Pension Fund Regs Must Consider Australian Concerns, Group Says

Proposed regulations for the Qualifying Foreign Pension Fund exemption from Section  897(a)(1)

6 September 2019

Internal Revenue Service
CC:PA:LPD:PR (REG-109826-17)
Room 5203, P.O. Box 7604
Ben Franklin Station,
Washington, DC 20044

Xx August 2019

Dear Sir/Madam

I am writing to you on behalf of members of the Financial Services Council (FSC) about the proposed amendments to 26 CFR part 1 under sections 897, 1445 and 1446 (the proposed regulations) relating to section 897(l) of the Internal Revenue Code of 1986, as amended.

The FSC is a leading peak body which sets mandatory Standards and develops policy for more than 100 member companies in Australia's largest industry sector, financial services.

Our Full Members represent Australia's retail and wholesale funds management businesses, superannuation funds, life insurers, financial advisory networks and licensed trustee companies. Our Supporting Members represent the professional services firms such as ICT, consulting, accounting, legal, recruitment, actuarial and research houses.

The financial services industry is responsible for investing almost $3 trillion on behalf of more than 14.8 million Australians. The pool of funds under management is larger than Australia's GDP and the capitalisation of the Australian Securities Exchange, and is the fourth largest pool of managed funds in the world.

Submission

Section 897(l) of the Internal Revenue Code of 1986 provides an exemption for qualifying foreign pension funds (QFPFs) from tax under the Foreign Investment in US Real Property Tax Act of 1980 (FIRPTA), which introduced section 897 of the Code and applies to gain or losses on certain dispositions of, and distributions with respect to, United States real property interests (USRPIs).

The proposed regulations are welcome and have responded to a number of the submission points made by Australian superannuation funds, and pension funds from other foreign jurisdictions, which were made during 2016 following the introduction of the QFPF exemption under the Protecting Americans from Tax Hikes Act of 2015 (the PATH Act).

Prior to finalizing the proposed regulations, Treasury and the Internal Revenue Service (IRS) have requested public submissions on all aspects of the proposed rules. Submissions must be made by 5 September 2019.

Australia has a common legislative and regulatory regime applying to superannuation funds (and approved deposit funds and pooled superannuation trusts) under the Superannuation Industry (Supervision) Act 1993 (SISA), the Superannuation Industry (Supervision) Regulations 1994 (SISR), prudential standards made by the Australian Prudential Regulatory Authority (APRA), and tax rules governed by legislation including the Income Tax Assessment Act 1936 and Income Tax Assessment Act 1997.

However, in addition to common issues for different types of superannuation funds, the structure of the proposed regulations raises some different concerns between Australian industry funds and retail funds, which are both subject to the same regulatory and tax regime. In Australia, industry funds have generally been established by employers and unions, while retail funds have generally been established by private sector wealth management businesses, such as banks. Despite the differences in establishment, most retail and industry funds are public offer (meaning any Australian can have an account with the relevant fund).

The proposed regulations have a requirement that an eligible fund must be established by a foreign government or “one or more employers”. The proposed regulations expressly state that an eligible fund established by a trade union, professional association, or similar group is treated as established by an employer (section 1.897(l)-1(c)(2)(ii)(C)(3)). This provides clarity for industry funds but is less clear on the treatment of retail funds that are established by for profit organisations.

The FSC respectfully submits that the draft regulations be clarified for the following matters:

• The proposed regulations should be expanded to include confirmation that an eligible fund will include funds established and offered to employees of any employers across the public spectrum.

• The definition of “ancillary benefits” should be expanded to include any ancillary benefit allowed or required to be paid by an eligible fund under the laws of the foreign country in which the fund is created or organized.

• Proposed section 1.897(l)-1(c)(2)(ii)(A)(2) and the definition of a “qualified recipient” should be expanded to include any individual validly allowed to be a member of an eligible fund under the laws of the foreign country in which the fund is created or organized.

• The ten year testing period for the integrity rule should be refined to more precisely target the mischief perceived by Treasury, which appears to be the avoidance of taxation on unrealized gains for USRPIs indirectly sold by non-QFPFs to QFPFs.

• The rules should clarify that a discrete, identifiable pool of assets held by an entity that itself is not a QFPF will qualify as a QFPF where those assets are held solely for the purposes of investing the assets of one or more QFPFs.

• The restriction on qualified controlled entities being wholly-owned by one or more QFPFs should either be:

  • relaxed to allow a de-minimis level of non-QFPF ownership, for example 5%;

  • modified such that a QFPF will retain the ability to access the exemption on their share of income or gains distributed by an investment aggregator vehicle where the majority of that aggregator is controlled by QFPFs; or

  • modified to trace through to the indirect ownership interest in the entity being tested where a direct owner is a non-qualifying pension fund solely due to it failing the 5% concentration test and members of that non-qualifying fund indirectly hold an economic interest of less than 5% in the tested entity.

These matters are discussed further in Appendix A.

We would be happy to discuss this request further. I may be contacted on mpotter@fsc.org.au or +61 (2) 9299 3022.

