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On 26 October 2011, the Commissioner of Taxation issued Taxation Determinations TD 2011/24 and TD 2011/25, dealing with the source of income and availability of tax treaty benefits, respectively, in relation to profits made by private equity (PE) funds from the sale of shares in an Australian corporate group acquired under a leveraged buy-out (LBO).
These TDs were previously issued as draft determinations on 1 December 2010. Two final TDs were also issued on that date, also dealing with PE LBO arrangements, namely TD 2010/21, dealing with whether the profit on sale by a PE fund of shares acquired in an LBO could be assessable as ordinary income and TD 2010/20, dealing with the application of the general anti-avoidance provision in Part IVA to 'treaty shopping' arrangements designed to prevent Australian tax from applying to such profits. These TDs and draft TDs were based on arrangements similar to the sale of Myer Ltd involving PE group, Texas Pacific Group (TPG), and were briefly discussed in the December 2010 edition of Acumen.
The suite of TDs dealing with profits derived by PE funds on sale of shares acquired in LBOs, based on the Myer/TPG transaction, is now complete. The TDs have effect both before and after their date of issue. While limited to LBOs, these TDs have implications for foreign PE funds, and indeed foreign residents, generally.
This article briefly discusses TDs 2011/24 and 25.
TD 2011/24 says that an Australian source in s 6-5(3) of the Income Tax Assessment Act 1997 (Cth) (1997 Act) is not dependent solely on where purchase and sale contracts are executed in respect of the sale of shares in an Australian corporate group acquired in a leveraged buyout by a PE fund. Rather, it says the source is determined having regard to all the facts and circumstances of the particular case.
The TD says the factors that are relevant when determining source in such a case (in addition to the place of execution of the purchase and sale contracts) include the following:
The TD gives the example of Priveq LP, a limited partnership (LP)1 formed in a low tax jurisdiction that is treated as a company for Australian income tax purposes and is not treated as a resident of Australia under s 94T of the Income Tax Assessment Act 1936(Cth) (1936 Act). Priveq LP is a PE fund whose main activities consist of acquiring companies and improving their business operations, with the ultimate goal of selling the shares for a profit. It acquires (through its wholly owned Australian subsidiary, Hold Co) all of the shares in Target Co (an Australian manufacturing company), with debt funding from Australian-based lenders. It stipulates that Target Co's business must be restructured. Advice Co (an Australian resident associate of the general partner of Priveq) undertook the pre-acquisition research of Target Co and negotiated the debt funding in Australiaon behalf of Priveq LP. Priveq subsequently disposes of the shares in Hold Co to New IPO, which is then sold by IPO. Contracts for the sale of Hold Co were negotiated in Australia and signed overseas.2
The Commissioner says that, weighing up all the factors, the profits derived by Priveq from the sale of Hold Co have an Australian source, on the basis that the activities that effected a greater return over the purchase price of Target Co were conducted in Australia, including obtaining debt funding, researching, selecting and acquiring Target Co and enhancing Target Co's business operations and profitability.
The TD says that 'different facts will, of course, potentially yield different results'.
The explanation section of the TD discusses what it considers are relevant aspects of an LBO by a PE fund, namely:
It also sets out the elements of the transaction culminating in the profit that, because they are undertaken in Australia (much of them by, or under the co-ordination of or in conjunction with, the local advisory entity, which the TD says is in effect doing the business of the PE firm/GP), are considered to give rise to an Australian source - these include:
The TD says that the actual contract of sale 'is but the final element crystallising the profit' and, therefore, the Commissioner considers it is not appropriate to focus on that element of the series of transactions to the exclusion of all others. LBO arrangements are therefore not considered to be cases where the sole source of the profit is the purchase and sale contracts. Rather, it is necessary to examine the significance of the activities conducted in Australia and, where most activities other than the execution of the purchase and sale contracts are conducted in Australia, the source of the profit is Australia.
The TD (unlike the draft TD) also raises the issue of apportionment of source, saying 'it is not possibly to exhaustively specify when the profit will be wholly Australian sourced or wholly sourced overseas or when, and to what extent, the profit will be apportioned'. It does not elaborate any further on the circumstances in which the Commissioner may consider an apportionment of source would be appropriate in cases such as these.
TD 2011/25 says that the business profits article of Australia's double taxation treaties will apply to Australian-sourced business profits of a foreign LP where the LP is treated as fiscally transparent in a country with which Australia has such a treaty (treaty country) and the partners in the LP are residents in that treaty country and meet any other applicable requirements under the treaty.
The TD also says the treaty will apply to the extent that the partner in the LP is itself an LP (interposed LP) and its partners (ultimate partners) are residents of a treaty country. The draft TD did not deal with interposed LPs. Accordingly, the business profits of the LP that are treated as the profits of the treaty country resident partners in the LP or interposed LP will not be subject to Australian tax, provided those profits are not attributable to a permanent establishment in Australia.
