Changes announced to support Islamic financing in Australia
A key announcement by the Federal Government in its recent Budget is a pledge to “enhance access to asset backed financing” by removing key barriers to the use of asset backed financing arrangements imposed by Australia’s current tax laws. While the announcement was made without much fanfare, it may prove to be one of the most significant tax changes in the Budget. Potentially, the announcement may open the door to Islamic financing in Australia, allowing Australian borrowers to access a new financial market to fund projects, particularly in the infrastructure and agricultural space.
The Board of Taxation’s report on Islamic financing was released on Budget night. The report notes that “access to diverse sources of offshore capital is important in the context of Australia being a net capital importer. The Board recognises that Islamic finance may provide a further finance option to help meet this demand, particularly for infrastructure projects in Australia”.
Norton Rose Fulbright has acted on Shariah-compliant financing structures throughout the world to fund large infrastructure projects (including PPPs) and privatisations including airports, hydro-power stations, toll roads and ports etc. Different Islamic financing structures are available to suit the risk and return profiles of different infrastructure types (including to address construction risk), however, the differential tax treatment when compared with other financing structures has been a significant impediment to the development of the market in Australia. For example, many Islamic financing transactions are not treated as a loan for tax purposes, but are instead subject to tax under the CGT or trading stock rules and can be subject to GST or stamp duty. As a result, Australia’s ability to access this source of funding has been limited. Transactions involving Islamic financing in Australia have to date required complex structuring and involved a combination of Islamic financing and conventional financing to create innovative hybrid structures.
More information about the Board of Taxation’s review
Back in April 2010, the Federal Government announced that the Board of Taxation would undertake a comprehensive review of Australia’s tax laws to ensure they do not inhibit the expansion of Islamic finance, banking and insurance products in Australia. Norton Rose Fulbright was amongst a small number of firms which contributed submissions to the Board proposing taxation reform at both the State and Federal level. The measures we suggested were to follow the United Kingdom approach. The changes would place transactions structured in a Shariah-compliant manner on a similar footing to conventional financing so far as the tax consequences are concerned.
While the Board’s initial Discussion Paper discussed a wider range of possible Islamic financing structures, its final report focuses on facilitating the following:
Murabaha: This is where an asset is sold for a deferred payment or series of payments which include a profit element. This type of transaction may be used, for example, in place of a mortgage loan to enable a residential house purchase.
Tawarruq: This is also known as a commodity Murabaha where a party buys an asset (typically a tradeable commodity such as platinum) on deferred payment terms, then immediately sells that asset in order to obtain use of the cash.
Ijara muntahia bittamleek: This is essentially a finance lease arrangement where the lessor makes a promise to transfer ownership of the asset at the end of the lease. There are differences from the typical Western finance lease, in particular that the rental for the whole term must be determined at the outset, and liabilities associated with ownership of the asset must be borne by the lessor.
Sukuk: This denotes a certificate representing a beneficial interest in assets, and is similar in function to a tradeable bond or note. A Sukuk sits above a Shariah-compliant underlying structure. The example in the Board’s report envisages a leased asset as the underlying transaction and the most likely structure in an Australian context, although various underlying structures may be used.
The Board made the following recommendations:
Recommendation 1: Amend the income tax law to ensure that, in respect of deferred payment arrangements whose main purpose is to raise debt finance, the finance gain or loss is treated the same as interest on a conventional borrowing. This and Recommendation 8 below primarily facilitate deferred asset purchase transactions such as the Murabaha and the Tawarruq.
Recommendation 2: Expand Division 240 of the ITAA 1997 (provisions relating to the characterisation of certain leases as a notional sale and loan) so that it applies to hire purchase arrangements relating to all assets (not just goods) and ensure that this same division applies to credit arrangements that have the same economic characteristics as a hire purchase arrangement. This primarily facilitates an Ijara muntahia bittamleek transaction.
Recommendation 3: Develop guidance on whether the return on a deferred payment arrangement or an asset based lease security (ie, the Murabaha, Tawarruq and Sukuk products) should come within the expanded definition of “interest” for interest withholding tax (IWT) purposes. IWT is payable on Australian source interest derived by a non-resident unless an exemption applies. There is uncertainty under the current tax regime whether the return on certain Islamic finance products would fall within the current definition.
Recommendation 4: Amend the income tax law to ensure IWT exemptions are made available for publically offered Islamic finance products with equivalent economic characteristics to debentures or those interests that are currently eligible for the IWT exemptions. This, together with recommendation 3 above, would facilitate foreign investment into both Tawarruq and Sukuk products and enable access to capital markets.
Recommendation 5: Develop guidance on whether certain Islamic finance products would come within the definition of “offshore banking activity” under the current law entitling such arrangements to concessional tax treatment for finance transactions that are economically equivalent to offshore banking activities. Such guidance should be helpful in the context of all the Islamic finance products considered by the Board’s report.
