The Commissioner has recently issued a draft taxation determination in relation to the taxation treatment of income gains made by private equity entities from the disposal of the target assets such entities have acquired. This arose because of concerns about a recent major float where the foreign private equity entity had remitted the proceeds from the sale offshore. Efforts made by the Commissioner to stop the profits leaving Australia were too late.

The Commissioner in the determination refers to what he says is a typical private equity transaction as follows:

  • the direct or indirect acquisition of interests (such as shares) in a target entity (such as a company), often by a non-resident private equity entity
  • the holding of those interests for a period during which operational improvements are usually made (such as improving the management and cost structure of the target entity) to increase earnings over the life of the investment and improve the value of the target entity
  • the subsequent sale of the target assets.

The determination deals with whether gains in these circumstances are taxable in Australia.

The private equity firm’s argument in this example was that the gains made were on capital account. Therefore because the private equity was a non-resident and the assets on which the gains were made was not taxable Australian property, such gains were not taxable in Australia. However the Commissioner’s argument was that the private equity firm made the gains from carrying on a business in Australia. Therefore any gains were on revenue account. This meant that the source of the profits were in Australia and taxable in Australia unless a double tax agreement, if applicable, provided for such profits to be taxed in the country of residence.

Although there has been much uninformed and hysterical debate in the media about the transaction and the effect that the determination may have on foreign investment, in reality there is nothing startling about the taxation determination. It involves the age old question of whether a gain is on capital or revenue account. In the early 1900s in a much quoted case the question that must be asked is whether the sum of gain that has been made is a mere enhancement of values by realising a security, or whether it is a gain made in an operation of business in carrying out a scheme of profit-making. This often is a grey area. Nevertheless it is difficult to see how gains made in the example can be anything other than revenue gains based on the case law over many years.

The determination is therefore not controversial despite the publicity.

What the determination does bring to attention is that foreigners intending to invest in Australia do need to give careful consideration to the structuring of their activities if they want gains to be taxed on capital rather than revenue account.

It is worth noting that in this area, the Courts have been more favourable disposed to finding gains made on a realisation of securities to be on capital account where those gains are made by a trust rather than a company.