The Australian Taxation Office (ATO) has released Draft Taxation Determinations TD 2009/D17 and TD 2009/D18.
TD 2009/D18 asks the question "can a private equity entity make an income gain from the disposal of the target assets it has acquired?" The answer is unsurprisingly 'yes'.
TD 2009/D17 states that Part IVA (general anti-avoidance provisions) may apply to arrangements designed to alter the intended effect of Australia's international tax agreements.
Foreign residents are liable to tax in Australia on:
- ordinary income derived directly or indirectly from all Australian sourcesi;
- statutory income from all Australian sourcesii; and
- other statutory income that is brought to tax by a provision on some basis other than having an Australian sourceiii.
Capital gains are an item of statutory incomeiv. Typically foreign investors in Australia will derive all capital gains on assets that are not taxable Australian propertyv, free of any Australian tax. However, where the non-resident is carrying on a trading activity or has entered into a profit making undertaking or scheme then the gains may be on revenue and not capital account. Where the profits made on the sale of assets are on revenue account, it is not relevant that there are capital gains tax exemptionsvi.
If the revenue gains generated by the non-resident investors are derived from an Australian source then the non-resident investor may be subject to Australian tax. I say "may" because we still need to consider the operation of any applicable double tax treaties between Australia and the country of residence of the investor. Typically, most treaties will prevent Australia from imposing tax on the business profits of a non-resident investor unless the non-resident has a permanent establishment in Australia.
The importance as to whether the profit is on revenue or capital account ultimately turns on the different source rules that apply to ordinary income versus statutory income.
The ATO states that "where a taxpayer enters into a profit making transaction in Australia in the course of carrying on a business or in carrying out a business operation or commercial transaction, the profit can be included in its assessable income under subsection 6-5(3) even if the profit arises from the sale of a CGT asset that is not taxable Australian property".
Following the Full High Court authority in FC of T v. the Myer Emporium Ltd (1987), (1987) 18 ATR 693 and Taxation Ruling TR 92/3, the Commissioner concluded that if a taxpayer carrying on a business makes a profit from a transaction or operation, that profit is income if the transaction or operation:
- is in the ordinary course of the taxpayer's business; or
- is in the course of the taxpayer's business, although not within the ordinary course of that business, and the taxpayer entered the transaction or operation with the intention or purpose of making a profit; or
- is not in the course of the taxpayer's business, but
- the intention or purpose of the taxpayer in entering into the transaction or operation was to make a profit or gain; and
- the transaction or operation was entered into, and the profit was made, in carrying out a business operation or commercial transaction.
In my view, the contentious issue is not whether the gain is on revenue or capital account but whether the intermediary holding entities used in structuring these investments are entitled to treaty benefits.
The interaction with double tax agreements with Part IVA
Tax agreements are bilateral arrangements between contracting states whose broad dual purpose is to eliminate double taxation between the country of residence and the country of the source of the income and also prevent fiscal evasion.
With respect to business profits derived by a foreign resident that are not attributable to a permanent establishment in the country of source, those business profits will be taxable only in the country of residence.
Section 4 of the International Tax Agreements Act (ITAA) incorporates the Income Tax Assessment Act 1997 (Assessment Act) into the ITAA and provides that both Acts shall be read as one. Further to the extent that there is any inconsistency between the two Acts, the ITAA has effect notwithstanding anything inconsistent with those provisions contained within the Assessment Act.
However, it is important to note that Part IVA is expressly excluded from this tiebreaker rule which potentially allows the ATO to apply Part IVA in a way inconsistent with the relevant treaties.
TD 2009/D17 confirms this theoretical point of law. However, applying Part IVA to the use of intermediary arrangements in practice is the interesting part.
The use of intermediary holding entities is a common element of many private equity deals internationally. However, the ultimate investors in private equity funds are typically sophisticated investors such as pension or superannuation fundsvii. While low tax jurisdictions such as the Cayman Islands are commonly used in private equity structures, the ultimate investors are commonly tax exempt pension funds that are resident in treaty countries like the United States. If those tax exempt investors invested directly in Australia, there is no doubt that they would be entitled to treaty protection. The fact that they do not invest directly but invest indirectly through conduit entities such as limited partnerships and intermediary holding companies arises for a number of reasons.
In TD 2009/D17 the Commissioner provides the following example at paragraph 2:
"NV Offshore BV (Offshore) is the Dutch holding company of a newly incorporated Australian company that acquires all of the shares in Target Co, an Australian manufacturing company. An Australian consolidated tax group is then formed. Offshore is in turn owned by a Luxembourg entity that is itself owned by an entity resident in the Cayman Islands. Various United States resident investors and a private equity group control the Cayman Islands entity. Their primary purpose for acquiring Target Co is to improve its business operations in the short term and then sell the consolidated group via an initial public offering for an amount greater than the purchase price. There are no commercial reasons for using a Dutch company and a Luxembourg company as intermediate entities in the ownership chain, although there is a tax benefit in having the profit derived from the sale of the group by a Dutch company rather than the Cayman Islands entity because of the Australia-Netherlands tax treaty in relation to business profits sourced in Australia. In the absence of commercial reasons for the interposition of the Dutch and Luxembourg entities between the Cayman Islands entity and the Australian company and having regard to the factors set out in paragraph 177D(b), it would be concluded that obtaining this tax benefit was the dominant purpose of one or more persons who carried out the scheme of acquiring Target Co in the manner undertaken."
The ATO's view is that these structures lack any commercial purpose. The ATO in its position generally seems fixated on the investment vehicle structured in the Cayman Islands and not the ultimate investors as evidenced by statements at paragraph 10 of TD 2009/D17:
"So, for example, investors who are residents of the United States, or indeed a group of investors who are residents of various jurisdictions, may want to join together in creating an investment fund in the form of equity interests in an entity in the Cayman Islands. If the funds of that entity were used to acquire Australian business assets, that Cayman entity would be the relevant taxpayer for the purposes of the Australian taxation system. For residents of a non-treaty country deriving a business profit sourced in Australia, it has always been readily understood that Australia would seek to tax that profit." [Emphasis added]
This ignores the fact that the Cayman Islands entity is not the ultimate investor beneficially entitled to the profit or gain. The ATO seems willing to look through the conduit entities resident in the treaty countries like the Netherlands but not the investment vehicle situated in the Cayman Islands itself.
The ATO simply does not seek to understand why US investors (who are entitled to treaty protection in their own right) would structure an investment through the Cayman Islands. If the ATO does so, they may realise that the reasons for the structure has little to do with Australian tax and more to do with US tax issues.
These issues have a long way to run and we can expect a lot more in the New Year.