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Privatisation and Infrastructure – Australian Federal Tax Framework (Chapter 4)

QUALIFICATION – THIS DOCUMENT IS CIRCULATED FOR COMMENT AND CONSULTATION ON THE

ISSUES IT RAISES RELATING TO THE TAXATION OF INCOME FROM PRIVATISATION AND

INFRASTRUCTURE ACTIVITY. THE ATO WILL INCORPORATE THIS AS A NEW CHAPTER FOUR OF THE

EXISTING FRAMEWORK DOCUMENT

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4. Areas of ATO Compliance focus This chapter outlines certain infrastructure-related issues with which the ATO has concerns. These

are rated as high risk from a compliance perspective and will be the subject of focus by the ATO

compliance teams.

Specifically the ATO is concerned about:

1) investors attempting to disguise an outgoing made to obtain a benefit that is capital in nature

under a PPP as a revenue outgoing;

2) investors endeavouring to exploit the tax benefits of stapled structures inappropriately;

3) investors having negative control of infrastructure trusts for the purposes of Division 6C and

the MIT rules;

4) arguments that some investors are not associate entities for thin capitalisation purposes;

and

5) attempts to fracture control interests.

The ATO encourages taxpayers to have regard to our concerns when structuring their investments in

the infrastructure sector and avoid taking positions which the ATO regards as high risk. This is

because we are highly likely to allocate compliance resources to look carefully at arrangements with

the features we are concerned about.

If you have undertaken one of these transactions or taken a position in respect of one of these issues

for a transaction we encourage you to let us know. Amended assessments resulting from voluntary

disclosure will always result in lower penalties than amended assessments arising as a consequence

of ATO compliance action.

4.1 Disguising a capital payment as a deductible outgoing As discussed in the PPP chapter, the ATO is familiar with the standard-form PPP structure and is

generally comfortable with it.

However, the ATO has seen a variation on the standard PPP structure which involves a receivables

purchase payment not being used by the Government to finance the construction payment to the

project trust. Instead, the receivables purchase payment is simply retained by the Government.

Where this occurs, the receivables purchase payment may, in reality, have been paid as part of the

consortium’s bid price to the Government for the grant of the right to operate and maintain the

asset in question.

Because, the consortium argues that the license payments are deductible under section 8-1, the

overall effect is to claim for the project trust a deduction for what is in reality part of the purchase

price paid to the Government for the right to operate the asset. Had the amount simply been paid as

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a purchase price (rather than as a license payment), then the payment would have been on capital

account.

The ATO sees the structuring of what is in reality a capital-account purchase price as a purported

deductible license payment as being high risk. The application of compliance resources would flow

from this risk rating.

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4.2 Exploiting the tax benefits associated of stapled structures

inappropriately Stapled structures are commonly used in the infrastructure sector. Generally, this business structure

combines a trust (‘the Asset Trust’) with a related operating company or trust (‘the Operating

Entity’). The Asset Trust owns (or holds a long-term lease over) land and the assets affixed to the

land and the Operating Entity rents the land from the Asset Trust and carries on business using those

assets. The units in the Asset Trust are legally or economically stapled to the units or shares in the

Operating Entity and usually cannot be sold or otherwise dealt with separately.

The ATO understands that stapled structures are favoured by investors, particularly non-resident

investors, because investors are able to receive returns on their investment in the land on a pre-tax

basis.

The ATO is familiar with, and broadly comfortable with traditional uses of this structure. That said,

there are a number of concerns the ATO has with particular aspects of it, and how these are

sometimes used. These are outlined below.

4.2.1 Tax treatment of a stapled structure

The net income of the Asset Trust will generally be taxed in the hands of the beneficiaries of the

Asset Trust under Division 6 of the ITAA 1936. This is because the Asset Trust carries on an “eligible

investment business” (EIB) within the meaning of section 102M of the ITAA1936. This involves,

broadly, investing in land for the purpose of deriving rent and/or investment or trading in certain

financial instruments.

The result of this is that:

if the beneficiaries of Asset Trust are non-residents – they may be entitled to the 15%

withholding rate for Managed Investment Trust (MIT) payments (distributions from the

Asset Trust); and

regardless of residency – there may be a significant deferral of a tax liability if the

distribution is a tax deferred distribution.

The Operating Entity on the other hand, derives income from carrying on a trading business in

relation to the assets owned by the Asset Trust. The Operating Entity is a trust or a company.

