Funds management tax - Election special edition

28 April 2022

As Australian voters are going to the polls on 21 May 2022, this is a timely reminder for trustees of managed trusts, to think about the tax elections they make. Sometimes, the choice is not simple… 

A broader policy behind the tax rules for managed trusts is to place the investor in the same or similar position they would be in, had they invested directly in the underlying assets of the trust. Where the tax outcomes do not align with the investment returns or cash yield, this can result in unitholders being taxed twice on certain amounts or taxed on income and gains before received. Sometimes, there is a need to create better certainty or to simplify the administrative burden of tax compliance. 

The tax rules sometimes provide an alternative treatment to help address these issues. As trusts are not all the same, the alternative treatment is offered as a choice, or election, to the trustee. 

As fund products seek to deliver on promises and meet investor expectations, the importance of elections becomes clearer. In this special edition, we revisit the more common elections that trustees should consider, including the following:

• Managed Investment Trust (MIT) capital account election
• Franking credit benchmark ceiling election 
• Attribution Managed Investment Trust (AMIT) election
• AMIT multi-class election 
• Taxation of Financial Arrangements (TOFA) ‘opt in’ election
• TOFA fair value election
• TOFA Foreign Exchange (FX) retranslation election
• TOFA hedging election
• TOFA financial reports election
• Short term FX election
• Foreign Hybrid Limited Partnership (FHLP) election

A quick reminder

Before we begin, a quick governance reminder. The Australian Taxation Office (ATO) is focussing on tax risk management frameworks. Before considering the implications of tax elections, trustees should be aware of the terms of the trust deed, disclosures made in offer documents, stated policies (e.g., tax, distribution and unit pricing) and the consistency of treatments from fund to fund and from year to year. 

MIT capital account election

What is it?

Where an Australian fund qualifies as a MIT, it is eligible to make an election to treat gains and losses on the disposal of “covered assets”, such as shares and units, as capital gains and losses¹. 

Benefit 

The capital account election was originally designed to provide certainty to trustees of investment trusts that gains on the realisation of equity investments are treated as capital gains rather than ordinary income.  Capital account treatment therefore allows investors to benefit from eligible discount capital gains from MIT distributions/attributions.

How? 

The making of the capital account election is reflected on the tax return form. The election can only be made in the first year the trust qualifies as an MIT². 

Beware

The election only applies to certain assets (i.e. covered assets) and is irrevocable. In addition, where the trust qualifies to make the election and the trustee chooses not to make the election, deemed revenue treatment applies to the covered assets (although arguably not in all cases)³. Trustees may be deemed if they do (elect), and deemed if they don’t.

Franking credit benchmark ceiling election 

What is it?

A trust must generally hold shares at risk for more than 45 days in order to obtain the benefit of franking credits from a dividend or distribution⁴. This is commonly referred to as the holding period rule. However, as an alternative to the holding period rule,  superannuation funds and widely held trusts can elect to apply a formula based ceiling (calculated by applying the All Ordinaries Index (Index) to the ‘net equity exposure’ of the taxpayer plus an uplift) to determine their entitlement to recognise franking credits in respect of the whole or part of the portfolio⁵.  

Benefit 

The benchmark ceiling election was designed to reduce compliance for institutional taxpayers which were considered low revenue risk.

How? 

An election is not required to be lodged with the ATO.  The trustee of the trust should retain a record of the election.

Beware

The benchmark ceiling election is irrevocable unless the Commissioner of Taxation (Commissioner) exercises his discretion. Where the equity exposure of the taxpayer differs from the Index, the buffer afforded by the ceiling may not be sufficient in some years where there are significant franked distributions, for example, where the composition of the portfolio changes over time. In addition, the benchmark ceiling election may no longer be appropriate where the fund is an AMIT which is deemed to have satisfied the 45 day rule (subject to integrity measures).

MIT - AMIT election

What is it?

