Generally speaking, Australian investment funds are formed where there is a nexus with Australia, whether that is because investments will be made into Australian assets, or because capital is to be raised from Australian investors. Where there is no such nexus with Australian assets or investors, Australia is not frequently used by advisers and managers for the formation of investment funds.
A significant recent trend in the Australian market has been the increasing inflow of capital to wholesale alternative funds, including recent record raisings by Australian private equity sponsors. These raisings are commonly underpinned by Australian institutional investors and superannuation funds, as large investors increase their allocations to alternative investment markets in pursuit of greater risk-adjusted returns. This trend is mirrored to some extent in the Australian retail funds space, as an increasing number of listed investment companies (LICs), listed investment trusts (LITs) and exchange-traded funds (ETFs) are being formed to cater for demand from retail investors for exposure to private-market assets.
Non-traditional private fund strategies such as private equity, hedge and real estate funds that may be associated only with wholesale funds in other jurisdictions can be undertaken by both retail and wholesale funds in Australia. As such, for the purposes of this chapter, references to "alternative funds" have been limited to funds with such investment strategies and that are only offered to "wholesale clients" (generally speaking, institutional, sophisticated and high net worth investors).
The most common structure for alternative funds in Australia is the unit trust, largely because of its tax flow-through status (unless a trust is a "public trading trust") and its flexibility from a structuring perspective. The interest of investors in a unit trust is unitised; ie, investors hold units in proportion to their investment.
If units are offered only to wholesale clients, the unit trust does not need to be registered with the Australian Securities and Investments Commission (ASIC), and is sometimes referred to in Australia as an "unregistered scheme". Most alternative funds in Australia are unregistered schemes but they may elect to become registered. If units are offered to "retail clients" (whether or not they are also offered to wholesale clients), the unit trust will typically be considered a retail fund, and will generally need to be registered with ASIC as a registered managed investment scheme (MIS) (see 3 Retail Funds for further discussion).
An alternative fund that is a registered MIS may be listed on a securities exchange such as the Australian Securities Exchange (ASX), or it may be unlisted. All unregistered MISs are unlisted.
An alternative fund may be "stapled" to another vehicle, such as another unit trust, a company, a limited partnership or an offshore investment vehicle.
Where a unit trust qualifies as a "withholding managed investment trust" (MIT) for Australian taxation purposes, a lower withholding tax rate is provided to certain offshore investors on certain income, which makes the unit trust an attractive investment vehicle for those investors.
Companies and Limited Partnerships
Companies and limited partnerships established under state legislation may also be used. However, those structures may be less attractive, as they generally do not provide for flow-through taxation. Under Australian tax law, partnerships are, essentially, treated as flow-through structures for tax purposes. However, in 1992, the tax legislation was amended to treat most limited partnerships as companies for tax purposes. Consequently, during the period that limited partnerships have flourished overseas, limited partnerships have not been seen as attractive vehicles for collective investment in Australia. That said, limited partnerships have been used as structures for alternative funds in some cases where tax concessions have been introduced for particular types of investments.
The government has a range of venture capital programmes designed to attract domestic and foreign investment to help Australian businesses to innovate, and to commercialise technologies. For example, concessions were introduced in 2002 to, among other things, restore flow-through tax treatment for certain venture capital limited partnerships known as "venture capital limited partnerships" (VCLPs) and "early stage venture capital limited partnerships" (ESVCLPs). However, the eligibility criteria are so restricted that many limited partnerships cannot qualify.
Tax concessions were also more recently introduced for investors in qualifying "early stage innovation companies" (ESICs). To qualify as an ESIC, the company must, among other criteria, be involved in innovation by satisfying certain tests through self-assessment, or receiving a determination from the Australian Taxation Office (ATO).
Draft legislation has been released by the government to introduce a new corporate collective investment vehicle (CCIV), and it is also proposed that a limited partnership vehicle will be introduced. It is proposed that these new structures will provide flow-through tax status. See 4.1 Recent Developments and Proposals for Reform for further discussion.
An alternative fund that is a unit trust will not need to be registered with ASIC, although the trustee of the fund will in most cases need an Australian financial services licence (AFSL). The core fund document is a trust deed and there is also often a management agreement, unit-holders' agreement and subscription agreements. Side letters may also be entered into. The fund is established upon the initial issue of units in the trust.
Companies and Limited Partnerships
If a company is to be used as an alternative fund in Australia, the company needs to be registered with ASIC. The process to incorporate the company involves obtaining consent from each of the proposed directors, secretary and occupier of the registered address (if required), preparing the company's constitution and having it signed by the members of the company, and applying to ASIC for the company to be registered by completing the prescribed ASIC form and paying the prescribed fee. Once all of the signed consents and the constitution have been received by ASIC, registration can occur in a matter of minutes for a proprietary company, unless a word in the company's proposed name is not already on ASIC's database or in the Macquarie dictionary, in which case it will take about one hour. Public companies usually take about one hour to be registered, although ASIC is allowed one day. As above, other fund documents may include a management agreement, shareholder agreement, side letters and subscription agreements.
Limited partnerships are governed by State and Commonwealth legislation in Australia. Accordingly, the process to register a limited partnership varies between jurisdictions, but generally involves an application being made to the relevant statutory authority that regulates the limited partnership.
Under Australian law, a trust is not a separate legal entity. Unlike shareholders in Australian companies limited by shares, and limited partners in limited partnerships, beneficiaries of a trust (including unit-holders of a unit trust) do not enjoy statutory limited liability. Instead, the position of beneficiaries of a trust is determined by general law principles and privately negotiated contractual arrangements.
Despite numerous recommendations by law reform bodies in favour of legislation providing for limited liability for unit-holders of public unit trusts (comparable with the protection afforded to shareholders in a limited liability company), there is currently no such protection under the Corporations Act 2001 (Cth) (Corporations Act) or any other Australian legislation, except in relation to unit trusts that are governed by the law of New South Wales (NSW), where the Trustee Act 1925 (the Trustee Act) has been amended to provide that beneficiaries of any unit trust governed by the Trustee Act are "not liable to indemnify the trustee or make any other payment to the trustee or any other person for any act, default, obligation, or liability of the trustee" arising on or after 22 November 2019. This statutory limitation applies to all unit trusts governed by the Trustee Act, regardless of the date of the trust's creation, subject to limited exceptions. Where a trust is not governed by the law of NSW, the liability of unit-holders will be determined by general trust law, which holds that a beneficiary may be personally and proportionately liable to a trustee for liabilities incurred by the trustee in the proper administration of a trust.
It is settled law, however, that where that liability does exist, it may be excluded or limited by an express provision contained in the relevant trust instrument. Such exclusion clauses are almost universally included in unit trust deeds in Australia. There are some circumstances, however, in which an exclusion clause protecting a beneficiary from personal liability may be held by the courts to be ineffective. In practice, there is a greater likelihood that these circumstances could arise where a trust is wholly owned by one beneficiary, or closely held by a small number of beneficiaries, rather than in the context of a widely held trust.
A regulated disclosure document does not need to be provided to wholesale clients and it is not necessary to provide any form of disclosure to such investors. However, it is customary in Australia to provide an information memorandum or other type of offer document (known in other jurisdictions as a "private placement memorandum"), often accompanied by an investor brochure or presentation, to Australian wholesale investors.
With the fourth largest private pension market in the world, the primary investor base in Australia is the superannuation fund sector. According to the Australian Prudential Regulation Authority's (APRA's) statistics, superannuation assets totalled AUD2.9 trillion as at 30 September 2019. The predominant types of superannuation funds in Australia are those regulated by APRA and exempt public sector superannuation schemes (EPSSSs) regulated by separate Commonwealth or State legislation. Superannuation funds continue to view the role of alternative assets favourably as part of portfolio construction (including exposure to hedge funds, private equity, real assets, venture capital, fund of funds and private placement debt) to complement primary allocations to equities, bonds, fixed interest and real estate.
Other Institutional Investors
Other major institutional investors include LICs, MISs (including ETFs, LITs and other types of public unit trusts), several government/sovereign wealth investors, a handful of major institutional investment managers (often aggregating superannuation investor money) and an increasing number of family office and high net worth individual investors.
The portion of overseas funds managed by Australian fund managers has grown significantly. A key issue for foreign investors when considering an investment in Australia is whether approval is required under Australia's foreign investment approval regime, which regulates certain types of acquisitions by foreign persons of equity securities in Australian companies and trusts, and of Australian businesses and real property assets.
