Australian Superannuation Funds Comment on Foreign Pension Fund Regs

Submission to Internal Revenue Service ― Exception for interests held by foreign pension funds [REG-109826-17]

4 September 2019

Mr Milton Cahn and Mr Logan Kincheloe
Internal Revenue Service
US Department of the Treasury
Via email:
milton.m.cahn@irscounsel.treas.gov
logan.m.kincheloe@irscounsel.treas.gov

5 September 2019

Dear Messrs Cahn and Kincheloe

CC:PA:LPD:PR (REG-109826-17)

Exception for interests held by foreign pension funds

The Association of Superannuation Funds of Australia (ASFA) is pleased to provide this submission in response to the consultation by the Internal Revenue Service (IRS) on proposed regulations proposing an exception from taxation for gains or losses of qualified foreign pension funds (QFPFs) attributable to certain United States real property interests (USPRI).

About ASFA

ASFA is a non-profit, non-political national organisation whose mission is to continuously improve the superannuation system, so all Australians can enjoy a comfortable and dignified retirement. We focus on the issues that affect the entire Australian superannuation system and its $2.9 trillion in retirement savings. Our membership is across all parts of the industry, including corporate, public sector, industry and retail superannuation funds, and associated service providers, representing almost 90 per cent of the 16 million Australians with superannuation.

General comments

By way of background, the Proposed Regulations provide guidance on the application of the exception from taxation on gains or losses of QFPFs attributable to USRPI. Specifically, the Proposed Regulations provide guidance on the application of requirements that must be satisfied to meet the definition of a QFPF and introduce anti-abuse provisions to provide a restriction on exemption from taxation on gain from the disposition of a USRPI recognized by certain non-qualified entities (anti-abuse provisions).

ASFA members have identified a number of concerns in relation to the operation of the Proposed Regulations. In particular, this submission considers issues arising from the proposed amendments to 26 CFR part 1 under sections 897, 1445 and 1446 of the Internal Revenue Code of 1986 (the Code) (the Proposed Regulations) that are relevant to Australian superannuation funds.

The Association of Superannuation Funds of Australia Limited

Our submission makes a number of observations with respect to the Proposed Regulations, focusing on issues of uncertainty or technical application that appear contrary to the policy objectives of the QFPF provisions. We have also provided additional background to the Australian superannuation regime, which conforms to the principles generally applicable to US pension plans around which the provisions of the statute appear to be modelled.

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If you have any queries or comments in relation to the content of our submission, please contact me on +61 3 9225 4027 or by email jstannard@superannuation.asn.au.

Yours sincerely

Julia Stannard
Senior Policy Advisor
The Association of Superannuation Funds of Australia Limited
Sydney, NSW

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Specific comments in relation to the Proposed Regulations

A. Requirement that “all of the benefits that an eligible fund provides are qualified benefits provided to qualified recipients”

We note that the purpose for which every Australian superannuation fund is maintained is expressly set out in section 62 of the primary Australian legislation governing superannuation funds, the Superannuation Industry (Supervision) Act 1993 (Commonwealth of Australia) (SISA 1993).

This section is commonly known within Australia as the “sole purpose test” and applies to all Australian superannuation funds regulated by the Commonwealth of Australia. Australian superannuation funds subject to regulation by one of its States or Territories are obliged to meet an equivalent requirement pursuant to a Heads of Agreement between the Commonwealth of Australia and each of its States and Territories.

Specifically, the sole purpose test requires that a superannuation fund must be maintained solely for one or more of the purposes set out in subsection 62(1)(a) (the core purposes), or for one or more of the core purposes together with one or more of the purposes set out in subsection 62(1)(b) (the ancillary purposes).

The core purposes include:

• the provision of benefits for each fund member on or after the member's retirement from any business, trade, profession, vocation, calling, occupation or employment in which the member was engaged

• the provision of benefits for each fund member on or after the member's attaining age 65¹

• the provision of benefits to the legal personal representative and/or the dependents of a fund member on or after the death of the member, provided that the death of the member occurred before he or she retired or attained age 65.

