The Full Federal Court has, subject to final orders being made, allowed the Commissioner’s appeal in Commissioner of Taxation v Resource Capital Fund III LP  FCAFC 37, deciding that:
- the US/Australia tax treaty (“US Treaty”) did not prohibit the Commissioner from assessing RCF, a Cayman Islands limited partnership (“Caymans LP”) that was treated as a fiscally transparent entity for US tax purposes, but as a company for Australian tax purposes, on the capital gain in question; and
- the valuation methodology adopted by the Federal Court (constituted by Edmonds J) that required each asset to be valued separately for Division 855 purposes was incorrect. Instead, Division 855 requires the assets to be valued as if they were offered for simultaneous sale as a bundle of assets.
Subject to any appeal, the Full Court’s decision affects businesses that:
- hold Australian investments through entities treated as fiscally transparent in foreign jurisdictions but as companies for Australian tax purposes; and
- hold Australian real property indirectly through foreign interposed entities.
In particular, the Full Federal Court’s decision could remove certainty regarding treaty protection that foreign private equity investors and others may have received from the decision at first instance, especially concerning investments in “land rich” entities. It also places a renewed emphasis on the valuation methodologies that foreign owners of Australian real property may need to use in order to determine whether the disposition of their investments will trigger an Australian tax liability.
Our alert on the decision at first instance can be found here.
At first instance, the Federal Court held that the Caymans LP was not subject to Australian tax on a capital gain arising from the disposal of the taxpayer’s interest in an Australian mining company because:
- the terms of the US Treaty protected the Caymans LP from tax as the US treated the gain as being derived by the partners in the Caymans LP (i.e. the Caymans LP should be considered to be fiscally transparent for Australian tax purposes and therefore not be able to be assessed for Australian tax); and
- in any event, the Australian foreign resident capital gains tax exemption applied to preclude Australia from taxing the capital gain arising on the disposal of the shares in the Australian mining company because those shares were not “taxable Australian real property”.
A return to uncertainty – accessing treaty benefits
The Full Federal Court overturned the trial judge’s decision, holding that the Caymans LP was an independent taxable entity which was liable to tax on Australian sourced income, and the US Treaty did not deny that liability to tax. The Full Federal Court reached this conclusion despite being referred to statements in the OECD commentary to the effect that the country of source should apply its domestic tax law according to the treatment of the relevant limited partnership in the partners’ country of residence.
The trial judge had previously held that the limited partners of the Caymans LP (and not the limited partnership itself) were eligible for treaty protection due to an inconsistency between the provisions of the DTA and Australia’s domestic tax laws. The trial judge had therefore erred, in the Full Court’s opinion, because the trial judge incorrectly resolved the inconsistency (at  of the Full Court’s judgment):
“in favour of the application of the DTA to the US partners in RCF against the application of the Assessment Act to RCF and held that the issue of the assessment to RCF was precluded by the DTA.”
The Full Court then went on to state that it may be open for the limited partners to obtain treaty relief (on the basis that it was appropriate for Australia to view the gain as derived by the partners resident in the US), but this was a separate question that the Court did not need to address. In view of these comments and the wider significance of the decision, we expect that the taxpayer will apply to the High Court of Australia for special leave to appeal against the decision.
Although the decision resolves some of the uncertainties raised in our earlier alert, it may now leave a degree of uncertainty for foreign investors investing into Australia through vehicles treated as fiscally transparent overseas.
In TD 2011/25 (which RCF sought to rely on), the Commissioner took the view that the business profits article (Article 7) in the US Treaty will apply to Australian sourced business profits of a foreign limited partnership where the limited partnership is treated as fiscally transparent in a country with which Australia has entered into a tax treaty and the partners in the limited partnership are residents of that tax treaty country (provided the Commissioner is satisfied as to residence of the limited partnership partners and other applicable treaty requirements).
The Full Court held that TD 2011/25 did not bind the Commissioner because the taxpayer had not established reliance and, in any case, the determination applied only to business profits and not to gains derived from the sale of land or interests in a land rich entity. While it did not assist the taxpayer, this aspect of the decision makes it clear that firms investing into Australia should still be able to rely on TD 2011/25 to secure a look-through approach to the extent that an investment is not in a land rich entity. In each case, it would be important to ensure that reliance on the determination could be established (eg. through the preparation of contemporaneous documents) in the event that a dispute arose as to whether the determination bound the Commissioner.
Application of the foreign resident capital gains tax exemption
The Full Federal Court also disagreed with the Division 855 valuation approach adopted by the trial judge.
Under the “principal asset test” in Division 855, shares in a company can be “taxable Australian real property” if the market value of the company’s assets that are Australian real property exceeds the market value of its assets that are not.
The trial judge took the view that Division 855 requires the market value of each asset to be determined as if each asset was the only asset offered for sale. The Full Federal Court disagreed, holding that the market value of the individual assets making up the bundle of assets held by the company must be ascertained as if they were offered for sale as a bundle, not as if they were offered for sale individually. This was because a sale, as a bundle of assets, would result in a valuation based on the assets’ highest and best use.
Foreign resident investors should ensure that, subject to any appeal to the High Court, their valuation methodologies for Division 855 purposes are consistent with the Full Court’s decision.