Alternative fund managers in Australia are typically established as proprietary companies, with two exceptions:
Public companies in Australia must have at least three directors, and at least two directors must ordinarily reside in Australia. Proprietary companies must have at least one director, who must ordinarily reside in Australia.
There are no restrictions under Australian law on the types of wholesale investors that can invest into an alternative fund (although this is subject to the constituent documents of the relevant fund, which may impose minimum investment requirements, and other restrictions). Trustees of Australian regulated superannuation funds are subject to investment restrictions that can impact the types of funds they may invest in. Key investment restrictions include prohibitions on borrowing and granting a charge over the assets of the superannuation fund, subject to limited exceptions. Accordingly, this may pose an issue in a fund structure where, under the laws of the relevant jurisdiction, the assets and liabilities of the fund are treated as the direct assets and liabilities of investors, such that any borrowing or charges at the fund level would be treated as borrowing or charges over investors' direct assets. It may also pose an issue where the terms of a fund expressly provide for borrowing by investors (eg, where the general partner is permitted to loan amounts to investors for calls) or allow the granting of a charge over the interest of an investor in a fund. Australian regulated superannuation funds may be able to address these restrictions by negotiating side letters regarding relevant fund terms (where applicable), or by investing in a fund indirectly through another vehicle.
Unit trusts that are not registered MISs are not regulated by any Australian financial services regulatory authority. The trustee of an unregistered MIS typically holds an AFSL and, in that capacity, is regulated by ASIC, but the unregistered scheme itself is not regulated.
Registered MISs are subject to extensive regulation that is overseen by ASIC.
Generally speaking, there are no restrictions on the types of investments that may be made by a unit trust, whether or not it is a registered MIS. However, the investments need to be permitted by the constituent document (trust deed) of the unit trust (which typically gives the trustee broad investment powers) and by the AFSL held by the trustee and manager of the fund.
Companies are also regulated by ASIC. Companies have broad investment powers under the Corporations Act, subject to any restrictions imposed by their constituent documents.
VCLPs and ESVCLPs must meet ongoing registration and reporting requirements to maintain their registration. The Department of Industry, Innovation and Science and the ATO jointly administer the VCLP and ESVCLP programmes on behalf of the government.
VCLPs and ESVCLPs are subject to strict investment restrictions that are difficult to satisfy. For example, VCLPs can only make investments in an Australian business with total assets of no more than AUD250 million, that is unlisted or will delist within 12 months, that has at least 50% of its employees and 50% of its assets in Australia and that does not have property development, land ownership, finance, insurance, construction or infrastructure, or make investments to receive interest, rents, dividends, royalties or lease payments as its predominant activity.
ESVCLPs are eligible to invest in, generally, an Australian business that has total assets of no more than AUD50 million, is unlisted, has at least 50% of its employees and 50% of its assets in Australia and does not have property development, land ownership, finance, insurance, construction or infrastructure, or make investments to receive interest, rents, dividends, royalties or lease payments as its predominant activity.
The ATO administers the ESIC programme. To qualify as an ESIC, the company must satisfy certain principles-based innovation tests or have the benefit of a ruling from the ATO.
Alternative funds do not need to be registered with ASIC and there are no ASIC-related ongoing filing, disclosure and conduct obligations that apply in respect of the operation and marketing of the fund.
To the extent that non-local service providers provide financial services in Australia, they may be carrying on a financial services business in Australia, which brings with it regulation.
Financial services include dealing in financial products or arranging for others to deal in financial products (eg, buying or selling financial products), holding financial products on behalf of someone (eg, providing custodial services), and providing financial product advice. If the activities are of a sufficient degree that they would be considered to be carrying on business in Australia, then the relevant service provider would be required to hold an AFSL authorising the relevant service.
Offshore managers who carry on a financial services business in Australia are subject to the same regulatory regime as local managers (see below), subject to the following:
Under the Corporations Act, a person who is in the business of providing financial product advice, dealing in financial products (including interests in an MIS and shares in a company) or arranging for dealing in financial products, providing custodial or depository services and/or who operates a registered MIS is required to hold an AFSL, unless an exemption applies. An AFSL is required in these circumstances, irrespective of whether the financial services are provided to retail clients, wholesale clients, or both.
To apply for an AFSL, an application in the prescribed form must be made to ASIC, accompanied by a series of supporting "proofs" and the prescribed fee. The supporting proofs identify the "responsible managers" nominated by the applicant to demonstrate its organisational competence, and address an extensive range of other matters, including the applicant’s compliance arrangements, adequacy of resources and risk management systems.
In assessing an application, ASIC considers whether the applicant:
See 2.1.2 Common Process for Setting up Investment Funds.
A person who markets alternative funds in Australia may, subject to the specific circumstances, require an AFSL because such marketing could amount to the person providing financial product advice and/or dealing in financial products.
At present, a suite of exemptions are available to certain FFSPs (see 4.1 Recent Developments and Proposals for Reform).
The categories of investors able to be targeted for investment into alternative funds in Australia will differ depending on the fund structure and regulatory status of the fund in question.
Alternative fund products that cannot (or do not) meet the regulatory requirements applicable to retail funds are prohibited from being marketed to any retail client. Those products can only be marketed and sold to wholesale clients in Australia; see 3.3.6 Marketing of Retail Funds. While a wholesale fund product of this type is not directly regulated, the fund operator/manager of a wholesale product established in Australia will typically still be required to hold an AFSL.
Further, even wholesale funds may generally only be marketed in Australia by (or via) an entity holding an AFSL, although limited exemptions apply for non-Australian funds that are marketed by non-Australian managers (see 2.3.3 Local Regulatory Requirements for Non-local Managers).
For alternative funds, there are no investor protection rules that restrict ownership of fund interests to certain investors.
ASIC has typically taken a co-operative approach to regulatory matters, routinely publishing consultation papers and regulatory guidance. ASIC does not generally discuss regulatory questions with individual fund managers or advisers in an ad hoc manner, typically reserving engagement for more formal consultation processes.
ASIC has generally also taken a co-operative approach to processing and dealing with breaches by fund managers. However, following the Hayne Royal Commission in 2018-19, ASIC is expected to apply the law more strictly, be less inclined to reach negotiated outcomes with rule-breakers, and be more willing to take legal action to set precedent and deter others.
ASIC tends to be punctual in dealing with matters within expected timeframes, although the expected timeframes for some regulatory processes (eg, the processing of applications for new AFSLs) have increased over the last few years.
Restrictions on Activities
Generally speaking, there are no restrictions on borrowing or on the types of investments that may be made by a unit trust, whether or not it is a registered MIS. However, the use of leverage and the types of investments must be permitted by the trust deed of the unit trust (which typically gives the trustee broad investment powers). See 2.3.1 Regulatory Regime for investment restrictions for alternative funds that are not unit trusts.
Protection of Fund Assets
The operator of a fund must typically comply with certain requirements regarding the appointment and supervision of custodians of the fund's assets. These requirements include that the custodian must:
AFSL holders must have adequate risk management systems. ASIC has provided guidance on risk management systems for responsible entities of registered MISs, covering matters such as strategic risk, governance risk, operational risk, market and investment risk, and liquidity risk. Licensed managers of funds that are not registered MISs may have regard to this guidance when complying with their own duty to have adequate risk management systems.
Valuation and Pricing
The responsible entity of a registered MIS must, if exercising a discretion in relation to determining the value of the assets of the fund, use a valuation method that is consistent with ordinary commercial practice for valuing the relevant asset, and produce a value that is reasonably current at the time new interests in the fund are issued, or interests are redeemed.
Insider Dealing and Market Misconduct
Australian law prohibits insider trading (subject to certain exceptions), and the making of misleading or deceptive statements (eg, when marketing a fund or raising capital).
Accessibility to Borrowing
Fund financing in Australia is an active market with funds being able to access leverage, including by way of subscription financing. The quantum, tenor and terms of the financing largely depend on the terms of the fund's constituent documents, the restrictions contained within those documents and, in the case of a subscription financing, the credit quality of the investors that provide the commitments to those funds and in the case of other financing, the underlying assets held by the fund.
In Australia, the main type of fund financing, particularly for funds that are in their earlier stages of the fund life cycle, is a subscription finance facility. As the fund matures, other types of facilities are made available by financiers, including "net asset value" (NAV) based facilities, hybrid facilities, umbrella facilities and unsecured facilities.
