On 1 December 2010 the Australian Taxation Office (ATO) issued two final Taxation Determinations (TD2010/20 and TD2010/21) and two draft Taxation Determinations (TD2010/D7 and TD2010/D8) concerning the Australian taxation treatment of profits derived by foreign private equity funds on disposal of investments in an Australian company.
TD 2010/20 and TD 2010/21 (2010TDs) were previously issued as draft Taxation Determinations TD 2009/D17 and TD2009/D18, respectively (2009 Draft TDs), which were issued in the wake of the ATO's decision to tax Texas Pacific Group (TPG) on the profit on the disposal of its shares in Myer under the IPO last year. The 2010 TDs confirm the views expressed in the 2009 Draft TDs that:
Numerous submissions in relation to the 2009 Draft TDs were made by the private equity industry, professional bodies and others, emphasising the detrimental effect that the Draft TDs would have on private equity investment, and the funds management industry, in Australia. The 2009 Draft TDs, as now confirmed by the 2010 TDs, attack structures that are commonly used by, and are well recognised by investors in, 'private equity' funds. These investors are typically superannuation funds, endowment funds, sovereign wealth funds and other institutional investors that are resident in North America, Europeand other OECD countries. The 2010 TDs arguably represent a departure from the ATO's previous practice in relation to the tax treatment of such private equity funds. While the ATO says that it will examine each case on its particular facts and circumstances, the concern is that the positions in the 2010 TDs (and that in TD2010/D7, if and when finalised) will effectively represent the ATO's 'default position'.
It is understood that the private equity industry will now focus its efforts on lobbying the Government for legislative change.
The 2010 TDs will take effect both before and after their date of issue, as will TD2010/D7 and TD2010/D8 (once they are issued in final form).
As well as the TPG case, another example of the ATO putting these views into practice can be seen from the recent release of the Federal Court's judgment in Commissioner of Taxation v Resources Capital Fund III LP (RCF) [2010] FCA 1247 (which was previously suppressed by a confidentiality order), granting the Commissioner freezing orders in respect of RCF's assets in Australia (mainly shares in ASX-listed companies). The judgment states that in November 2010 the Commissioner issued assessments to RCF for the 2006 and 2008 income years, assessing it on gains derived from the assignment of a royalty granted by St Barbara Mines Limited, an ASX listed gold mining company, and the sale of 100 million shares in that company.
TD2010/21 says that the profit made by a non-resident private equity entity on the sale of shares in a company group acquired in a leveraged buy-out (LBO) may be included in the assessable income of the vendor as ordinary income where the profit has an Australian source (as to which see TD2010/D7, discussed in 4 below).
The TD says that, where shares in a target are acquired by a private equity entity under an LBO with a short to medium term time frame, it is likely that the shares are acquired for the purpose of profit-making by sale such that the profit will constitute ordinary income. This view is based on the ATO's understanding that private equity LBO acquisitions involve:
The TD says the relevant purpose is that of the non-resident private entity itself rather than the investors in that entity and it is the objective purpose that must be discerned. While the TD says this will depend on the circumstances of each particular case, it says, however, that the ATO considers this form of private equity investment to be one where the 'overwhelming majority' of the yield is estimated, in advance, to be derived from the sale of the target assets, with the 'overwhelming part' of both the manager's remuneration and the limited partners' yield is envisaged to be sourced from the disposal proceeds.
For a private equity entity resident in a country with which Australia has a tax treaty, by virtue of the 'business profits' article of the treaty, a revenue profit will generally not be taxable in Australia if the entity does not have a permanent establishment in Australia, subject to the operation of Part IVA (as to which see TD2010/20 discussed in 3 below). However, for an entity resident in a non-treaty country, the profit will be taxable in Australia, subject to the views in TD2010/D8 (see 5 below).
If, on the other hand, the gain were on capital account, a non-resident entity would not be taxable in Australiaunder the capital gains tax rules unless the target company's assets consisted principally of Australian real property (held directly or indirectly).
TD 2010/20 looks at an example of a structure involving a Dutch holding company, with a newly incorporated Australian subsidiary that acquires all of the shares in Target Co, an Australian manufacturing company. The Dutch company is wholly owned by a Luxembourg entity that is in turn owned by an entity resident in the Cayman Islands, in which US resident investors hold interests and which is controlled by a US private equity group. This has to date been a fairly common structure for private equity investments in Australia. In the example, the primary purpose for acquiring Target Co is to improve its business operations in the short term and then sell the Australian group via an IPO for a price greater than the purchase price.