The taxable income derived by the Operating Entity:

if it is a company, or is taxed like a company under Division 6C – will be taxed at 30%; or

if it is taxed as a trust – either:

o in the case of resident investors - at the investor’s marginal rate of tax, or

o in the case of non-resident investors – at the rate of tax applicable to a trustee

assessment – generally between 30% to 47.5% (because MIT payment withholding

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tax rates may not be available if the investor controls an entity that does not carry

on an EIB).

4.2.2 ATO’s general stance on the use of stapled structures

As a general proposition, a taxpayer’s decision to establish a business using a particular type of

entity, such as a trust rather than a company would not attract the attention of the ATO - even if

that decision was, at least in part, driven by tax considerations.

A stapled structure is simply another example of a type of vehicle through which a business may be

carried on. As such, the ATO does not see stapled structures as being inherently high or low risk.

The ATO acknowledges that the proliferation of stapled structures is the consequence of a policy

decision by Government to allow passive income derived from certain investments to be taxed in the

hands of the ultimate investors, even where those investments are in assets that are used in the

active business of a related party.

What matters, when assessing whether a stapled structure presents a compliance risk, is:

the kinds of transactions entered into by the stapled entities;

the reason for entering into those transactions; and

the tax consequences that arise from those transactions.

The following types of transactions are of concern to the Commissioner and will be taken to be high

risk from an ATO compliance perspective.

Investors

Asset Trust

Operating

Entity

Profits taxed at 30% and may not be tax deferred

Profits taxed at 15% and/or tax

deferred

Rent, interest or other forms of EIB

income

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4.2.3 Shifting of profits across a staple

The ATO is concerned about any type of transaction which has the effect of inappropriately shifting

income from the Operating Entity to the Asset Trust. For example:

1) the use of an equity swap under which the Asset Trust acquires the right to a return based

upon the economic performance of the Operating Entity;

2) A lease under which rental payments to the Asset Trust are calculated to substantially

capture the profits of the Operating Entity;

3) A loan from Asset Trust to the Operating Entity - unless there is only a small margin over the

rate of interest charged on external monies borrowed by the Asset Trust.

4) The Asset Trust and the Operating Entity having unequal levels of gearing. For example, a

transaction we have seen is where the Asset Trust was only 40% geared and the Operating

Entity was 99% geared.

5) Different interest rates being charged on unitholder or shareholder debt as between the

Asset Trust and the Operating Entity.

6) Where the Asset Trust and the Operating Entity are purchasing a privatised government

business – a Purchase Price allocation that does not have a reasonable basis. A reasonable

basis would have regard to:

a) the nature of the business being privatised, particularly given that, post-

privatisation, the business will constitute a single unified business;

b) the way in which the allowable revenue of the business is calculated by the relevant

regulator (if the business is subject to regulation on the amount of revenue);

c) the total purchase price paid by both entities;

d) the fair value of the assets held by the Asset Trust and the Operating Entity. (An

approach that allocates the purchase price firstly to tangible assets and then any

residual purchase price to intangible assets may not reflect the fair value for the

intangible assets. The intangible assets should be subject to their own fair and

reasonable valuation); and

e) previous privatisation transactions.

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The ATO takes the view that arrangements which are potentially designed to shift profits from the

Operating Entity to the Asset Trust are high risk from ATO compliance perspective. The ATO may

review some arrangements to determine whether:

Part IVA applies;

the swap, interest or rental payments are deductible to the Operating Entity under section

8-1 of the ITAA 1997;

the Asset Trust indirectly controls or is able to indirectly control the Operating Entity within

the meaning of section 102N(1) of the ITAA 1936; and

the rental payments might not constitute “rent” for the purposes of the definition of eligible

investment business in section 102M of the ITAA 1936.

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4.2.4 Restructuring an existing infrastructure business into a staple with no non-

tax purpose

The ATO also takes the view that Part IVA potentially applies to a restructure of an existing

infrastructure business conducted by a single company into a business conducted by two or more

entities stapled together. To that end, the ATO will treat restructures of that kind as high risk in

terms of compliance.

An example of a restructure which would be of concern to the ATO is described below:

1) There is a company carrying on an infrastructure business that is wholly owned by non-

resident investors. The Company owns the following types of assets:

freehold land;

fixtures on land;

chattels;

intangible assets, such as licenses to operate the business; and

goodwill.

The business currently derives income by charging customers in exchange for the provision

of certain services.

2) The non-resident investors establish a new trust in Australia – Hold Trust (Asset). Often each

investor will also set up its own resident holding trust.

