On 3 April 2014, the Full Federal Court handed down its decision in Commissioner of Taxation v Resource Capital Fund III (RCF), L.P. [2014] FCAFC 37, allowing the Commissioner's appeal against the decision of Edmonds J at first instance1. Edmonds J held that RCF, a Cayman Islands limited partnership (LP), in which 97% of the partnership interests were held by residents of the United States (US) and which was managed by a US limited liability company, was not subject to Australian capital gains tax (CGT) on a gain arising on the sale of shares in Santa Barbara Mines Limited (SBM), an Australian listed company with gold mining operations in Western Australia.
The Full Federal Court2 held as follows:
In relation to the Treaty Issue, the Full Court said it may be open to the US partners to argue that they should obtain the benefits of the DTA on the basis that it may be appropriate for Australia to view the gain as derived by the partners and apply the DTA accordingly. However, their Honours declined to express a view on this. Such an approach would be consistent with the Commissioner's views in TD 2011/25 in relation to Article 7 (the business profits article), even though the Full Court said this ruling could not be binding in relation to Article 13. It is noted that Article 13 would permit Australia to tax the US resident partners.
In rejecting RCF's submissions that TD 2011/25 was binding in this case, the Full Court also pointed out that the taxpayer must show they had acted in reliance on the ruling.
If the capital gain were taxed in the hands of the partners, certain issues arise, including the application of the 'non-portfolio interest test', the treatment of partners that are tax exempt or foreign sovereign entities and partners that are not treaty country residents.
The TARP Issue may have less future significance, given the proposed amendment to treat intangible assets such as mining information and goodwill as part of the mining tenements (and therefore TARP) for the purposes of the principal asset test. Tangible assets such as plant and equipment will presumably remain non-TARP for this purpose.
At first instance, Edmonds J held as follows:
The Full Federal Court disagreed with Edmonds J on both issues.
The Full Court held there was no inconsistency between Article 13 of the DTA and the Assessment Act for the purpose of s 4(2) of the Agreements Act, saying that any disconformity in the tax treatment arose because of differences between US and Australian domestic tax law - that is, the US treats the LP as fiscally transparent and taxes the partners, while Australia treats the LP as a taxable entity, as if it were a company.
Edmonds J had held that, as RCF was a fiscally transparent entity in the US, it was not a resident of the US for US tax purposes or the DTA. His Honour accepted RCF's argument that Article 13 did not authorise Australia to tax the capital gain to RCF, on the basis that it only authorised Australia to tax such gains to a US resident. He rejected the Commissioner's argument that, as Article 13(7) states that, except as provided in the previous paragraphs of Article 13, Australia or the US (as applicable) can tax capital gains in accordance with its domestic law and as the DTA granted primary taxing rights to Australia as the source country, that was the end of the matter. His Honour accepted RCF's argument that the gain was derived by the US partners, not RCF.
The Full Court held (with respect, correctly) that Edmonds J had erred in construing Article 13 as containing the negative implication that, in the case of an LP treated as fiscally transparent in the country of residence, the source State is precluded from taxing the LP and is only permitted to tax the partners. The Full Court said the paragraphs of the OECD Commentary on which his Honour relied did not support this conclusion. Rather, their Honours said, the Commentary says the DTA does not apply to an LP that is not a resident of either country (as in the case of RCF)6 and simply expresses the principle that the source State should take into account the way in which the income is taxed in the State of residence of a person (such as a partner) seeking the benefit of the DTA and that, where income has flowed through a transparent partnership to the partners, who are liable for tax on it their State of residence, the income is appropriately viewed as being paid to or derived by the partners. They said the Commentary is about the application of the DTA, not its terms - that is, if a source State does not accept that that the LP qualifies as a resident of the other State because it is not liable to tax and the partners are liable to tax in that State, then the source State is expected to treat the partners as if they earned the income directly for the purposes of the DTA.
Their Honours concluded that:7
RCF is an independent taxable entity in Australia and liable to tax on Australian sourced income and the DTA does not gainsay RCF's liability to tax … there is no inconsistency between the DTA and the provisions of the Assessment Act with respect to the tax treatment of RCF.
They went on to say:8
It may be open to argument by the US partners that they should obtain the benefits of the DTA on the basis that it was appropriate for Australia to view the gain as derived by the partners resident in the US, and to apply the provisions of the DTA accordingly, as discussed in the OECD commentary (about which we express no view) but that consideration is a separate issue to the question of whether the effect of provisions of the DTA was to allocate the liability differently to the Assessment Act … it follows therefore that the assessment was not precluded by s 4(2) of the Agreements Act. [emphasis added]
If this argument were accepted, the outcome would be that Article 13 would permit Australia to tax the US resident partners (as Edmonds J contemplated)9 and the question would then be whether the gain would be taxable to the partners under Division 855 in view of the 'non-portfolio interest test' (as discussed further below under 'Taxing the gain to the partners'). It appears that Edmonds J contemplated that the gain would be subject to Australian tax in their hands.
The Full Court also rejected RCF's argument that the Commissioner was precluded from assessing RCF because of TD 2011/25, in which the Commissioner ruled that, where partners in an LP are residents of a treaty country, they are entitled to the benefits of Article 7 of the relevant DTA in respect of their share of the partnership income or gains and such income or gains will not, to that extent, be taxed to the LP. The Full Court said this ruling was not relevant as it deals with Article 7 and not Article 13.
The Full Court also noted that a ruling can only be binding with respect to a taxpayer if the taxpayer can show they acted in reliance on the ruling.
The TARP Issue involved the question of whether (as held by Edmonds J) the principal asset test in s 855-30(2) requires the separate determination of the market value of each of the entity's assets (or of all of the TARP assets as a class and all of the market value), as opposed to the market value of all its assets on a going concern basis.