The ancillary purposes include:

• the provision of benefits for each member on or after termination of the member's employment (which includes resignation and redundancy) from an employer who had at any time contributed to the fund in relation to the member

• the provision of benefits for each member on or after the member's temporary or permanent cessation of work on account of physical or mental ill-health

• the provision of benefits in respect of a deceased member, to the member's legal personal representative and/or to dependents of the member, where the member dies after retirement or after reaching age 65

• the provision of such benefits as the primary Australian prudential regulator of superannuation funds (the Australian Prudential Regulation Authority or APRA) approves in writing.

We note that, while the Australian superannuation system had its foundations in arrangements between employers and employees, the system has historically evolved to facilitate the provision of retirement, pension and other benefits required by law to employee members, their spouses, self-employed persons and the broader Australian community. Accordingly, most large Australian superannuation funds provide benefits to persons outside the strict definition of either current or former employee members (for example, self-employed persons, spouses of employee members, and unemployed persons). The same regulations and restrictions on contributions and payments of benefits apply to all non-employee members as to employee members. Moreover, non-employee members represent only a minority of the overall members of a given fund.

While Australian superannuation funds are subject to legislative and regulatory requirements governing certain information and records with respect to their members, these relate to Australian tax segregation requirements. They typically do not need to separately identify certain categories of members that may be relevant under the Proposed Regulations, such as whether members are unemployed, self-employed, or current or former employee members who have rolled over their benefits from one superannuation fund to another (the latter are generally categorized as “rollover members” without any more granular categorisation).

Further, Australian superannuation legislation has strict requirements limiting the circumstances in which benefits may be paid, requiring that the primary occasion when benefits are paid is at retirement or upon reaching retirement age. Australian superannuation funds also acquire insurance cover (or sometimes self-insure) in respect of the death or disability of members, and the benefits paid to members or their dependents in these circumstances are an integral part of the Australian superannuation system. In addition, section 62 of the SISA 1993 permits the government regulator to approve the provision of certain new ancillary benefits. Notably, some of the benefits approved by the regulator and treated as ancillary under the Australian federal law may not fit into the narrow definition of “ancillary benefits” in the Proposed Regulations — that is, “benefits payable upon the diagnosis of a terminal illness, death benefits, disability benefits, medical benefits, unemployment benefits, or similar benefits”.

For example, pursuant to the First Home Super Saver (FHSS) scheme, first home savers who make voluntary contributions into the superannuation system can withdraw those contributions (up to certain limits) and an amount of associated earnings for the purpose of purchasing their first home. The Explanatory Memorandum to the Act which implemented the FHSS scheme² notes that payments of an amount under the FHSS scheme “is consistent with the sole purpose test on the basis that making the payment is an ancillary purpose in accordance with paragraph 62(1)(b)(v) of the SISA 1993”³.

In addition, release of benefits in certain other circumstances (referred to as “release of benefits on compassionate grounds”) also form an important feature of the Australian superannuation system. For example, under Regulation 6.19A of the Superannuation Industry (Supervision) Regulations 1994, a superannuation fund may release member's benefits upon such member's application in the following circumstances:

A member applying for a release of benefits on these compassionate grounds must provide the required documentation and obtain a determination from the Commissioner of Taxation to certify that such member or a dependent is eligible for the release.

Note that new circumstances where early release of benefits is allowed on compassionate grounds are periodically added to the law. For example, it is currently suggested by the Australian Government that the early benefit release be available for victims of family and domestic violence.

Given the overarching sole purpose requirement in section 62 applies to all superannuation funds (as discussed earlier), any changes to Australian law that allows the release of benefits would need to be consistent with the sole purpose test. However, it is not clear at this point whether early benefit release on these or other grounds allowed in the future, if approved, would fall under the ancillary purpose in section 897(l), regardless of the fact that it would be permissible by Australian superannuation law.

Finally, we note that non-pension/retirement benefits (such as those pursuant to the FHSS scheme and on compassionate grounds) represent only a small percentage of the annual benefits paid to beneficiaries from a given fund each year.

Clarification needed to the Proposed Regulations

If no modifications are made to the QFPF requirements regarding qualified benefits and qualified recipients to clarify the above points, uncertainty would exist for all large Australian superannuation funds regarding the conditions to be a QFPF for reasons that do not appear to be within the intended policy of section 897(l) of the Code.