The restrictions on borrowing by a fund in Australia depend on the individual circumstances applicable to that fund, most relevantly, its jurisdiction of formation, the type of fund vehicle, the investors in that fund and the relevant constituent documents. In general, with the exception of a superannuation fund, there are limited restrictions on a fund's ability to borrow money in Australia. Apart from the contractual arrangement that is commercially agreed with the financier, which will contain the terms on which the fund can borrow, the main limitations are as follows.
Trustees of superannuation funds are prohibited from borrowing and granting a charge over the assets of the superannuation fund, subject to limited exceptions. However, superannuation funds may be able to employ certain fund structures to facilitate their investments in Australia with fund finance facilities.
The security structure of fund financing depends on the financier's credit requirements and the nature of the fund. For a subscription financing facility in Australia, the fund typically grants security over:
The typical security package is often supported with an express power of attorney granted by the general partner or trustee of the fund in favour of the financier. This allows the financier to exercise capital call rights in the event of a default. Security is not usually taken over the underlying assets of the fund for a subscription line but for hybrids and NAV facilities, financiers will often require that those investment level assets be secured in favour of the financier.
A notice of the assignment and security interest granted in favour of the financier is typically provided to investors at the time the financing is obtained. Financiers often require that the investor of the fund provide an investor consent letter, which serves as:
The financier will require control over the bank account into which the investors deposit their capital call proceeds to secure those proceeds upon default, so an account control arrangement will need to be entered into (such as an account bank deed). If the bank account is held outside of Australia, it is necessary to seek advice from foreign counsel regarding the security arrangements.
Common Issues in Fund Finance
Some of the common issues that arise in relation to fund financing, with a focus on subscription financing, are outlined below.
SPV investor structural issues
Some investors may choose to invest in a fund through a special purpose vehicle (SPV) rather than directly investing into that fund. In such cases, the financier must determine where the ultimate credit of the investor lies. As such, financiers tend to look for recourse to the ultimate investor. Financiers will need to establish privity of contract (or a contractual nexus) with the ultimate investor before they will have direct recourse to the ultimate investor. In practice, the extent of the acknowledgement to be provided by any ultimate investor regarding its liability in respect of the SPV's obligations does vary.
Sovereign wealth funds and sovereign immunity
In the current market, sovereign wealth funds investing into funds have proliferated. Those sovereign wealth funds will have the benefit of sovereign immunity protecting them from enforcement action or shielding them from liability absolutely. As those investors will rarely waive their immunity and often require the fund to acknowledge their immunity, financiers are cautious in allocating borrowing base credit for their commitments.
In providing subscription financing, financiers would typically expect that the fund documentation allows for each investor to be jointly and severally liable to fund capital calls provided it does not exceed the full amount of their respective uncalled capital commitments. However, this is not always the case. An overcall limitation occurs where an investor has defaulted and the fund is unable to call upon the remaining non-defaulting investors for the shortfall. Depending on the extent of such overcall, financiers may require further structuring to ensure that the capital calls from the non-defaulting investors are sufficient to repay the financer in full even if some of the investors default on their funding obligations.
Interest withholding tax (IWT) considerations may be relevant to fund financing, particularly for funds resident in Australia who borrow money from non-Australian financiers (unless they borrow from the Australian branch of such a financier). While the liability to pay IWT rests with the non-resident financier, the obligation to withhold the IWT amount (and pay this to the ATO) is imposed on the Australian resident fund. However, IWT is not payable if one of the various exemptions applies. The three most common exemptions are:
For tax purposes, MISs may be managed so that they are taxed under a concessional regime as a MIT or an attribution-managed investment trust (AMIT).
There are a variety of other fund structures that might also be used that are subject to different tax regimes. These include unit trusts (that are not MITs or AMITs), companies, limited partnerships, VCLPs and ESVCLPs.
MITs are tax-transparent or flow-through entities in that taxation is generally imposed on the unit-holders. The trustee may be liable to pay withholding tax in certain circumstances, including on behalf of foreign resident unit-holders; where the MIT is a "withholding MIT", the trustee may pay a final withholding tax at potentially concessional rates (see below) or, where the MIT is not a withholding MIT, the trustee is generally liable to pay a non-final withholding tax on account of Australian-sourced income or gains. Losses of trusts, including MITs and AMITs, do not flow through to investors.
The main advantages of MITs include:
Resident investors in MITs will generally be taxed on a proportion of the taxable income of the MIT; that proportion is the proportion of the trust law income of the MIT to which they are made presently entitled (as generally determined in accordance with the MIT’s constitution).
Australia’s tax system can produce a separation between the economic and tax outcomes for unit-holders. As a result, it is possible for the resident investor to receive payments in excess of the amounts included in their taxable income or vice versa (any excess being the "tax-deferred distribution"), and reduces the investor’s cost base in their units. Unless the cost base of the units has been reduced to zero, the tax on this income is deferred until the investor disposes of the units.
Resident investors will also generally be taxed on any gains made on the disposal of their interest in the MIT. Investors that are individuals, trusts or superannuation funds and hold their interest on capital account may be entitled to a tax concession that reduces the amount of the capital gain on which they are assessed by up to 50% (depending on the type of investor).
Payments of dividends, interest or royalties to a non-resident by a MIT will generally be subject to withholding tax. The rate of withholding is 30% for unfranked dividends, 10% for interest and 30% for royalties under domestic law, but those rates may be lowered under an applicable double tax agreement (see below).
Payments of other forms of income will also generally be subject to withholding. Non-resident investors in MITs will generally benefit from a concessional rate of withholding on fund payments from the MIT of 15% where the payment is made to a resident of a country with an exchange of information agreement with Australia (EOI country) and 30% to a resident of a non-EOI country.
Non-resident investors are generally not subject to any tax on distributions of capital gains (provided the MIT is a fixed trust), unless the gain relates to the disposal of "taxable Australian property" (this being, in broad terms, direct or indirect interests in Australian land), in which case such investors may be eligible for the reduced 15% withholding.
Similarly, if the non-resident holds their units in the MIT on capital account, they will not generally be subject to capital gains tax on disposal of their units unless their units in the MIT are taxable Australian property. If their interest is taxable Australian property, then the sale of their interest may be subject to a non-final withholding tax of 12.5% of the sale price ("foreign resident CGT withholding").
An AMIT is a particular type of MIT and is tax-transparent or a flow-through entity; one of the key conditions that must be satisfied for a MIT to be an AMIT is that the rights to income and capital are clearly defined at all times.
Under the AMIT regime, unit-holders are generally taxed on the amount attributed to the unit-holder on a fair and reasonable basis in accordance with the trust constituent documents, rather than based on their proportionate present entitlement to trust income.
The AMIT regime also provides a number of other concessions, including relevantly:
Other Australian Trusts
There are other kinds of Australian trusts, including unit trusts, that do not qualify for the MIT or AMIT regimes, but that might also be used as investment fund structures. These trusts generally also benefit from tax transparency, but do not benefit from the concessions discussed above, such as deemed capital account treatment or the lower MIT withholding rates.
One key tax risk that Australian funds must manage is that certain trusts that are "public trading trusts" do not benefit from tax-transparent treatment and are instead taxed in the same way as a company at the corporate tax rate. Generally, a trust will be taxed in this manner if it:
Another tax-related issue that Australian funds must consider is whether the fund satisfies the definition of a "fixed trust", which has the benefit of certain tax outcomes that investors might ordinarily expect, such as in respect of the distribution of franking credits and the potential ability to access prior year tax losses.
Since the Federal Court’s decision in Colonial First State Investments Ltd v Commissioner of Taxation  FCA 16 and the ATO’s views published in respect of that decision, there has been some uncertainty regarding what would constitute a fixed trust. The narrow interpretation of fixed trust accepted by the Federal Court has been widely interpreted to mean there are very few trusts that qualify as a fixed trust in the absence of a favourable exercise of the Commissioner’s discretion.
One advantage of falling within the concessional AMIT regime is that a trust that qualifies for AMIT is deemed to be a fixed trust.
Australian companies do not benefit from tax transparency and will be subject to the corporate tax rate on worldwide income. The corporate tax rate is generally 30%, although some companies may be eligible for a lower 27.5% rate if, broadly, they have annual aggregate turnover less than AUD50 million and derive 80% or less of their assessable income from passive investments.
An ESIC is a company that meets certain qualifying criteria (see above). It will be taxed as a company for Australian tax purposes. Certain investors acquiring shares in a qualifying ESIC may be entitled to certain tax concessions in relation to their investment. In addition, investors may be able to disregard certain capital gains realised on shares in qualifying ESICs that have been held for certain holding periods.