The TD says there are no commercial reasons for using a Dutch company and a Luxembourg entity in the ownership chain, but there is a tax benefit in having the Dutch company hold the assets rather than the Cayman entity, as the Dutch company is entitled to the benefits of the Dutch/Australian double tax treaty. Therefore, the TD says, in the absence of countervailing commercial reasons for the interposition of Dutch Co and the Luxembourg entity, having regard to the 8 factors in s 177D(b) of the ITAA 1936, it would be concluded that the obtaining of this tax benefit was the dominant purpose of one or more persons who entered into the scheme of interposing these 'conduit entities' to acquire Target Co. Accordingly, Part IVA applies to enable the Commissioner to make a determination to cancel the tax benefit.
The TD notes that no tax would be paid in either the Netherlands or Luxembourg, due to the participation exemption in the Netherlands and various EU directives. The ATO has said this is what concerns them most and that they are 'comfortable' with no tax being payable in Australia under arrangements using investments made directly from treaty countries such as the US, UK and Canada, as long as tax is paid in the entity's or the investor's home country.1 This is reflected in the views in draft TD2010/D8, discussed in 5 below.
Draft TD2010/D7 deals with the source of profits on the sale of shares in an Australian corporate group acquired in an LBO by a foreign private equity fund. It says the source is not dependent solely on where the purchase and sale contracts are executed but rather is to be determined having regard to all the facts and circumstances of the particular case. This is not in itself controversial.
The draft TD uses the example of a limited liability partnership (LLP) in a low tax jurisdiction, which incorporates an Australian Hold Co to acquire all of the shares in Target Co, an Australian manufacturing company. Prior to purchasing the shares, Advice Co, an Australian resident entity controlled by the LLP, undertakes research into Target Co and conducts negotiations in respect of obtaining funding from Australian based lenders for the acquisition. These activities are undertaken by Advice Co in Australia. The LLP later sells Holdco under an IPO and derives a profit. The sale contracts are executed outside Australia. This is not, however, a typical structure. It would in fact be highly unusual for the fund to own or control the manager, which would normally be a separate, unrelated entity (other than being, or being related to, the entity that acts as the general partner of the fund) that provides management and/or investment advisory services to the fund under a service agreement, in return for fees and/or a 'carried interest' in the fund.
The draft TD concludes that, weighing up the various elements that give rise to the profit on sale of the shares in Hold Co, the profit has an Australian source. This it says is because, notwithstanding that the contracts are executed outside Australia, the activities that in substance gave rise to the profit (including obtaining debt funding, researching, selecting and acquiring Target Co and making improvements to enhance its sale value) took place in Australia. It says these are the 'key factors' increasing or impacting on the profit and, if these activities are undertaken in Australia, the source of the profits will be in Australia. The draft TD says the execution of the contracts is simply the act which crystallises the return but does not, in substance, effect the increase in return upon investment.
It is submitted that the views expressed in draft TD2010/D7 are based on a highly selective reading of the case law on source and are inconsistent with the leading cases in Australia, Hong Kong, India and the UK.
Draft TD2010/D8 deals with the application of the business profits article (Article 7) of Australia's double tax treaties to Australian-sourced business profits of a foreign 'limited liability partnership' (LLP) where the partners in the LLP are residents of a country with which Australia has such a tax treaty.
The draft TD says that the Commissioner will give such treaty resident limited partners the benefit of the treaty to the extent that the business profits in question are taxable in the hands of those partners in their country of residence and they meet any other applicable requirements of the treaty (e.g. 'qualified person' requirements). It says the ATO will apply this approach regardless of whether the treaty in question specifically provides for transparent entities.
This is subject to the proviso that the Commissioner must be satisfied that the partners are persons who are residents of the relevant treaty country for the purposes of that treaty. Presumably, a certificate of residence from the tax authority in the investor's country of residence will be sufficient for this purpose.
The views in draft TD2010/D8 are said to be consistent with OECD practice, although they represent a departure from the ATO's practice to date.
The draft TD says a 'limited liability partnership' for this purpose is any entity that is not a resident of Australia and satisfies the definition of 'limited partnership' in the ITAA 1997. That definition refers to 'an association of persons (other than a company) carrying on business as partners or in receipt of income jointly [i.e. a 'partnership' as defined in the ITAA 1936], where the liability of at least one of those persons is limited'. In that case, the draft TD would appear not generally to apply to a corporate entity, such as a limited liability company (LLC), even if it is treated as fiscally transparent in the country of residence of the relevant member.2 There seems no reason in principle why this concession should not extend to fiscally transparent LLCs as well as LLPs.
Further, the proviso in the draft TD would seem to limit its application to LLPs where all of the partners are residents of treaty countries (and can satisfy the Commissioner that they are such residents and are entitled to the benefits of the treaty).
The views in draft TD2010/D8 are welcome. They should also ameliorate the impact of the views in TD2010/20, TD2010/21 and draft TD2010/D7, as discussed above, for LLPs whose partners are resident in treaty countries. However, in practice the proviso may prove a significant limitation on the application of the draft TD, given that it appears that the Commissioner must be satisfied that each of the partners is a resident of a treaty country and entitled to treaty benefits.
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