On 17 October 2014, the High Court (Crennan & Keane JJ) refused the application by Resource Capital Fund III, LP (RCF) for special leave to appeal against the Full Federal Court’s decision in Commissioner of Taxation v Resource Capital Fund III, L.P.  FCAFC 37 (handed down 3 April 2014), in which the Full Court allowed the Commissioner’s appeal against the decision of Edmonds J at first instance.1
This article discusses the RCF case and a subsequent AAT decision dealing with similar issues and also briefly discusses:
- Some implications if a ‘look-through’ approach to LPs were adopted for the purpose of applying double tax treaties to partners;
- The position of sovereign wealth investors;
- Changes and proposed changes to the non-resident capital gains tax (CGT) rules (in particular the principal asset test) and the proposed new withholding rule.
Facts of RCF case
RCF was a Cayman Islands exempted limited partnership (LP), in which 97% of the partnership interests were held by residents of the United States (US) (principally funds and institutions). It was a foreign partnership for US federal income tax purposes and a non-resident of Australia for Australian tax purposes.
RCF made a capital gain on the sale (in 2 tranches in July 2007 and January 2008) of shares in Santa Barbara Mines Limited (SBM) (later called St Barbara Limited), an Australian listed company with gold mining operations in Western Australia. RCF’s total shareholding in SBM was 11.95%. The Commissioner assessed RCF on the capital gains.
Relevant provisions of ITAA
Under s855-10 of the Income Tax Assessment Act 1997 (Cth) (together with the Income Tax Assessment Act 1936 (Cth), theITAA), non-residents are only subject to Australian capital gains tax (CGT) on CGT assets that are ‘taxable Australian property’ (TAP). In the case of shares or trust interests, this requires that:2
- The taxpayer has a ‘non-portfolio interest’ in the relevant entity, which requires that the taxpayer (either alone or together with one or more ‘associates’) has a voting interest in the entity of 10% or more (directly or indirectly through interposed entities)3; and
- The entity satisfies the ‘principal asset test’, which requires that the total market value of the entity’s assets (held directly by the entity or indirectly through other entities in which the taxpayer has a non-portfolio interest) that are ‘taxable Australian real property’ (TARP) exceeds the total market value of its assets that are not TARP.4
Federal Court and Full Federal Court decisions
At first instance, Edmonds J held that RCF was not subject to Australian CGT on the sale of the SBM shares because:
- Australia was prevented from assessing the gain by Article 13 of the Double Taxation Agreement between Australia and the US (DTA); and
- The capital gain was not assessable in any event as the shares were not TAP because SBM did not satisfy the ‘principal asset test’.
The Full Court allowed the Commissioner’s appeal on the basis that:
- the DTA did not apply to RCF as it was a Cayman Islands LP that was taxable as a company under the ITAA and was not a resident of the US for US tax purposes; and
- the principal asset test was satisfied.
The Full Court noted that it may have been open for the US resident partners to obtain the benefits of the DTA on the basis that Australia should view the gain as derived by them, but declined to express a view on this. This would be consistent with the Commissioner’s views in TD 2011/25 in relation to Article 7 (which, as the Full Court noted, is not binding in relation to Article 13). Any such protection may, however, be of little benefit to the partners if the Commissioner can tax the LP because it is not a US resident.
In a separate decision,5 the Full Federal Court considered valuation issues in relation to the principal asset test. RCF contended the test was not satisfied at the time it disposed of the first tranche of SBM shares (in July 2007), arguing that the market value of its mining information and plant and equipment (non-TARP assets at that time) was to be determined by taking the mid-point between the replacement and scrap values of these assets, on the basis that this is what a hypothetical willing but not anxious purchaser that is assumed not to have the assets would be prepared to pay to acquire them. The Court rejected this as unsupported and speculative and held that RCF had not discharged its onus of proof.
Submissions for the applicant
The applicant submitted that the case raised a matter of general public importance in relation to the construction of DTAs based on the OECD model, namely how the DTA applies where one state treats an entity (such as an LP) as the taxpaying entity, while the other state treats it as fiscally transparent and taxes the partners. It argued that the Full Court:
- in treating the LP (which is not a separate legal entity) as the taxpayer, rather than the US resident partners, denied the partners the benefit of the DTA, thus frustrating the overriding effect given to the DTA under the International Tax Agreements Act 1953; and
- did not address the ‘fundamental and threshold issue’ of who is the proper taxpayer to be assessed on the gains in conformity with the DTA.
It was submitted that, as the source state, Australia should accord treaty protection to the US resident partners by treating them as having derived the gain, rather than taxing the LP6 and that the Full Court erred in saying there was no inconsistency between the DTA and the ITAA with respect to taxation of the gain to RCF. Rather, the inconsistency was between US and Australian tax law and ‘it is that very inconsistency between the different tax treatment of the party states which it is the fundamental purpose of the [DTA] to address’. The Full Court’s reasoning, the applicant said, was based on the ‘false premise’ that whether there was an inconsistency depended on assuming RCF was the proper taxpayer.