Although Australian companies are subject to tax, Australia has a comprehensive dividend imputation regime intended to prevent the double taxation of dividends paid to Australian resident investors out of profits that have already been taxed in the company.
If the distribution has been "franked" (ie, paid out of taxed profits), the resident shareholder will be subject to tax on the grossed-up (pre-tax) amount of the dividend entitled to a tax offset of an equivalent amount to that of the franking credit attached to the distribution.
Where the distribution is unfranked, the resident investor will be taxed at their marginal tax rate on the distribution without any corresponding gross-up or tax offset.
Companies are not entitled to the capital gains tax discount that may be available to Australian resident individuals and trusts (50%) or complying superannuation entity (33.33%). Australian resident investors in LICs who receive a dividend attributable to a capital gain may be entitled to a deduction that reflects the CGT discount the shareholder could have claimed if they had made the capital gain directly. In addition, foreign income tax offsets are not available for Australian resident shareholders in respect of foreign tax paid by an Australian company.
Non-resident investors do not benefit in the same way from Australia’s dividend imputation regime, although dividends that are fully franked (ie, paid out of profits that have been taxed) are not subject to any further tax. Otherwise, dividends paid by Australian companies to non-resident investors will generally be subject to a final withholding tax at 30% (subject to the availability of any protections under a Double Tax Agreement – see below).
An investor that is a governmental entity or a tax-exempt "superannuation fund for foreign residents" may be exempt from Australian dividend withholding tax under Australia’s sovereign immunity regime (although, as noted below, the government has introduced legislation narrowing the scope of this exemption).
Australia also has "conduit foreign income" rules under which, where certain criteria are met, foreign-sourced income of a company that, broadly, is not subject to Australian tax in the hands of the company can be distributed to foreign investors without being subject to Australian dividend withholding tax.
Australian Limited Partnerships
Limited partnerships – except VCLPs and ESVCLPs (see below) – are generally taxed as companies and do not benefit from tax transparency or flow-through treatment (and are referred to as "corporate limited partnerships").
VCLPs and ESVCLPs
VCLPs and ESVCLPs are taxed on a flow-through basis as partnerships, meaning losses of partnerships may flow through to partners (subject to integrity restrictions). In addition, these structures benefit from generous tax concessions, described below, but are subject to stringent investment criteria, including registration with Innovation and Science Australia (see 2.3 Regulatory Regime).
A foreign qualifying investor in a VCLP is generally not subject to tax on its share of any gain (whether on revenue or capital account) arising on the disposal of an eligible venture capital investment by the VCLP, provided (among other conditions) the VCLP holds the asset at risk and for at least 12 months. This concession is not available to Australian investors.
An investor (whether resident or foreign) in an ESVCLP is entitled to tax exemptions for both income and capital gains on its share of any gains arising on the disposal of eligible venture capital investments by the ESVCLP, as well as a non-refundable carry-forward tax offset of up to 10% of their eligible contributions.
Tax Treaty Network
Australia has entered into tax treaties with over 40 other states around the world, including the USA, the UK, India, China and Singapore. A notable exception is Hong Kong.
Generally speaking, foreign investors from treaty countries are entitled to reduced withholding tax rates on distributions of dividends, interest and royalties. Withholding taxes on the distributions of dividends are generally reduced from 30% to between 0% and 15%; on interest can be reduced from 10% to 0%; and on royalties are generally reduced from 30% to between 5% and 10%.
The majority of Australia’s tax treaties are based upon the OECD Model. Australia has also signed and ratified the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI), which entered into force for Australia on 1 January 2019. The MLI may modify the impact of double tax agreements (DTAs) that Australia has entered into. Australia has nominated 42 of its 43 DTAs (with the exception of its more recent DTA with Germany) as covered tax agreements under the MLI. Based on the known positions adopted by other jurisdictions, the MLI is expected to modify (to varying degrees) the operation of approximately 32 of the covered tax agreements (this number could change if additional tax treaty partners sign and ratify the MLI and nominate their treaty with Australia).
As a result, depending upon the elections of the other states, the DTAs between Australia and those states may be modified. Australia has provisionally adopted, for example, Article 3 of the MLI, which ensures income derived by or through a fiscally transparent entity is considered to be income of a resident for treaty purposes to the extent that the jurisdiction of residence treats the income as income of one of its residents under domestic law. Where the MLI affects a DTA, Article 3 may improve a limited partner’s ability to claim the benefits of the DTA (where the DTA does not otherwise have a comprehensive equivalent article).
In addition, Australia has concluded DTAs that contain specific provisions that address interposed fiscally transparent entities (eg, with Japan) may have the effect of enabling limited partners to claim the benefit of double tax agreements.
FATCA and CRS Regimes
Broadly, the Foreign Account Tax Compliance Act (FATCA) requires non-US financial institutions to perform due diligence on their account-holders and to provide information on US account-holders to the US Internal Revenue Service (IRS). Australia has entered into an intergovernmental agreement with the USA (IGA), which allows Australian financial institutions to provide information and make reports to the ATO rather than the IRS, and for the ATO to pass that information on to the IRS. In broad terms, the IGA means that "Australian Financial Institutions" (as defined in the IGA) (AFIs) will not be exposed to 30% FATCA withholdings on payments of US-source income that are made to them (except in the case of significant non-compliance by an AFI with its FATCA obligations). Nor are they required to deduct 30% FATCA withholdings on payments made by them, except in limited circumstances. The obligations under the IGA have been implemented into Australian law and penalties apply for failure to meet them.
In summary, the obligations of an AFI include conducting certain due diligence procedures on its account-holders and reporting specified information to the ATO on an annual basis in relation to financial accounts held with it by US citizens, US tax residents and certain other US entities. It must also register with the IRS.
An entity will be an AFI if it is any of the following types of "Financial Institution": a "Custodial Institution", a "Depository Institution", an "Investment Entity" or a "Specified Insurance Company" (each of which is separately defined under the IGA), and it is resident in Australia or is an Australian branch of a non-Australian Financial Institution. The definition of Financial Institution covers more than what would commonly be thought of as a "financial institution", and would include most investment funds in the "Investment Entity" category, although the position should be verified in each case.
AFIs cannot "opt out" of their FATCA obligations. However, the IGA exempts certain "Non-Reporting Australian Financial Institutions" from having to comply with the due diligence and information reporting requirements, including government entities or agencies, superannuation entities and public sector superannuation schemes, certain entities that have an almost exclusively local client base and do not solicit customers outside Australia, and certain investment advisers and investment managers.
Australia has also enacted legislation to give effect to the Common Reporting Standard (CRS), which came into effect from 1 July 2017. Similarly to FATCA, the CRS regime requires financial institutions to conduct certain due diligence procedures and report specified information to the ATO on an annual basis in relation to any accounts held with them by a foreign resident or by an entity controlled by a foreign resident.
The financial institutions that are required to perform due diligence and report under the CRS in Australia are broadly similar to those under FATCA, although there are some differences in the definitions of the categories of "Financial Institution", and there are fewer exemptions under the CRS regime. The due diligence requirements under the CRS are also similar to those under FATCA, although the CRS requires due diligence to be performed on a wider set of accounts than under FATCA, as certain de minimis account balance thresholds under FATCA for due diligence purposes do not apply under the CRS.
Penalties apply for non-compliance with the regime.
Tax Structuring Preference for Investors
The Australian income tax implications of investing through a particular type of fund depend upon the individual circumstances of the investor (including its residency) as well as the nature and type of investment.
As a general matter, the ability of MITs and AMITs to elect to treat qualifying assets as being on capital account is attractive to many investors (both Australian and foreign). This is because deemed capital account treatment avoids the vexed question of whether the gains made by MITs/AMITs are on revenue or capital account, and because foreign residents are not subject to tax on capital gains made from disposals of assets that are not taxable Australian property. In addition, MITs/AMITs that are withholding MITs offer a concessional (15%) rate of tax on certain types of income for investors in information-exchange countries.
Certain eligible categories of foreign investors may also be attracted to investments in VCLPs since qualifying gains on disposals of VCLP assets are generally exempt from Australian tax. Similarly, both Australian and foreign resident limited partners may be attracted to investments in ESVCLPs since qualifying gains on disposals of ESVCLP assets are similarly exempt from Australian tax. In addition, carried interest is generally taxable as a capital gain. Given the stringent conditions that apply to the VCLP and ESVCLP regimes, the favourable tax concessions are generally harder to access.
