Property funds unlikely to use new corporate collective investment vehicle regime

By Alexis Kokkinos - January 25, 2019

Whilst attractive from a commercial aspect, unfortunately, the tax risks associated with the proposed CCIV regime could place CCIVs at a significant disadvantage as compared to MITs, which can result in double taxation and a tax rate to investors of 63%. It is expected that this significant tax risk will likely result in an underutilisation of the regime in the long term, unless this issue is addressed.

A. What is the key concern with the CCIV regime?

The Treasury has released draft legislation on the new corporate collective investment vehicle ("CCIV") regime, being a proposed alternative to the current managed investment trust ("MIT") regime which is earmarked to commence on 1 July 2019.

As explained below, the CCIV regime may provide (in many cases) commercial benefits as compared to running a scheme through a MIT.

However, the Treasury have taken a stricter approach to the taxation treatment of a CCIV, such that if a sub-fund fails certain “passive tests” under the so-called public trading trust rules, the sub-fund is forever treated as a company for income tax purposes.  Furthermore, no franking credits are provided for income tax paid by the sub-fund, ultimately resulting in double taxation to investors. 

To demonstrate, a gross return of $100 would be taxed at the company level first at 30% (i.e. $30) with the remaining amount potentially taxed at the top marginal rates of 47% (e.g. $33) when a dividend of $70 is paid to the investors.  The effective tax rate in such a case is equal to 63%, resulting in double taxation.  In our view, it is disappointing that the Government is supporting a regime that could potentially apply double taxation and a tax rate of 63%.

This does not occur for MITs where either: (1) non-public trusts (e.g. closely held MISs) are normally taxed as ordinary trusts; or (2) public trading trusts (which are taxed as companies) can generally frank dividends to their unit holders. 

The potential difference in the tax treatment of a CCIV as compared to a MIT could be disastrous for a fund manager and investors (especially where the tax risks are not otherwise disclosed or outlined to investors).

B. How are we responding?

The exposure draft is likely to be the final piece of draft legislation on the CCIV regime before it is introduced into Parliament.  Pitcher Partners will be making a submission on the exposure draft, in particular the treatment of excluded sub-funds that breach the public trading trust provisions. 

If you are considering establishing a CCIV or if you are considering a restructure of your existing funds into the CCIV regime, we would be happy to talk you through the application of these provisions. Further information has been prepared below to allow you to gain a more detailed understanding of the draft legislation, its structure and how it will apply to various transactions as well as its interactions with other legislation.  Please note that the section below are general in nature and may be subject to change on the finalisation of the legislation.

C. What is a CCIV?

A CCIV will be a new type of company under the Corporations Act (limited by shares) that will have a public company as a director (the corporate director) with an AFSL authorising it to operate the business and conduct the affairs of the CCIV through sub-funds.  The structure of a CCIV is briefly outlined in the diagram below.

Source: Pitcher Partners

A CCIV is similar to an MIT, run under a single umbrella, with the Corporate Director taking on a similar role to that of the Responsible Entity of a trust.

D. What are sub-funds?

In substance, a sub-fund is very similar to a trust in Australia.  A sub-fund will constitute a distinct and protected part of the CCIV’s business which will be segregated from any other sub-fund of the same CCIV. Assets and liabilities of the CCIV are to be allocated to each sub-fund of the CCIV in accordance with the allocation rules. The sub-funds of a CCIV will make up all of the business of the whole CCIV.  Each sub-fund is established on its registration by ASIC (irrespective of whether it is a wholesale or retail CCIV). 

While each sub-fund will be a separate and distinct cell of the CCIV, it will not have a legal personality.  Accordingly, it will not be able to enter into contracts, sue and be sued in its own name, cannot acquire, hold or dispose of assets or liabilities in its own name. All of these acts will all be done by the CCIV (on behalf of a sub-fund) which has legal personality (similar to the trustee of a trust).

E. How do investors invest in a CCIV and a sub-fund?

A CCIV may issue shares and debentures to investors, provided that each security is referable to only one sub-fund. Accordingly, each investor will hold an investment in a specific sub-fund of the CCIV.

F. How are returns paid to investors?

CCIVs may pay dividends, redeem redeemable preference shares and reduce their share capital in a similar way to other companies. Such payments are made in respect of the securities that are referable to only one sub-fund.

As CCIVs are likely to distribute income and capital to their members on a frequent basis during an income year (e.g. quarterly distributions which may comprise of both income and capital), some modifications are to be made to the Corporations Act to modify the ordinary rules that apply to companies.  For example, dividends may not need to be paid out of profit (provided the company is solvent) and capital returns may not require shareholder approval.  The modified rules proposed are similar to the rules that apply to trusts in an MIT environment.

G. Will there be wholesale and retail CCIVs?

A CCIV may be either retail or wholesale, with retail CCIVs subject to a regulatory framework that encompasses additional regulatory protections necessary for retail investors. Wholesale CCIVs are subject to a more limited regulatory framework.  The regulatory framework is similar to registered and unregistered MITs.

H. How is a CCIV and its sub-funds taxed?

The CCIV tax regime is similar to the current Attribution Managed Investment Trust (“AMIT”) regime.  Each sub-fund will be regarded as a separate tax entity and will (effectively) be taxed like an AMIT (i.e. on a flow through basis, with taxable income flowing through to members) if certain eligibility requirements are satisfied.  Sub-funds that meet these eligibility requirements will be called Attribution Sub-Funds (“ASF”).  As a consequence of having both AMITs and CCIVs applying the same tax provisions, the flow-through tax provisions have been renamed from the AMIT provisions to the Attribution Investment Vehicle (“AIV”) provisions.

