On 1 December 2010, the Australian Taxation Office (ATO) released the long awaited final tax determinations (Final TDs) dealing with:
• whether a profit arising on the disposal of shares in a company group acquired in a leveraged buyout (LBO) is taxable on revenue account (TD 2010/21); and
• whether treaty benefits, which provide an Australian tax exemption, can be denied under the general anti-avoidance rule (Part IVA) in circumstances where a company (which is resident in a country with which Australia has concluded a double tax treaty agreement (DTA)) is interposed between an Australian investment and an entity which would not be entitled to tax treaty benefits (TD 2010/20).
The conclusions in the Final TDs broadly accord with the ATO's position in the Draft Tax Determinations TD 2009/D18 and TD 2009/D17 issued in December 2009.
Two newly issued draft tax determinations (Draft TDs) have also been released. In summary:
- the first Draft TD addresses the question of the "source" of the gain on the realisation of an investment and in particular, the relevance of the place of execution of purchase and sale contracts relating to shares. An Australian source is required in order for the ATO to assert taxing jurisdiction over a revenue gain made by a non-resident (TD 2010/D7); and
- the second Draft TD deals with the issue of whether Australia's DTAs operate to shield Australian sourced revenue gains of a foreign limited liability partnership (LLP) where the partners in the LLP are residents of a country with which Australia has entered into a DTA and the LLP is treated as "fiscally transparent" in the country of residence of the partners (TD 2010/D8).
Both Draft TDs are open for comment until 28 January 2011. We would be pleased to assist clients in making any submissions prior to the closing date.
Key implications for private equity
- The Final TDs and Draft TDs represent a significant tax development affecting private equity funds.
- While the implications are most relevant to foreign private equity funds, the Commissioner's views on the capital / revenue distinction mean that it is of critical importance that a domestic private equity fund qualifies as a managed investment trust (MIT) and that the MIT makes the required capital account election to ensure capital account treatment for investors.
- Many conventional offshore private equity fund investment structures into Australia will no longer be the preferred method for investment into Australia. For funds seeking to exit existing investments, TD 2010/D7 (dealing with source) is problematic in that it clearly reduces the importance of the "place of contract" in determining the source of a private equity gain. Also of concern are the Commissioner's views on the application of Part IVA to what he views as arrangements designed to create a foreign source. This Draft TD will undoubtedly be the subject of significant lobbying.
- The use of a foreign "fiscally transparent" LLP collective investment vehicle, which directly holds Australian investments, provides a clearer path for private equity investment into Australia and a potential means of dealing with the impasse between the private equity industry and the ATO. The effectiveness of this investment strategy will depend upon partners in the LLP being resident in a country with which Australia has a DTA and that country taxing the partners on the profits of the LLP. However, the key practical issue for private equity funds will be how they establish the tax residence of their investors (particular where those investors are funds of funds). Also, the ATO will need to work closely with the industry on streamlining administration, particularly where an LLP has investors who are eligible for tax relief under a DTA and investors who are ineligible (the ATO approach suggests that unless all partners have the appropriate tax residence, the LLP will be subject to tax and partners will need to separately prove their tax residence to the ATO and seek tax refunds).
TD 2010/21 - Revenue or Capital Gains?
The Commissioner asserts that gains made where an entity is acquired in a LBO or by a non-resident private equity entity are likely to be revenue account rather than capital account. This conclusion was widely anticipated. However, the ATO does acknowledge that the characterisation will depend on all the circumstances of a particular case and each case will be assessed on its merits.
The issue is important for non-resident investors because capital gains for those investors on a sale of shares would ordinarily be exempt from Australian income tax (one exception being the sale of shares in land-rich entities). Gains on revenue account are not eligible for this exemption.
The ATO acknowledges that gains made by residents of countries with which Australia has a DTA will not usually be subject to Australian income tax as the gain would be treated as a "business profit". However, this leaves it open for the ATO to assert that a taxing right may still exist where the non-resident has a "permanent establishment" in Australia. This is not specifically addressed in TD 2010/20.
The ATO also caveats the position by stating that the exemption for residents of DTA countries will not apply where Part IVA (the general anti-avoidance provision) is applied to deny the benefits of that DTA (this is dealt with specifically in TD 2010/20).