The tax treatment of investors in domestic funds is generally discussed above. The following contains a brief discussion regarding foreign funds operating in Australia.
Foreign Unit Trusts
A foreign unit trust is similarly taxed as a flow-through entity for Australian tax purposes.
An Australian resident unit-holder in a foreign unit trust will generally be taxed in a similar way to an investment in an Australian unit trust. One difference relates to capital gains made from the disposal of assets by a foreign resident trustee of a "foreign trust for CGT purposes" that are not taxable Australian property. In such a case, the Commissioner of Taxation has taken the view that the capital gain will not be included in any unit-holder’s assessable income, whether the unit-holder is an Australian resident or foreign resident. The unit-holder would generally, however, be subject to tax on receipt of a payment attributable to such a capital gain. In addition, the Commissioner has recently taken the view that such an amount is not eligible for the capital gains discount.
Australia has also enacted transferor trust rules that, where they apply, attribute the profits of a foreign trust to the transferor of property or services to the foreign trust. The rules, however, largely apply to discretionary trusts.
Foreign resident unit-holders are generally only subject to tax on Australian-sourced income; where the foreign resident unit-holder is presently entitled to a share of trust income that is Australian-sourced, the trustee must withhold tax on behalf of the non-resident at the non-resident’s marginal rate and such withheld tax is creditable against the foreign resident’s end-of-year tax liability (see above).
Investment Management Regime Rules
Australia has an investment management regime (IMR) that applies to certain non-resident entities that satisfy a widely held test. The IMR provides two tax concessions:
Foreign Resident Limited Partnerships
Foreign resident corporate limited partnerships are, subject to the foreign hybrid rules discussed below, generally taxed as companies for tax purposes.
Where the foreign hybrid rules apply, the corporate limited partnership will not be treated as a company but will remain a partnership for Australian tax purposes. The partnership will be treated as a transparent entity for Australian tax purposes. Various tests must be satisfied in order for a limited partnership to qualify as a foreign hybrid, including that the limited partnership is not a resident for the purposes of the tax law of any other foreign country.
Where the limited partner is a resident of a country with which Australia has concluded a DTA, the limited partner’s ability to claim the benefits of the DTA to ensure the corporate limited partnership is not subject to income tax (at least as to a proportion of its income or gains) has been the subject of some recent dispute.
In particular, in a recent decision, the Federal Court determined that US-resident limited partners in a Cayman Islands limited partnership were entitled to claim the benefits of the business profits article in the Australia-United States DTA to dispute the assessment relating to the gains made by that limited partnership. However, the Full Federal Court overturned the decision of the Federal Court at first instance. In doing so, it ruled that each limited partnership was a "taxable entity" under Australian tax law rather than, as was held at first instance, the limited partners. This meant the limited partnerships, rather than limited partners, were required to establish any rights to benefits under the Australia-United States DTA.
Where the corporate limited partnership is a foreign resident, distributions to limited partners will generally be treated as dividends and:
Stamp duty is a tax imposed by the States and Territories of Australia on certain transactions, particularly where they might involve direct or indirect changes in ownership of Australian land; some jurisdictions also impose stamp duty on certain business transactions.
This can potentially affect the activities and transactions entered into by the investment fund, but also can affect investors acquiring interests in (or disposing of interests in) the fund, including minority interests in the fund or indirect interests in the fund (particularly, as discussed above, where the fund owns interests in land). Each State and Territory’s stamp duty regime, however, contains various concessions, including relevantly for funds that satisfy certain widely held or wholesale tests. These funds typically benefit from a higher threshold, such that stamp duty is not triggered unless there is a change in ownership of a "significant interest" in the fund (as defined in the relevant stamp duty legislation of each state and territory).
Where stamp duty is imposed, it is generally assessed at maximum rates of between 4.5% and 5.75% (depending on the jurisdiction) on the dutiable value of the transaction (being the greater of the consideration paid or market value). Higher rates can apply to foreign investors in residential land.
Goods and Services Tax
Goods and Services Tax (GST) is a form of value added tax imposed on "taxable supplies". Certain activities and transactions undertaken by investment funds could be subject to GST, including leasing office space or selling certain types of land. GST does not generally apply to the acquisition or disposal of units in a unit trust.
The most common structure for retail funds in Australia is the unit trust. See 2.1.1 Fund Structures for details. As noted above, if units in a unit trust are offered to "retail clients", the unit trust will generally need to be registered with ASIC as a registered MIS. A "retail client" is an investor that is not a "wholesale client".
Registered MISs that are not listed on a securities exchange are typically used to invest in equities, fixed interest, mortgages and, to a lesser extent, real estate.
Registered MISs may be listed on a securities exchange such as the ASX. Registered MISs listed on the official list of the ASX may invest in a range of assets, including real estate (known as A-REITs), infrastructure and equities (known as LITs). Registered MISs may also be quoted under the AQUA Rules of the ASX as ETFs, managed fund products and structured products. These three product types would be expected to trade generally at a price close to NAV or the price that reflects the underlying instruments that the product seeks to track.
As discussed in 2.1.1 Fund Structures, to a lesser extent, companies and limited partnerships established under state legislation may also be used for retail funds. For example, LICs can be used as an alternative to a LIT. The proposed new CCIV would also be available for retail funds (see 4.1 Recent Developments and Proposals for Reform).
The process for setting up a retail investment fund in Australia varies depending on the type of investment fund used and the profile of the investors.
Assuming the retail fund is a unit trust, the unit trust will generally need to be registered with ASIC as an MIS. An application to register the MIS must be lodged with ASIC by the proposed trustee of the MIS (referred to as the responsible entity). The application must include a copy of the MIS constitution (being the trust deed) and compliance plan, as well as the relevant ASIC forms and prescribed fee. ASIC has 14 days in which to consider the MIS registration application and is required to register the MIS within that timeframe unless it appears to ASIC that:
If ASIC registers an MIS, it must give it an Australian Registered Scheme Number. The fund documents for a registered MIS may also include a management agreement, custody agreement and an application form (which would accompany the regulated disclosure document referred to as a "product disclosure statement", or PDS). It is less common for a unit-holders' agreement or side letters to be put in place for a registered MIS, as registered MISs are generally widely held by passive investors.
A registered MIS that is to be listed on the ASX will also need to apply for admission to the ASX and/or quotation of units in the MIS on the ASX. Alternatively, interests in a registered MIS may be quoted under the AQUA Rules of the ASX.
If a company or limited partnership is to be used as a retail fund in Australia, the process to incorporate or register the fund is set out in 2.1.2 Common Process for Setting up Investment Funds.
See 2.1.3 Limited Liability.
Mandatory disclosure to investors is required only where interests in an investment fund are offered or issued to retail clients. The form of disclosure document varies depending on whether the interests in the investment fund are "financial products" or "securities". Interests in a registered MIS are financial products, and a PDS must be provided to retail investors before a financial product is offered or issued to them. The content requirements for PDSs are detailed and prescriptive, particularly in relation to the disclosure of fees and costs. Ongoing disclosure to investors is also required in relation to material events or developments during the life of the fund.
If interests in an investment fund constitute "securities", such as shares in a company or debentures, the form of disclosure document that must be provided to retail investors is a "prospectus". The prospectus content requirements are also set out in the Corporations Act and are more principles-based than the prescriptive requirements applicable to PDSs.
Operators of registered MIS are required to provide an annual report to retail investors. The personalised report, known as a periodic statement, covers the performance of the investor's investment in the fund, transactions by the investor in the fund (eg, redemptions or additional investments), and the direct and indirect costs of their investment. These statements are not public, but are sent to individual investors.
Operators of registered MIS are also required to prepare an annual financial report containing the financial statements for the year, the notes to these, and a directors' declaration about the statement and notes. The statements must be audited. The operator is also required to prepare a director's report for each financial year, containing information that investors would reasonably require to make an informed assessment of the operations of the scheme, the financial position of the scheme, and the business strategies and prospects for future financial years. These documents must be lodged with ASIC, and sent to members, within three months of financial year end. They are publicly available and may be obtained from ASIC for a fee. Operators of funds (or members of their group) will typically hold an AFSL. Each year AFSL holders must lodge a copy of their complete financial statements – which includes a profit-and-loss statement, balance sheet, note disclosures and audit report – with ASIC. These records can be obtained from ASIC for a fee.