Recommendation 6: Develop guidance on whether investment by a managed investment trust (MIT) in a Sukuk would constitute “eligible investment business activity” in order for the MIT to maintain its eligibility for trust taxation treatment under Division 6 of the ITAA 1936.
Recommendation 7: The current taxation framework for partnerships and joint ventures should not be amended. This reflects the view of the Board that the 4 structures described above should be the focus of the Government’s reforms.
Recommendation 8: Develop guidance on the characterisation of the ‘profit’ element of Islamic financing arrangements and its treatment for GST purposes. In particular, it is recommended that the guidance clarify whether the ‘profit’ component is to be considered as: (i) a debt, credit or right to credit or (ii) a charge or mortgage over real property (in the case of property transactions).
Recommendation 9: The current reduced input tax credits (RITC) regime for financial supplies should be maintained and not extended to other input taxed supplies such as input taxed residential premises.
Despite these changes, the Government’s reference to Islamic finance being used in infrastructure projects highlights stamp duty as a key issue which the Federal Government has limited power to address. Currently, only Victoria has introduced a limited exemption to prevent double duty on property purchases by individuals. Stamp duty costs represent a significant impediment for Islamic financing structures and, without relief being implemented by the States and Territories, Islamic finance involving real property in Australia is likely to be restricted.
Timing and implementation
The measures are intended to apply from 1 July 2018. We expect that the Government will consult with industry to ensure that the new rules provide enough flexibility to attract different sources of financing. We hope that State and Territory Governments will also support these developments with necessary stamp duty reforms.
New incentives for investors in early stage venture capital funds
The recent introduction of the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 (Bill) reflects the Federal Government’s commitment to further its National Innovation and Science Agenda. The measures should help in boosting the use of pooled venture capital focused funds as a way of channelling investor capital into otherwise cash starved start ups in the technology and innovation sectors. In the second reading speech, the Treasurer stated:
“The tax incentives for funding provided through venture capital limited partnerships [VCLP] including early stage venture capital limited partnerships [ESVCLP] are designed to attract investments at the growth stage of a company’s development. At this stage, entrepreneurs can face further difficulties accessing funding, despite typically receiving a few rounds of initial funding, as they are not yet able to market themselves for public or broader investor buy-in.”
A key plank is the introduction of a new 10% tax offset available to fund investors. The tax offset will supplement the existing tax concessional status of investments into such vehicles.
The Government has also used this as an opportunity to relax some of the strict parameters for operation of complying venture capital limited partnership structures and that have to date discouraged many fund managers from using such vehicles to capture investor capital.
Coincidentally, the Bill complements the Significant Investor Visa regime, which, since July 2015, mandated that aspiring high net worth migrants invest $500,000 of their $5 million Australian investment into a complying venture capital fund for a minimum 4 year holding period.
This article aims to provide a summary of the key measures related to investments in ESVCLPs. Some of the measures also apply to VCLPs and AFOFs registered with Innovation Australia.
New tax offset available for investors in ESVCLPs
The changes are expected to take effect from July 1, 2016, and complement the existing broad based investor tax exemption potentially available to complying investments in ESVCLPs.
- limited partners in ESVCLPs may be eligible for a 10% non-refundable carry-forward tax offset on contributions made to the ESVCLP during an income year; and
- tax offset applies to ESVCLPs that are unconditionally registered after 7 December 2015, and to contributions made after 1 July 2016. Some transitional rules may apply for contributions prior to this date.
Significant Investor Visa (SIV) investors as a source of funding
The high risk nature of tech start-ups and the relatively cautious Australian attitude towards venture capital (at least relative to the United States) has significantly limited the amount raised in pooled venture funds. The new tax offset regime will complement the changes made (in July 2015) to the significant investor visa (SIV) regime, and hopefully deliver a new source of investor capital from high net worth non-resident individuals wishing to access the SIV visa.
Broadly, the SIV operates as a provisional visa that provides a pathway to permanent residency for SIV holders who meet certain requirements. An SIV applicant must invest at least $5 million in complying investments over four years, allocated as follows:
- minimum of $500,000 in eligible Australian venture capital or growth private equity fund(s) investing in small start-ups and small private companies. A vehicle must be registered with Innovation Australia as an ESVCLP, VCLP or AFOF (venture capital fund of funds);
- minimum of $1.5 million in an eligible managed fund(s) or Listed Investment Company (LICs) that invest in ‘emerging companies’ listed on the ASX; and
- minimum of $3 million in managed fund(s) or LICs that invest in a combination of eligible assets that include ASX listed companies, infrastructure trusts, preferred equity, eligible corporate bonds or notes, deferred annuities and commercial real property.
