Answer ... Unit trusts investing in portfolio interests in financial assets, or ‘passively’ investing in real estate to derive rent, will generally have flow-through tax treatment, and income and capital gains will be taxable in the hands of unitholders (if Australian tax residents) or on a withholding basis (from distributions to non-Australian tax resident unitholders).
A public unit trust that carries on a ‘trading business’ for a relevant tax year is generally denied flow-through tax treatment and is treated as if it were a company for most tax purposes, including being subject to the applicable corporate tax rate. The cases in which a unit trust will be considered to carry on a ‘trading business’ include:
- conducting real estate development or similar activities; or
- controlling, or having the ability to control, a trading business.
Taking into account these tax considerations, the Australian market developed what is known as a ‘stapled trust’ structure, which generally involves investors being offered units in a trust (that restricts its activities to those necessary to retain flow-through tax treatment) stapled to units in another trust, or to shares in a company, that in either case carries on or controls a trading business (often using land or infrastructure leased to it by the trust). This structure became very common for investment in infrastructure such as toll roads, seaports and energy utilities. Although there has been long-standing use of these types of stapled structures, the Australian government recently enacted measures to limit the benefits of stapled structures –albeit with a transitional period of continuing favourable treatment for certain eligible arrangements. A 30% withholding tax rate on distributions of certain kinds of ‘non-concessional’ income has been introduced, and may, for example, apply to investments in agricultural land or residential housing (other than affordable housing). At the same time, steps were taken to codify, and to an extent pare back, access to concessional tax treatment through flow-through trusts for foreign pension funds and sovereign entities.
There are special rules for eligible domestic investment trusts that are widely held, known as managed investment trusts (MITs). Unit trusts that are eligible to meet the criteria for MIT status may attract a concessional tax profile for non-resident investors, including (potentially):
- flow-through of tax treaty rates on dividends, interest and royalties;
- a concessional withholding tax rate (15%) on distributions of other Australian source income, such as rental income by real estate-based MITs; and
- tax-free treatment of non-Australian source income and capital gains.
Additionally, MITs can elect for capital account treatment of gains on the realisation of eligible investments (subject to various exceptions, including land held as trading stock, debt interests and certain financial arrangements), which may be advantageous to both Australian and foreign resident investors. For example, non-resident investors are subject to withholding tax under the capital account election only in relation to gains from the disposal of an interest held (directly, or in some cases, indirectly) by the MIT in real property situated in Australia (defined broadly). Australian resident individuals and superannuation funds, on the other hand, can access discounted capital gains tax treatment where the relevant investment was held by the MIT for at least 12 months.
Eligibility for MIT status requires the following, among other things:
- Certain investment management decisions are made within Australia;
- The trust meets a widely held requirement (which may potentially also be satisfied if a substantial part of the unitholder base comprises certain types of widely held investors, such as pension funds); and
- The trust has an investment strategy that excludes the taking of controlling interests in portfolio entities that carry on a trading business.
Unit trusts may be operated in any manner as determined in the trust deed adopted by the trustee, which may, for example, provide for operation as either an evergreen or closed-end fund. For taxation purposes, MITs may elect to be treated as ‘attribution MITs’ which, among other things, permits the trusts to attribute income and gains of different character to different members in accordance with entitlements under the trust instrument. It also allows the trusts to correct errors or delays in finally ascertaining trust income by making adjustments in the year the need for correction is discovered, rather than having to reopen prior year distributions and tax filings.
While foreign investment funds will not generally be subject to Australian capital gains tax on portfolio investments in Australian businesses, capital gains tax can be incurred in the case of non-portfolio investments in companies, trusts or limited partnerships holding land or mining assets – for example, an interest of 10% or more in an entity for which more than 50% of its asset value is attributable to ‘taxable Australian property’ such as real estate or mining or petroleum interests.
Some controversy has arisen as to how these rules apply to investments by foreign limited partnerships which are eligible for flow-through treatment in the home jurisdictions of the investing partners (eg, the United States) and hence arguably entitled to flow-through tax treatment under Australian tax treaties with those jurisdictions. Litigation in the federal courts has not yet finally resolved the issue, but has apparently concluded that the limited partnership itself cannot claim the benefit of the treaty protections for transparent vehicles (Commissioner of Taxation v Resource Capital Fund IV LP  FCAFC 51).
Limited partnerships are generally treated under Australian tax law as companies – that is, they are taxed at the company tax rate and do not offer flow-through tax treatment. However, exceptions to this general rule apply to limited partnerships that are registered with the Australian government to engage in eligible venture capital investment activities. These types of limited partnerships can be used for certain venture capital and certain private equity investment strategies. Legislation provides for registration of venture capital limited partnerships (VCLPs), early stage venture capital limited partnerships (ESVCLPs) and Australian venture capital funds of funds (AFOFs). Each of these may be eligible for certain capital gains tax concessions on qualifying investment activities. For example, eligible foreign investors will generally not be subject to Australian tax on realised capital gains by VCLPs on eligible venture capital investments held for at least 12 months. The concessional treatment of eligible venture capital investments has been supplemented by a regime for ‘early stage innovation companies’ (ESICs) that includes an upfront tax offset for up to 20% of the value invested (but capped at $200,000) and a capital gains tax exemption for ESIC shares held for at least 12 months, but less than 10 years. Early stage investor tax concessions may also be available to start-up fintech businesses for investments made after 1 July 2018