Resource Capital Fund case

Articles Written by Jane Trethewey

Introduction

In Resource Capital Fund III, L.P. v Commissioner of Taxation [2013] FCA 363 (RCF), the Federal Court (Edmonds J) held that a Cayman Islands limited partnership (LP) in which 97% of the partnership interests were held by residents of the United States (US) was not subject to Australian capital gains tax (CGT) on a gain realised on the sale of shares in an ASX-listed gold-mining company.

In allowing the taxpayer's appeal, Edmonds J held that:

  • The assessment could not properly be issued to RCF by virtue of the double taxation agreement (DTA) between Australia and the US (the Treaty Issue).
  • The capital gain was in any event required to be disregarded by s 855-10 of the Income Tax Assessment Act 1997 (Cth) (1997 Act) because the 'principal asset test' was not satisfied, that is, the sum of the market values of SBM's assets that were 'taxable Australian real property' (TARP) did not exceed the sum of the market values of its non-TARP assets (the TARP Issue).

The Commissioner of Taxation (Commissioner) has appealed to the Full Federal Court.

Executive summary

The Treaty Issue

The judgment raises some interesting issues concerning the interpretation and operation of Australia's DTAs and their impact on Australia's ability to tax capital gains made by a foreign limited partnership.

Subject to the outcome on appeal, the decision on the Treaty Issue indicates that, if all (or substantially all) of the partners of a non-Australian resident LP are residents of a country with which Australia has a DTA (or at least a DTA substantially similar to the US DTA), Australia cannot tax a capital gain to the LP under Article 13 of the DTA (the 'alienation of property' article) but rather must assess the partners.

This does, however, raise some issues that are not addressed in the judgment, in particular:

  1. What if a significant percentage of the interests in the LP are held by partners who are not residents of a country with which Australiahas a DTA?
  2. How does the 'non-portfolio interest test' (which requires the taxpayer to have an associate-inclusive shareholding interest in the relevant company of at least 10%) apply to the limited partners where (as in RCF) the LP's shareholding is more than 10% but each partner's interest is less than 10%?

If the partners satisfy the 'non-portfolio interest test' (as discussed further below), unless the partner is exempt from Australian tax (e.g. because of sovereign immunity) or has Australian losses against which it can offset the gain, in most cases they are likely to be liable for the same or a greater amount of Australian tax on the gain than the LP, although they should be entitled to a foreign tax credit in their country of residence. However, while most of Australia's DTAs would allow Australiato tax a partner resident in the other country on a capital gain such as the gain here, some older DTAs may not.

The LP may need to satisfy the Commissioner that the partners are residents of a DTA country.1

Any logistical issues that may arise for the Commissioner in collecting the tax from the partners rather than the partnership should be overcome by the proposed new withholding requirement announced in the 2013-14 Federal Budget.

The TARP Issue

Much of the judgment in relation to the TARP Issue is likely to be rendered irrelevant in future by virtue of proposed changes to the relevant provisions announced in the 2013-14 Federal Budget.2 However, it does provide some guidance in relation to valuation for the purpose of the principal asset test which may have continuing relevance.

The facts of RCF

The facts of RCF

  • RCF is a private equity fund that invests primarily in resources stocks. It is an LP formed in the Cayman Islandsunder the Cayman Exempted Limited Partnership Law 1991in 2003. RCF's general partner (GP), Resource Capital Associates III, LP, was also a Cayman Islands LP and it was managed by a USlimited liability company, RCF Management LLC, based in Denver.
  • RCF had about 62 limited partners at the relevant times, none of which held an interest of more than 8.5% in the total contributed capital of RCF. Over 97% of the contributed capital was held by US residents, principally funds and institutions.
  • None of RCF, its GP, Manager or any of the limited partners was a resident of Australia.
  • RCF held 100 million ordinary shares in the company in question, St Barbara Mines Limited (SBM), comprising 11.95% of SBM's share capital, which RCF had acquired in March 2006. RCF sold 52.2 million of the SBM shares (5.68% of SBM's share capital) on 26 July 2007 and sold its remaining SBM shares on 29 January 2008, making a total capital gain (before transaction costs) of $58,250,000.
  • SBM was listed on Australian Securities Exchange Ltd (ASX) and carried on business as a gold miner in Australia, its key assets being its Southern Cross and Leonora operations in Western Australia.
  • RCF returned the gain on sale of the SBM shares in its USpartnership returns. RCF was treated as a 'fiscally transparent' or 'flow-through' vehicle for US tax purposes and the gain was therefore not subject to US tax in the hands of RCF but rather was subject to (or exempt from) US tax in the hands of the limited partners in accordance with their respective partnership shares.
  • As an LP, RCF is treated for Australian income tax purposes as a company rather than a partnership, under Division 5A of Part III of the Income Tax Assessment Act 1936 (Cth) (1936 Act) (together with the 1997 Act, the Assessment Acts).
  • The Commissioner of Taxation (Commissioner) issued default assessments to RCF under s 167 of the 1936 Act for the income year ended 30 June 2008, assessing it on a net capital gain of $58,250,000 in respect of the sales of the SBM shares and applying a penalty of 75% (later reduced to 25%).