Submissions for the ATO
The ATO submitted that special leave should be refused because, among other things, this was not a suitable case for resolution of the DTA issues, given Article 13 permits Australia to tax US residents on gains on direct and indirect interests in Australian real property. It also submitted that it cannot be said that the DTA precludes the assessment of RCF and only permits assessment of the partners because:
- firstly, the DTA does not deal with which entity can be assessed; and
- secondly, this would result in non-US resident partners effectively getting relief under the DTA (as the whole assessment to the LP would be set aside as excessive) and therefore double non-taxation of the gain.
Counsel for the ATO pointed out (as did Crennan J) that nothing in the Full Court’s decision denied individual US resident partners the ability to claim the benefit of any relief under the DTA in respect of their share of partnership profit to which they were potentially entitled. However, as the gains related to Australian real property, they could be taxed in Australia under Article 13 (the alienation of property article), which applied rather than Article 7 (the business profits article). Counsel also pointed out that partners could obtain treaty relief by claiming credit in the US for Australian tax paid at the LP level and, if necessary, could invoke the mutual agreement procedure under Article 24 of the DTA.
In response, the applicant argued that:
- application of Article 13 to individual partners was a matter only the partners could contest, which they cannot do while the assessment is only to the LP, and
- any double non-taxation of the gain as a result of according treaty protection to the LP’s gain would be due to a flaw in the ITAA and its relationship with the DTA.
Decision to refuse special leave
Crennan J (delivering the High Court’s decision) noted that the Full Court had found the LP was an independent taxable entity in Australia and, as it was not a resident of the US, it was not entitled to the benefits of the DTA. Her Honour said the decision was not attended by sufficient doubt to warrant special leave.
Double Taxation Agreements and the ‘look-through approach’
Given the potentially significant issues raised in the RCF case concerning the interaction between the ITAA and DTAs where there is a mismatch between contracting states as to the taxable entity, it is disappointing that the High Court did not take this opportunity to consider these issues, particularly given the Full Court said it may be appropriate for Australia to view the gain as derived by the partners and apply the DTA accordingly.7
Such look-through approach would be consistent with the ATO’s views in TD 2011/25 in relation to Article 7 (the business profits article in most DTAs), although it is noted that this TD now specifically states that it only applies to the extent that the profits are not dealt with in another Article of the DTA, e.g. Article 13 (the alienation or property article in most DTAs).
Most (but not all) of Australia’s DTAs specifically allow (in the alienation of property article) Australia to tax gains on real property situated in Australia, including (in most cases), shares or comparable interests in a company the assets of which consist wholly or principally of such real property.
The look-through approach does, however, raise some issues in relation to the application of the ‘non-portfolio interest test’ to partners and the treatment of foreign sovereign investors.
Non-Portfolio interest test
If the look-through approach were applied, a question arises as to whether the partners (some or all of whom would not have had an individual interest of 10% or more in the LP) would satisfy the non-portfolio interest test (which, as noted above, is associate-inclusive). For partners whose interest is less than 10%, this may depend on whether the partners can be regarded as ‘associates’ of each other or of the partnership for this purpose.8
In the case of an ordinary partnership, a partner is an associate of the partnership and of each other partner in the partnership, regardless of their percentage interest in the partnership. In the case of an LP, on the other hand, as the LP is deemed under the ITAA to be a company rather than a partnership and the partners are deemed to be shareholders,9 a partner will only be an associate of the partnership if the partner (alone or together with its associates, which would not necessarily include the other partners) has a majority interest in, or ‘sufficient influence’ over, the LP. Arguably, it is this associate test that will apply even if the LP is treated as a fiscally transparent partnership by virtue of the DTA. In that case, none of the partners in RCF would have been an associate of RCF or each other (assuming they were not otherwise associates).
On that basis, the look-through approach could result in the LP’s capital gain escaping tax, unless it is applied only to attribute to partners who are resident in a DTA country their respective shares of the tax payable by the LP so that those partners can claim any protection afforded under the relevant DTA.
Foreign sovereign investors
It is also unclear whether the look-through approach would enable the doctrine of sovereign immunity (if applicable) to apply to exempt foreign sovereign investors in a fiscally transparent LP from Australian tax in the same way as if they had made the investment directly. In the Compendium to TD 2011/25 (which deals with the application of Article 7 to fiscally transparent entities), the ATO simply states that ‘leaving aside the existence of a permanent establishment, if a business profit within Article 7 is made by a sovereign wealth fund entity resident in a country with whom we have a tax treaty, that country has the taxing right … if there is no treaty we have the taxing right’. The ATO does not say whether it would apply the sovereign immunity principle to exempt a sovereign investor from any Australian tax even if Australia has a taxing right, although it appears from this statement that it may not.