3) Hold Trust (Asset) acquires units in another new trust in Australia, Asset Trust.

4) The freehold land and the fixtures are sold at fair value by the Company to the Asset Trust.

5) The Asset Trust enters into a lease with the Company, and pays rent for the use of the land

and fixtures.

6) The Company continues to operate the business and receive payments from the end-user

customers.

The (indirect) interest that the Investors hold in the Asset Trust and the Company are stapled.

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Risk rating for these types of restructures

The ATO considers this transaction to be high risk from a compliance perspective. The risk rating

arises as a result of a consideration of the following factors:

there is no change in ultimate underlying ownership of the business;

the only effect is to substantially reduce the Company and the Investor’s ultimate tax

liability; and

there are no non-tax related purposes for undertaking the restructure.

As a consequence, the ATO considers that there would be a high risk that the tax benefit obtained,

being the deductions arising from the obligation of the Company to pay rent to the Asset Trust

Foreign jurisdiction

Australia

Foreign investors

Hold Trust

(Asset)

Customers

2. Setting up of new Hold Trust

(Asset)

3. Setting up of new Asset Trust

4. Sale of Freehold and fixtures on land

5. Lease of Freehold and fixtures on land

6. End-user charges

Company Asset

Trust

1. Existing ownership structure

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would be cancelled under Part IVA. Compliance resources would be allocated in accordance with this

risk rating.

Variation involving a company sale and subsequent splitting up

The ATO has seen a variation on the above transaction that it considers to be of especially high risk

in terms of compliance.

The transaction is structured as follows:

1. The Foreign Investors sell their shares in the Company to another set of investors. The

Foreign Investors then claim that there is no capital gains tax liability due to Division 855.

2. The new investors acquire the Company under a new Australian Company, triggering a

consolidation under Part 3-90, and obtaining a cost base uplift to market value.

3. Consistent with the transaction outlined above, the Company then sells land and fixtures to

a new Asset Trust, and the Asset Trust leases the land and fixtures back to the Company.

The overall result of these transactions is that tax is not being paid on the pre-sale increase in the

capital value of the business, and reduced tax is also being paid on the future profits of the business.

The ATO considers this type of structuring to be of particular concern, and strongly discourages

taxpayers from undertaking it. If taxpayers do adopt this structure, compliance activities will be

undertaken in relation to the application of Part IVA.

This means that Part IVA could apply to the vendor, the purchaser, or both. The tax benefit could be

the avoidance of capital gains tax, the obtaining of the consolidation uplift, the availability of the

rental deductions, or a combination of these. The ATO may seek to argue counterfactuals based on a

simple asset sale and/or a simple share sale without the on-sale to the Asset Trust.

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4.3 Negative control for the purposes of Division 6C and the MIT rules The issue of ‘control or being able to control’ is relevant both for the purposes of Division 6C and the

MIT rules.

Taxpayers should consider the previous guidance provided in relation to the ATO’s view on control,

including that it extends to “negative control”. Taxpayers should also refer to the draft discussion

paper released on September 2nd 2015.

Importantly, in determining whether an entity controls or is able to control the trading business of

another entity (the Operating Entity), regard must be had not only to contractual and formal

governance arrangements, but also to the conduct of the relevant parties in reality and any informal

understandings that the parties may have.

In judging whether there is a compliance risk of one or more investors controlling a trading business

being conducted by another entity, the ATO considers the following matters to be relevant:

the overall nature and significance of the investment the investor has in the Operating Entity

or any other entity stapled to the Operating Entity;

the length of the investment; and

the day-to-day reality of the investors involvement, or otherwise, in the business.

From a compliance perspective, when determining whether there is control or the ability to control,

the ATO will always have regard to the contractual and other formal governance arrangements. The

ATO may allocate compliance resources to test whether there is control evidenced by conduct or

informal understandings where an investor has a stake of 20% or more.

Where an investor has a stake of 30% or more, the ATO will allocate compliance resources to test

whether there is control evidenced by conduct or informal understandings.

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4.4 Definition of associate entity under section 820-905 Investors typically finance investment in infrastructure by way of a mixture of debt and equity.

Accordingly, the thin capitalisation rules in Division 820 of the ITAA 1997 will be relevant to

determine whether all the debt deductions in respect of the debt are allowable. In the course of

applying the thin capitalisation rules, the question may arise as to whether the investor is an

associate entity of the entity or entities they directly (or indirectly) own an interest in for the

purposes of paragraph 820-905(1)(b).