The issues

Edmonds J said there were 2 issues in the appeal, namely:

  1. Whether the assessment to RCF was precluded by the DTA (the Treaty Issue); and
  2. Whether any capital gain was to be disregarded under s 855-10 of the 1997 Act because the sum of the market values of SBM's TARP assets did not exceed the sum of the market values of its non-TARP assets at the dates of disposition by RCF of its SBM shares (i.e. because the 'principal asset test' test in s 855-30 was not satisfied) (the TARP Issue).

Edmonds J held that the answer to both questions was 'yes', although he said it was not actually necessary to decide the TARP Issue given his decision on the Treaty Issue.

The Treaty Issue

His Honour said the Treaty Issue was the first issue to be considered. Presumably, his Honour saw this as a threshold issue because, even if the capital gain was assessable under Australia's domestic tax law, the DTA meant that the Commissioner had assessed the wrong taxpayer. It might, however, be argued that the TARP Issue is the threshold, issue, given that, if the principal asset test is not satisfied, the capital gain is not assessable under Australia's domestic tax law (by virtue of s 855-10) and the DTA is therefore irrelevant.

In considering the application of the DTA in this case, his Honour discussed the following articles of the DTA3: Article 1 (providing that the DTA applies to 'persons' who are residents of one or both of the Contracting States); Article 3 (which provides that a 'person' includes a partnership)4; Article 4 (which provides that a person is a resident of the US if (relevantly) the person is resident in the US for the purposes of its tax); Article 7 (business profits) and Article 13 (alienation of property). His Honour also discussed general principles of treaty interpretation,5 including the Vienna Convention, decided cases6 and the OECD Commentary on the relevant articles of the OECD Model Convention.

The Treaty Issue specifically concerned the application of Article 13 of the DTA, which provides (relevantly here) as follows:

  1. Income or gains derived by a resident of one of the Contracting States from the alienation or disposal of real property situated in the other ContractingStatemay be taxed in that other ContractingState;
  2. For the purposes of this Article:

(b)  the term "real property", in the case of Australia, shall have the meaning which it has under the laws in force from time to time in Australia and, without limiting the foregoing, includes:  

(i)  Real property referred to in Article 6;

(ii) Shares or comparable interests in a company, the assets of which consist wholly or principally of real property situated in Australia;

       7. Except as provided in the preceding paragraphs of this Article, each Contracting State may tax capital gains in accordance with the provisions of its domestic law.

The Commissioner submitted that RCF was a resident of the US for the purposes of the DTA but, even if it was not, Article 13 of the DTA gave Australia an unlimited right to tax the gain on the SBM shares. Edmonds J rejected these submissions. Firstly, his Honour said RCF was not a resident of the US under its domestic tax law (and therefore not for the purposes of the DTA). His Honour applied the test of residence that is applicable for companies under UStax law, under which a corporation is a US resident if formed under US state law. As RCF was formed under Cayman Islands law and not US law, his Honour said it was therefore not a US resident.

It is noted that the residence article (Article 4) of the US DTA (unlike other treaties that are based on the OECD Model and most of Australia's DTAs) does not contain a 'liable to tax' test for residence for the purpose of the treaty.

His Honour went on to say that, in any event, whether RCF was a US resident was not relevant to the outcome, given that it was treated as fiscally transparent for US tax purposes and was not a resident of Australia.

In relation to the Commissioner's second point, his Honour said Article 13 does not authorise the taxation of a gain that is not made by a resident of one of the Contracting States and Article 13(7) only authorises Australia to tax capital gains to a resident of the US and therefore did not authorise taxation of the gain to RCF, not being a resident of the US. Normally, however, an entity that is not a resident of either country for the purpose of a DTA would not generally be entitled to treaty protection under that DTA.7

His Honour relied on the OECD Commentary in relation to partnerships and other fiscally transparent entities, noting that the OECD Commentary on Article 1 of the OECD Model8 states that, when partners are liable to tax in the country of their residence on their share of partnership income, it is expected that the source country (in this case, Australia) will apply the provisions of a DTA:

'as if the partners had earned the income directly so that the allocative rules in Articles 6 to 21 will not be modified by the fact that the income flows through the partnership (OECD Commentary on Art 1, para 6.6)' (at [65])

His Honour went on to say that the OECD Commentary on Article 1:

'… is founded upon the principle that the State of source should take into account, as part of the factual context in which the Convention is to be applied, the way an item of income, arising in its jurisdiction, is treated in the jurisdiction of the person claiming the benefits of the Convention as a resident (OECD Commentary on Art 1, para 6.3)' (at [67])

and that the interpretation in the OECD Commentary:

'… avoids denying the benefits of tax conventions applying to a partnership's income on the basis that neither the partnership, because it is not a resident, nor the partners, because the income is not directly paid to them or derived by them, can claim the benefits of the Convention with respect to that income (OECD Commentary on Art 1, para 6.4)' (at [66])

