Following the recent actions taken by the Australian Taxation Office to freeze the bank accounts of the private equity firm TPG, the Commissioner of Taxation has released two draft Taxation Determinations (TDs):
- TD 2009/D17 Treaty Shopping - Can Part IVA of the Income Tax Assessment Act 1936 apply to arrangements designed to alter the intended effect of Australia's International Tax Agreements network?; and
- TD 2009/D18 Can a private equity entity make an income gain from the disposal of the target assets it acquired?
The draft TDs are focused on the private equity sector of the financial investment industry and somewhat unusually rely on the Wikipedia entry for Private Equity to define the private equity target arrangements!
TD 2009/D18: Can a private equity entity make an income gain from the disposal of the target assets it has acquired?
Private equity and the capital/revenue distinction
The distinction between gains which are capital in nature and profits which are revenue in nature is of critical importance to both resident and non-resident investors. In summary, this is because capital gains are generally eligible for concessional tax treatment.
Resident individuals and trusts are eligible for a 50% discount on capital gains arising on certain assets that have been held for more than 12 months. Superannuation funds are eligible for a 1/3 CGT discount (reducing their 15% tax rate to 10%). Revenue gains are taxable in full.
Broadly, non-residents are only subject to CGT where their Australian investments are taxable Australian property (TAP). TAP includes:
- taxable Australian real property (TARP) (ie: land, mining rights, etc);
- assets used in carrying on a business through a permanent establishment located in Australia; or
- an indirect Australian real property interest, being a non-portfolio interest (ie: greater than 10%) in an entity that is an Australian land rich entity (ie: greater than 50% of entity's assets by value are TARP).
This concession allows non-resident investors (including investors in private equity funds) to dispose of non-portfolio interests in Australian companies (private or public), that are not land rich, and derive capital gains that are not subject to Australian CGT.
This concessional CGT treatment is not available to a non-resident to the extent that gains made on the disposal of the shares in these companies are more appropriately treated as revenue gains, being gains derived in the course of carrying on a business.
Where the gains are not capital gains (for example, because they are acquired with a pre-determined sale strategy or as part of a business of buying and selling assets), then such revenue gains may be taxed in Australia where:
(a) they are derived from an Australian source; and
(b) provided Australia's right to tax the gains is not limited under the terms of a double tax agreement.
Accordingly, the current controversy surrounding the tax treatment of gains made by private equity funds involves the following key considerations:
- is a private equity fund carrying on a business or is a private equity fund a passive investor?
- does a private equity fund acquire investments with a pre-determined sale strategy?
- are the gains made by private equity funds Australian sourced?
- is Australia's right to tax these gains limited by the terms of a double tax agreement?
The resolution of these issues will depend on all the facts and circumstances.
Unsurprisingly, the Commissioner considers that the disposal of assets by a private equity entity (ie: not only shares, but other assets – presumably the Commissioner is contemplating gains on business/asset sales as well) may be included in the ordinary income of a private equity entity under s.6-5(3).
Section 6-5(3) provides that foreign residents include in their assessable income any ordinary income derived from Australian sources. The focus of TD 2009/D18 is on foreign resident private equity entities and does not outline the Commissioner's position in respect of resident private equity entities.
Presumably, the Commissioner's analysis in respect of foreign resident private equity entities would apply equally to resident private equity entities (the assessing provision being s.6-5(2)), subject to existing and proposed deemed capital treatment for certain resident entities (see discussion below).
The Commissioner's analysis cites what are widely considered to be the leading authorities on this particular issue, being California Copper Syndicate (Limited and Reduced) v Harris (1904) 5 TC 159 and (somewhat ironically) the Full High Court decision in FCT v The Myer Emporium (1987) 163 CLR 199.
Briefly, these cases are authority for the following propositions:
- where the owner of an investment chooses to realise it, and obtains a greater price than what it was acquired for, the enhanced price is not profit;
- where enhanced values are obtained from realisation or conversion of an asset, the gains may be revenue gains where what is done is not merely a realisation or change in investment, but an act done in what is truly the carrying on, or carrying out of a business;
- the fact that a profit or gain made on the realisation of enhanced value is the result of an "isolated transaction" or "one off" commercial venture does not preclude it from being characterised as income, where a taxpayer has entered into the isolated transaction or commercial venture with a profit making intention or purpose; and
- each case must be considered according to its own facts, the key question being "Is the sum of gain that has been made a mere enhancement of values...or is it a gain made in an operation of business carrying out a scheme of profit making?"
The Commissioner considers in TD 2009/D18 what private equity activities typically involve in terms of acquisition, returns and realisation (see paragraphs 10, 11 and 12 – it is here the Commissioner relied upon the Wikipedia entry for Private Equity).
The Commissioner concludes (understandably) that each case depends on its own facts – that is, a weighing up of the factors driving returns, the investment strategy, the legal form and the substance of the transaction. Reference should also be made to the guidance in TR 1992/3 Whether profits on isolated transactions are income. Unfortunately this uncertainty in unlikely to be resolved without legislative change.
Even where the issue is litigated, the analysis required on a case by case basis may not provide clear principles that apply to all private equity transactions.
Accordingly, uncertainty may remain for private equity entities and the risk that the Commissioner may seek to treat gains made on the disposal of assets as revenue gains will undermine investor and market confidence.
