Australian unit trusts

Sections CF 2(1)(i), CF 2(6)(a), CF 3(2)(c)(ii), CF 8(a), DJ 11B and OB1 of the Income Tax Act 1994 and sections CD 7B, CD 7C, CD 21B, DB 44 and OB1 of the Income Tax Act 2004

Introduction

An issue of units in an offshore unit trust when there is an arrangement to issue the units instead of vesting money or property absolutely in the unit holder will be treated as a taxable bonus issue. Amendments also clarify that an amount that vests absolutely in a unit holder of an offshore unit trust is treated as a taxable dividend. The changes close a loophole that allowed certain New Zealand investments in Australian unit trusts to be tax-free.

Background

An opportunity existed for New Zealand resident investors to use Australian unit trust (AUT) structures to reduce or eliminate tax on certain investment income. This problem gave rise to a significant tax base maintenance concern and provided an incentive for New Zealand residents to use AUT structures rather than New Zealand vehicles when making certain investments.

Income earned by non-Australian residents through an AUT that is not sourced in Australia is not subject to Australian tax if it is distributed in the same year that it is earned. Previously, this income could also escape New Zealand tax if it was distributed by way of a non-taxable bonus issue of new units in the AUT. The amendment was introduced by Supplementary Order Paper number 210 on 11 May 2004.

Key features

• The amendments treat as a taxable bonus issue an issue of units in an offshore unit trust where there is an arrangement to issue the units instead of vesting money or property absolutely in the unit holder (sections OB 1 of the 1994 Act and CD 7C of the 2004 Act).
• An amendment also clarifies that an amount vesting absolutely in a unit holder of an offshore unit trust is treated as a taxable dividend (section OB 1 of both Acts and sections CF 2(1) (i) of the 1994 Act and CD 7B of the 2004 Act).
• The application of the change is limited to offshore unit trusts (various sections).
• An amendment also ensures that companies deriving exempt offshore dividends can claim an appropriate deduction for expenses incurred (sections DJ 11B of the 1994 Act and DB 44 of the 2004 Act).

Application date

The amendments apply to amounts vested and units issued on or after the date the Act came into force, 21 December 2004.

Detailed analysis

The problem dealt with by the amendments

When applicable, New Zealand's international tax rules tax offshore equity investments comprehensively. An exemption exists, however, for investments in countries that have a similar tax system to New Zealand's. These countries are known as "grey list" countries, and Australia is included on this list. For many investors this means that they are taxed only on a distribution of dividends derived from these offshore entities.

Under New Zealand tax law investments in unit trusts, including offshore unit trusts, are treated as investments in a company. Trust law still applies to these investments such that if the trustee of a trust vests funds absolutely in a beneficiary, the beneficiary has an absolute beneficial interest in those funds. The dividend tax rules applicable to companies treat amounts that are distributed from a company to a shareholder as a taxable dividend. Therefore, given that a unit trust is treated as a company, and the beneficiary of the unit trust gains an absolute beneficial interest in an amount, the absolute vesting of that amount in a beneficiary was, before the amendment was made, probably already treated as a dividend for tax purposes.

Previously, however, an amount that would otherwise be treated as a dividend could, in certain circumstances, be non-taxable if it was distributed by way of a "bonus issue" of new units rather than cash. Section OB 1 defines a "bonus issue" as, essentially, the issue by a company to a shareholder of new shares in a situation where the company does not receive consideration for the issue. If the shareholder pays for the new units this is not a "bonus issue".

The problem with the rules as they were was that a unit holder could, when units of a particular class were purchased, agree that future amounts that the trustee or the trust deed vested absolutely in them were to be reinvested in new units rather than distributed in cash. If such an agreement was made it would appear that, before the amendment, the reinvestment of the amount was not consideration provided by the unit holder to the unit trust. This means that the unit trust could issue new units that were treated as "bonus issues". These could then be treated as non-taxable bonus issues.