Certain widely held unit trusts which are MITs may also be eligible to elect to be classified as AMITs⁶.

Benefit 

MITs that become AMITs are afforded certainty of fixed trust status, and the tax components are ‘attributed’ (including streaming of tax components) to unitholders (rather than relying on traditional trust taxation concepts such as present entitlement). In addition, AMITs can treat acceptable discrepancies as timing differences (referred to as “unders” and “overs”), and determine cash distributable income independently of taxable income. Where taxable income exceeds cash distributable income, members of an AMIT can make cost base uplifts to mitigate double taxation. An AMIT is also deemed a ‘qualified person’ for franking credit entitlement purposes subject to the Commissioner’s discretion.

How? 

The trustee of an eligible MIT can make the election and should make a record of that election. However, the election is not required to be lodged with the ATO.  The choice to become an AMIT is then evidenced by lodging an AMIT tax return form instead of a trust tax return form. Importantly, the trust deed/constitution may need to provide the trustee with the power to make the election.

Beware

The choice to become an AMIT is irrevocable, however AMIT status requires the trust to be a MIT on an on-going basis and the trustee will therefore need to monitor MIT eligibility criteria such as the widely held/closely held tests, particularly if the trust is in start-up phase.  In addition, trustees will need to navigate a number of integrity measures which may incur penalties/additional taxes arising in certain circumstances. These include where unders/overs culpability thresholds are exceeded, discrepancies in ‘AMIT member annual’ statements, and where overs of franking credits cannot be adjusted in the prescribed manner.

AMIT - multi-class election

What is it?

AMITs with multiple unit classes may be eligible to elect for each class to be treated as a separate AMIT⁷.

Benefit 

Under the election, AMITs can essentially become an umbrella fund with separate classes where each class is treated as a separate AMIT. Each class can have different investment strategies and management fees which can appeal to different types of investors. This can result in reduced compliance and costs.

How? 

The trustee of an eligible AMIT can make the election and should make a record of that election. However, the election is not required to be lodged with the ATO.  The choice is then evidenced by lodging an AMIT tax return form with schedules for each class.

Beware

AMITs that elect for multi-class treatment will need to lodge separate schedules for each class as part of its annual AMIT tax return. In addition, multi-class AMITs will need to be aware that entity tax attributes such as tax losses are quarantined to each class on a separate AMIT basis. If the trust fails AMIT status for a given income year, the taxable income of the trust must be calculated in aggregate across all classes.

TOFA ‘opt in’ election

What is it?

Where the TOFA regime does not automatically apply (because certain size thresholds are not met), the trustee can elect that TOFA applies⁸.

Benefit 

TOFA allows trusts to make a number of tax timing elections which could better align tax outcomes for unit holders and/or reduce the administrative compliance burden of the trust and thereby lower costs. See further below for information about TOFA tax timing elections. 

How? 

Whilst the ATO has provided a form that can be used to make this election, it is not a requirement to use this form, and the election is not required to be lodged with the ATO. The trustee of the trust should retain a record of the election.

Beware

Trustees should be aware that the election is irrevocable and only applies to financial arrangements entered into from the income year the election is made.

TOFA fair value election 

What is it?

Trusts taxed under the TOFA regime can elect that certain financial arrangements (including equities that are recorded at fair value through P&L in the financial statements) are taxed on a fair value basis⁹ rather than a prescribed compounding accruals or realisation basis.

Benefit 

Under this election, the taxation treatment of financial arrangements is aligned with the accounting treatment (i.e. fair value through P&L) thereby minimising timing differences.

How? 

Whilst the ATO has provided a form that can be used to make this election, it is not a requirement to use this form, and the election is not required to be lodged with the ATO. The trustee of the trust should retain a record of the election.