An entity is an associate entity of another entity if the first entity is an associate under section 318 of

the ITAA 1936 and one of the paragraphs in subsection (1) applies. Paragraph 820-905(1)(b) will be

satisfied if the first entity is accustomed or under an obligation (whether formal or informal), or

might reasonably be expected, to act in accordance with the directions, instructions or wishes of the

investors in relation to:

1) the distribution or retention of the entity's profits; or

2) the financial policies relating to the entity's assets, debt capital or equity capital.

The directions, instructions or wishes, may be or might reasonably be expected to be,

communicated directly or through interposed entities.

4.4.1 Size of investment

In determining whether an investor is an associate of an entity it directly (or indirectly) owns an

interest in, consistent with the above discussion in relation to control for the purposes of Division 6C

and the MIT rules, regard must be had not only to contractual and formal governance arrangements

for the entity, but also to the conduct of the relevant parties in reality and any informal

understandings that the parties may have.

In judging whether there is a compliance risk of one or more investor being an associate of an entity

it has an interest in, the ATO considers the following matters to be relevant:

the overall nature and significance of the investment the investor has in the entity it has an

interest in, and any other entity stapled to that entity;

the day-to-day reality of the investor’s involvement, or otherwise, in the business.

From a compliance perspective, when determining whether an investor is an associate of another

entity, the ATO will always have regard to the contractual and other formal governance

arrangements. The ATO may allocate compliance resources to test whether an investor is an

associate of an entity by reference to conduct or informal understandings where an investor has a

stake of 20% or more.

Where an investor has a stake of 30% or more, the ATO will allocate compliance resources to test

whether an investor is an associate of an entity by reference to conduct or informal understandings.

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4.4.2 Negative control

Irrespective of the size of any investment, and consistent with the above discussion on control in

relation to Division 6C and MIT rules, the presence of certain veto rights and/or negative control

clauses could cause an investor to be an associate of an entity or entities they directly (or indirectly)

own an interest in.

In determining this, taxpayers should consider the previous guidance provided in relation to the

ATO’s view on control as referred to above, including that it extends to “negative control”.

Taxpayers should also refer to a recently released draft discussion paper as also referred to above.

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4.5 Fracturing of control interests As outlined above, the level of an investor’s stake in another entity is relevant to the question of

control for Division 6C and the MIT rules, as well as the associate entity test in section 820-905.

Given that context, there may be an incentive for investors to hold their stake in another entity not

through one investment vehicle, but multiple investment vehicles.

For example, instead of an investor holding a 50% stake through a single resident trust, it might seek

to hold that stake through 10 interposed trusts, each having a 5% stake.

The investor may do this in order to ensure:

Each trust is not subject to Division 6C because it does not ‘control’ an entity carrying on a

trading business.

Each trust can avail itself of MIT status because similarly it does not ‘control’ an entity that

carries on a trading business.

Each trust is not an ‘associate entity’ of the entity the investor wants to invest in. This might

be done to enable the ten trusts to gear up without having to take into account any

investments they might hold in associates. This may effectively enable the entire structure

to be double geared – once at the entity level and then again at the level of the ten trusts.

The ATO however considers that the fracturing of control interests in the manner described above

will give rise to a high compliance risk. A specific area of concern is whether the fracturing may

constitute a scheme to which Part IVA may apply.

Other types of fracturing of control interests about which we have similar concerns include where”

different types of control and/or veto rights are artificially placed in different entities within

an investor’s structure. An example of this would be where relatively minor rights might be

vested in a unit trust which has a large stake in an investment, but more significant rights are

vested in the 100% unitholder of that unit trust. The ATO’s concern here is that this artificial

fracturing might be being used to suggest that the unit trust does not control the entity that

owns the investment.

different governance arrangements are put in place with the effect that an Operating Entity

effectively controls the Asset Trust, but the immediate holders of interests in the Asset Trust

themselves are said to not control the Asset Trust. This is despite the holders of interests in

the Asset Trust and the Operating Entity having the same underlying owners. The ATO would

have concerns that while the overall effect is to give control over the entire business to the

investors, only the entities in the “Operating” side of the structure would actually be said to

control any of the entities they invest in. This would, in turn, enable non-eligible investment

business income-producing assets to be placed in the Asset Trust, and be taxed on a flow-

through basis.

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The ATO would consider both of these types of fracturing of control interests to pose a high

compliance risk of being a scheme to which Part IVA may apply.