His Honour also referred to the policy objective of preventing double taxation of capital gains derived by US residents on the disposal of interests in Australian entities while retaining Australian taxing rights that was stated in the Explanatory Memorandum to the Bill for the Act that gave legislative force to the 2001 Protocol to the DTA, saying:

'This policy objective would not be achieved if Australia is authorised under either Article 13(1), or is otherwise at large under Article 13(7), of the [DTA] to tax the gain to RCF the limited partnership. The US resident limited partners will be liable to US tax on a capital gain without credit for the Australian tax assessed to RCF on the gain. On the other hand, by authorising Australia to tax a gain in the hands of the US resident limited partners, the [DTA] recognises Australia's taxing right, but at the same time provides in Article 22(1) a credit for any Australian tax suffered as a result of the exercise of that right and so prevents double taxation of the gain. In short, the policy objective is achieved rather than being frustrated under the position contended for by the Commissioner in the present case.'(at [69])

His Honour concluded9 that, while Article 13(1) authorises Australia, by its domestic tax law, to tax the US resident limited partners on their respective distributive shares of the gain derived by them on the sale of the SBM shares by RCF (if its requirements are otherwise satisfied), it does not authorise Australia to tax that gain to RCF (the LP) as a non-transparent company. It therefore followed, his Honour said, that there was an inconsistency between the application of the DTA and the application of the Assessment Acts as to the entity or entities to be taxed on the gain and, in accordance with s 4(2) of the International Tax Agreements Act 1953(Cth) (Agreements Act), the inconsistency has to be resolved in favour of the application of the DTA to the limited partners as against the application of the Assessment Act to RCF.

Accordingly, Edmonds J held that the DTA precluded issue of the Assessment to RCF.

Comments on the Treaty Issue

Comments on the Treaty Issue

Taxation of LP

His Honour's reasoning above, as noted by Michael Kandev and Matias Milet,10 treats the fact that Article 13 of the US DTA permits Australia to tax the capital gain to the US resident partners as prohibiting taxation of the gain to the LP, which for Australian tax purposes was treated as having derived the gain and was held not to be a US resident. This point might be challenged in the Commissioner's appeal.

Nevertheless, subject to the outcome of the appeal process, the decision in RCFwould appear to be authority that Australia cannot tax an LP on a capital gain it makes if the LP is not tax resident in Australia and is treated as fiscally transparent in the country of residence of all (or substantially all) the limited partners, being a country with which Australia has a DTA (or at least a DTA in substantially similar terms to the US DTA). Rather, the decision indicates that such gain would need to be assessed in the hands of those limited partners (presumably in accordance with their respective interests in the LP) .

In RCF, some 3% of the partnership interests were apparently held by non-US residents, which presumably Edmonds J did not consider to be significant. The decision does not address the case where a more substantial percentage of the partnership interests are held by partners who are not residents of a country with which Australiahas such a DTA. What would be the position if that percentage were, say, 50% (or even 10%)?

The decision suggests an 'all or nothing' approach - that is, the DTA applies to the LP if all (or substantially all) of the partners are residents of a treaty country but not if a significant proportion of the partnership interests are held by non-treaty residents.

It might be argued that a more appropriate result would be that the LP is not taxed on any share of its capital gains to which relevant treaty resident partners are entitled, with such gains being taxed in the hands of those partners and the LP being taxable on any balance to which non-treaty resident partners are entitled.

This would arguably be consistent with the Commissioner's position in Taxation Determination TD 2011/25 in relation to revenue gains of a foreign hybrid LP (that are not in respect of 'taxable Australian property' (TAP) under the CGT rules). The Commissioner accepts that the business profits article (Article 7) of a DTA should apply in relation to any share of such gains to which treaty residents are entitled, such that he will not tax that share in the hands of the LP (provided the tax residence of the partners can be established to the Commissioner's satisfaction).

However, in the case of revenue gains that are not subject to the CGT provisions, the result would generally be that treaty resident partners are not taxable on the gain pursuant to Article 7. In the case of gains subject to the CGT provisions, on the other hand, the treaty resident partner may still be taxable on the gain under Article 13 (if the shares are TAP ‑ see below), as most of Australia's DTAs would not generally protect partners from Australian CGT in these circumstances.

How would the capital gain be treated in the hands of the limited partners?

As noted, Edmonds J held that it was inconsistent with the US DTA to assess the capital gain to RCF (in accordance with Division 5A of the 1936 Act) and therefore s 4(2) of the Agreements Act applied to resolve the inconsistency in favour of the DTA.11 His Honour said that, pursuant to the DTA, the capital gain would need to be assessed in the hands of the USresident partners.

However, his Honour did not (as he did not need to) say anything about the treatment of the gain in the hands of those partners, in particular the application of the 'non-portfolio interest test' (NPIT). As noted below in relation to the TARP Issue, boththe NPIT (which requires that the entity holding the shares and its associates had an interest of 10% or more in the relevant company) and the principal asset test must be satisfied for the shares to be 'indirect real property interests' and therefore TAP, on which non-residents are subject to CGT under Division 855. The question arises as to how the NPIT is to be applied in assessing the partners on their respective shares of the capital gain.12

While RCF held more than 10% of the shares in SBM (and therefore passed the NPIT), none of the partners had an individual interest of 10% or more. However, the NPIT (in s 960-195) is associate-inclusive and therefore, if RCF and each of the partners are 'associates' for this purpose, each partner would pass the test.

