As foreshadowed in our November 2009 funds bulletin, the Australian Taxation Office (ATO) has released two eagerly anticipated draft tax determinations (draft TDs) dealing with:
- whether a private equity entity can make an income gain from the disposal of the target assets it has acquired (TD 2009/D18); and
- whether treaty benefits (ie an Australian tax exemption) can be denied in circumstances where a company (which is resident in a country with which Australia has concluded a double tax treaty) is interposed between an Australian investment and an entity which would not be entitled to tax treaty benefits (TD 2009/D17).
The conclusions in the draft TDs accord with the ATO's position in relation to the TPG/Myer transaction. Please refer to our November funds bulletin where we discussed that transaction.
The draft TDs do not deal with the question of the "source" of gain on realisation of an investment. An Australian source is required in order for the ATO to have taxing jurisdiction over the relevant gain.
The draft TDs represent a further significant tax development affecting funds, and follow in the release of exposure draft legislation (ED) dealing with the taxation of gains by managed investment trusts (MITs). Please refer to our December funds bulletin.
Closing date for Submissions
Both draft TDs are open for comment until 29 January 2010. We would be pleased to assist clients in making any submissions prior to the closing date.
TD 2009/D18 - Revenue or Capital Gains?
The Commissioner asserts that private equity style gains are likely to be revenue account rather than capital account. This conclusion was widely anticipated.
The issue is important for non-resident investors because capital gains for those investors on a sale of shares would ordinarily be exempt from Australian income tax (one exception being the sale of shares in land-rich entities). Gains on revenue account are not eligible for this exemption.
However, the Commissioner acknowledges that where the gain is derived by a resident of a country with which Australia has concluded a double tax agreement, the gains would generally be exempt from Australian income tax except where Part IVA (anti-avoidance provision) is applied to deny the benefits of that treaty.
Click here to view the draft TD.
TD 2009/D17 – Application of Part IVA
TD 2009/D17 acknowledges that Australia's double tax agreements ordinarily prevent Australia from taxing gains of a revenue nature, except where the non-resident has a permanent establishment in Australia.
The Commissioner's view is that he will attempt to apply the domestic anti-avoidance provisions to deny the benefit of the relevant treaty where there are no sound commercial reasons for creating a particular pattern of holding interests and where an arrangement is put in place merely to attract the operation of a particular tax treaty with Australia. The Commissioner uses the example of TPG's three tier structure involving a Dutch company (entitled to the treaty benefits) which was owned by a Luxembourg company and which in turn was owned by a Cayman Islands company. Neither the Luxembourg company, nor the Cayman Island company would have been entitled to benefits under the treaty and would have been taxable on the gain.
This draft TD potentially has broader implications outside of the private equity space, in terms of investment vehicle choices more generally.
Click here to view the draft TD.
Private equity considerations
There are a number of key observations emerging from the recent developments relating to the TPG/Myer transaction, the MIT ED and these draft TDs. In particular:
- for domestic private equity vehicles, which cannot qualify for deemed capital account treatment (MITs) or tax exemptions for qualifying investors (VCLP/ESVCLP), the draft TDs mean that those funds are likely to face significant ATO scrutiny and challenges to any position that gains are on capital account, with no legislative safe harbour which can be adopted;
- for foreign private equity vehicles, it would seem that if these draft TDs are finalised in their current form, significant uncertainty will remain in relation to their inbound investment structures;
- the uncertainty for both domestic and foreign private equity funds, will only be resolved by a change in ATO policy, specific legislation, or alternately a legal challenge which is ultimately resolved by the High Court;
- in the meantime, it would seem that private equity will need to consider:
- what factors, specific to the relevant fund, support an argument that the fund's circumstances are able to be distinguished from the fact patterns described in the revenue account draft TD (relevant to both foreign and domestic funds);
- revisiting existing structures, having regard to the relevant ATO criteria described in the draft TD dealing with Part IVA (relevant to foreign funds);
- whether exits can be achieved without triggering an Australian source for the foreign fund (this will be difficult to achieve in an IPO context); and
- alternative investment structures for future investments – for instance, more direct investments from the ultimate foreign investors using Australian based collective investment vehicles which qualify for MIT / VCLP / ESVCLP treatment.