Recently, the Federal Court of Australia handed down its decision in Resource Capital Fund III LP v Commissioner of Taxation  FCA 363 (“RCF”).
In RCF, the Court (constituted by Edmonds J) considered whether a Cayman Islands limited partnership (“Caymans LP”) was taxable in Australia on a capital gain arising from the disposal of the taxpayer’s interest in St Barbara Limited (“Australian Mining Company”), an ASX listed Australian mining company.
The Court found that the Caymans LP was not subject to Australian tax on those gains because:
- the terms of the US/Australia tax treaty (“US Treaty”) protected the Caymans LP from tax as it should be considered to be fiscally transparent for Australian tax purposes in accordance with the US Treaty. This was the case notwithstanding that the Caymans LP was not a US resident entity; 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 as those shares were not “taxable Australian real property”.
RCF is likely to be of particular importance and interest to foreign private equity investors and any other “fiscally transparent entities” that invest in Australia. In particular, the decision provides greater tax certainty for such investors in relation to whether treaty benefits are available where an investment is made through a fiscally transparent vehicle.
In particular, in RCF, the Court provided its views on such issues as:
- how tax treaties should be applied in the context of determining the tax liabilities of fiscally transparent entities and investors in such entities;
- how tax treaties should be interpreted, and the relevance of extrinsic materials; and
- how the foreign resident capital gains tax exemption should be applied in the context of investments in Australian mining companies.
RCF is also relevant for a number of Australian and foreign taxpayers in the large business space as it addresses some of the topical tax issues relating to valuation of mining projects.
As RCF was a decision of a single judge of the Federal Court, it is possible – if not likely – that the Commissioner may seek to appeal the decision in higher courts. Accordingly, taxpayers who are interested in the Court’s finding in the decision should monitor the developments regarding the case closely.
A link to the decision is available here.
Profits generated by foreign fiscally transparent entities may be treaty protected
The central issue considered in RCF was whether the terms of the US Treaty prevented the Commissioner of Taxation from assessing the Caymans LP for Australian tax on the capital gain that arose from the sale of its investment in the Australian Mining Company.
Although the Caymans LP was domiciled in Cayman Islands, the US Treaty was relevant to the Court’s consideration as the manager of the Caymans LP and nearly all of the limited partners of the Caymans LP were US residents for tax purposes.
The Court concluded that the US Treaty did prevent Australia from assessing the Caymans LP on the basis that:
- the Caymans LP was not a US resident and was fiscally transparent for US tax purposes;
- the US Treaty did not authorise Australia to tax the gain to RCF as the US Treaty only applied to residents of the US; and
- it is the relevant limited partners in the Caymans LP, and not the Caymans LP itself, that should be assessed to tax (and, to the extent available, eligible for treaty benefits) on the profits derived on the sale of the shares in the Australian Mining Company.
Interestingly, the Court’s reasoning is, in part, consistent with the Commissioner’s previously publicly expressed views on this issue. In particular, in Taxation Determination TD 2011/25, the Commissioner accepted that where partners in a fiscally transparent foreign limited partnership were resident in a treaty country, the terms of Australia’s treaty with that country could apply to protect the partner from Australian tax on the profits of the foreign limited partnership that was attributable to the partner.
The Court, however appears to have taken this view and reasoning to the next level, and in a way that limits the Commissioner’s ability to assess foreign investment funds that are fiscally transparent in other treaty jurisdictions.
In particular, the Court appears to have decided that Australia is prevented from taxing the Caymans LP on the basis that it is inconsistent with how the US Treaty operates – being to treat the relevant profits as being derived by the underlying limited partners. This is the case notwithstanding that the Caymans LP cannot avail itself of the US Treaty directly.
There are, however, a number of questions over the scope and application of the decision to other arrangements. In particular:
- the conclusion appears to have been reached without any comprehensive consideration of the identity of the underlying partners in the Caymans LP, including whether they are themselves eligible to claim the benefits of the US Treaty (or any other treaty). It would seem that residence of the partners in the US was itself sufficient, not whether they would otherwise have been entitled to access the benefits of the US Treaty. The ATO’s view in the Tax Determination requires a consideration of whether treaty protection is actually available in relation to each particular limited partner; and
- the decision was reached notwithstanding that not all partners were subject to United States tax laws. The Court’s conclusion would seem to require that the Commissioner assess the partners not subject to the US tax laws directly although this is not expressly considered in the decision.
To provide taxpayers with greater certainty, it is hoped that these issues are more specifically addressed if the decision in RCF is appealed.
Application of the foreign resident capital gains tax exemption
Although the Court decided in RCF that the Caymans LP was treaty protected, the Court also considered for completeness whether the foreign resident capital gains tax exemption would otherwise have been available to preclude Australia from taxing the capital gain. This essentially turned on whether shares in the Australian Mining Company were “taxable Australian real property” which, in turn, depended on the application of the “principal asset test”.
Under the “principal asset test”, shares in the Australia Mining Company can be “taxable Australian real property” if the market value of its assets that are Australian real property exceeds the market value of its assets that are not.
In this regard, the Court decided that the “principal asset test” should be applied in the following way:
- each asset that is an Australian real property asset and which is not an Australian real property asset should be identified;
- each such asset should be separately valued. For these purposes, it is not possible to value the Australian Mining Company as a going concern and then allocate that going concern value to each asset; and
- each “market value” of each asset of each relevant category should be summed to determine whether the aggregate “market value” of the non real property assets exceeds the “market value” of the real property assets.
On that basis, the Court found in favour of the taxpayer and found that based on the valuations provided to it, the “principal asset test” was failed.
The Court’s findings in this regard are useful as they provide foreign investors with greater certainty regarding how the “principal asset test” is to be applied. The guidance in RCF is likely to be particular important for those foreign funds and other investors who have taken stakes in Australian mining and resources companies which typically have significant Australian real property holdings and are likely to be “closer to the edge” under the “principal asset test”.
Other interesting aspects of the decision
Although the availability of treaty protection and the application of the “principal asset test” were the decisive issues in RCF, the judgment given by Edmonds J also touched upon a number of interesting issues.
These issues include:
- goodwill under the principal asset test – the Court also expressed the view that “goodwill” can be considered a non-Australian real property asset for the purposes of the “principal asset test”, but only where there is goodwill in the legal sense and the property of the relevant entity;
- assumptions in the hypothetical market for determining “market value” – in RCF, the Court was required to consider the “market value” of certain assets that were highly specific to the other assets held by the Australian Mining Company, such as mining information. Edmonds J expressed the view that when determining the “market value” of such assets, an additional assumption should be applied in determining the “market value” of such assets. In particular, on the basis that “market value” is to be determined based on the “highest and best use” for the asset, it should be assumed that the hypothetical purchase holds the mining assets to which the mining information relates;
- relevance of extrinsic materials in interpreting tax treaties – in RCF, Edmonds J considers at some length the issue of whether and the extent to which extrinsic materials, such as OECD commentaries, can be referred to when interpreting Australia’s tax treaties. The Court suggests in RCF that extrinsic materials may be considered in interpreting tax treaties to confirm the meaning of the tax treaty, or determine the meaning of the treaty when it is ambiguous or leads to a result that is absurd or unreasonable; and
- expert opinions – Edmonds J also rejected various submissions by the Commissioner that certain expert evidence provided by valuers engaged by the taxpayer was inadmissible on the basis that it was unclear what the basis of the views expressed in that evidence was. This suggests that it is not, strictly speaking, essential for an expert to identify the basis for their opinion in expressing their opinion, provided the expert has considerable experience over a long career.