Under the definition of 'associate' in s 318 of the 1936 Act, a partnership and each of its other partners is an associate of a partner, whereas a company is only an associate of a shareholder under s 318 if the shareholder and/or any of its other associates, has a majority voting interest in, or 'sufficient influence' over, the company.13

Therefore, if RCF were an ordinary partnership, it would be an 'associate' of each partner, as would each other partner. However, as RCF is a 'corporate limited partnership' under s 94D of the 1936 Act, it is deemed (under s 94J and s 94K) to be a 'company' and not a 'partnership' for the purpose of the Assessment Acts and the partners are deemed (under s 94Q) to be shareholders. In that case, it would appear that (assuming none of the partners are otherwise associates of each other), neither the LP nor any of the other partners would be an 'associate' of any of the limited partners under the Assessment Acts.

What are the implications of the Agreements Act and Edmonds J's decision on the Treaty Issue for applying the NPIT and the 'associate' tests in s 318 in assessing the gain to the partners? In particular, does the Agreements Act as interpreted by Edmonds J in RCF mean:

  1. the LP is to be disregarded entirely; or
  2. Division 5A (but not the LP) is to be disregarded, such that the LP is treated as an ordinary partnership and not as a company; or
  3. the LP and/or Division 5A are to be disregarded in determining which taxpayer to assess but not in applying Division 855 and s 318 to the partners?

The OECD Commentary says that, where the country of residence of the partners treats the partnership as fiscally transparent, the source country should apply the provisions of the DTA 'as if the partners had earned the income directly'. This suggests that the LP is to be ignored entirely (i.e. approach (a) above). This would mean that, even if the LP satisfies the NPIT, where a partner's interest is less than 10%, the partner would not be subject to Australian CGT on the shares if the LP is ignored for this purpose, notwithstanding that, if the LP had been an ordinary partnership to which Division 5A did not apply, the partner would have satisfied the NPIT and been subject to CGT by virtue of the 'associate' provisions.

The result should be the same under the approach in (c), where neither the LP nor Division 5A is disregarded in applying the NPIT and s 318 to the partners such that the associate test for shareholders in a company rather than partners in a partnership applies.

If, however, the approach in (b) above is correct, such that the LP is treated as a 'partnership' and not a 'company' in applying the Assessment Acts (including s 318), the partners would all be associates of one another and the NPIT would be satisfied for each of them.

Each of the above approaches would avoid the potential double taxation problem of concern to Edmonds J in RCFand to which the OECD Commentary on Partnerships is directed and it is not entirely clear which approach would be adopted if the issue came before a Court or Tribunal. Perhaps this issue will be considered in the appeal even though not directly relevant to the case.

The TARP Issue

The TARP Issue

While his Honour said his conclusion in relation to the Treaty issue was sufficient to allow the appeal, he nevertheless went on to consider the TARP Issue, as the parties had agreed that he should do so. His Honour noted that an appeal court would have the benefit of his reasons on the TARP Issue.

Why is the TARP Issue important?

The TARP Issue is key to the question of whether the capital gain in respect of the SBM shares is assessable to a foreign resident. This is because:

  1. Under s 855-10 of the 1997 Act a capital gain or loss arising from a CGT event is disregarded if the taxpayer is a foreign resident just before the CGT event and the CGT event happens in relation to a CGT asset that is not TAP;
  2. The table in s 855-15 sets out what CGT assets are TAP - under item 2 of the table, TAP includes an 'indirect Australian real property interest';
  3. Under s 855-25, a membership interest (in this case a share) held by an entity (the 'holding entity', i.e. RCF or its partners in this case) in another entity (the 'test entity', i.e. SBM) will be an indirect Australian real property interest (and therefore TAP) if the interest passes the following tests:

(i)          the 'non-portfolio interest test' (in s 960-195) - this test requires that the holding entity and its associates has a shareholding interest in the test entity of 10% or more, either at the time of the CGT event or throughout a continuous 12-month period in the 24 months ending at that time; and

(ii)         the 'principal asset test' (in s 855-30) - this test requires that the sum of the market values of the test entity's (i.e. SBM's) assets that are TARP (which includes a 'mining, quarrying or prospecting right' if the minerals, petroleum or quarry materials are situated in Australia)14 exceeds the sum of the market values of its assets that are not TARP.

What did the TARP Issue involve?

Edmonds J said (at [80]) the TARP Issue involved consideration of a number of underlying issues, including:

  1. the proper construction of the principal asset test in s 855-30(2), in particular what is to be valued;
  2. the hypothesis upon which the valuation is to be made and the application of that hypothesis to the case at hand;
  3. the appropriate valuation methodologies to measure what is to be valued.

