The flap that fixed our foreign funds

Market watchers have long been familiar with the butterfly effect – an application of chaos theory that says that a small change halfway around the world can have major consequences here. However, even those directly involved would have been surprised that an updated accounting standard in the United States would lead to a major reform in taxation rules for foreign managed funds in Australia.

The "small change” was the implementation of a new accounting standard in the US (ASC 740-10, more widely known as ‘FIN48'). Under FIN48, US managed funds are required to examine all of their tax positions, including for current and prior income years, and assess whether their claimed tax position is sustainable based on its technical merits. Where the tax position is sufficiently uncertain, they are required to make provisions in their financial accounts to reflect possible adverse tax assessments in the future.

On its face, this seems unremarkable. But it soon became apparent that once funds conducted their due diligence the tax position that they had assumed existed on their investments in Australia was far from certain. It was possible that they should have been paying more tax than they were.

The immediate impact of this was for foreign fund managers who were previously investing via Australia to reassess their investment strategies. It has resulted in an estimated $500 million of managed funds being frozen until the tax position is resolved.

Meanwhile, as the storm surrounding the new accounting standards was brewing, the Australian Financial Centre Forum, chaired by Mark Johnson, was asked to investigate the opportunities and constraints facing the government in the development of an Australian financial centre.

The report found that the tax position of foreign funds was uncertain and discouraged foreign funds from using Australian fund managers. It recommended a new regime to provide certainty for foreign fund managers investing in or via Australia – an Investment Manager Regime. The Johnson Report, and the later review of Australia's Future Tax System, also recommended clarifying the tax law to ensure that income which Australian fund managers earn for foreign clients on foreign assets – conduit income – is not to be subject to Australian tax.

So the government faced two potential courses of action. One option would have been to aggressively pursue the revenue that may technically be owed by foreign fund managers. Treasury estimates that the government was collecting in the order of $50 million per annum from these funds. However, that figure is likely to be just a fraction of the total amount potentially taxable if all such funds were within the Australian tax net.

While superficially attractive, the practical limitations of this approach have long been recognised. As far back as 1975, the Asprey Committee identified the difficulties associated with taxing managed funds transactions.

These practical and legal difficulties are even more pronounced today with the increasing global trade in financial products. It would also have placed Australia out of step with practice in financial centres such as London, Singapore, Hong Kong and New York.

The alternative approach – which the government has adopted – is to progress an IMR which provides clear tax rules for foreign managed funds while ensuring appropriate protections and safeguards so that Australia's tax base is not undermined. On Thursday, the Senate will consider the Bill which introduces the first two steps in implementing the IMR.

1. Foreign investors can now be certain that when investing in Australia or overseas through an Australian intermediary their investments will not attract Australian tax merely by use of that intermediary – which will encourage the use of our fund managers.

2. The legislation will also allow funds that are currently frozen as a result of FIN48 to be released, by confirming that if they have not already received a tax bill they would not be getting one in the future.

This legislation has benefited from detailed consultation with industry to ensure that both the technical details were right but also that it reflects existing structures of foreign managed funds.

Once the legislation is passed, the final step in implementing the IMR will be to develop ongoing rules to address the tax treatment of foreign managed funds' investment in Australian assets and determine the types of assets which are eligible.

The government's intent is that the "small changes” involved in Australia's IMR will have a major impact on the development of Australia as a regional financial centre.

Bill Shorten is the Federal Minister for Employment and Workplace Relations, Financial Services and Superannuation.