The precise scope of the foreign sovereign immunity doctrine for Australian tax purposes is not clear, given there is no legislative provision. Legislation to codify the principle, providing an express exemption from Australian income tax and withholding tax for foreign governments and sovereign wealth funds in respect of certain passive income, was proposed in 2005-6 and a consultation paper was released in November 200910 and detailed consultations ensued. However, the current Federal Government announced in November 2012 that it would not proceed with this proposal.
Accordingly, foreign sovereign immunity remains a matter of administration by the ATO.11 It is generally necessary for a foreign sovereign entity (e.g. a foreign sovereign wealth fund) to obtain a private ruling from the ATO to confirm that the principle applies to it in respect of a specific investment.
In its publication, ‘Private rulings for sovereign immunity – supporting information’ (providing guidance on preparing a private ruling application about the exemption from Australian income tax or withholding tax under the doctrine of sovereign immunity), the ATO says that:
- it provides relief from Australian tax for income derived from the non-commercial activities of foreign governments and entities that form part of foreign governments (which may include a company wholly owned by a foreign government); and
- each case turns on its own facts and it is not possible to provide a ‘bright-line’ test for determining whether the relief applies, although a portfolio holding in a company (i.e. 10% or less of the equity) will generally be accepted as ‘non-commercial activity’.
The ATO has confirmed in a number of private binding rulings that the doctrine of sovereign immunity extends to special purpose vehicles of sovereign wealth funds.
Practical effect of the RCF decision
From a practical point of view, the RCF decision should not adversely affect foreign private equity investment in non-land rich businesses which fall outside the scope of Division 855.12 Where, however, the investment involves the mining sector or other land intensive operations, treaty relief may not be available if the seller is not resident in a treaty country or the capital gains article (Article 13) in the relevant DTA preserves Australia’s taxing rights.
AP Energy case
Subsequent to the first instance decision in RCF, the Administrative Appeals Tribunal (AAT) was called upon to consider the principal asset test and valuation of mining information in AP Energy Investments Limited v FC of T 2013 ATC 10-355 (AP Energy).
AP Energy concerned the sale in December 2007 by a Chinese registered investment company of most of its 21.4% shareholding in Abra Mining Limited (Abra), an Australian listed gold exploration company, to another non-Australian resident company. The question was whether Abra satisfied the principal asset test, such that the gain on the sale was subject to Australian CGT.
The AAT said that the ‘discounted cash flow’ (DCF) method may be appropriate for valuing the assets where the entity is a producer (as in RCF) but, where the entity is an explorer (as in AP Energy), the market value of mining information should be determined on the basis of the price that would be paid in a hypothetical sale to a buyer who would need to recreate the mining information to continue exploration. The AAT found that, in this case, the ‘sunk cost’ valuation method adopted by the taxpayer was acceptable and more appropriate than DCF.
Changes to non-resident CGT rules
Principal asset test
Following the decision of Edmonds J at first instance in RCF (in which his Honour considered the proper construction of s855-30 and the valuation principles to be applied), the then Federal Government announced changes to the principal asset test, with effect from 14 May 2013, to treat intangible assets connected to the mining rights (such as goodwill and information) as part of those rights and therefore TARP. The current Federal Government said it would analyse the effect of the outcome of the RCFappeals before proceeding with the proposed amendments.
Changes were also announced to prevent ‘multiplication’ of non-TARP assets as a result of dealings within a company group, which have been enacted.13
The former Government also announced it would introduce a new withholding rule, requiring purchasers of TAP from a non-resident to withhold 10% of the gross sale price on account of the seller’s tax liability, to apply from 1 July 2016. The current Government has announced it will proceed with this change, with residential property valued at less than $2.5M being excluded. A Discussion Paper was released on 31 October 2014.
Submissions in response to the Discussion Paper have highlighted a number of issues, including:
- whether a CGT liability will arise for the seller depends on a number of factual matters that may not be within the buyer’s knowledge (e.g. the seller’s residency status and whether or not the asset is TAP for the seller). For example, it may be difficult for a buyer of shares or trust interests (which are only TAP if they satisfy the non-portfolio interest and principal asset tests), especially in an on-market transaction. In an off-market transaction, these issues will at least need to be factored into a buyer’s due diligence inquiries and the warranties and indemnities required in the sale contract; and
- compliance cost and risks for payers (given that the measure could apply to a range of transactions, including transactions that are relatively minor or occur wholly outside Australia) and cash flow implications for sellers, which may affect commercial viability of some projects.14