The TD gives 3 examples, as follows:
The TD does not apply where the fiscally transparent entity is not a partnership (e.g. where it is an LLC or other incorporated form of entity). However, the Explanation says the Commissioner will accept that an entity that is treated as a 'partnership' under the commercial law of the treaty country (and is also fiscally transparent under that country's tax laws) is a partnership for this purpose.
The explanation points out that the tax treatment of the LP in its country of formation is not necessarily relevant in determining whether and how the treaty between the country of residence of its partners and Australia applies. However, if the LP is formed in another treaty country that treats the LP as resident and taxes the LP on its profits, Australia will be obliged to afford treaty benefits under that treaty to the LP itself in respect of the Australian sourced business profits.
While there are comments in the TD that might suggest that all of the partners in the LP and interposed must be residents of a treaty country, it would appear from the examples and other statements in the TD that this is not the case. That is, treaty benefits will apply to the extent that the profits are attributable to partners or ultimate partners resident in treaty countries and the remaining profits will presumably be taxed in the hands of the LP.
The TD contains some additional comments on the 'practical administration' issues that were not in the draft TD.
These practical issues arise in relation to satisfactorily establishing the ultimate partners, their residence and share of the Australian business profit, as well as the need to consider the application of the tax treaty with the country of residence of any interposed LP that is resident in a treaty country. More complications arise where there are multiple interposed LPs and where the partners and ultimate partners are resident in different countries (some of which may not be treaty countries).
As a consequence, the TD says that the onus is on the GP of any involved LP to demonstrate that a limited partners is a tax resident of a treaty country. This will need to be discussed with the Commissioner on a case by case basis. The TD notes that industry discussions indicated that the investor client base for the relevant types of PE funds is relatively small and investors are predominantly from treaty countries. It is therefore envisaged that fund managers will generally be aware of the residence of their ultimate investors and that, given the relatively stable partnership arrangements (i.e. investors don't normally change during the life of the fund), the information initially provided by the fund manager to the ATO should generally be sufficient, unless there is a material change in the partnership's members.
However, in the absence of the provision of sufficient identifying information, and where appropriate, the Commissioner will use his 'garnishee' powers to collect the debt arising on any subsequent assessment from third parties and will consider the use of other available remedies if necessary. If the Commissioner is subsequently satisfied that tax treaty benefits are available, a refund of any tax collected can be sought.
It is noted that the TD assumes that the LP will be a non-resident for Australian tax purposes (and the TD will not apply if the LP is an Australian resident. However, under s 94T of the 1936 Act, an LP that is formed outside Australia will be a resident of Australia either if it carries on business in Australia orits central management and control is in Australia - that is (unlike for a company), simply carrying on business in Australia is enough to make an LP an Australian resident, regardless of where its central management and control is located. The TD does not address the question of whether the fact that the profit derived by the PE fund is regarded as a business profit with an Australian source means that the fund is relevantly carrying on business in Australiaso as to be an Australian resident. It would seem that the TD is tacitly accepting that this is not sufficient to make the fund an Australian tax resident. It would, however, be preferable for this issue to be expressly clarified.
The ATO's position in relation to the taxation treatment of the Myer/TPG transaction and the release of the TDs and draft TDs on 1 December 2010 gave rise to considerable uncertainty for offshore funds and caused particular difficulty for funds that were required to prepare their financial reports in accordance with US accounting standards and therefore to report their 'uncertain' tax positions under 'FIN 48'. This had potentially adverse implications for the Australian funds management industry as it discouraged foreign funds from making Australian investments and using Australian intermediaries.
Accordingly, the Assistant Treasurer announced on 17 December 2010 and 10 May 2011 that the 1997 Act would be amended to deal with these issues for the 2011 and prior income years. In January 2011, the Assistant Treasurer also announced certain 'conduit income' changes for foreign funds using Australian fund managers from 1 July 2011. Exposure draft (ED) legislation for the proposed changes (which are the first instalment of the 'investment manager regime' (IMR)) was released on 16 August 2011. The proposed IMR changes are discussed in a separate article in this edition of Acumen (IMR article).
However, as discussed in the IMR article, the proposed FIN 48 measures in the ED only apply to income that would otherwise be foreign-sourced is treated as having an Australian source because it is attributable to a permanent establishment in Australia arising by reason only of using an Australian-based fund manager. They therefore do not address the issues raised by the TDs (namely, income or gains from Australian investments having an Australian source under general source rules). They also do not apply to the type of investments dealt with in the TDs (as non-portfolio investments are excluded), nor do they address issues in relation to the capital/revenue distinction or residence. Further, the measures apply only to widely held funds - as noted in the IMR article, various issues arise in relation to this test.
1 The draft TD had used the example of a limited liability partnership (LLP).
2 The facts in the example in the TD are more detailed than those in the draft TD.
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