Expert evidence

Both parties called expert witnesses on matters of gold mining geology and valuation. RCF relied on valuation reports from Ernst & Young (EY) and Lonergan Edwards & Associates (LEA), while the Commissioner relied on valuation reports from Romar Valuation Services Pty Ltd (Romar) and Axiom Forensics Pty Ltd (Axiom) (together with EY and LEA, the Experts).

A 'conclave' of the Experts was held prior to the hearing, as a result of which they made adjustments to their assumptions and conclusions and tendered a Joint Report (EJR), setting out common ground and areas of dispute and annexing their revised reports.

Edmonds J ultimately rejected the valuations of the Commissioner's Experts, Romar and Axiom, as discussed further below.

Relevant assets

The parties agreed that SBM's assets included the following specialised mining assets:

  • mining tenements;
  • plant and equipment;
  • mining information;

and the following general assets:

  • cash, working capital, derivatives and other financial assets
  • goodwill (and/or other intangibles); and
  • tax losses.

There was some dispute as to whether there was a further asset, being a 'gold premium', as discussed further below.

Construction of s 855-30

After considering the statutory context and purpose of s 855-30 and Division 855 and the text of s 855-30, Edmonds J held that the 'principal asset test' requires a separate valuation of each asset and not valuation of all of the TARP assets as a class and all of the non-TARP assets as a class and 'certainly not' the determination of all the company's assets on a 'going concern' basis.

His Honour said that s 855-30 required:

  • Firstly, determination of the market value of each asset;
  • Next, the classification of the assets into TARP and non-TARP assets;
  • Finally, summing of the values in each class to determine whether the sum of the market values of the TARP assets exceeds the sum of the market values of the non-TARP assets.

'Going concern' basis and goodwill

His Honour said:

'it is trite that the value of a business on a going concern basis valued by reference to the present value of predicted earnings of the business may be greater than the sum or aggregate of the individual market value of each identifiable asset comprising the business'.15

However, he said, whether the difference is to be allocated to goodwill in the legal sense may not be relevant in this case, as, if it is goodwill in the legal sense, it will be property that is clearly not TARP and if it is not, it will not be property and therefore neither TARP nor non-TARP. It is not entirely clear, however, why the fact that it is not property would necessarily prevent it from being a non-TARP 'asset', which does not need to be 'property'.16 In any event, this will be irrelevant under the proposed changes discussed further below.

His Honour also said that, if a going concern valuation of all of SBM's assets is used as a surrogate for undertaking separate valuations of its individual assets on a stand-alone basis, this will result in an overstatement of those values and, depending on the basis of allocation, of the market values of the TARP assets, the non-TARP assets or both. In short, he said it 'jumbles' the value of the goodwill or the 'marriage value' of the assets, with its sources.17

Valuation hypotheses - what is market value?

All of the experts adopted the following formulation of market value as:

'the value that would be agreed, in an open and unrestricted market, between a knowledgeable, willing but not anxious buyer and a knowledgeable, willing but not anxious seller acting at arm's length.'18

His Honour said this does not involve an inquiry into the price a vendor could actuallyhave obtained for it on a given date but is predicated on a hypothetical sale, citing the following comment of Griffiths J in Spencer(at 432):

' … the test of the value of land is to be determined, not by inquiring what price a man desiring to sell could actually have obtained for it on a given date, i.e. whether there was in fact on that day a willing buyer, but by inquiring "what would a man desiring to buy the land have had to pay for on that day to a vendor willing to sell if for a fair price but not desirous to sell?"'19

His Honour also cited Isaacs J in Spencer (at 440-441), who said the 'fair price' of the asset was the price 'which a hypothetical prudent purchaser would entertain if he desired to purchase it for the most advantageous purpose for which it was adapted'. This is sometimes referred to as the 'highest and best use' test.20

While the Experts agreed that the highest and best use of SBM's 'specialised assets' was in a business of mining the reserves in SBM's mining tenements, the parties disagreed as to what this meant.

Edmonds J rejected as 'fundamentally wrong' the Commissioner's submission that it required a valuation on the basis of a sale of all the assets as a going concern and an allocation of that total combined asset market value between TARP and non-TARP assets. His Honour preferred RCF's approach of valuation of each asset on a stand-alone basis as the starting point but said it required a further assumption in relation to mining information and plant, namely that it was used in a manner consistent with its highest and best use, i.e. in a business of mining the reserves in SBM's tenements.21

Valuation methodologies - how is the hypothetical value determined?

Edmonds J said that adoption of the above hypotheses (i.e. the hypothetical price, by reference to the highest and best use as interpreted by his Honour as discussed above, as the determinant of the individual market values of the assets), meant different methodologies would be needed for different assets.

