a hub. With the Government coffers dwindling and the zeitgeist of the big end of town paying more tax, this is unfortunately far from a likely outcome.
1. Report of the Australian Financial Centre Forum, Australia as a financial centre: Building on our strengths, 17 November 2009.
2. The Board of Taxation, Review of Tax Arrangements Applying to Collective Investment Vehicles, December 2011.
3. Above n1, at page 62.
4. Refer Subdivision 118-F of the ITAA97. For simplicity, reference is made in this article to only VCLPs and not to the related vehicles: VCMPs, ESVCLPs, and AFOFs.
5. Above n2 at page 42.
6. Changes to State and Territory partnership law were required to give the VCLP legal personality, which is not a feature of limited partnerships.
7. These have been relaxed somewhat by amendments contained in the Tax Laws Amendment (Tax Incentives for Innovation) Act 2016.
8. The risk of this approach is however that gains may be taxable as Australian sourced ordinary income per TD 2010/21
9. Above n2 at page 41.
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