ESVCLP liberalisation measures
The existing ESVCLP regime contains a number of integrity measures that need to be met by general partners in order to access certain tax exemptions/concessions. The Bill will relax some of the measures, as summarised below.
- the maximum allowable fund size (ie committed capital) for an ESVCLP will be increased from $100 million to $200 million;
- the requirement that an ESVCLP divest an investment once the investee entity’s assets exceeds $250m will be removed. Instead, a partial CGT exemption will apply for disposal of a high value investee that is retained in the ESVCLP and disposed of down the track;
- changes to remove uncertainties arising out of an ESVCLP investing into a pure holding company. In general, where an ESVCLP has invested in an entity (investee), that investee will be entitled to invest in an underlying entity provided the investee controls the underlying entity and the underlying entity satisfies the ‘eligible venture capital investment’ requirement;
- relaxing the need (and cost) for an audit of small start ups (less than $12.5 million entity value) that are not otherwise required to be audited under the Corporations Act;
- changes to facilitate investment by a Managed Investment Trust (MIT) into an ESVCLP. Currently, an MIT may risk breaching the ‘public trading trust’ rules and therefore lose tax transparency if it takes a controlling stake in an ESVCLP that takes controlling positions in underlying investee companies. The new measures will require that the MIT and its associates not represent more than 30 per cent of the committed capital of the ESVCLP (and that the Managed Investment Trust is not the general partner of the ESVCLP); and
- innovation Australia will now be able to issue public or private rulings in relation to whether particular investments will qualify as eligible investments. Given the consequences to an ESVCLP of making an ineligible investment, this ruling process should provide additional certainty to general partners. Innovation Australia will be required to follow a 60 day timeframe for private ruling applications, subject to certain extension rights.
Australian update on CIVs, Asia Region Funds Passport and Islamic financing
After much anticipation, Australia’s Federal Treasurer Scott Morrison handed down his first Federal Budget on May 3, 2016. The Budget unveiled two significant tax changes designed to attract capital from overseas investors.
New collective investment vehicles and Asia Region Funds Passport
The Federal Budget introduces two new collective investment vehicles (CIVs), a corporate CIV from July 1, 2017 and a limited partnership CIV from July 1, 2018 for which a new tax and regulatory framework will be required. Because these vehicles are internationally recognised and easy to use structures it is anticipated that they will make Australian domiciled investment vehicles a more attractive place for overseas investors to invest. In addition, these new investment structures can support the new Asia Region Funds Passport regime - an APEC initiative, the pilot program for which is scheduled to commence in 2017. These new CIV structures are more familiar to many non-resident investors than the unit trust structures that operate in Australia.
The Australian Federal Government has been reviewing the tax treatment of CIVs since May 2010, when the then Assistant Treasurer and the then Minister for Financial Services, Superannuation and Corporate Law announced that the Government would ask the Board of Taxation (Board) to review the tax treatment of CIVs, including whether a broader range of tax flow-through CIVs should be permitted.
The CIV changes in the Budget are based on the recommendations made by the Board of Taxation in the final report it released on June 4, 2015. It is anticipated that the new CIVs will be tax flow through vehicles that will operate in a similar way to Australian managed investment trusts. They will be required to meet similar eligibility criteria, such as being widely held and engaging in primarily passive investment.
These proposed new CIVs strengthen the international competitiveness of Australia’s funds industry, and accordingly build on a key theme arising out of the final report of the Financial System Inquiry into Australia’s banking and financial sector.
The Asia Region Funds Passport reached another important milestone when on April 28, 2016 Australia, Japan, South Korea and New Zealand signed the Memorandum of Cooperation (MOC) which completes international negotiation of the passport arrangements and is the culmination of over six years work. New Zealand, Australia, Japan, Korea, the Philippines, Singapore and Thailand have contributed expertise to developing the framework.
The MoC comes into effect on June 30, 2016 and any other eligible economy that signs the MoC before then will be an original participant in the passport. The MoC also ensures that any other eligible APEC economies are able to participate in the passport even after it comes into effect.
Participating economies have up to 18 months from June 30, 2016 to implement domestic arrangements. Activation of the passport will occur as soon as any two participating economies implement the arrangements under the MoC.
Asset backed financing – Islamic investment
The Federal Government in its Budget also pledged to “enhance access to asset backed financing” by removing key barriers to the use of asset backed financing arrangements imposed by Australia’s current tax laws. While the announcement was not made with much fanfare, it may prove to be one of the most significant tax changes in the Budget. It is anticipated that the announcement may open the door to Islamic financing in Australia, thereby allowing Australian borrowers to access a new financial market to fund real estate and infrastructure projects.This tax measure will apply from July 1, 2018.”