Resident private equity entities
It is worth noting that presently, resident private equity entities are able to take advantage of the deemed capital treatment for Early Stage Venture Capital Limited Partnerships (ESVCLPs) or Venture Capital Limited Partnerships (VCLPs) regime as contained in Division 118-F of the Income Tax Assessment Act 1997.
Generally, non-resident limited partners of an ESVCLP or VCLP are able to disregard capital gains made by the ESVCLP or VCLP on the disposal of eligible investments. Further such gains are also exempt from income tax as ordinary income.
While the treatment provided by this regime is favourable to non-resident limited partners, it is unavailable to resident limited partners. Resident general partners are however able to take advantage of the "carried interest" capital treatment for gains (CGT event K9).
At this stage the ESVCLP/VCLP regime success has been limited due to problems in target assets meeting the relevant eligibility criteria and the permitted entity value of any target being limited to $250m.
A more promising recent development is the release of the exposure draft legislation for deemed capital treatment for Managed Investment Trusts (MITs). Under these proposed reforms, an eligible MIT that meets the requisite criteria can make an irrevocable election to have all gains (or losses) on the disposal of assets subject to the CGT rules. For further information see Minter Ellison Tax Brief of 17 December 2009.
TD 2009/D17: Treaty shopping – can Part IVA of the Income Tax Assessment Act 1936 apply to arrangements designed to alter the intended effect of Australia's International Tax Agreements network?
TD 2009/D17 is referred to in TD 2009/D18 (see discussion above), and has practical relevance for offshore structuring of private equity entities, particularly where Australian sourced revenue gains are derived.
The general anti-avoidance provisions under Part IVA are incorporated into the International Tax Agreements Act 1953 (the legislation which gives tax treaties force of law in Australia), and generally prevail.
The Commissioner in TD 2009/D17 considers the general anti-avoidance provisions under Part IVA may apply where a taxpayer has obtained a tax benefit in connection with a scheme which is designed to alter the intended effect of Australia's tax treaties.
Australia seeks to tax non-residents only on their Australian sourced income, subject to modifications contained in any tax treaty between Australia and the foreign jurisdiction.
Relevantly, the "business profits" article of most tax treaties to which Australia is a party to, provides that an enterprise is subject to tax only in the jurisdiction it is a resident of, unless the enterprise operates a permanent establishment in the other Contracting State – in which case, the other State has a right to tax the business profits of the permanent establishment. Accordingly, in the absence of a permanent establishment in Australia, residents of jurisdictions with whom Australia has concluded a tax treaty are only subject to their domestic tax rules.
Residents of jurisdictions with whom Australia has not concluded a tax treaty are, ordinarily, subject to Australian tax on any Australian sourced income.
This is a material issue for collective investment entities such as LLCs or LLPs operating out of tax havens such as the Cayman Islands, British Virgin Islands, etc. Despite investors in such entities being largely resident in jurisdictions with which Australia has concluded a tax treaty, where the relevant entity for Australian tax purposes is the LLC or LLP and this is not resident in a Tax Treaty jurisdiction, then the benefits of the Treaty may not be available to the ultimate.
Australia has not concluded tax treaties with many CIV jurisdictions (including the Cayman Islands and British Virgin Islands). Australia would seek to tax any business profits of these collective investment vehicles that are attributable to an Australian source.
The Commissioner considers that "no particular adverse taxation conclusions ought to follow from the use of a Cayman Islands entity to make an investment into Australia, the use of more complication structures to make the same investment may require broader consideration".
The Commissioner acknowledges that there may be sound commercial reasons for the use of such structures. However in the absence of commercial reasons, the Commissioner considers an inference may be drawn that such structuring has been used "…merely to attract the operation of a particular tax treaty…" and is explained by taxation considerations.
Specifically, where a scheme involves the interposing of a holding company resident in a treaty country between:
- the tax haven entity; and
- the Australian holding entity holding the target assets,
there is potential for the tax haven entity to obtain a tax benefit under the scheme.
The Commissioner considers that while Part IVA requires consideration of the facts of each case, where:
- the interposed entities conduct no other commercial or business activity other than to legally hold interests in the next entity; and
- there are no regulatory reasons for the interposition of entities
it is difficult to identify a commercial purpose for such a structure other than the obtaining of a tax benefit.
Accordingly, non-residents investing in Australian investments via Treaty countries need to consider carefully the commercial reasons for interposing entities between the tax haven entity and the Australian resident entity in order to manage the potential application of Part IVA. In this regard, TD 2009/D17 provides taxpayers with some guiding principles on potential structures that will attract Australian anti-avoidance rules.
Comment on draft Determinations
Whilst the draft TDs in their current form (in particular, TD 2009/D18) are likely to result in calls from industry to address the uncertainty currently surrounding the taxation treatment of gains made by private equity funds and other non residents on their Australian investments (ie: preferably by introducing legislative reform), comments by the Treasurer on this issue would indicate that such legislative reforms (assuming they are in fact ever introduced) are unlikely to materialise in the short term - particularly since 2010 is an election year.
Taxpayers have been invited to comment on the draft Determinations at the following address:
Contact officer: Des Maloney
Address: Australian Taxation Office
GPO Box 9977
Melbourne VIC 3001