The taxation of private equity profits in Australia remains a contentious issue two years on from the transaction which first focused people’s attention, TPG’s IPO of Myer. Whilst the Australian Taxation Office (ATO) continues to pursue TPG for over $738 million in what it considers to be unpaid taxes (including penalties and interest), TPG are not the only foreign PE firm to have drawn the attention of the ATO in recent years.
This article seeks to highlight some of the relevant considerations for investors and to identify particular arrangements which have the potential to provide Australian tax certainty for offshore PE firms.
In what circumstances can Australia tax foreign PE firms when they exit Australia
Australia has ended up in the interesting position where:
(a) under our capital gains tax (CGT) rules, the gains made by non-residents on the sale of shares in Australian company or units in an Australia trust will not normally be subject to tax where the profits are considered to be on capital account1; but
(b) if the gains are considered to be sourced in Australia and income (either in the ordinary course of the business or arising from a profit making undertaking), Australian law allows those gains, subject to any limits imposed under an applicable double tax agreement (DTA), to be taxed.
For the most part, as many foreign PE funds are located in jurisdictions which do not have a comprehensive DTA with Australia (for reasons not related to tax), this can mean that direct investments into Australia where the gain is Australian sourced and on income account will be subject to Australian tax.
In practice, PE firms have traditionally invested into Australia through countries which have a comprehensive DTA with Australia. In the event that a gain is made by the fund on exit, the argument made is that Australia should have no right to tax the gain as:
(i) the gain on exit is on capital account and,
(ii) even if the gain is on income account and Australian sourced, Australia is prohibited from taxing that gain as it was made by a resident of a country which has a comprehensive DTA with Australia2.
What approach is the ATO adopting to PE investments?
In 2009, the ATO released two draft determinations. The determinations set out the ATO’s view that gains made on investments by PE firms were not automatically on capital account, indeed in many situations it would be expected that the gains would be income gains and therefore not eligible for the CGT exemption. Furthermore, in the context of a “common” PE investment structure utilising a company or companies interposed in a DTA country, the ATO would seek to apply Australia’s tax anti-avoidance provision, Part IVA, in circumstances where the arrangement was put in place, merely to attract the operation of a DTA.
After considerable criticism the ATO, in December 2010, released 2 further draft determinations. Importantly, one determination provides that treaty relief may be available for certain investors where:
- the investment in Australia is made through a tax transparent limited partnership (i.e. where the partners, not the partnership itself, are subject to tax on the partnership’s income)"
- the ATO is satisfied that the investors would, themselves, be able to benefit from a comprehensive DTA,
the ATO will not seek to tax gains made by the limited partnership referable to those investors.
Whilst the ATO “concession” has been welcomed, significant practical difficulties arise when seeking to satisfy the ATO of the availability of this concession for a particular PE fund. This normally necessitates a private ruling being obtained from the ATO. Furthermore, a detailed tracing exercise needs to be undertaken. Importantly, this concession is not available unless the investment vehicle is tax transparent.
Are there any other ways of investing other than though a limited partnership?
The short answer is yes. Australia has two specific regimes that can provide certainty for foreign investors in relation to their Australian investments.
The first of these is the relatively new managed investment trust (MIT) regime. This allows eligible unit trusts to make an election to treat their investments on capital account. Unit trusts are generally tax transparent for Australian tax purposes thereby allowing non-resident investors to treat their share of a gain made on exit as a capital transaction and therefore exempt from Australian tax. There are some limitations around the use of MITs for PE style investments which will need to be considered on a case by case basis.
The other regime is one that has been around for a number of years but which has never really reached its full potential. This is the venture capital limited partnership (VCLP) regime which was really Australia’s first attempt at attracting venture capital / PE investors. The regime provides significant benefits for investors including an exemption for non-residents from Australian tax on income and capital gains made on qualifying investments with carried interest also being considered to be a capital gain. It is, however, extremely limited in its application specifically in relation to the value and nature of eligible investments.
However, the expectation is that there will be further reform in this area in the short to medium term. A review is currently being undertaken by the Australian Board of Taxation of the tax treatment of collective investment vehicles (including VCLPs) and the report is due by the end of this year.
In summary while the continuing uncertainty on the tax front is not ideal, it is not all doom and gloom. There are ways that a degree of certainty can be obtained by foreign PE houses for their Australian investments - however this will require some careful thought before an investment is made.