The Australia Taxation Office ('ATO') has now released two final and two draft rulings which deal with key taxation issues for both domestic and international Private Equity ('PE') Funds and their investors.
The key issues arising from the rulings are as follows:
- The ATO considers PE fund gains are often not capital gains, which could adversely impact both domestic and non-treaty international investors and carried interests alike. Accessing the MIT (managed investment trust) capital account election is therefore critical for domestic PE funds and their investors – TD 2010/21
- The source of gains (relevant for international PE funds) is likely to be in Australia, even where contract negotiations take place outside Australia – TD 2010/D7
- Treaty benefits are therefore critical for international PE funds and their investors. However, it is important not to trigger anti-avoidance rules in 'operating' the PE fund – TD 2010/20
- Treaty benefits should be available where the ultimate investor is resident in a treaty country and subject to tax in their home country (e.g. a US investor, investing through a Cayman limited partnership can get the benefits of the Australia/USA treaty) – TD 2010/D8.
A brief summary of each of the rulings is provided below.
Taxation Determination 2010/21 - confirms the ATO's final view on capital versus revenue gains made by PE Funds. Although each case must be determined as a question of fact, the ATO consider that profits made on the sale of private equity investments are likely to be revenue gains and not capital gains. This is significant as revenue gains do not qualify for the following tax concessions applicable to capital gains:
- Foreign investors are generally exempt from Australian tax on capital gains unless the asset qualifies as Taxable Australian Property (mainly direct or indirect interests in Australian real estate and mining, quarrying and prospecting rights)
- Australian investors can qualify for the capital gains tax discount (50% for individuals and trusts and 33% for superannuation funds).
Examples in the determination suggest that important factors in deciding on capital versus revenue income are:
- the objective intention of the private equity entity (as opposed to its investors)
- the timeframe of the investment, and
- whether there are low or negative returns during the holding period.
The determination also notes that the treatment of revenue gains of non-residents depends on "source" and whether treaty benefits apply (see below).
Taxation Determination 2010/D7 – deals with the Australian source of gains and losses made by PE Funds. The ATO consider that a foreign PE Fund may be taxable on 'Australian sourced' profits from the sale of shares in an Australian corporate group in a leveraged buy-out, even if the purchase and sale contracts are executed outside Australia.
Specifically, the ATO considers that where the following activities are performed in Australia:
- the business ability in assessing suitable target enterprises (i.e. preparatory activities, including assessments of profitability and risk)
- making operational improvements, and
- the steps making the acquisition of the business possible (such as arranging finance),
then, the source of profits will be in Australia.
Further, where the source of the income is properly outside Australia, the ATO will consider applying the general anti-avoidance provisions to tax the income profits where the Commissioner determines that there was a 'scheme' entered into with the 'sole or dominant purpose' of reducing the Australian assessable income.
This draft TD is particularly relevant for offshore PE Funds that are established in non-treaty countries and non-treaty resident international investors. This follows because, in the ATO's view, these Australian sourced profits will not be treaty protected. By contrast, an offshore PE Fund resident in a treaty country (or a tax-transparent offshore fund whose investors are resident in a treaty country) will only be taxable on Australian sourced profits which are attributable to a permanent establishment in Australia. The ruling assumes the PE Fund does not otherwise have an Australian permanent establishment.
The ruling seems to merge the activities of the PE Fund with the underlying investment company and its board in examining source. This appears novel and inconsistent with the underlying investment structure and therefore potentially inconsistent with the approach adopted in existing case law in considering this difficult question of source.
Taxation Determination 2010/20 – deals with the application of Australia's general anti-avoidance rules (in Part IVA of the Income Tax Assessment Act 1936 (Cth)(Avoidance Rules)). Specifically the ATO confirm that these rules can apply to deny the benefits of a double tax agreement (Tax Treaty) to inbound PE investors who structure their investment into Australia through multiple jurisdictions without economic substance or commercial justification. The Avoidance Rules provide the ATO with the power to cancel any tax benefit obtained in connection with a scheme structured to reduce income tax, including a scheme to obtain Tax Treaty benefits.
TD 2010/20 also provides some good news for the PE sector, and significant planning opportunities. The ruling essentially provides confirmation that an investment by an offshore investor resident in a Tax Treaty country through a fiscally transparent entity (e.g. a Cayman LLP) into Australia should be entitled to Tax Treaty benefits and would not attract the Avoidance Rules.