Beware

Trusts should be aware that the election is irrevocable and only applies to financial arrangements entered into or acquired from the income year the election is made. In addition, as investments are treated on a mark to market or fair value basis, the cash yield of the trust may not align with the tax outcomes to unitholders. The eligibility criteria must be met on an ongoing basis. The revenue account treatment of gains may mean the Capital Gains Tax (CGT) discount concession is forgone.

TOFA FX retranslation election

What is it?

Trusts taxed under the TOFA regime can elect that foreign currency exchange fluctuations (on financial arrangements denominated in foreign currency), i.e. FX gains and losses, are taxed in alignment with the accounting treatment thereby minimising timing differences¹⁰.

Benefit 

This election simplifies the calculation of FX gains and losses for tax purposes by aligning it with the accounting treatment of FX gains and losses.

How? 

Whilst the ATO has provided a form that can be used to make this election, it is not a requirement to use this form, and the election is not required to be lodged with the ATO. The trustee of the trust should retain a record of the election.

Beware

Trusts should be aware that the election is irrevocable. Depending on the volatility of the foreign currency, the economic gain may vary depending on whether the FX translation is taken into account. The TOFA FX retranslation election can apply to all foreign currency denominated financial arrangements, or it can be limited to certain qualifying foreign currency accounts. 

TOFA hedging election

What is it?

Trusts taxed under the TOFA regime can elect that the hedging election applies to qualifying hedging arrangements to align the tax character and timing of hedging arrangements with the treatment of the underlying hedged item¹¹.

Benefit 

Trusts that make the hedging election can manage the mismatches that arise in character (i.e. revenue versus capital in nature) and timing in respect of hedging instruments and hedged assets/liabilities. Mismatches can occur where, for example, gains from the realisation of hedging instruments are recognised as ordinary income, whereas gains from the realisation of the underlying hedged instrument are recognised as a capital gain (character), and/or where each arrangement has different maturity dates (timing).

How? 

Whilst the ATO has provided a form that can be used to make this election, it is not a requirement to use this form, and the election is not required to be lodged with the ATO. The trustee of the trust should retain a record of the election.

Beware

The requirements to satisfy the hedging election are complex and may require significant time and costs to comply with.  The documentation requirements to evidence the existence of an effective hedge and to undertake hedge accounting are particularly onerous.

In the 2020-21 Federal Budget, the Government announced it would make technical amendments to the TOFA legislation to enable access to hedging rules on a portfolio hedging basis. Draft legislation in respect of these proposals is yet to be released.

TOFA financial reports election

What is it?

Trusts taxed under the TOFA regime can elect that that financial reports election apply to tax financial arrangements (including equities) to align the tax treatment of these arrangements with the accounting treatment¹².

Benefit 

Under this election, the tax treatment of financial arrangements is consistent with the accounting treatment eliminating timing differences on financial arrangements. This can significantly reduce tax compliance costs. 

How? 

Whilst the ATO has provided a form that can be used to make this election, it is not a requirement to use this form, and the election is not required to be lodged with the ATO. The trustee of the trust should retain a record of the election.

Beware

Trusts should be aware that the election is irrevocable and only applies to financial arrangements entered into from the income year the election is made. In addition, the cash flow of the trust may not align with the tax outcomes. The revenue account of treatment of gains may mean the CGT discount concession is forgone. As with most of the TOFA tax timing elections, the eligibility criteria must be met on an ongoing basis. 

Short term FX election

What is it?

Short term FX gains and losses (i.e. those arising between acquisition or disposal and payment time, where that time is less than 12 months) are generally treated as having the same character as the relevant asset (e.g. if the FX gain or loss relates to a capital asset it will take on the character of the capital asset). A trust can elect that this treatment does not apply and the FX gain or loss is treated separately as an assessable amount or allowable deduction respectively¹³.

Benefit 

Trustees may decide it is more beneficial to recognise an FX gain or loss as assessable or deductible rather than incorporating those amounts in the calculation of the cost base of assets. 

How? 