In relation to the mining rights, his Honour said the hypothetical price would be the value which could be extracted from the tenements by mining them, ascertained by reference to the discounted cash flows (DCF) less the cost (time delay as well as outlay) of re-creating the mining information and replacing the plant and equipment that is assumed not to be owned by the owner of the mining rights and not otherwise available for purchase.22

In relation to mining informationand plant and equipment, his Honour said the hypothetical price would be in a range (the 'bargaining zone') between a low point of zero (in the case of mining information) or the sale for removal price (in the case of plant and equipment) and a high point being the cost (time delay and outlay) to the hypothetical buyer of re-creating the mining information or plant. His Honour agreed with RCF's submission that, in both cases, to determine the fair value of the asset in a hypothetical sale transaction, the appropriate point in the range is that which allocates the benefit to the user of immediate acquisition of the asset equally between the hypothetical seller and buyer (i.e. the half-way point).23

Classification of SBM's assets

It was common ground that (under the existing law):24

  • SBM's mining rights were its only material tangible assets that were TARP; and
  • the plant and equipment and mining information were not TARP.25

In relation to the mining information, Edmonds J noted that information is not itself property.26 As such, it cannot be 'real property' for the purposes of paragraph (a) of the definition of TARP in s 855-20, nor (under the current law) does it come within the definition of 'mining, quarrying or prospecting right' for the purposes of paragraph (b).

Axiom and Romar allocated some of the plant and equipment value to footings, which they said were fixtures to the tenements. His Honour agreed with RCF's submission that, if they were fixtures, they were affixed to the land and not to the mining rights and, as the land was not owned by SBM, the fixtures were not owned by RCF (while affixed) and were therefore not TARP assets.27

Presumably SBM's right to remove those assets would be a non-TARP asset.

The Experts also took different views on the treatment of the so-called 'gold premium' (i.e. the difference between the value of the shareholder's interests in a gold company based on its market capitalisation and the value of the company using the DCF method). Edmonds J said this is arguably not an asset of the company at all but, if it is, it is a non-TARP asset.28

In future, however, if the changes announced in the 2013-14 Federal Budget are enacted, intangible assets such as mining information, goodwill and any 'gold premium' will be treated as TARP (see further below).

The Expert valuations

All of the Experts started with a measure of the market value of SBM's total assets and proceeded to the value of the mining rights as a residual item after deducting the assessed value of the non-TARP assets, including the specialised assets of mining information and plant and equipment. There was agreement as to the value of most the non-business assets (all of which were non-TARP), other than the tax losses, goodwill and a receivable in respect of an option.29

All but Romar assessed the market value of SBM's total assets using a DCF method, while Romar used a market capitalisation method (which produced a significantly higher total market value than the DCF method, with Romar allocating all of the excess to TARP rather than non-TARP assets). Edmonds J rejected Romar's valuation,30 agreeing with RCF's submissions that the market capitalisation method was unreliable and the DCF method was to be preferred and disagreeing with Romar's allocation of the excess amount to the TARP assets.

Edmonds J also rejected the valuation of the Commissioner's other Expert, Axiom, on the basis that it took the approach of valuing SBM's assets on a going concern basis and then deducting the value of the non-TARP assets, treating the balance as the market value of the TARP assets. Further, Axiom used the book value to value the plant and equipment (while acknowledging that book value of such an asset was 'rarely an accurate measure of its market value') and also used book value to value the mining information or an alternative 'replacement value' measure, using figures it was instructed to adopt and had not independently determined.

The taxpayer's Experts, EY and LEA, both used a DCF method to calculate the total value of SBM's assets.

EY determined the maximum value of the TARP assets (i.e. the mining rights) by calculating the DCF value of the business that could be built with those mining rights and deducting the costs of acquiring the other, non-TARP building blocks (i.e. plant and equipment and mining information), on the assumption that SBM's actual mining information and plant and equipment assets were not available to the purchaser. This was done by reducing the DCF value for the anticipated delay in production while the assets were recreated (using a net present value calculation) and then deducting the expected out of pocket costs of recreation. They said this was a 'maximum' value for the TARP assets, which was higher than it should be, because:

  • the business was valued on a going concern basis and assuming the mining rights would be sold together rather than separately, without any reduction for the 'marriage value'; and
  • no purchaser would pay the full value of the business less the expected costs, as they would also want a profit margin.

LEA approached the calculation of the maximum value of the TARP assets in a similar way. They also took account of SBM's expected rehabilitation liabilities at the end of the mining operations in their revised valuation.

LEA valued the non-TARP assets other than plant and mining information at their realisable value. They valued the plant at replacement cost (including an adjustment to allow for the 'non-linear relationship between plant and equipment capacity and costs') and the mining information at cost plus an amount to take into account cash outlays and loss of cash flow until the recreation process was complete (i.e. delay costs).

EY's valuation resulted in a TARP/Total assets ratio of 10.7% at 1 July 2007 and 43.2% at 30 June 2008, while LEA's ratios for those dates were 10.6% and 31.1%, respectively. Axiom's and Romar's valuations produced ratios of well over 50% at both times.

It should be noted that Division 855 requires the principal asset test to be determined at the time of the relevant CGT event, which in this case was 26 July 2007 and 29 January 2008. It was presumably accepted by the parties that valuations at the beginning and end of the year were a reasonable proxy for the values at the relevant dates.

