OPINION | The government has announced some welcome changes to the tax rules affecting foreign investors in Australian funds management products, but reforms are still needed to the non-resident withholding tax regime to help the industry attract global capital.

It is now two years since Treasury launched the investment manager regime (IMR) on July 1, 2015. This is the framework foreign investors rely on to avoid uncertainty in their exposure to Australian taxes when investing directly or with the assistance of an Australian manager or adviser.

The IMR is a key part of Australia’s armoury to compete against the likes of global financial centres Luxembourg and the United Kingdom in attracting foreign investors to local fund managers.

Until very recently, however, there was a big chink in the armour, caused by a lack of clarity around the technical application of our tax laws that was making foreign investors nervous. Not only was this deterring future investment, but it was also creating a real risk that some major global investors might pull their money out of Australian-operated managed funds.

Therefore, Australia’s path to becoming a formidable global financial services powerhouse was given a crucial boost last week when the government stated it would take swift action to clarify that foreign investors are protected from tax residency issues that can arise simply because they use an Australian-based manager.

Without an IMR, foreign investors are taxed on all the income they earn from a fund Australians manage, regardless of whether the income is from Australian-based investments – such as property or businesses – or investments located offshore.

Strengthening our IMR against unintended consequences will create much needed certainty for foreign investors.

This is critical, because, like all countries, Australia has a right to tax income earned from activities that occur on its soil, meaning earnings from businesses and property that are physically located here. But it doesn’t, and shouldn’t, tax income earned from assets in a third country.

Take, for example, an investor from Germany who is investing in a US toll road using an Australian-based manager. Without the IMR, the German investor would be taxed on all US income as if it were generated on Australian soil.

Doesn’t seem right? It’s not.

An IMR prevents this bizarre outcome from occurring and ensures that the investor pays only the relevant US-based tax. This level of certainty is critical if that foreign investor is a large pension or endowment fund.

Australia still gets its fair share of tax. Like any exporter, the Australian-based manager pays tax on any fees it earns from providing services. And the German client would also pay tax on any income earned from investing in Australian property or real-estate funds.

Next in the reform queue

The IMR is a large step in the right direction but there is still more to do for Australian financial services to be globally competitive. To help further strengthen the IMR, the next action the government needs to take is changing our non-resident withholding tax.

This is one tax policy setting that does not currently rank well internationally.

On a recent trip to Thailand – one of our counterpart countries in the upcoming Asia Region Funds Passport – the Financial Services Council was told in no uncertain terms that Australia’s tax system needs to change. This is something local fund managers hear frequently. One of our members received the following in an email from a potential overseas investor: “…the general feeling in the market is that Australia is not very tax friendly on foreign investments.”

Industry is awaiting further changes from the government to simplify withholding tax for investors using the Asia Region Funds Passport.

Investments in the passport are restricted to equities and bonds – assets that are usually exempt from withholding tax under our current taxation rules. But our headline tax rates for these assets are high and our system is complex. Investors are easily turned off by the chance they may not meet the exemptions.

Overseas investors account for just 3.4 per cent of our $2.8 trillion funds under management in Australia, compared with about 30 per cent for the UK, 65 per cent for Hong Kong, and 80 per cent for Singapore.

A competitive withholding tax system removes one of the barriers to an overseas investor choosing Australia as a destination for their capital.

Our IMR is an essential piece of the blueprint for Australia to become a global financial centre written in 2009 by ex-Macquarie Bank deputy chairman Mark Johnson. Reform of our withholding tax system is the final piece of the puzzle now required to ensure Australia can properly transition into a service economy driven by our biggest sector, financial services.

Sally Loane is the chief executive of the Financial Services Council.