Yours sincerely,

Michael Potter
Senior Policy Manager, Economics & Tax
Financial Services Council

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Appendix A

1 — Clarification for retail superannuation funds

Broadly, retail superannuation funds are established by wealth management groups and are public offer funds (open to any new members). As a result, while employees of the particular organization that establishes the fund are able to become members, employees of other businesses which did not establish the fund are also able to join.

Industry superannuation funds are also public offer funds but were established by trade unions or similar bodies and are typically operated such that fees charged to member accounts remain within the fund for the provision of other benefits to members (i.e. not for profit).

As public offer funds, retail superannuation funds achieve similar outcomes for employees as section 401(k) plans operated by financial services institutions external to the employer sponsor.

Proposed section 1.897(l)-1(c)(2)(ii) requires that an eligible fund must be established by either a foreign country or “one or more employers to provide retirement or pension benefits to participants or beneficiaries that are current or former employees or persons designated by such employees in consideration for services rendered by such employees to such employers.”

In the case of industry funds, clarity is provided in proposed section 1.897(l)-1(c)(2)(ii)(C)(3), which states:

(3) An eligible fund established by a trade union, professional association, or similar group is treated as established by any employer that funds, in whole or in part, the eligible fund.

Unfortunately, there is less clarity for retail funds as although they have typically been established by a corporate group that includes and employer, they are established to provide retirement or pension benefits to both current/former employees of that employer and any other individuals from the wider public. This particular issue is common to industry and retail funds but only industry funds have been explicitly acknowledged in the abovementioned section of the proposed regulations.

The FSC submits there is no reason for differentiating between industry funds and retail funds, as each are subject to the same legislative and regulatory regimes under SISA and SISR, with APRA filling the same prudential role in governing both (and the Australian Taxation Office also regulates the same taxation regime for both types of fund). In particular, both types of funds are subject to:

• the same licensing and registration requirements under SISA for granting Registrable Superannuation Entity licenses (Section 29B SISA);

• the same requirements for a trustee to operate the superannuation fund (Section 19 SISA);

• the same requirement that the fund is operated solely for one or more prescribed core purposes under Section 62 SISA, encompassing:

  • the provision of benefits for each member of the fund on or after the member's retirement or reaching the attainment of an age not less than the age specified in the regulations; or

  • the provision of benefits in respect of each member of the fund on or after the member's death, occurring before the member's retirement or reaching the attainment of an age prescribed in the regulations.

  Certain ancillary purposes are also allowed provided the core purpose requirement is met, with allowable ancillary purposes aligning with the definition of “Ancillary benefits” in the proposed regulations, subject to the comments further below.

• the same prudential standards set by APRA (under Section 31 SISA), governing matters such as:

  • who is allowed to contribute to funds;

  • the amount of money a fund is allowed to accept;

  • the circumstances in which a fund is allowed to accept money; and

  • the level of benefits and assets that a fund is allowed to provide and hold, respectively.

• the same conditions prescribing the only circumstances when benefits can be released to individual members and requiring amounts to be paid only as set out in the regulations (regulation 6.19A ad Schedule 1 SISR).

• the same taxation regime.

Accordingly, industry and retail funds are required to be operated in the same manner and for the same purpose of primarily providing for member's retirement and pension outcomes.

To provide clarity on this outcome, the proposed regulations should be expanded to explicitly confirm that an eligible fund will include funds established and offered to employees of any employers across the public spectrum.

Alternative approach to simplifying qualification for QFPF status

In the alternative, the proposed regulations could be expanded to adopt a “white list” approach, whereby pension plan regimes regulated in a list of countries (prepared by Treasury or the IRS) could automatically be treated as QFPFs or be subject to a reduced set of qualifying requirements. This would only apply to countries with robust pension regimes that Treasury is satisfied align with the policy intent of the section 897(l) exemption.

An example of this approach is the United Kingdom's Qualifying Recognized Overseas Pension Scheme (“QROPS”), which provides tax concessions on the transfer of UK pension balances to eligible foreign pension funds. To qualify, a foreign pension fund must meet certain requirements and be established in certain foreign countries, including EU Member States countries with which the UK has a double taxation agreement including provisions for the exchange of information or a tax information exchange agreement.

2 — Scope of Ancillary benefits definition

The proposed regulations define “ancillary benefits” as “. . . benefits payable upon the diagnosis of a terminal illness, death benefits, disability benefits, medical benefits, unemployment benefits, or similar benefits.”

The scope of ancillary benefits that may be provided by Australian superannuation funds is tightly regulated. The legislated conditions of release can change over time, for example:

• From 1 July 2017 Australia introduced a First Home Super Saver Scheme, which allowed individual superannuation members to undertake early withdrawals of voluntary contributions from their superannuation account for the purpose of purchasing their first home. Legislative restrictions limit the total amount that can be withdrawn to AUD$30,000 and also regulate when and how this can occur (including a requirement for the ATO to approve the withdrawal via a determination).

• Under SISA there is the ability for individual members to make early withdrawals of limited amounts from their superannuation accounts as they approach retirement (Transition to Retirement schemes).

• Superannuation benefits can be withdrawn early on limited grounds, including terminal illness and severe financial hardship. The Australian Government is currently considering some changes to these arrangements which would largely result in further restrictions on access.

