Impact of Important New Changes to Tax and Contract Enforcement you need to know!
REAL ESTATE INVESTMENT ALERT NO. 11
In this Alert:
- New tax integrity measures likely to impact property market;
- New rules restricting enforcement rights will affect property documents from 1 July 2018 – get ready.
NEW TAX INTEGRITY MEASURES LIKELY TO IMPACT PROPERTY MARKET
A stapled structure is one in which investors have an equal ownership interest in 2 structures, one being a trust and the other generally being a company. The securities in each cannot be traded separately and so are regarded as being “stapled”,
Since the introduction of the Managed Investment Trust (MIT) regime in 2008 (the purpose of which was to encourage the investment of foreign capital in Australia and bolster the Australian funds' management industry), many property businesses, particularly listed ones, have adopted a stapled security structure. This structure provides flexibility to enable distributions of passive income by a trust, where the income is derived from investments in Australian non-residential real estate, to be taxed (in respect of foreign investors) at a lower rate (currently 15%) than payable by domestic investors.
This regime was always intended to be limited to passive income (such as rent paid by third parties to landowning entities) and not apply to trading income.
Foreign investors receiving distributions on account of passive income (known as eligible investment business income) are taxed via the MIT withholding tax regime. Trading income is generally taxed at company tax rates.
Although stapled structures were used prior to the introduction of the MIT regime, since its introduction their use has increased due to the significantly better tax outcome that can be achieved by foreign investors.
The Federal Government has identified that stapled structures are being used to convert trading income into passive income resulting in such income being taxed at a rate substantially less than would be the case if it retained its character as trading income.
The Treasurer issued a report on this on 27 March 2018 which contained a number of “integrity measures” intended to overcome the above issue and other matters associated with investments by foreign investors in Australian funds and stapled structures.
The “integrity measures” and how they will affect the property market.
Without going into detail, in our view the main consequences to the property market of the measures introduced by the Treasurer are:
Investment by foreign pension funds is likely to be reduced
- Foreign government and non- government pension funds (which are exempt from tax in their home jurisdictions) currently enjoy exemptions from interest and dividend withholding taxes.
- The amount of their investments in Australian entities is likely to be reduced as from 1 July 2019 as they will then be subject to a new limit as to the level of ownership they can have in Australian funds to continue to take advantage of current interest and dividend withholding tax exemptions. As from 1 July 2019, their investment must be limited to less than 10% and they must have no “influence over the entity’s key decision making”.
- If the above requirements are not met foreign pension funds will be subject to ordinary withholding tax rates for interest and dividend distributions.
Foreign investors will need to undertake additional due diligence
Foreign investors are more likely to avoid staple structured businesses where there is a risk that trading income is being converted to passive income. As from 1 July 2019, to the extent that the funds paid to the investor are attributable to trading income, such amounts are to be taxed at 30% rather than 15%.
Investment by foreign government investors is likely to be reduced
As from 1 July 2019, Investment by foreign governments is likely to be reduced due to current exemptions from a number of taxes being restricted to circumstances where their investment is limited to less than 10% and they have no “influence over the entity’s key decision making”.
Foreign investors may significantly reduce their investment in funds holding agricultural land
Investment by foreign investors in MIT compliant entities which own agricultural land is likely to be significantly reduced. From 1 July 2019, rent from agricultural land will not be regarded as eligible investment business income (to which the lower MIT tax concession applies). As a result, the tax on distributions of such income is likely to double.
Fund managers will need to ensure their systems are adjusted to account for the changes
Due to the transitional arrangements to apply, (see below) fund managers will need to ensure that their systems will be able to comply with both the existing regime (for existing investors) and the new regime as from 1 July 2019. They will also need to clarify what regime is to apply to investments made between 28 March 2018 and 30 June 2019
To avoid the need to significantly restructure existing investments, investments in place as of 27 March 2018 are subject to a 7-year transitional period starting from 1 July 2019. During this period the current regulations will continue to apply.
It is unclear from the Treasurer’s Report what law will apply to investments made between now and 30 June 2019.
NEW RULES RESTRICTING ENFORCEMENT RIGHTS WILL AFFECT PROPERTY DOCUMENTS FROM 1 JULY 2018 – GET READY
Restrictions on operation of “ipso facto” clauses
“Ipso Facto” clauses are those found in most commercial agreements which provide one party with a right to vary or terminate the agreement or exercise rights under it if a certain event occurs in relation to the other party (Defaulting Party). The most common events where this applies are the insolvency of the Defaulting Party or the appointment of an administrator or receiver.
Why are they a problem?
The perceived problem with such clauses is that they may be triggered even if the Defaulting Party can continue to perform its obligations under the agreement. In addition, once the relevant circumstance arises, the ability of the non-Defaulting Party to exercise the abovementioned rights creates uncertainty regarding the Defaulting Party which has negative flow-on effects across that party’s business.
For example, other agreements may be put into default thereby potentially cutting off supply chains and funding critical to the continuation of the Defaulting Party’s business.
What legal changes are coming?
The Corporations Act 2001 (Cth) has been amended with the result that as from 1 July 2018, parties to an agreement with a company will not be entitled to exercise their ipso facto rights under the agreement in relation to the company in any of the following circumstances:
- (in the case of a listed company) the company making a public announcement that it will be applying to a court to enter into a scheme of arrangement,
- the company applying to a court to enter into a scheme of arrangement,
- the company is subject to a scheme of arrangement,
- the financial position of the company in any of the above circumstances;
- the company having a receiver appointed over all or substantially all of its assets,
- the financial position of the company if a receiver has been appointed over all or substantially all of its assets,
- the company has a voluntary administrator appointed,
- the financial position of the company if a voluntary administrator has been appointed.
The result of this is that, in the absence of getting a court order to the contrary, the non-Defaulting Party will generally need to continue to comply with its obligations under the agreement unless there are other circumstances, which are not related to the above matters, which entitle the non-Defaulting Party to exercise its rights of variation or termination.
How will this affect property documents?
In the context of non-residential real estate transactions, the vast majority of documents entered into are with a company, either in its own capacity or as trustee of a trust.
Consequently, the rights of the parties to those documents against any companies which are a party will, as from 1 July 2018, be subject to the above restriction. This includes documents such as:
- contracts for sale of land,
- commercial leases,
- joint venture agreements.
- development management agreements, and
- building contracts.
Whereas prior to 1 July 2018 it would be normal practice to terminate or at least vary the terms of such documents in the circumstances mentioned above, subject to our comments below, this will no longer be possible as from that date.
It will, therefore, be necessary to review the relevant clauses in those documents to determine what other triggers could be included which would allow a non-Defaulting Party to continue to exercise the rights it had prior to 1 July 2018. The ability to exercise such rights are particularly important in circumstances where the non-Defaulting Party has a concern about the ability of its corporate counterparty to perform its obligations under the document.
Regulations can be passed to:
- extend the circumstances in which the above restriction applies, and
- exclude transactions to which such restrictions apply.
It will, therefore, be important to consider such regulations to check if:
- any additional circumstances are subject to the restrictions; and
- whether the type of documents to which a company is a party have been excluded from the operation of these new rules. For example, documents entered into prior to 1 July 2018 may be excluded, although as at the date of writing this Newsletter there are no regulations in place to be able to confirm this.
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Peter Faludi Consulting
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