On the evening of Tuesday 14 May 2013, the Treasurer delivered his sixth Federal Budget (Budget). The key measures announced in the Budget that are relevant to M&A activity, and that we will focus on further in this article, relate to:
- the changes to the thin capitalisation rules which, amongst other changes, reduce the gearing ratios which are permissible without a taxpayer being denied tax deductions for debt related expenses;
- the proposed denial of debt deductions on borrowings used to acquire certain interests in foreign companies (eg non-portfolio interests); and
- the changes to the taxation of non-residents with respect to land related investments (including a proposed withholding tax applicable from 1 July 2016).
Changes to the thin capitalisation rules
The Government announced that it will reduce the amount of potential interest deductions (and other debt deductions) available to foreign controlled and/or outbound entities funded by debt. At present the Australian thin capitalisation statutory safe harbour entitles Australian taxpayers to claim debt deductions on debt subject to the level of gearing not exceeding 75% (in the case of non-financial entities) of the accounting value of the entity’s assets (less non-debt liabilities). For general entities (eg, non-financial institution taxpayers), the statutory safe harbour will be reduced from 75% to 60% of assets (less non-debt liabilities) effectively reducing the permissible debt to equity ratio from 3:1 to 1.5:1. The measures are proposed to take effect for income years commencing on or after 1 July 2014. This means that many existing Australian investments will effectively have an approximately 13.5 month window in which to reorganise their capital structures if they wish to comply with the revised safe harbour debt:equity ratios, and the revised ratios will be relevant for the capital structuring of future investments.
Some taxpayers who breach the safe harbour ratio rely instead on another thin capitalisation threshold referred to as the arm’s length debt test (ALDT), which broadly allows for a level of gearing that corresponds to the amount of debt the Australian operations of a business could source from third-party banks (subject to certain assumptions and modifications). Hidden in the announcements on Budget night was the message that the Australian Government will task the Board of Taxation with undertaking a review of the effectiveness of the arm’s length debt test to make it easier to administer, to reduce compliance costs, as well as the overall targeting of the ALDT. The terms of reference for the review are expected to be released in coming weeks. While there is nothing explicitly stated in the Government’s announcement regarding changes to the ALDT (and Assistant Treasurer David Bradbury was in the press after Budget night emphasising the availability of the ALDT, despite the changes to the safe harbour), there are concerns in the market that Treasury has considered abolishing it entirely. As such, taxpayers who rely (or will rely after 1 July 2014) on the ALDT are advised that the abolition, or significant curtailing, of the ALDT following the Board of Taxation’s recommendations may be a possibility.
We further note that the ATO continues to apply the transfer pricing rules (which have been recently strengthened) to determine the overall level of taxable profit that the Australian business of a multinational group should be making in Australia. If the ALDT were abolished (or materially curtailed) it would also mean that, in practice, the ATO / Treasury (rather than taxpayers, their lenders and the markets) would be the arbiters of what constitutes an appropriate capital structure for Australian taxpayers in a multinational group. Regrettably, this indicates an increasing level of Government intervention in the day-to-day running of Australian businesses.
Denial of debt deductions on debt used to acquire foreign companies
A further measure announced on Budget night relates to the removal of what the ATO considers to be a loophole in section 25-90 of the Income Tax Assessment Act 1997. Section 25-90 enables Australian taxpayers to claim deductions for interest and other debt deductions where the dividends which they will receive on their shareholding are exempt from Australian income tax (eg foreign non-portfolio shareholdings). These measures are proposed to take effect from income years commencing on or after 1 July 2014.
We believe that these measures (together with the proposed changes to the thin capitalisation rules) will have a significant impact on the use of Australia as a location for regional holding companies. These measures will likely result in a significant unwinding of most Australian centred debt funded holding structures because of the denial of interest and other debt deductions post 30 June 2014.
In making these amendments, there is a presumption that the deduction available under the current law is being abused as part of profit shifting structures with no significant change to economic activity in Australia. However, this overlooks the fact that many deductions being claimed under section 25-90 relate to structures which have been put in place as a result of genuine mergers and acquisitions.
Changes to non-resident capital gains tax rules
The last of the key announcements made on Budget night that is expected to have a significant impact on M&A activity are the changes made to the taxation of capital gains made by a non-resident. There were two key measures announced, the first relates to determining whether a gain made by a non-resident on a disposal of shares in an Australian company will be taxable in Australia, and the second introduces a specific withholding regime.