The election must be in writing but is not required to be lodged with the ATO. The trustee of the trust should retain a record of the election.

Beware

A newly established trust is currently not able to make this election as it must have been made by 16 January 2004 unless the Commissioner provides a later date. However, the Commissioner is not empowered to allow a longer period for a choice to be made for entities that were not in existence at the start of the applicable commencement date (1 July 2003) or that did not come into existence within 90 days after the start of the applicable commencement date¹⁴. Both the current and previous Governments have proposed amendments to these rules to allow new entities to make this election, but no legislation has been released to date.

Foreign Hybrid Limited Partnership election

What is it?

Australian trusts investing in a qualifying foreign limited partnership and/or a foreign limited liability company can elect to treat those entities as a FHLP and foreign hybrid company (FHC) respectively – allowing for partnership tax treatment rather than defaulting to corporate tax treatment¹⁵.

Benefit 

Partnership treatment allows certain tax attributes to flow through a FHLP/FHC such as foreign income tax offsets (FITOs) in respect of underlying foreign income taxes. In some scenarios, realised gains on assets of the FHLP/FHC may be capital gains and further may be eligible to qualify as discount capital gains.

How? 

The election is not required to be lodged with the ATO and is evidenced by the lodgement of a partnership return for the FHLP or FHC. The Australian trust must lodge the partnership return if it is the largest investor in the FHLP/FHC unless its holding is less than 10%. 

Beware

Whether a FHLP/FHC election should be made requires careful consideration of the potential tax attributes that can be obtained by the partner, a thorough understanding of the level of compliance required (e.g. annual partnership return) and an understanding of the availability and access to relevant information. In addition, where the foreign limited partnership / foreign limited liability company is a controlled foreign company, and the partner is an attributable taxpayer, FHLP/FHC treatment applies automatically. A combination of contentious tax issues and inconsistent approaches to compliance has resulted in increased ATO scrutiny on cross border investments into foreign investment vehicles.

The takeaway

Meeting the obligation to act in the best financial interests of investors, and maintaining a robust tax risk management framework for good governance, are essential. Additionally, financial products need to meet the outcomes promised to - and the expectations of - their target audience. Trustees need to carefully consider  the implications of an election, not only based on the current circumstances of the fund but to also consider future scenarios and volatile market conditions. 

Further, in some situations, such as with digital assets, there may be sufficient uncertainty as to the legal form and tax recognition points, which are emerging and as yet unresolved. As some elections are irrevocable (perhaps to mitigate the perceived ‘undue optimisation’ of choice), further care and diligence is needed when making an election where there is uncertainty. Perhaps one thing is certain: the increasing importance of flexibility.

While elections come down to a choice, the implications require careful consideration as there are benefits, risks and trade-offs to assess. To discuss your next election decision further, please contact your PwC expert.

Footnotes

¹ Section 275-115 of the Income Tax Assessment Act 1997 (ITAA 1997)

² Section 275-115 of the ITAA 1997

³ Section 276-120 of the ITAA 1997

⁴ Paragraph 207-145(1)(a) of the ITAA 1997 and Division 1A of former Part IIIAA of the Income Tax Assessment Act 1936 (ITAA 1936)

⁵ Section 160APHR of Division 1A of former Part IIIAA of the ITAA 1936

⁶ Section 276-10 of the ITAA 1997

⁷ Section 276-20 of the ITAA 1997

⁸ Subsection 230-455(7) of the ITAA 1997

⁹ Section 230-210 of the ITAA 1997

¹⁰ Section 230-255 of the ITAA 1997. Where TOFA applies, the weighted average cost election under Regulation 775-145.01 is not needed.

¹¹ Section 230-315 of the ITAA 1997

¹² Section 230-395 of the ITAA 1997

¹³ Section 775-80 of the ITAA 1997

¹⁴ ATO Interpretative Decision ATO ID 2013/53

¹⁵ Division 830 of the ITAA 1997