On 1 December 2010 the Australian Taxation Office (ATO) released its long awaited tax determinations relevant to offshore private equity investments into Australia. The determinations had previously been released in draft form in December 2009 following the publicity associated with the ATO issuing tax assessments on two affiliates of Texas Pacific Group – the global private equity firm behind the listing of the Myer retail group last year (see our legal update 17 December 2009 Taxation of foreign investment gains in Australia - policy and practice in conflict? by David Coombes).

While changes to the managed investment trust taxation regime have, to some extent, addressed the taxation concerns of Australian private equity funds (see our legal update of 3 August 2010 Managed Investment Trust Reforms Now Law), it is doubtful whether the final determinations will do much to ease the concerns of foreign private equity firms, depending on the structure by which those firms make investments into Australia. There will no doubt be a desire on the part of many in the private equity industry to seek legislative changes to provide more certainty for foreign investors.

Taxation Determination TD 2010/21

This had previously been released as Draft TD 2009/D18 and was entitled “Income tax: can a private equity entity make an income gain from the disposal of the target entity it has acquired?” The final taxation determination bears the title “Income tax: can the profit on the sale of shares in a company group acquired in a leveraged buyout be included in the assessable income of the vendor under subsection 6-5(3) of the Income Tax Assessment Act 1997”.

Despite the change in name of the tax determination, the main thrust of the final determination is the same as that in the draft, namely, that a profit made by a private equity entity from the disposal of shares in an Australian company acquired for the purpose of profit making by sale in a commercial transaction (such as a LBO with a short on to medium time frame) will constitute ordinary income for the purposes of section 6-5(3) of the Income Tax Assessment Act 1997 (which includes in a foreign resident’s assessable income, ordinary income derived from Australian sources). The treatment of the profit as ordinary income rather than a capital gain is important because non-residents are generally not subject to capital gains tax on profits from the sale of Australian investments except in limited circumstances. If the profit is treated as income it will be subject to tax if it has an Australian source.

There is, to some extent, a little more clarity provided in the final tax determination as to the circumstances in which a profit on sale by a foreign investor will be treated as income rather than capital. An exmple in the determination, involving an off-shore pooled investment trust, involves a proft on sale that would be treated as capital rather than income. An important feature of this example, however, is that the trust seeks to maximise long-term returns and there was no plan to later sell the interest at a profit at the time it was acquired. The sale being occasioned “due to changing financial circumstances arising from the need to fund the retirement of non-residents from the trust and adjust to increases in the cost of capital arising from the global financial crisis.”

ATO View on ‘source’ of profit

For private equity funds that are in countries with which Australia does not have a tax treaty, if the profit from the share sale is treated as ordinary income, then Australian tax will apply if that income has an Australian source. Along with the release of the final determination, the ATO also released a draft taxation determination TD 2010/D7 - Income Tax: is ‘Australian source’ in subsection 6-5(3) of the Income Tax Assessment Act 1997 dependent solely on where purchase and sale contracts are executed in respect of the sale of shares in an Australian corporate group acquired in a leveraged buyout by a private equity fund?

The short answer given in this draft determination is “no” and that source of income is determined having regard to all the facts and circumstances of the particular case. In the context of a foreign private equity fund, executing contracts for the sale of shares in an Australian company outside Australia may not necessarily ensure that the source of profits from the sale is also outside Australia.

The draft determination contains a lengthy discussion of the source principles and the relevance of the various steps and activities undertaken in a leveraged buyout arrangement. The key factors seen as increasing or impacting on the profit are:

  • the business ability in assessing suitable target enterprises
  • making operational improvements and
  • the steps making the acquisition of the business possible (such as arranging finance).

Where these activities are undertaken in Australia – as the ATO understands is the case in a typical LBO - the source of the profits will be treated as being in Australia and thereby subject to Australian tax.

The draft determination makes the comment that where taxpayers implement a plan designed to ensure that profits arising from the divestment of private equity investments are not sourced in Australia, the ATO will consider whether the general anti-avoidance rules in Part IVA of the Income Tax Assessment Act 1936 may apply to those arrangements.

Importance of Tax Treaties

Accordingly, TD 2010/21, and the new draft determination TD 2010/D7 may hold little joy for private equity funds located in countries which do not have tax treaties with Australia. TD 2010/21 indicates the importance of tax treaties to the Australian treatment of profits of private equity funds. The business profits article in those treaties will determine which country has the taxing rights in respect of any profit that is of an income nature. Generally the country of residence will be entitled to tax those profits. On this basis, the tax determination indicates that private equity funds resident in treaty countries will not usually be subject to tax on their Australian sourced business profits.

Attempts by private equity funds to structure investments into Australia so as to take advantage of tax treaties are addressed in Tax Determination TD 2010/20: Income tax: treaty shopping – can Part IVA of the Income Tax Assessment Act 1936 apply to arrangements designed to alter the intended effect of Australia’s international tax agreements network?

This determination had previously been released as draft determination TD 2009/D17 and the views of the ATO remain unchanged. Where a private equity fund is located in a country with no tax treaty with Australia and an investment into Australia is structured via entities established in countries which have tax treaties with Australia, the following comment is pertinent:

“Where an arrangement is put in place merely to attract the operation of a particular tax treaty in the context of a broader structuring arrangement, this may be a scheme which otherwise satisfies the terms of part IVA and any tax benefit obtained in relation to such a scheme may be cancelled.”