In broad terms, non-residents are required to include in the calculation of their net capital gains, any capital gains or capital losses made with respect to a disposal of taxable Australian property. This includes non-portfolio interests (10% or more) in companies whose principal assets are real property situate in Australia which is defined to include mining, quarrying or prospecting rights if the if the minerals, petroleum or quarry materials are situated in Australia.

In a recent case, a limited partnership formed in the Cayman Islands had sold a non-portfolio interest in a mining company. However the limited partnership consisted of a number of limited partners none of whom held more than an 8.5% interest in the limited partnership. The limited partnership was treated as a separate taxable entity for Australian tax purposes, irrespective of whether it was a resident of Australia for Australian income tax purposes or not, but was treated as fiscally transparent or flow-through for US tax purposes irrespective of whether it was resident in the US for US tax purposes or not.

The Federal Court had to consider whether the USA double tax agreement applied to prevent the gain made on the sale by the limited partnership of the non-portfolio shareholding in the mining company from being taxed in Australia. There was also a question of whether or not the principal asset test had in any event been passed in relation to the mining company because if the principal asset test was not passed, the gain was not assessable in any event under Australian domestic law.

The Court noted that the treatment differences of limited partnerships under Australian and USA domestic laws create various difficulties when it comes to applying the provisions of double tax treaties to partnerships.

The Commissioner argued that the limited partnership was the relevant entity for assessing the gain whereas the taxpayer argued that the limited partners were the relevant entities for assessing the gain. If the company passed the principal asset test then if the relevant taxpayer was the limited partnership the holding was a non-portfolio interest and therefore taxable Australian property but if it was the limited partners then each did not hold a non-portfolio interest in the company and therefore the shares would not be taxable Australian property under Australian domestic law. Article 1(1) of the USA double tax agreement provides that it applies to persons who are residents of one or both Contracting States. Article 4(1)(b)(iii) has the effect that a resident of the USA for the purposes of the agreement includes a person who is a resident in the USA for the purposes of its tax.

In this case it was clear that the limited partnership was not a resident of the USA for the purposes of its tax but rather it was the limited partners who were subject to tax in the USA because the limited partnership was fiscally transparent for USA tax purposes.

Article 13(1) of the USA double tax agreement provides that income or gains derived by a resident of one of the Contracting States from the alienation or disposition of real property situated in the other Contracting State may be taxed in that other State, real property being defined sufficiently wide to cover the shares which had been disposed of in this case if the assets consisted wholly or principally of real property situated in Australia (real property being defined to include rights to exploit or explore for natural resources).

However because the limited partnership was not a resident of the USA for the purposes of its tax Article 13(1) could not apply to authorise the taxation of the capital gains made on the disposal of the shares. This includes Article 13(7) which provides that except as provided elsewhere in the article each Contracting State may tax capital gains in accordance with the provisions of its domestic law.

The Court said that state although the High Court had decided that the ordinary principles of statutory construction meant that the clear meaning of the text was to prevail over historical considerations and extrinsic materials subject to a proviso that where necessary, assistance can be drawn by consideration of the context which includes general purpose and policy of a provision, in particular the mischief it is seeking to remedy this was not to be taken as a rejection of the general principles of interpretation of double tax treaties coming out of the various decisions including the High Court itself in an earlier decision which had held that regard could be had to extrinsic material such as the OECD Commentary.

The Court therefore had regard to the OECD Commentary in relation to the corresponding article in the Model Convention to article 1(1) of the USA double tax agreement in interpreting the meaning of article 1(1). The Commentary provides that when partners are liable to tax in the country of their residence on their share of partnership income it is expected that the source country will apply the provisions of a convention as if the partners had earned the income directly so that the classification of the income for purposes of the allocative rules of Articles 6 to 21 will not be modified by the fact that the income flows through the partnership.

Having regard to this Commentary it was clear that Article 13(1) of the double tax agreement was to operate in relation to income or gains derived by the limited partners and not the limited partnership. This was because it was the limited partners who were subject to USA tax on the income from the partnership and therefore were the residents of the USA for the purposes of the agreement.

The Court noted that this was consistent with the policy behind the double tax agreement which was to avoid double taxation. If it was the partnership, rather than the limited partners, who were subject to tax in Australia in relation to the gains made on the disposal on the shares, then the result would be that the limited partners would also be subject to tax in relation to the same gains in the USA without any credit for the tax paid by the limited partnership. On the other hand, the interpretation of the double tax agreement in the manner set out in the Commentary results in the policy objective of that agreement being met. This is because the effect of this interpretation authorises Australia to tax a gain in the hands of the US resident limited partners but at the same time provides a credit for any Australian tax suffered as a result of the exercise of that right and so prevents double taxation of the gain.

However as it turned out it would not have matter in any event because the principle asset test was not passed so even if the limited partnership was the entity to be taxed on the gain, the shares were not taxable Australian property and therefore any capital gain or capital loss was required to be disregarded.