TD 2010/20 - Application of Part IVA
TD 2010/20 acknowledges that Australia's DTAs ordinarily prevent Australia from taxing gains of a revenue nature, except where the non-resident has a permanent establishment in Australia.
The Commissioner states that he will attempt to apply Part IVA to deny the benefit of the relevant DTA where there are no sound commercial reasons for creating a particular pattern of holding interests, the interposed entity does not conduct any significant commercial activity and where an arrangement is put in place merely to attract the operation of a particular DTA with Australia.
The Commissioner uses the example of TPG's three tier structure involving a Dutch company (entitled to the DTA benefits) which was owned by a Luxembourg company and which in turn was owned by a Cayman Islands company. Neither the Luxembourg company, nor the Cayman Island company would have been entitled to benefits under the DTA and would have been taxable on the gain.
In referring to Draft TD 2010/D8, the Commissioner acknowledges that a tax benefit may not arise (and therefore Part IVA would not apply) if instead of being a company, the Cayman Islands Entity in the example above was a LLP. This would be the case where the residence of the investors in the LLP was in a country with which Australia has a DTA, that country taxes the partners on the profits of the LLP, and the investors' residence is verifiable.
TD 2010/D7 – The "source" of a gain in a LBO or when made by a private equity entity
TD 2009/D7 outlines the ATO's view that the place of contract for the purchase and sale of shares in an Australian corporate group will not be determinative of the source of the income of the gain. Although the place of contract is of some relevance, the ATO states that the source of a gain will need to be determined by taking into account all of the facts and circumstances of the particular case.
This view reiterates the long-established case law on the question of source which recognises that the "ascertainment of the actual source of a given income is a practical, hard matter of fact".
The ATO mentions the following factors which would be relevant in determining the source of a gain in a private equity context, including where the following income earning activities have taken place:
- preparatory activities, including an assessment of risk and profitability have been undertaken;
- the source of funding and its negotiation;
- the execution of purchase and sale contracts;
- the making of payments;
- the active management of the investment in the target entity and making operational improvements such as streamlining the target's activities and financing to improve the investment return;
- the development of a business plan and management support activities during the period of investment in the target company
The ATO states that some of these factors are more important than others in assessing source, including:
- the place where there has been an assessment of suitable target companies;
- where the operational improvements are made; and
- where the steps which made the acquisition possible are undertaken (such as the arrangement of finance).
Importantly, in its explanation, the ATO indicates that it may also invoke Part IVA where deliberate steps are undertaken to ensure that the source of a particular gain is outside of Australia.
TD 2010/D8 – Is treaty protection available to shelter business profits of a foreign LLP where the partners of the LLP are resident in a DTA country
Draft TD 2010/D8 affirms the OECD position, that a resident of a DTA country is able to avail themselves of DTA protection where they invest indirectly through an LLP which is treated as a "fiscally transparent" entity in that investor's country of residence, ie where the partners are taxed on their share of the income of that LLP in their country of residence.
Accordingly, the ATO will provide DTA benefits to each of the partners of the LLP where the ATO is satisfied the particular partners are resident in a country with which Australia has concluded a DTA. However, practical issues will arise because the ATO indicates that the provision of DTA benefits is conditional on the LLP being able to verify the place of residence of the investors in the LLP. The ATO states that DTA benefits will not be extended where the place of residence of the investors cannot be established.
The tax treatment afforded to the investor in their country of residence is also fundamental as DTA benefits will not be extended by Australia where the LLP is not treated as a fiscally transparent entity in their country of residence.
Taking into account the views expressed by the ATO in the Final TDs and Draft TD 2010/D7, this will generally mean that the LLP will be liable to Australian income tax if:
- partners are not resident in a DTA country; or
- partners are resident in a DTA country but their jurisdiction of residence does not subject the profits of the LLP to tax in the hands of the partner (ie the DTA country does not recognise the LLP as "fiscally transparent").
The principle outlined in the Draft TD have been established for some time in tax treaty practice and these principles have been directly reflected in more recent treaties which Australia has negotiated including those with the United States, Japan and New Zealand. However, the ATO takes the view these principles are also to be reflected in the administration of other tax treaties.