Investors in retail funds typically include individuals ("mum and dad investors"), family trusts and companies, small businesses, and self-managed superannuation funds (SMSFs). Consumers can choose to manage their own superannuation through the establishment of an SMSF, which have grown in popularity, particularly amongst high net worth clients and family offices. SMSFs are entities with four members or fewer, all of whom are trustees or directors of the corporate trustee, and are regulated by the ATO.
Institutional and other wholesale investors may also invest in retail funds, but those types of investors generally prefer to invest in wholesale funds (including the "alternative funds" discussed in 2 Alternative Investment Funds).
See 2.2.2 Legal Structures Used by Fund Managers.
There are no restrictions under Australian law on the types of investors that can invest in a retail fund (although this is subject to the constituent documents of the relevant fund, which may impose minimum investment requirements, and other restrictions).
Unit Trusts and other Structures
See 2.3.1 Regulatory Regime.
Retail funds will need to be registered with ASIC prior to establishment and various ongoing filing, disclosure and conduct obligations apply in respect of the operation and marketing of the fund throughout its life.
Non-local service providers of retail funds are subject to the same requirements as non-local service providers of alternative funds. See 2.3.2 Requirements for Non-local Service Providers.
Non-local managers of retail funds are subject to the same regulatory requirements as non-local managers of alternative funds. See 2.3.3 Local Regulatory Requirements for Non-local Managers.
See 3.1.2 Common Process for Setting up Investment Funds.
A person who markets retail funds in Australia may, subject to the specific circumstances, require an AFSL because such marketing could amount to the person providing financial product advice and/or dealing in financial products.
In general terms, retail clients are typically only able to access an Australian domiciled fund product that meets various regulatory requirements, including requirements relating to the registration of the fund as an MIS and regulation of the fund operator and manager. In addition, retail funds may only be marketed in Australia by (or via) an entity holding an AFSL. Funds that meet these onerous regulatory requirements are able to be marketed to all potential investors (whether retail or otherwise).
To the extent that retail investors invest in a unit trust, the trust will generally need to be registered as an MIS. Australia also has design and distribution requirements for retail financial products (including managed funds) and ASIC has a product intervention power.
See 2.3.8 Approach of the Regulator.
See 2.4 Operational Requirements.
Refer to 2.5 Fund Finance in relation to financing available to non-retail funds. The key difference in the financing available to retail funds is that subscription finance facilities are generally not made available, given the open-ended nature of retail funds. Accordingly, the key sources of financing available to retail funds are unsecured debt facilities or financings secured by the underlying assets of the fund; often described as NAV facilities. Where there is a depth and breadth of assets held by retail funds, the debt financings are more commonly unsecured. As with non-retail funds, the governing documents for the fund will typically contain restrictions on the use of leverage at the fund level. Where retail funds obtain secured facilities, the kind of security that can be provided to financiers will depend on the underlying assets of the fund. Property funds will often provide security right down to the asset level, including mortgages over key properties. Due diligence is required to determine what underlying assets contain restrictions on granting security. In relation to funds that have non-wholly owned investments, security will not be available from the underlying asset level. Security may be available over the equity in the underlying asset but whether any restrictions on the grant of security by shareholders exist under the relevant shareholder agreements will require review. These facilities may include NAV or borrowing base covenants that regulate the amount of borrowings available to the fund by reference to the value of the fund's underlying assets (over which security is granted in the case of secured facilities).
See 2.6 Tax Regime.
Recent Legal Changes
CCIVs and LPCIVs
Draft legislation has been released by the government for public consultation to introduce a new CCIV, and it is also proposed that a limited partnership vehicle (LPCIV) will be introduced in the future. The introduction of the CCIV and the LPCIV is intended to broaden the range of Australian investment vehicles available to Australian and offshore investors and encourage further offshore investment into Australian funds, by extending flow-through tax status to investment vehicles with which overseas investors are more familiar. While it is anticipated that, if and when introduced, the CCIV will be more commonly used for retail funds, given the limited partnership's status as the vehicle of choice for private equity and other alternative funds internationally, the expectation is that the proposed LPCIV will appeal to managers of, and investors in, alternative funds.
Foreign Financial Services Providers
ASIC currently offers certain relief from the need to obtain an AFSL to certain FFSPs who provide financial services in Australia only to wholesale clients. Subject to the satisfaction of any relevant conditions:
However, ASIC is proposing to repeal both forms of relief, replacing the limited connection relief with a more narrowly construed relief with more onerous conditions, and requiring all other FFSPs who operate a financial services business to obtain a foreign AFSL, albeit subject to fewer obligations than those applying to Australian entities who hold an AFSL. A transitional period will prevail for those FFSPs relying on the sufficient equivalence relief until 31 March 2022, while the transitional period for those FFSPs relying on limited connection relief will end on 30 September 2020. ASIC continues to consult on the proposed changes, with the proposed repeal date for both forms of relief having been extended to 31 March 2020.
Extension of Banking Executive Accountability Regime to AFSL holders
One proposed reform that could impact licensed investment fund managers (and therefore of potential relevance to both wholesale and retail investment funds) is the government's proposed extension of the Banking Executive Accountability Regime to AFSL holders, as well as other APRA-regulated entities and certain other financial sector participants.
The government will imminently release a consultation paper on the proposed extension of the regime to AFSL holders. It is not yet clear whether certain exemptions from the regime will be available for particular AFSL holders (such as investment managers of wholesale alternative funds who do not market their products to retail investors or consumers).
If extended to AFSL holders, the regime may include additional regulatory and compliance obligations binding on the entity that holds the AFSL and its senior management. This may include an obligation on the entity to nominate and notify the regulator (most likely to be ASIC) of its key senior executives or "accountable persons"; additional statutory duties and obligations that attach to both the AFSL holders and its accountable persons; the preparation of additional compliance and accountability frameworks; potential regulation of the remuneration structure of accountable persons; and additional regulatory notification obligations.
Design and distribution obligations and ASIC's product intervention powers
In 2019, new legislation intended to improve the quality of financial products and provide additional safeguards for retail investors and consumers was introduced:
Asia Region Funds Passport
The Asia Region Funds Passport came into effect on 1 February 2019 and provides a multilaterally agreed framework to allow Australian fund managers to offer interests in qualifying managed funds to retail investors across multiple participating economies in the Asian region with limited additional regulatory requirements. Similarly, fund managers in other participating economies will be able to market their qualifying funds to Australian investors using the more streamlined regulatory process. For offshore funds to qualify as an Australian passport fund, the fund must be a registered MIS. At present, there are no Australian passport funds registered with ASIC.
Recent Tax Changes
The government has recently introduced extensive reforms to the tax laws applicable to "stapled structures", which are essentially arrangements where two or more entities that are commonly owned are bound together such that interests in them cannot be bought or sold separately. Typically, at least one of these entities is a trust seeking to benefit from flow-through taxation in respect of certain qualifying passive investments (an "asset entity"), while another entity would carry on a trading business and be taxed as a company at the corporate tax rate (an "operating entity").
The reforms are intended to address concerns about non-residents accessing the concessional MIT withholding tax rate of 15% in respect of, in essence, active trading income through the use of stapled arrangements. The reforms address these concerns by imposing a final withholding tax at the corporate rate of 30% to distributions derived from trading income that has been converted into passive income using a MIT, excluding rent received from third parties.
Higher MIT withholding tax rate for agricultural and residential land
The government has also introduced measures that deny the concessional 15% withholding tax rate in respect of rent from residential housing (other than commercial residential or certain student accommodation) and agricultural land. This also applies to any capital gains distributed to investors that are attributable to the sale of residential housing or agricultural land.
Restrictions on withholding tax exemptions
Previously, superannuation funds for foreign residents that are exempt from tax in their country of residence were exempt from interest and dividend withholding tax. The government has introduced measures to limit the exemption to portfolio-like investments only. Similarly, the exemption from income and withholding tax for foreign sovereigns is now also limited to portfolio-like investments in certain assets.
Proposed tax measure – CGT discount
The government has also announced a change to the application of the 50% capital gains tax discount for MITs and AMITs. Currently, the capital gains tax discount applies to MITs and AMITs at the trust level. The proposed measure is intended to prevent beneficiaries that are not entitled to the CGT discount in their own right from getting a benefit from the CGT discount being applied at the trust level.