ASFA considers that the following clarifications should be made:

B. Definition of a qualified holder not to include “any trust, corporation, governmental unit, or employer that, at any time during the testing period [. . .] was not a qualified foreign pension fund, a part of a qualified foreign pension fund, or a qualified controlled entity”

As discussed in the Preamble to the Proposed Regulations, the intention of the anti-abuse provisions in the Proposed Regulations is to curtail tax avoidance in the situation where a foreign person that is not a qualified foreign pension fund (non-QFPF) could use a QFPF as a conduit to sell a USRPI to a purchaser without incurring tax under section 897 of the Code on the unrealised gain of the seller.

Example 8 in §1.897(l)-1(e) includes a scenario that illustrates the above policy intent of the anti-abuse provisions. Specifically, in this example, Fund is a QFPF organised in Country C that meets the requirements of §1.897(l)-1(c)(2) of the Proposed Regulations. On November 1, 2016, Fund acquired all the stock in OpCo, which was formed by a third party on January 1, 2016. During the period from January 1, 2016 and October 31, 2016, OpCo was not a QFPF, a part of QFPF, or a qualifying controlled entity (QCE). OpCo owned Property A (that is, USRPI) before November 1, 2016. On June 1, 2017, OpCo realised $100 of gain on the disposition of Property A. In this example, because OpCo is not a qualified holder with respect to the disposition of Property A, the $100 gain it realized is not exempt from tax under section 987(l) of the Code.

While we generally agree with the policy behind the anti-abuse provisions, we note that the definition of a “qualified holder” in the Proposed Regulations as currently drafted would potentially disallow a tax exemption under section 897(l) of the Code in situations that are outside of the intended policy of these rules and, therefore, could potentially present policy concerns underlying such rules. The below examples illustrate some of these situations.

Example 1:

Fund is a QFPF organised in Country C that has met the requirements of §1.897(l)-1(c)(2) of the Proposed Regulations for taxable year 2017 and in all the preceding years since it was formed. In taxable year 2018, the Fund's present value of ancillary benefits exceeded 15 per cent of the total benefits that it reasonably expected to provide. In taxable year 2019 and subsequent years, Fund meets all the requirements of §1.897(l)-1(c)(2) of the Proposed Regulations, including the de minimis threshold of ancillary benefits in §1.897(l)-1(c)(2)(ii)(B)(2) of the Proposed Regulations. In taxable year 2027, Fund disposes of its USRPI, which it acquired during or after the 2019 year and realises a $100 gain. Applying §1.897(l)-1(d)(11)(ii) as currently drafted, Fund will not be exempt from tax under section 897(l) of the Code because it was not a qualified holder during the testing period.

It does not appear to be the policy goal to extend the application of the anti-abuse provisions to the above described and similar situations, where otherwise qualified foreign pension funds that have no intention of tax avoidance would fall within a broadly defined limitation of a qualified holder for the period of ten years merely by failing to meet any of the definitional requirements in §1.897(l)-1(c)(2) at any time other than when the USRPI is disposed of.

Example 2:

Fund is a QFPF organized in Country C that meets the requirements of §1.897(l)-1(c)(2) of the Proposed Regulations. In 2018, Fund acquires HoldCo that is not a qualified holder at the time of the acquisition. HoldCo, in turn, wholly owns OpCo A and OpCo B, both treated as corporations for US federal income tax purposes and organized in Country A and Country B, respectively. OpCo A holds USRPI and OpCo B does not hold any USRPI as of the qualification date. OpCo B acquires USRPI in 2019 and disposes of it in 2020, realising $100 of gain. OpCo B will not be exempt from tax under section 897(l) of the Code because HoldCo and, accordingly, OpCo B are not qualified holders during the testing period.

It appears that the expansive approach to the anti-abuse provisions would cause certain otherwise qualified controlled entities in the situations similar to the one described in Example 2 to recognise gains under section 897(a) of the Code on a disposition of USPRI during the testing period even if such USRPI was acquired after the qualification date. This result does not appear to be in line with the intended policy goal of the anti-abuse provisions and would potentially be adverse to the policy objectives of section 897(l) to promote investment in US infrastructure.