The TARP Issue - Principal Asset Test

The judgment would appear to support the following propositions:

  • for the purpose of the principal asset test in s 855-30(2), the company's assets are to be valued separately (i.e. asset by asset) and not together as a class (i.e. TARP and non-TARP) or otherwise on a going concern basis.
  • under the current law, neither goodwill nor mining information is TARP.
  • mining plant and equipment (including any fixtures on land that is not owned by the company, under current law at least) are not TARP.
  • the market value of the assets is the price that would be paid in a hypothetical arm's length sale between a willing but not anxious buyer and a willing but not anxious seller, being the price that a prudent buyer would be prepared to pay if they wished to buy the asset for the most advantageous purpose for which it was adapted (the 'highest best use test').
  • in the case of specialised mining assets, such as mining information and plant, it must be assumed that the assets will be used in a business of mining the reserves in the relevant tenements (the highest and best use of those assets).
  • the hypothetical buyer is assumed not to have, or otherwise be able to acquire, any of the required special assets, such that their value is based on the value to the buyer of immediate acquisition of the asset - this should be an amount somewhere between a minimum of zero (for mining information) or the sale for removal price (for plant and equipment) and a maximum amount being the outlay and time delay (lost production) cost to the buyer of recreating those assets. As the hypothetical buyer and seller are assumed to have equal bargaining power, the price should be the mid-point in that range (the 'bargaining zone'), sharing the notional benefit equally between them.

Proposed changes to the principal asset test

Proposed changes to the principal asset test

In the 2013-14 Federal Budget on 14 May 2013, the Government announced that it will make changes to the principal asset test in Division 855, presumably in response to Edmonds J's decision in RCF. These changes are proposed to apply to CGT events occurring on or after 1 July 2016.

Relevantly, intangible assets connected to the mining, quarrying or prospecting rights (notably mining, quarrying or prospecting information and goodwill) will be treated as part of the rights to which they relate - and therefore as TARP - for the purpose of the test.

It is not clear to what other intangible assets this will apply. It does not appear that it is proposed to include tangible assets, such as plant and equipment.

Withholding

There is currently no general requirement under Australian law for a buyer of Australian real property interests from a foreign seller to withhold an amount in respect of Australian tax from the purchase price. A number of jurisdictions already have such a withholding requirement, including the US, Canada, Singapore, South Africa, Peru.

Given the difficulties the Commissioner faces in recovering tax from foreign entities that may not have any significant assets in Australia (and the heightened need to maximise tax revenue), it is not surprising that a new withholding rule has been announced in the 2013-14 Federal Budget. The proposed rule (also to apply from 1 July 2016) will require a purchaser of real property (presumably including indirect real property interests) from a foreign seller to withhold 10% of the sale price and remit it to the Commissioner. Public consultation on this measure will be conducted and a discussion paper is to be released by the end of 2013.

Some other issues

Revenue account gain

The Commissioner does not appear to have contended that the gain in RCFwas on revenue account, relying solely on the CGT provisions. Presumably, if the CGT provisions do not apply (because, as Edmonds J held in this case, the shares were not TAP), the Commissioner would not seek to tax the gain on revenue account, on the basis that the US resident partners would be entitled to the benefit of the business profits article (Article 7) of the DTA, in accordance with Taxation Determination TD 2011/25.31 This does not, however, mean that he would not seek to argue that a gain was on revenue account if the partners are not residents of a treaty country.

Residence of LP

The Commissioner also apparently accepted that RCF was not a resident of Australiaunder s 94T of the 1936 Act. He must therefore have accepted that RCF did not carry on business in Australia (being one of the 3 tests of residency for an LP under s 94T), which presumably means he did not regard the purchase and sale of shares on the ASX as amounting to carrying on business in Australia (it is not clear from the case whether RCF had any other Australian investments). This is of course welcome and it is hoped that the Commissioner would not seek to contend that an LP is Australian resident simply because it has Australian investments.

If RCF had been an Australian resident LP for Australian tax purposes, Edmonds J would presumably have held that Australia could tax it on any capital gain as a deemed Australian resident company.



[1] See Taxation Determination TD 2011/25.

[2] The relevant changes announced in the Federal Budget are discussed briefly below - see also our separate article on changes to some of Australia's international tax rules announced in the Budget.

[3] At [36] - [45].

[4] It should be noted that Article 3 of the OECD Model Convention does not specifically refer to a 'partnership' but does refer to 'any other body of persons', which the OECD Commentary says includes a partnership.

[5] At [46] - [53].

[6] Including: Thiel v FCT (1990) 171 CLR 338, Applicant A v Minister for Immigration and Ethnic Affairs (1997) 190 CLR 225; FCT v Lamesa Holdings BV (1997) 77 FCR 597; McDermott Industries (Aust) Pty Ltd v FCT (2005) 142 FCR 134; Russell v FCT (2011) 190 FCR 449, Minister for Immigration and Multicultural and Indigenous Affairs v QAAH of 2004 (2006) 131 CLR 1; NBGM v Minister for Immigration and Affairs (2006) 231 CLR 52; FCT v SNF (Australia) Pty Ltd (2011) 193 FCR 149; Minister for Home Affairs v Zentai (2012) 289 ALR 644.