Banking Executive Accountability Regime: Insights and Implementation
The Banking Executive Accountability Regime (BEAR), operational since mid-2018, requires certain institutions, and individual directors and senior employees, to take steps to conduct business in accordance with specified accountability obligations: acting with due care, skill and diligence, honestly and with integrity; open and constructive dealings with the Australian Prudential Regulation Authority (APRA); and, most significantly, prevent matters arising that would adversely affect the organisation's prudential standing or reputation. A "map" of accountability for every aspect of the business must be created and each accountable individual must have a clear statement of their accountabilities. Remuneration deferral and claw-back requirements exist for those accountable individuals.
The Final Report of the Financial Services Royal Commission (Royal Commission) recommended, among other things, expanding the scope of organisations caught by BEAR along with the introduction of the Australian Securities and Investments Commission (ASIC) as a "co-regulator" responsible for consumer protection and market conduct aspects of BEAR with APRA remaining responsible for prudential aspects. Responding favourably to the Final Report, the Australian government went one step further – proposing that the scope of BEAR be extended to all Australian financial services licensees, credit licensees, market operators and clearing and settlement facilities.
If the government's proposal is adopted, such businesses must make sure that individual executive accountability for everything that happens in that company is clearly allocated and steps are taken to ensure as much as is possible that, in essence, bad things do not happen. It is not clear whether the deferred remuneration obligations from BEAR will also be extended more broadly – in particular the variable remuneration four-year deferral period. If so, this will have a significant impact on the remuneration arrangements of many executives in the sector. This will create challenges for organisations in their recruitment and retention of senior executives as well as their management of internal remuneration relativities between regulated and non-regulated staff.
The authors recommend that companies begin embedding BEAR accountability principles even before they become mandatory as proactive implementation of BEAR will help demonstrate a company's commitment to strong governance, sound culture and clear accountability.
There is also potential business upside to be realised through implementing a BEAR programme, in particular in terms of improved clarity of reporting lines and responsibilities along with enhanced executive engagement. For an organisation to derive positive benefit from BEAR, rather than just incurring a compliance burden, time and effort is required to identify and resolve accountability gaps and unnecessary overlaps. Untangling accountabilities is rarely achieved in haste.
The authors foresee potential difficulty arising from the Royal Commission's proposed co-regulatory arrangement between APRA and ASIC, under which ASIC will be responsible for consumer protection and market conduct aspects of BEAR while APRA will be responsible for prudential aspects. For example, notwithstanding that it is a distinction at the heart of the "twin peaks" model, the conceptual distinction between an issue raising a question of "market conduct" and one that may affect "prudential" standing or reputation can be, as a practical matter, opaque. How BEAR is ultimately amended to give effect to the Royal Commission's recommendation will be crucial to avoiding additional complexity for financial services organisations seeking to identify and promptly report issues to the appropriate regulator.
MinterEllison has the unique multidisciplinary expertise required to help companies design and deliver BEAR implementation, including corporate governance, regulatory, employment law and risk management expertise.
Implications for Fund Managers in a Post-Financial Services Royal Commission World
Following its review of misconduct of Australia’s financial services sector, the 1,068-page Final Report of the Financial Services Royal Commission (Royal Commission) was made public on 4 February 2019. While a significant part of the focus of the Final Report is not directly focused on fund managers, many of the issues highlighted in the Final Report are equally applicable to fund managers.
A key overarching theme of the Final Report is corporate culture and the Final Report places culture as a “root cause” of misconduct in the financial services industry, describing culture as something that can both drive misconduct and discourage it. Like other participants in the financial services sector, fund managers have not historically given enough attention to the importance of culture and this will need to change.
The Final Report has been upfront in declaring that the responsibility for corporate conduct lies with the fund manager's board and this will have consequences for the board’s role, priorities and accountabilities. Going forward, fund manager boards will need to ensure that they are more across significant matters arising in the business. Fund manager boards will need to balance both financial and non-financial risks.
Although the Final Report's recommendations in relation to executive remuneration are confined to entities regulated by APRA, a number of the comments in the Final Report apply equally to fund managers. In particular, the Final Report is critical of the failure to properly implement remuneration arrangements that involve a variable component measured against management of risk. A proactive implementation of BEAR as it stands now will help demonstrate a fund manager's commitment to strong governance, sound culture and clear accountability.
A major principle of the Final Report is that “culture, governance and remuneration march together”: they reinforce each other, for better or worse. It identifies a starting point for putting things right for customers and wider risk management. Boards and senior executives have primary responsibility both for misconduct identified and for using the remuneration, governance and culture levers to turn their institutions around.
Remuneration, conflicts of interest and vertical integration
In the Final Report's view, remuneration marches with conflicts of interest. The Final Report observes the conflict between legal duties and self-interest has for too often been resolved in favour of self-interest. Conflicts are the immediate mechanism causing misconduct and poor management of non-financial risks. The Final Report recommends banning conflicted arrangements in intermediary remuneration. The Final Report also recommends limiting the value of variable pay for frontline staff and senior executives by limiting the quantum of pay related to financial metrics such as sales, revenue or group performance. Avoiding conflicts of interest for intermediaries, along with extending best interest duties and limiting variable pay, provided the justification for leaving vertical integration in place as a business model.
The recommendations will nevertheless result in a continuation of the trend away from vertical integration in the industry, even in the absence of forced structural separation – death by a thousand cuts? Consequently, although the Royal Commission recommendations fall short of mandating structural change within financial services entities, the authors anticipate divestment and capital management initiatives to dominate the strategic thinking of the boards of some of the larger players in 2020.
Key issues for fund managers to consider
Is a framework in place to monitor and review culture and governance?
Fund managers should have in place a framework focused on building a culture that will mitigate misconduct risk. This framework should adopt a risk-based approach, monitor the cultural drivers of misconduct with the entity and ensure that proper attention to sound management of conduct risk is adopted.
Do the remuneration policies properly mitigate non-financial and conduct risks?
Going forward, fund managers will need to ensure that they have implemented remuneration policies to encourage appropriate management of non-financial risks and in a way to reduce misconduct risk.
Should fund managers start preparing for BEAR now?
Should the government's foreshadowed approach be adopted, every fund manager will need to make sure that individual executive accountability for everything that happens in that entity is clearly allocated and that steps are taken to ensure, as much as is possible, that, in essence, bad things do not happen. Further, review of remuneration for accountable individuals and remuneration policy generally will be necessary and can raise sensitive issues for organisations vying to attract and retain talent. These can be significant tasks and fund managers should start early.
What Does the Future Hold for Financial Advice Reforms?
Since the commencement of the "Future of Financial Advice" (FOFA) reforms in 2013, the Australian financial services regulatory environment has experienced tectonic change, particularly in relation to retail investors.
At the time, FOFA was considered to be a drastic change, banning commissions, introducing a new best interests duty for providers of personal advice and requiring financial advisers to provide annual fee disclosure statements and obtain biennial client "opt-in" to continue services.
However, since that time the industry has experienced unforeseen changes of an even greater magnitude, culminating in the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry.
One of the key recommendations made by the Royal Commission was the ending of "grandfathered" payments, trail commissions payable in respect of clients that purchased financial products before the FOFA reforms.
Since 1 January 2020, product issuers are no longer able to make grandfathered payments, and instead any commissions and other benefits that would otherwise have been payable must be passed on to clients that hold the products in a "just and equitable" manner.
The reforms to bring about this change were introduced into Parliament in August 2019 and shortly thereafter ASIC began the process of surveying industry participants to gather information on the types of grandfathered payments currently being made, the recipients and the steps being taken to address the cessation.
Meeting the reforms, while a relatively straightforward concept in theory, is proving to be a significant challenge for the industry, with a number of questions arising in relation to practical implementation, such as whether rebating is required at all under agreements that contain a severance clause for illegal or unenforceable provisions.
A further by-product of ASIC's enquiries was that a number of financial services providers quickly began taking stock of their remuneration arrangements and revisiting the positions that were taken in terms of permissibility of payments with the benefit of hindsight having had over six years living and breathing the reforms and the "new world" perspective of "community expectations" – the indelible mark of the Royal Commission.
With a number of other reforms recently introduced and on the horizon, such as the newly implemented Financial Adviser Standards and Ethics Authority Code of Ethics, and the new Product Design and Distribution reforms that introduce a new product accountability regime, questions are already starting to arise in relation to whether other aspects of FOFA beyond grandfathering require review and resetting or will be superseded. For example, FOFA currently exempts certain "stamping fee" payments in respect of listed investments that are now being considered against the Code of Ethics requirements.
