Foreign investors in Australian resources projects receive important income tax guidance from Federal Court

All foreign investors into Australian companies, especially resources companies, will need to review their approach to Australian tax risks, following a successful appeal by partners of two private equity investment vehicles against income tax assessments of the proceeds of their disposal of investments in an Australian resources company (Resource Capital Fund IV and V LP v Commissioner of Taxation [2018] FCA 41; Clayton Utz acted for the successful applicants).

RCF's operations and disposal of shares in an Australian company

Resource Capital Fund IV LP and Resource Capital Fund V LP were US-based private equity operations established in the Cayman Islands. Investment decisions were made by an Investment Committee meeting in the US, while various management companies conducted the day-to-day operations.

In 2007, the Funds, together with other investors, invested in a WA-based mining company known as Talison Lithium and disposed of their interest in a 2013 scheme of arrangement. The ATO issued special assessments to the Funds for their gains on disposal of Talison shares.

Five issues in dispute

In coming to its finding for the applicants, the Court dealt with five key issues.

Who were the correct parties to the action?

The ATO argued that the Funds themselves were "taxable entities" with standing to the tax appeal.

Though the Funds were tax transparent in both the US and the Caymans, under Australian tax law the Funds had to be taxed as if they were companies. There was also expert evidence that the Funds were not separate legal entities under Caymans law and the proper parties to sue and be sued were the ultimate general partners.

The Court held that the Funds were not separate taxable entities; the correct parties to assess were the partners, not the partnership. However, the Court found that such procedural irregularity could be remedied and determined that the assessments were valid. Nevertheless, the fact that the partners were the correct parties to the action was favourable to other parts of the applicants' case.

Were the funds protected by an ATO ruling on Australian-sourced business profits of foreign limited partnerships?

The Funds relied on an ATO public ruling TD 2011/25 as being apposite to their circumstances; they also led extensive evidence that they relied on the ruling.

The Court agreed that the Commissioner was bound by the ruling, and the extensive, unchallenged evidence that the Funds had relied upon it. Therefore, the Commissioner was bound by the ruling unless Article 7(6) and Article 13 applied and the gains were "wholly or principally attributable" to real property in Australia.

Were the funds protected by the Australia/US tax treaty?

The Funds argued that they were protected from Australian tax by the Treaty as the Talison gain was a "business profit" and Talison's assets were not principally real property situated in Australia. The ATO argued that the Treaty did not apply to the Funds and that, even if it did, Talison's assets were principally Australian real property.

The Court held that the partners of the Funds were entitled to Treaty protection; the relevant "residents" for Treaty purposes were the partners of the Fund and the Treaty did not transform the partnership Funds into "persons" for Treaty purposes.

Was the Talison gain ordinary income with an Australian source?

The Funds argued that the Talison gain was not ordinary income as there was no profit-making intention from the outset of the investment and the substance of the transaction and key transaction steps happened offshore.

The Court held on the characterisation of the gain that ordinary income, as profitable realisation of the investment was one of the Funds' objectives from the outset and that there were key transaction steps that happened offshore and also key steps that happened onshore and pointed to an Australian source.

However, this was not determinative, as the Funds were entitled to rely on the ruling and Treaty protection.

Was the Talison gain liable to Australian capital gains tax?

This question turned on whether or not Talison's assets were over 50% taxable Australian real property (TARP). Very broadly, TARP comprises all interests in land, mining and exploration interests and certain buildings and improvements.

This issue required very technical and specialised analysis by appropriately qualified valuation experts. A core aspect of the Funds' valuation evidence was the use of the "Netback method" which was a methodology for separating Talison's mining and processing activities. The Funds' experts found Talison's assets to be less than 50% TARP; the ATO's, more than 50%.

Accepting the Funds' evidence, the Court held that the Funds were not liable to an Australian capital gain:

  • the "netback method" used by the Funds' experts, which is a method for separately valuing the mining and processing operations, was acceptable, reasonable and reliable;
  • certain leases and licences that allow processing, but not mining operations are not TARP and the value of those leases and licences, as well as processing plant and equipment, are non-TARP;
  • value attributable to the period after expiry of the current mining leases should be valued as a non-TARP asset; and
  • intercompany loans were to be valued on a gross, not net basis.

What foreign investors in Australian companies should do next

Foreign partnerships investing in Australia should consider where their ultimate partners are resident. If it is in a country with a tax treaty with Australia (most of our major trading partners) they may be entitled to treaty protection or protection under ruling TD 2011/25.

All foreign investors into Australian resource companies should consider how they value those companies for Australian capital gains tax purposes. These are often complex valuations that require careful consideration and selection of the right methodology.