[7] For a discussion of these and other issues (including the relevance of OECD Commentaries), see 'Resource Capital Fund III: A Canadian Perspective on Applying a Treaty to a Hybrid Partnership' by Michael N. Kandev and Matias Milet in Special Reports, Tax Notes International, 24 June 2013. The authors note the Canadian case of TD Securities (USA) LLC v. R (2008-2314(IT)G); 2010 WTD 69-23, in which the Tax Court of Canada held that a Delaware LLC was a resident of the US for the purposes of the Canada-US DTA. In that case, Canada (the source country) held that the LLC (which was treated as fiscally transparent in the US) was a resident of the US for the purposes of the DTA, on the basis that the LLC's income was liable for US tax in the hands of its sole member, a US corporation.

[8] Article 1 of the OECD Model provides that the Convention applies to persons who are residents of one or both of the Contracting States. Article 1 of the US DTA is in substantially the same terms.

[9] At [78]-[79]

[10] See footnote 6

[11] DTAs are given the force of law under the Agreements Act). Section 4(1) of that Act provides that, subject to s 4(2), the Assessment Acts are incorporated, and are to be read as one, with the Agreements Act and s 4(2) provides that the provisions the Agreements Act has effect notwithstanding anything inconsistent with those provisions contained in the Assessment Acts (apart from Part IVA).

[12] It is noted that Subdivision 106-A of the 1997 Act deals with the application of the CGT rules to capital gains made by 'partnerships' (which would not include LPs that are treated as companies under Division 5A), providing that any capital gain or loss from a CGT event happening to the partnership is made by the partners individually, with each partner's gain or loss being calculated by reference to the partnership agreement (or partnership law if there is no agreement) and each partner having its own cost base for their interest in the CGT asset of the partnership. The Sub-division also provides that capital gains and losses can arise for a partner when they leave a partnership or for the remaining partners if a partner leaves the partnerships. There can also be CGT consequences if the proportionate interests of partners change.

[13] An entity or entities has a 'majority voting interest' in a company if they are in a position to cast or control the casting of more than 50% of the maximum number of votes that might be cast at a general meeting and has 'sufficient influence' if the company, or its directors, are accustomed or under an obligation (whether formal or informal), or might reasonably be expected, to act in accordance with the directions, instructions or wishes of the entities or entities (whether communicated directly or through interposed entities).

[14] As defined in s 855-20

[15] At [97], citing FC of T v Murry (1998) 193 CLR 605 at [49] and Commissioner of Territory Revenue v Alcan (NT) Alumina Pty Ltd (2008) 156 NTR 1 (Alcan (NT))

[16] See Taxation Ruling TR 2004/13, dealing with the concept of 'asset' under the consolidation provisions in Part 3-90 of the 1997 Act.

[17] At [97], citing Angel J in Alcan (NT) at [116]

[18] At [98], citing Spencer v The Commonwealth (1907) 5 CLR 418 (Spencer) at 432 (Griffiths CJ), 441 (Isaacs J).

[19] At [99].

[20] At [100], also citing Boland v Yates Property Corporation Pty Ltd (2007) 167 ALR 575 at [271]-[294].

[21] At [102] - [104].

[22] At [105], citing the Supreme Court of WA in Nischu Pty Ltd v Commissioner of State Taxation (WA) (1990) 21 ATR 329 and the Full Court in Commissioner of State Taxation (WA) v Nischu Pty Ltd (1991) 4 WAR 437.

[23] At [106] - [108].

[24] As noted above and discussed briefly below and in our separate article referred to in footnote 2, changes have been announced that will affect these issues in the future.

[25] At [109] - [110].

[26] At [113], citing FC of T v United Aircraft Corporation (1944) 68 CLR 525 at 534 and Pancontinental Mining Ltd v Commissioner of Stamp Duties [1989] Qd R 310.

[27] At [112].

[28] At [111].

[29] EY and LEA included $24M for the tax losses, while Romar included $8M and Axiom nil. LEA included $6M for the option receivable and the other Experts nil. LEA included $20M for goodwill and, Axiom and Romar included $10M and EY nil. However, all the Experts agreed that goodwill did not have any material value in a gold mining business, save for a relatively small value for management goodwill (and so presumably the values they included for goodwill were referable to other tangibles, which, like goodwill, are not TARP).

[30] Apparently the Commissioner's submissions relied only on the Axiom valuation and did not rely on the Romar valuation.

[31] TD 2011/25 was issued on 26 October 2011, which was after the issue of the Assessment in this case but before the case was heard.

Important Disclaimer: The material contained in this article is comment of a general nature only and is not and nor is it intended to be advice on any specific professional matter. In that the effectiveness or accuracy of any professional advice depends upon the particular circumstances of each case, neither the firm nor any individual author accepts any responsibility whatsoever for any acts or omissions resulting from reliance upon the content of any articles. Before acting on the basis of any material contained in this publication, we recommend that you consult your professional adviser. Liability limited by a scheme approved under Professional Standards Legislation (Australia-wide except in Tasmania).

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