I. What are the eligibility requirements for an ASF?

Sub-funds of a CCIV will be subject to similar tax eligibility criteria as required by MITs to be AMITs.  These eligibility requirements include passing the widely-held test, not being closely-held, being limited to carrying on passive income activities and being an Australian resident.  Rather than having a responsible entity with an AFSL, it will be mandatory that an ASF be part of a CCIV under the Corporations Act (i.e. which requires the CCIV to have a Corporate Director with an AFSL).

J. Why are there greater tax risks with a CCIV?

Both CCIVs and MITs will be subject to the public trading trust provisions.  These provisions require “public” entities to only carry on passive activities (e.g. using land for rental purposes).  A breach of these rules for “public” entities results in such entity being taxed as a company.

There are key differences in how the public trading trust provisions will apply as between MITs and CCIVs. 

The first is that the test is applied annually for a MIT.  Accordingly, a MIT that fails the test in one year can satisfy the rules in a subsequent year.  However, once the public trading trust provisions are failed for a sub-fund, the sub-fund is required to be taxed as a company for the remainder of its existence.

Furthermore, a MIT that is taxed as a company is entitled to frank distributions to its investors, which reduces the instance of double taxation. Unfortunately, the Treasury have decided to classify non-complying sub-funds as non-frankable entities.

Finally, closely held MITs are not subject to the public trading trust provisions and are taxed as trusts.  For example, a MIT that has 20 ultimate investors.  However, a closely held sub-fund is instead taxed as a company (as it cannot satisfy being an ASF) and is not entitled to frank distributions.

K. Would a sub-fund choose to roll-out of the CCIV?

The exposure draft provides an optional ability for a sub-fund to roll out of a CCIV where it breaches the public trading trust provisions (“excluded sub-fund”).  However, the rollover ignores that fact that, in many cases, this will be practically impossible from a commercial perspective. 

For example, where the sub-fund is a leveraged property fund, the rollover ignores the significant commercial costs associated with: (a) refinancing the property in the new rollover vehicle; (b) obtaining financial approval from both senior and second mortgage lenders; (c) the additional stamp duty and GST cost associated with the rollover of property; (d) whether the disposal would (instead) be treated on revenue account rather than capital account (i.e. as the rollover is only provided for CGT assets); (e) whether the rollover recipient will be a public company under the Corporations Act; (f) whether a PDS will be required to give effect to the rollover where shares are issued as a part of the rollover arrangement; and (g) the recipient entity being limited to only a company rather than to a trust. 

In our view, the option provided by Treasury will generally be problematic and insufficient to deal with the issues related to an excluded sub-fund from a commercial perspective.

L. Which funds are likely to be at a greater tax risk under the CCIV regime?

Generally speaking, debt and equity schemes have a lower risk of failing the public trading trust provisions.  Accordingly, there is likely to be a lower risk of running such funds through a CCIV platform.

However, the following provides an outline of a number of schemes that could potentially have a greater risk of failing the public trading trust provisions or being taxed as a company under the CCIV regime:

  • Wholesale funds where it is uncertain whether the scheme will obtain 25 members or where 10 members own 75% or more of the scheme.
  • Shorter term property funds that may not be able to demonstrate whether they have been established primarily for the purpose of deriving rent (as compared to generating a profit on the sale of property).
  • Property funds that do not derive rental income (e.g. a hotel or short-term accommodation that derive license fee type income).
  • Property funds that have a mixed use within the fund (e.g. commercial / retail for rent and residential for sale) or mixed income sources (e.g. rental income coupled with a high level of profit rent or ineligible car parking income).
  • Equity funds that hold substantial interests (e.g. 26%+) in other trading entities (e.g. a PE type fund holding substantial interests in ESIC entities).
  • Alternative funds that invest in assets that are not otherwise listed in the public trading trust provisions (e.g. certain crypto currencies, gold, carbon certificates, farms, etc).

The above is not intended to be a complete and exhaustive list of schemes that may encounter higher risks under a CCIV regime as compared to a MIT regime, but provides some examples of where fund managers need to be careful when choosing the appropriate structure for their scheme.

M. For a P2P fund, would a separate sub-fund be used for each debt?

Applying the AIV rules, a sub-fund will be able to make a class election. This means that a sub-fund could issue multiple classes of shares and have each class effectively treated as a separate entity for the AIV rules.  The benefit of this approach is that only one tax return is required for the sub-fund, even though multiple classes may exist within that sub-fund.

If (instead) the CCIV wishes to create a sub-fund for each debt, then this could result in additional compliance costs, as each sub-fund requires tax registration (ABN / TFN) and tax reporting (BAS / tax return).

N. Can an existing AMIT rollover into a CCIV?

Yes, provided that certain requirements are satisfied, it may be possible for an existing AMIT to roll into a CCIV.  The exposure draft proposes comprehensive tax rollover, which extends to revenue assets and tax losses, amongst other things.  The commercial and legal implications for rolling into a CCIV would need to be considered (including the cost required to establish and consolidate the funds into a CCIV).

O. How about state taxes?

Unfortunately, the exposure draft package is silent on the implications of various State taxes on a CCIV.  For example, if a property CCIV is established with independent sub-funds (each holding property), it would be expected that the CCIV will be treated as a single company (from a State perspective).  This may give rise to cross over land tax grouping issues as well as cross-over stamp duty issues when investors leave one sub-fund.  We believe it is critical that the various State Governments seek to provide amendments that cater for the various State taxes.

P. Are there administrative technical consequences for an amit?

Yes.  The exposure draft requires a number of definitions and sections to be changed in Division 276.  Those AMITs that have hard wired definitions and section references into their trust deeds and constitutions may need to update these documents for the new legislative terms and references once the exposure draft becomes legislation.

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