By maintaining clear records of investors and their entitlement to Australian Tax Treaty benefits, foreign PE investors with any investments (or contemplated investments) in Australia now have an opportunity to minimise the risk that the ATO will seek to apply the Avoidance Rules to deny Tax Treaty benefits on the future sale of an investment.
Taxation Determination 2010/D8 – confirms the availability of treaty benefits to treaty resident investors who invest through fiscally transparent limited partnerships. Australian tax law generally treats a limited liability partnership as a company taxpayer and accordingly, the question of treaty benefits for the underlying limited partners arises.
This draft ruling confirms that Australia will allow the benefits of a DTA to the Limited Partners in a limited liability partnership provided.
- The limited partners are 'resident' in a country with which Australia has a double Tax Treaty, and
- The limited partners are subject to tax in their home country.
This view is consistent with the OECD model commentary on Article 1 and the report of the OECD Committee on Fiscal Affairs "The application of the OECD Model Tax Convention to Partnerships".
The OECD Model Commentary (refer paragraphs 2 – 6.7 of the OECD Commentary on Article 1) provides for the source country to acknowledge how income arising in its jurisdiction is treated in the country of residence of persons claiming the benefits of the Convention. Australia recognises that the domestic tax law of treaty partner countries may require flow-through tax treatment to Australian source income derived through an interposed entity.
The following example illustrates that treaty relief is available even where the fiscally transparent entity is formed in a third State with which Australia has no double Tax Treaty.
Cayman LLP is a limited liability partnership formed in the Cayman Islands. The limited partners in Cayman LLP are resident in a country with which we have a Tax Treaty. The general partner of Cayman LLP is a private equity firm, and is also resident for tax purposes in the treaty country.
For that country's income tax purposes, Cayman LLP is treated as fiscally transparent, such that income derived by Cayman LLP is liable to tax in the hands of their resident partners, to the extent of their interest in Cayman LLP. Cayman LLP is also a 'corporate limited partnership' within the meaning of that term in section 94D of the Income Tax Assessment Act 1936 (ITAA 1936) and is therefore treated as a company for Australian income tax law purposes. Cayman LLP is not treated as an Australian resident under section 94T of the ITAA 1936.
Cayman LLP acquires all of the shares in Target Co, an Australian manufacturing company. The primary purpose of the partners in Cayman LLP for acquiring Target Co is to improve its business operations in the short term and then sell Target Co via an initial public offering for an amount greater than the purchase price. This activity is undertaken through an independent agent acting as such in Australia in the ordinary course of its business. Cayman LLP derives profits from the sale of Target Co at a price higher than that for which it was acquired. These profits are Australian-sourced and are not attributable to a permanent establishment in Australia.
Article 7 of the relevant Tax Treaty prevents Australia from imposing income tax on profits of an enterprise of the other country unless such profits are attributable to a permanent establishment in Australia. Although the profits in this example are derived by Cayman LLP, these profits are liable to tax in the hands of the limited partners under their home country's income tax law and are not taxed in the Cayman Islands. Therefore, provided the Commissioner is satisfied that the partners of Cayman LLP are residents of that treaty country, the treaty will be applied such that the profits of Cayman LLP will not be subject to tax in Australia to the extent the limited partners are liable to tax in the treaty country on those profits and they meet any other applicable requirements under the relevant Tax Treaty.
However, the ATO warn that practical difficulties arise where a partnership is organised in a non-treaty country, especially in a country with which Australia does not have a Tax Information Exchange Agreement ('TIEA') in force, and the residence of the partners is not able to be verified. Without the co-operation of the partners of a LLP, it is difficult – practically speaking – to verify who are the recipients of the partnership's profits or their place of residence. Australia has over 60 double tax treaties or TIEAs, including TIEAs with the Cayman Islands (although not all of these signed treaties have been enacted under our domestic laws).
As such, and in line with the concerns expressed in the OECD Report, the Commissioner considers it inappropriate to afford treaty benefits (that is, under the Business Profits Article) where the residence of the partners cannot be established. When the treaty residence of the partners is unable to be verified by the Commissioner, the income derived by the LLP may be assessed in Australia in the hands of the LLP itself and where the Commissioner is satisfied subsequently that partners in the LLP are resident in a treaty partner country, and that treaty benefits are available, a refund of the tax collected can be sought. Where appropriate, the Commissioner will apply section 255 of the ITAA 1936 or section 260-5 of Schedule 1 to the Taxation Administration Act 1953 to third parties to secure the debt. The Commissioner will consider other available remedies if necessary.
Minter Ellison has extensive experience in advising domestic and international PE Funds on their investments and would welcome the opportunity to assist with any current or future investments.