These ancillary benefits represent only a small part of the total benefits provided by an Australian superannuation fund, typically well below the 15% threshold allowed for ancillary benefits under section 1.897(l)-1(c)(2)(ii)(B)(2).

It can be expected that the nature and range of ancillary benefits allowed under Australian superannuation rules, and other foreign pension regimes, will change over time as ageing populations and developments in medical and social trends necessitate reform. To accommodate potential changes whilst preserving the integrity of the QFPF exemption, the definition of “ancillary benefits” should be expanded to include any ancillary benefit allowed or required to be paid by an eligible fund under the laws of the foreign country in which the fund is created or organized.

If Treasury had concerns that this change (and changes suggested below) were too broad, it could also apply a “white list” approach to confine it to a prescribed list of countries.

3 — Scope of fund members

As noted earlier, many Australian superannuation funds are public offer funds and it is possible that fund members may have never been employees, e.g. spouses of employees or other independently wealthy individuals.

The requirements in proposed section 1.897(l)-1(c)(2)(ii)(A)(2) appear potentially too restrictive for eligible funds established by one or more employers as the fund must have been established to provide retirement or pension benefits to either current or former employees, or persons designated by such employees. Although the proposed regulations provide welcome clarification that self-employed individuals will be treated as both employers and employees, it is not clear whether an independently wealthy individual that is neither self-employed nor has ever been an employee would qualify (e.g. where wealth has arisen from an inheritance or family support). These circumstances will be unusual and represent a very small number of members in any particular fund but there is no de minimis allowance in the proposed regulations.

Accordingly, both proposed section 1.897(l)-1(c)(2)(ii)(A)(2) and the definition of a “qualified recipient” should be expanded to include any individual validly allowed to be a member of an eligible fund under the laws of the foreign country in which the fund is created or organized.

4 — Integrity rule

The proposed regulations contain a ten year testing period during which a QFPF or qualified controlled entity may not be eligible for the exemption if at any time during that testing period any of the qualifying requirements in proposed section 1.897(l)-1(c)(2) have not been met.

The FSC submits this integrity rule is too severe for a number of reasons, including that it could apply to USRPIs acquired after a failure of the qualifying requirements. The integrity rule also appears to be drafted too broadly as it appears contrary to the statement in the Economic Analysis section of the preamble that the bright-line test of limiting ancillary benefits to 15 percent or lower “. . . may result in a small number of foreign pension funds oscillating between qualifying and not qualifying on a year-to-year basis . . .”. If the integrity rule applies to any failure to meet a qualifying requirement in a ten year period, it appears a foreign fund would be disqualified over that ten year period and could not oscillate between qualifying and not qualifying on a yearly basis during the testing period.

Accordingly, the integrity rule should be refined to more precisely target the mischief perceived by Treasury. From the description in the preamble, the perceived mischief appears to be the potential for avoidance by a non-QFPF foreign person where a USRPI is held indirectly via a foreign subsidiary and that foreign subsidiary is sold to a QFPF (thereby escaping US taxation on any gain on the USRPI if sold while indirectly held by the QFPF). Rather than applying a broad ten year testing window, the integrity rule should be targeted towards avoidance of taxation on unrealized gains for USRPIs indirectly held by non-QFPFs, e.g. by taxing such gains if an indirectly held USRPI is transferred to a QFPF.

5 — Superannuation via life insurance companies

The preamble provides welcome clarity that Treasury and the IRS intend that a broad range of preferential tax regimes applicable to retirement or pension funds should qualify for the QFPF exemption. This comment follows mention in the preamble of a prior submission referring to eligible funds taxable as insurance companies which are subject to preferential taxation.

Australia's superannuation regime allows regulated superannuation funds to utilize aggregator investment vehicles, of which there are two primary types used in Australia: 

Although the preamble's acknowledgement of insurance company arrangements is helpful, further clarity directly in the proposed regulations is needed that a discrete, identifiable pool of assets held by an entity that itself is not a QFPF will qualify as a QFPF where those assets are held solely for the purposes of investing the assets of one or more QFPFs.

Finally, it is possible that a PST may have members that are small superannuation funds in Australia, which are subject to regulation under SISA and SISR but have a maximum of four members (self-managed super funds or SMSFs). SMSFs cannot be QFPFs because of the limit on any single qualified recipient holding rights to more than 5 percent of the assets or income of an eligible fund. In order to prevent the existence of any minority SMSF investors in a PST from tainting the QFPF status for the majority of QFPF investors, the restriction on qualified controlled entities being wholly-owned by one or more QFPFs should either be:

• relaxed to allow a de-minimums level of non-QFPF ownership, for example 5%;

• modified such that a QFPF will retain the ability to access the exemption on their share of income or gains distributed by an investment aggregator vehicle where the majority of that aggregator is controlled by QFPFs; or

modified to trace through to the indirect ownership interest in the entity being tested where a direct owner is a non-qualifying pension fund solely due to it failing the 5% concentration test and members of that non-qualifying fund indirectly hold an economic interest of less than 5% in the tested entity.