Clarification of Australian Taxing Rights over Indirect Australian Real Property Interests
Under Australian tax law as it stood prior to Budget night, non-residents were broadly not subject to capital gains tax (CGT) on the disposal of shares in an Australian company unless the underlying assets of the company predominantly relate to taxable Australian real property (TARP). Broadly, the test involves comparing the value of the TARP assets of the company with the non-TARP assets of the company (referred to as the Principal Asset Test). If the value of the TARP assets outweighs the value of the non-TARP assets, the shares in the company will be considered taxable Australian property (TAP), and a disposal of those shares will be subject to CGT.
TARP includes interests in Australian land, but also extends to mining rights and exploration tenements. In the recent Federal Court decision in Resource Capital Fund III LP vs Commissioner of Taxation  FCA 363 (RCF), in valuing the TARP assets of a business and the non-TARP assets of a business Edmonds J favoured an approach whereby assets such as mining information and plant (which are not considered “land” assets for the purposes of the test) are severable and distinct assets from mining rights and exploration tenements (which are considered land for the purposes of the test). This resulted in the somewhat unexpected outcome that a gain made by a non-resident investor on the disposal of shares in an Australian gold mining company was not taxable in Australia.
On Budget night, Treasury announced measures (seemingly aimed squarely at the Court’s approach in RCF) with the result that in determining the value of the TARP assets of the entity in which the interest is held, intangible assets connected to the rights to mine, quarry or prospect for natural resources (notably mining, quarrying or prospecting information, rights to such information and goodwill) will be treated as part of the rights to which they are related. The practical effect of this change is that investors who hold shares in mining companies who, in light of the RCF decision may not have otherwise held shares which constitute TAP, will now be taken to hold TAP assets, and be subject to Australian CGT on a disposal of their shares.
In addition, in comparing the TARP assets vs the non-TARP assets of a business, the existence of an income consolidated group was effectively ignored. As such, a planning opportunity sometimes employed was to skew the value of the non-TARP assets in a consolidated group by creating intra-group receivables (which are counted as non-TARP assets). Treasury also announced measures that will treat intercompany dealings between entities in the same tax consolidated group as not forming part of the Principal Asset Test calculations, thereby ensuring that assets cannot, in effect, be counted multiple times, thereby diluting the true asset value of the group. Accordingly, non-residents contemplating a disposal of shares in a company, which has previously carried out such structuring, will need to revisit their Australian tax position.
Both of the measures described above apply to CGT events occurring after 7:30pm on Budget Night (14 May 2013).
Withholding from Foreign Residents disposing of assets that give rise to an Australian Tax liability
A more controversial measure announced on Budget Night applies to CGT events occurring on or after 1 July 2016.
A non-final withholding tax regime will be introduced to support the operation of the foreign resident CGT regime. In broad terms, if a non-resident disposes of certain TAP, the purchaser will be obliged to withhold and remit to the ATO 10% of the proceeds from the sale. Residential property transactions valued under $2.5 million will be excluded from this measure. It should be noted that not only will this withholding apply to the taxation of capital gains, it will also apply where the disposal of the relevant TAP asset is likely to generate gains on revenue account, and therefore be taxable as ordinary income rather than as a capital gain. Following the announcement of this measure, the Government proposes to consult on the design and implementation of the regime to minimise compliance costs including permitting pre-payment of tax liabilities by the seller, removing a withholding obligation where it can be shown that no gain will arise and streamlining any payments required including through the use of intermediaries.
Key implications of these CGT reforms
There are a number of key implications for non-resident investors arising from these measures, including:
- Investment decisions may have been made in the past based on the expectation that a disposal of their shares would not be taxable in Australia. With the proposed changes which render mining, quarrying or prospecting information, rights to such information, goodwill and other intangible assets as if they are part of the mining right and hence TARP, foreign resident taxpayers will now need to factor in potential CGT liability on an exit of their investment. Clearly this may not have been contemplated at the time of making the investment.
The proposed introduction of a withholding regime raises many practical issues. For example, sellers will need to proactively engage with buyers (and potentially the ATO), prior to a sale proceeding, to have an established and certain position on whether:
- the asset being disposed of constitutes TAP; and
- whether a gain even arises.
Absent action from the seller, the possibility exists of a withholding impost which exceeds the amount of gain realised by the seller on disposal of the relevant asset. A simple example illustrates the principle: assume that a non-resident acquires shares in company A for $100 and sells those shares two years later for $90. Even though the non-resident has made a $10 capital loss, under the proposed rules a $9 withholding obligation exists for the purchaser of those shares. The seller would need to then lodge a tax return to claim the tax back.
There may well be practical difficulties associated with complying with this regime in circumstances where a purchaser is outside the Australian tax system, for instance in circumstances where one non-resident sells to another.