Australia's funds management sector has been handed a significant blow to competition and performance following the government's decision to double a withholding tax for investors in managed investment trusts (MIT).
In Tuesday's 2012 federal budget, the Labor government announced it would increase the final withholding tax for investors in MITs from 7.5 per cent to 15 per cent from 1 July 2012.
The increase was a reversal of the government's plan to progressively lower the tax from 30 per cent to 7.5 per cent, according to a Henry Davis York budget analysis paper.
"In 2009, the government introduced new MIT rules which offered a flat-rate final withholding tax for non-resident investors who invested into the Australian market through a MIT," the paper said.
"Internationally, the 7.5 per cent withholding tax rate was seen as competitive and many foreign investment funds have started to use this structure to invest in Australia.
"This created opportunities for Australian fund managers because in order to qualify for the reduced withholding tax rate, the MIT needed to engage the services of an Australian responsible entity and investment manager."
The change created serious challenges for the local funds management industry, it said.
The sudden increase would "significantly" undermine the forecast returns for existing funds that had modelled their investment profiles on the 7.5 per cent withholding tax rate, the paper said.
Financial Services Council (FSC) director of policy Martin Codina said the change was a "very negative outcome" for the industry.
"This is completely unexpected," Codina said.
"The purpose for lowering this particular withholding tax, as stated by this government, was to attract foreign investment particularly into property and infrastructure.
"You now have to question whether or not foreign investors will continue to invest into those sectors with this surprise U-turn."
He said the reversal would affect the performance of the funds and would place make it more difficult to compete for capital in the region.
As a result, the FSC will lobby the government as a priority to encourage it not to proceed with the reversal.
"The FSC will engage with all sides of parliament, including the independents, to highlight the importance of this measure, particularly at a time when Australia has a significant infrastructure backlog," Codina said.
"Measures like this send very mixed signals to foreign investors and to global financial services companies. On the one hand, they are committing to follow through with an investment manager regime (IMR), which we fully support. On the other hand, it is increasing taxes on Australian assets."
The Trust Company corporate clients general manager Andrew Cannane said the company was "extremely disappointed" by the proposed changes, particularly by the government's failure to consult with key industry stakeholders.
"The MIT regime was brought in to promote foreign investment into Australia, grow our investment management industry and promote Australia as a financial services hub for the region," Cannane said.
"We believe that this legislation was succeeding and was proving incredibly beneficial to the wider Australian economy - stimulating the financial services industry and creating jobs for all of the service providers supporting the MIT industry."
He said while the tax rate was not the sole consideration of investors, the MIT regime finally brought in a regionally competitive tax regime.
"Changes to the rate undermine the confidence of foreign investors to invest into Australia with certainty," he said.
"We are actively engaging directly and via industry bodies to lobby for a proper review and consultation of these MIT changes."
Opposition assistant treasury spokesman Mathias Cormann said the government's "tax grab" on MITs raised serious fears about Australia's sovereign risk profile.
"It will create further uncertainty yet again and completely destroys Labor's credibility on claims it is working to make Australia a financial services hub," Cormann said in a statement.
"Foreign investors and the funds management industry will be left wondering, what's coming next from this government?
"The doubling in the withholding tax rate puts Australia out of step with comparable rates in the Asia-Pacific region and destroys any pretence that Labor wants to make Australia a regional financial services hub."
In December last year, the government announced it would implement the third and final element of an IMR, a key recommendation of the Johnson report.