This is clearly the wrong result from a policy perspective. The amounts which vest absolutely in the beneficiary are economically equivalent to a dividend and should, therefore, be treated equivalently. The fact that the shareholder has chosen to have the amount reinvested in a new unit should not alter the dividend character of the amount that vests absolutely.

Examples of structures that caused particular concern are those that invested back into New Zealand government stock. This is problematic because, if the New Zealand resident had invested in the government stock directly rather than through the AUT, full New Zealand tax would have been paid on the interest income.

The solution

Amendments to definition of taxable bonus issue (section OB 1 and section CD 7C of the 2004 Act)

The main amendment is to the definition of "taxable bonus issue" in section OB 1 and the definition of dividend in section CD 7C of the 2004 Act. The amendment provides that an issue of units in an offshore unit trust that are made as part of an arrangement when units are issued instead of the unit trust vesting money or property absolutely in the unit holder is a taxable bonus issue. This ensures that unit holders in offshore unit trusts cannot, essentially, agree to have distributions reinvested in new units in order to escape dividend taxation.

Amendments to dividend definition (sections CF 2(1)(i) of the 1994 Act and CD 7B of the 2004 Act))

Section CF 2(1)(i) has been amended and new section CD 7B inserted, to put beyond doubt that amounts distributed by an offshore unit trust that vest absolutely in the unit holder are treated as taxable dividends.

While it is almost certain that an amount that vests absolutely in a beneficiary is already treated as a dividend under sections CF 2(1)(a) of the 1994 Act and CD 3(1) and CD 4(1) of the 2004 Act, this amendment puts the issue beyond doubt. For the amendments to deal effectively with AUT structures it is vital that a vesting from a unit trust is treated as a dividend. If it could be argued that such a vesting was not treated as a dividend, the AUT structures could still provide an opportunity for New Zealand resident investors to minimise or eliminate tax on their investments.

This could be achieved by the AUT vesting an amount of income absolutely in the New Zealand resident beneficiary. This would result in the income not being taxed in Australia and, if the amount that was vested was not a dividend for New Zealand tax purposes, the amount would not be taxed in New Zealand. It would not be necessary for the vesting to be accompanied by the issue of a new unit. The vested amount would simply be reflected in a higher value for existing units. If the New Zealand resident beneficiary held such units on capital account, this additional value could be realised as a tax-free capital gain when the unit was eventually sold.

Expenditure derived by a company in deriving exempt dividends

The problem that arose in the AUT investment context is that, as a result of the amendments, the treatment of certain bonus issues of units from unit trusts have changed from non-taxable in nature to taxable dividends. For a company that holds units in such a unit trust, this will result in the issue of those units being treated as exempt dividends under section CB 10(1) of the 1994 Act and section CW 9(1) of the 2004 Act and, therefore, subject to a dividend withholding payment (DWP) deduction of 33%. Expenditure incurred by the New Zealand resident company in deriving the exempt dividends is not likely to be tax-deductible, in the absence of the current amendment, as the expenditure would have been incurred to derive exempt income (section BD 2(2)(b) of the 1994 Act and section DA 2(3) of the 2004 Act). The problem has existed for some time and was on the government's tax policy work programme.

From a policy perspective a full deduction should be allowed when the income is fully subject to either New Zealand income tax or DWP. However, if a New Zealand resident company derives a dividend from a non-resident company, situations can arise where the dividend is not subject to full New Zealand tax or full DWP. Allowing a full deduction in these situations would give rise to an inappropriate result.

The amendment solves this problem by, essentially, providing that a deduction be allowed for expenditure incurred by a company deriving dividends that are exempt under section CB 10(1) of the 1994 Act and section CW 9(1) of the 2004 Act to the extent that DWP on the dividends is not relieved by the conduit tax rules (new section DJ 11B of the 1994 Act and section DB 44 of the 2004 Act).