Eyes are also on ASIC as to its enforcement of FOFA following a number of high-profile prosecutions under its new "Why not prosecute" mandate and also whether it will review its guidance, which is keenly relied upon by industry.
FOFA alone involved cataclysmic change but has eventuated to be just one of many reforms that are fundamentally reshaping the way financial services are provided in Australia.
The New Foreign Financial Service Providers Regime
Currently, foreign financial service providers (FFSPs) regulated by certain overseas entities may provide financial services to wholesale clients in Australia by relying on relief (Class Order Relief) granted by ASIC, which exempts FFSPs from the need to hold an Australian Financial Services (AFS) licence under Section 911A of the Corporations Act 2001 (Corporations Act), provided that the FFSP complies with certain conditions under the Class Order Relief. FFSPs not relying on the Class Order Relief by 31 March 2020 will not be eligible to rely on this relief.
In June 2018, ASIC released Consultation Paper 301 (CP 301), which proposed to repeal the Class Order Relief and to implement a modified AFS licensing regime for FFSPs to obtain a "foreign AFS licence" (foreign AFS licence). Following consultation with industry and the review of the submissions on its proposals in CP 301, ASIC determined to proceed with the foreign AFS licensing regime. ASIC is currently undertaking a further consultation process with the proposed changes contained in Consultation Paper 315 (CP 315) and a draft Regulatory Guide 176 (RG 176). The authors are currently awaiting further guidance from ASIC and an updated RG 176, which is expected by March 2020.
What has ASIC proposed in CP 315 and RG 176?
New Funds Management Relief
ASIC has proposed new licensing relief for foreign fund managers to professional investors (Funds Management Relief). Custodial and depository services are not included in the Funds Management Relief. The relief will be subject to a cap and will only be available if less than 10% of annual aggregated consolidated gross revenue, including that of related entities, is generated from the provision of funds management financial services in Australia.
Repeal of Limited Connection Relief
The limited connection relief currently contained in ASIC Corporations (Foreign Financial Services Providers – Limited Connection) Instrument 2017/182 (formerly Class Order 03/824) (Limited Connection Relief) will be repealed as proposed by ASIC in CP 301. The Limited Connection Relief was extended to 31 March 2020 while ASIC consults on the Funds Management Relief and repeal of the Limited Connection Relief. ASIC has proposed a transition period of six months to 30 September 2020 should it proceed, enabling FFSPs to seek a foreign AFSL if applicable.
Reverse solicitation relief
ASIC is considering the position where an Australian professional client initiates contact with an FFSP (reverse solicitation). Currently, ASIC does not propose to grant relief in this situation due to the lack of information from industry about how it would be used and its concerns about monitoring compliance with its conditions.
Sufficiently equivalent jurisdictions
ASIC will implement a foreign AFS licensing regime for FFSPs relying on the "sufficient equivalence" licensing relief. Currently, those regimes assessed as "sufficiently equivalent" are Germany, Hong Kong, Luxembourg (for fund management and investment companies), Singapore, the UK and the USA. Foreign AFS licensees will be exempt from a number of obligations applying to full licences on the basis that they are subject to overseas requirements that would achieve similar regulatory outcomes. The draft RG 176 provides guidance on how foreign providers may apply for the foreign AFS licence. ASIC has extended the sufficient equivalence relief until 31 March 2020 and the new foreign AFS licensing regime will commence on 1 April 2020. FFSPs currently relying on the sufficient equivalence relief will have a transition period of 24 months until 31 March 2022 to comply with the new regime.
The authors' take on CP 315 and the draft RG 176
In summary, the authors support the proposed Funds Management Relief and the new foreign AFS licensing regime. However, the firm has submitted to ASIC that the basis on which the Funds Management Relief is proposed to be provided (ie, the revenue cap, conditions imposed and the limited definition of portfolio management services) is too restrictive and would likely inhibit the Australian financial services market.
The firm has also submitted that repealing the Limited Connection Relief would be detrimental to the competition of the Australian financial services markets and would diminish access for emerging and innovative FFSPs to provide financial services in the wholesale market and considers that ASIC has not identified any material justification for repealing the Limited Connection Relief.
The authors believe that the proposed Funds Management Relief or any reverse solicitation relief would not address all of the circumstances in which the Limited Connection Relief is appropriately used. In respect of the draft RG 176, the firm has submitted that further guidance is required in relation to applications to extend the new foreign AFS licensing regime to new jurisdictions and regulators. Clarification is also required on the process for FFSPs who are currently relying on the current sufficient equivalence relief to apply for the new licence.
The New Design and Distribution Obligations Regime
The implementation of the new design and distribution obligations (DDO) will be a key area of focus for much of the financial services industry in 2020. The new obligations that will commence on 5 April 2021 have been introduced in response to recommendations made in the Treasury's Financial System Inquiry and provide for a more consumer-centric approach to the design, marketing and distribution of financial products to retail clients.
What are the obligations?
The DDO was introduced into Chapter 7 of the Corporations Act by the Treasury Laws Amendment (Design and Distribution Obligations and Product Intervention Powers) Act 2019 and the accompanying Corporations Amendment (Design and Distribution Obligations) Regulations 2019.
Under the new obligations, issuers and distributors will have increased responsibility to design and distribute products that are fit for their purpose and consistent with the likely objectives, financial situation and needs of the consumers they are intended for.
Specifically, issuers will be required to make an appropriate target market determination (TMD) for their products identifying, amongst other things, the intended class of consumer. Issuers will also be required to take reasonable steps that will (or are reasonably likely to) result in distribution being consistent with the TMD, to notify ASIC of significant dealings inconsistent with the TMD, to conduct reviews of the TMD and to keep certain records.
Distributors will be subject to complementary obligations to not engage in retail product distribution unless they reasonably believe a TMD has been made or is not required, to take reasonable steps that will (or are reasonably likely to) result in distribution being consistent with the TMD, to notify the issuer of significant dealings that are inconsistent with the TMD and to keep certain records.
What products does it apply to?
The DDO applies broadly to financial products that require a product disclosure statement, securities that require a prospectus, financial products under the Australian Securities and Investments Commission Act 2001 (ASIC Act) – eg, credit contracts, consumer leases, including those regulated under the National Consumer Credit Protection Act 2009 (eg, credit cards, homes loans, funeral expenses policies) – and credit facilities under the ASIC Act. Certain products – such as MySuper products, margin lending facilities and fully paid ordinary shares in a company – are excluded. The DDO will apply to both new and existing products that will be issued.
What next? Implementing the new framework
The DDO commences on 5 April 2021. To ensure compliance by this date, issuers and distributors will need to review and update existing compliance and product governance frameworks to incorporate the DDO. Issuers and distributors will also need to implement their new frameworks, including by making TMDs for all relevant existing products.
The industry will also need to consider ASIC's recent Consultation Paper 325 in relation to its proposed new Regulatory Guide: Product design and distribution obligations. Comments on the consultation paper are due by 11 March 2020, following which, ASIC proposes to issue the final regulatory guide ahead of the DDO commencing on 5 April 2021.
Asia Region Funds Passport
Background to the Asia Region Funds Passport
The Asia Region Funds Passport is an international initiative designed to facilitate capital raising by fund managers operating in participating economies, from retail investors located in other participating economies.
As at January 2020, the participating economies are Australia, New Zealand, Japan, South Korea and Thailand. Observer economies include Singapore, Malaysia, Chinese Taipei, Hong Kong and the Philippines.
The passport arrangements were launched on 1 February 2019. From that date, Japan, Thailand and Australia were ready to receive registration applications from local prospective passport funds and entry applications from foreign passport funds. New Zealand became ready to do so on 26 July 2019. South Korea's implementation processes are not yet complete.
The passport arrangements provide the opportunity for fund managers to distribute their fund products in participating economies, where it would otherwise be more difficult to do so.
In order to take advantage of the passport arrangements, the prospective passport fund must, in summary:
The Passport Rules are set out in the Memorandum of Cooperation on the Establishment and Implementation of the Asia Region Funds Passport (Annex 3). The Passport Rules include rules about permitted investments, portfolio restrictions and limits, breach reporting, notifying the home and host regulators of certain changes, custody, financial reporting, annual reviews of compliance with the Passport Rules, redemption and valuation and deregistration.
Specific requirements for a foreign passport fund to be distributed in Australia
For a foreign passport fund to be eligible for distribution in Australia, the operator of the foreign passport fund must:
ASIC Regulatory Guide 138 provides further information regarding the Australian Passport Rules, applicable Australian legislation, regulations and registration procedures.