Clarification needed to the Proposed Regulations

ASFA considers that a narrower approach to the anti-abuse provisions will better serve the policy goals of these rules and this could be achieved through the following modifications.

C. Requirement that all of the interests in a QCE are held by one or more QFPFs

In ASFA's view, the definition of a QCE is overtly strict and would benefit if modified to include a de minimis rule, whereby if a certain de minimis ownership percentage in a trust or corporation (for example, 5 per cent) is directly or indirectly held by a non-QFPF, such trust or corporation should still be treated as a QCE.

To prevent non-QFPF entities inappropriately accessing the exemption, such a non-QFPF de minimis owner of that QCE should be required to recognise a gain or loss on any disposition of USRPI held through the QCE under section 897(a) of the Code. Promulgating this rule would:

A comment to the Proposed Regulations had requested a rule under which direct or indirect ownership of a QCE by a non-QFPF would be permitted to accommodate non-QFPF managers and directors, whose interest in the QCE may be required by the corporate law of certain jurisdictions. The Treasury, however, concluded that permitting non-QFPFs to own an interest in a QCE would impermissibly expand the scope of the section 897(l) exception by allowing non-QFPF taxpayers to avoid tax under section 897.

ASFA considers that the Treasury's reservation might easily be addressed if a non-QFPF taxpayer owns a minimal amount of a QCE — for example, 5 per cent — provided that this taxpayer is taxed under section 897(a) of the Code. This would comport with the overarching purpose of section 897 of the Code and the Proposed Regulations, and more specifically would:

Support for this position can be found in the Proposed Regulations, which permit the exemption under section 897(l) of the Code to apply to eligible partners investing in USRPI through partnerships, even though an interest in the partnership may be owned by a non-QFPF. In the absence of congressional intent, ASFA does not see a policy reason to differentiate between the partnership, trust, and corporate forms. We note that while prior versions of section 897(l) of the Code included language exempting QFPFs from taxation under section 897(a) if they invested in USRPI “directly (or indirectly through one or more partnerships)”, this investment through a partnership requirement was removed in 2018 by the Tax Technical Corrections Act of 2018 (PL 115-141). In other words, there does not appear to be any policy or statutory reason to differentiate between entities with QFPF and non-QFPF owners/beneficiaries be they partnerships, trusts, or corporations.

Moreover, permitting de minimis non-QFPF ownership of a QCE (where a non-QFPF is taxed under section 897(a) of the Code) allows QFPFs to be indifferent to the form of entity that is chosen for investment purposes as they may have access to the considerable technical expertise of investment or fund managers in the corporate/trust context similar to what they have with general partners in the partnership context. It would therefore appear, in ASFA's view, that modifying the definition of a QCE to include a de minimis ownership exception would further the policy behind enactment of section 897(l) of the Code.

D. Requirement that a qualified segregated account is maintained for the sole purpose of funding qualified benefits to qualified recipients

By means of background, under section 117 of the SISA 1993, all Australian superannuation funds may pay to employers a rebate of fund contributions if certain requirements are satisfied. These requirements include:

The reason that section 117 allows a payment to a contributing employer is that uncertainty of future investment returns means employer contributions into a defined benefit scheme will never precisely match the ultimate liabilities. Employer contributions may be appropriate for expected future defined benefit pension liabilities, yet a surplus may arise in the fund as time passes. The rebate of such over-funded amounts does not represent the payment of a benefit by a superannuation fund but reflects the return of employer contributions that were originally considered necessary to fund future qualified benefits but have proven to be surplus following movements in actuarial calculations of the fund's financial position (for example, due to better than anticipated investment return).

If the payment of surplus amounts from a defined benefit fund to an employer prevented a fund from qualifying as a QFPF, it would become necessary to keep the surplus contributions in the superannuation funds' accounts until a fund exited any investment in USRPI. This would appear to contradict the policy behind the requirement of maintaining a qualified segregated account.

Accordingly, ASFA considers that the final version of the regulations should clarify that a rebate of any over-funded amount by a foreign defined benefit pension fund to employers, where such amount arose from an original contribution made for the sole purpose of funding qualified benefits, is also consistent with that sole purpose, as the conditions in section 117 (above) ensure such fund continues to be adequately funded to provide future qualified benefits.