The 3 assets considered in the case were:
At first instance, Edmonds J said that, in assessing the market value of these assets, each had to be valued separately as if they were the only asset offered for sale. His Honour also said that the test for determining market value10 (i.e.by reference to what a hypothetical willing but not anxious purchaser would be prepared to pay and a hypothetical willing but not anxious seller would be prepared to accept for the asset) required the assumption that the purchaser would be able to use the assets in a manner consistent with their 'highest and best use'11 (in this case, in the business of mining the reserves in SBM's tenements), which for mining information and plant means it must be assumed that the hypothetical purchaser owns the mining rights, so as to be able to best use those assets.
His Honour therefore valued the mining information and plant and equipment by reference to the discounted cash flow (DCF) of SBM's mining operations, minus the cost (time delay and outlay cost) of recreating the information or replacing the plant and equipment, which assets are assumed not to be owned by the hypothetical purchaser (who, as noted, is assumed to already own the mining rights) and notto be otherwise available for purchase.
The Full Court disagreed with his Honour's conclusion that the assets had to be valued separately, on the assumption (in the case of mining information and plant) that the hypothetical purchaser already owned the relevant mining rights, and upheld the Commissioner's contention that the assets had to be valued on the basis of a simultaneous sale of SBM's assets to the same hypothetical purchaser.
In reaching this conclusion, the Full Court had regard to the language and statutory context of s 855-30(2) and the purpose for which the market values were to be determined, namely 'to determine where the underlying value resides in SBM's bundle of assets'.12 On that basis, the Court held the market values of the individual assets in that bundle were to be ascertained as if they were offered for sale as a bundle, rather than on a stand-alone basis as separate sales. Their Honours noted that all the valuation experts had agreed that, in the case of a simultaneous sale to one purchaser, the purchaser could expect to acquire the mining information and plant for less than their recreation cost and with little or no delay.
On the basis of their reasons and the parties' submissions, the Full Court noted that it appeared the Commissioner would be successful on this issue but gave the parties time to consider the reasons and indicate whether any issue remained to be determined concerning the calculations.
The Full Court did not refer to Article 4(1)(b)(iii) of the Australia/US DTA, which deals specifically with transparent entities, providing that, in relation to any income derived by a partnership, the partnership shall not be treated as a resident of the US except to the extent that the income is subject to US tax, either in its hands or in the hands of a partner. Presumably, this would not have affected the Court's decision.
Edmonds J did, on the other hand, deal with this Article.13
His Honour rejected the Commissioner's argument that Article 4(1)(b)(iii) did not require that the partnership must be recognised by the US as a resident separate from the requirement that the income of the partnership must be taxed in the hands of a US resident partner. Rather, he accepted RCF's argument that Article 4(1)(b)(iii) did not apply to it because it was not a US resident partnership, as it was organised under the laws of the Cayman Islands and, analogously with the US test of residence for corporations (which is based on where the corporation is organised), was therefore not a US resident for US tax purposes.
As noted, the Full Court said it may be open to the US partners to argue that they should obtain the benefits of the DTA on the basis that it may be appropriate for Australia to view the gain as derived by the partners and apply the DTA accordingly. However, the Court declined to express a view on this.
It is submitted that such an approach would be consistent with the Commissioner's views in TD 2011/25 in relation to Article 7, even though the Full Court said this ruling could not be binding in relation to Article 13. Arguably, however, there is no basis for distinguishing between Article 7 and Article 13 in this regard.
If the capital gain were taxed in the hands of the partners, certain issues arise, as discussed below.
One question that arises if the gain falls to be taxed to the US resident partners is whether the shares would be TAP for such a partner, so as to be subject to Australian CGT.
For shares to be TAP, in addition to the 'principal asset test', the 'non-portfolio interest test' must be satisfied. This requires that the taxpayer, either alone or together with 'associates', holds (or has rights to acquire) 10% or more of the shares in the company.
As no single partner of RCF would have held 10% or more of the shares in SBM, this test would most likely only be satisfied if the partners were deemed to be 'associates' of one another. While partners in a partnership are 'associates' under the Assessment Act, shareholders in a company are not. As the LP is deemed to be a company, and the partners to be shareholders, under the Assessment Act (ignoring the DTA), arguably the partners would not be 'associates' and therefore would not satisfy the non-portfolio interest test. It is not clear, however, whether this is affected if the LP is treated as a look-through partnership for the purposes of the DTA.14
If the partners were subject to tax on the gain, again consistently with TD 2011/25, a treaty resident partner that is tax exempt for Australian tax purposes would obtain the benefit of that exemption. In relation to foreign sovereign investors, however, it is not entirely clear whether the Commissioner accepts the sovereign immunity principle applies in relation to a partner in an LP.15
If any of the US resident partners were subject to US tax on their share of the LP's gain, double taxation would result if the US does not allow the partners credit for the Australian tax paid by RCF.16
In that case, the US partners may have recourse to the mutual agreement procedure (MAP) under Article 24(1)(a) of the DTA (if it is within the 3-year time limit), which would provide for them to present their case to the US competent authority (i.e. the IRS) on the basis that they have been subject to tax that is not in accordance with the DTA. In that case, the IRS could seek to reach agreement with the ATO to prevent the double taxation.
Where any partner is not a resident of a country with which Australia has a DTA, presumably the LP would be taxed on any share of a capital gain to which such a partner is entitled, in accordance with the Commissioner's views in TR 2011/25.17 In that case, for the purpose of the non-portfolio interest test, presumably the LP's total shareholding interest would be taken into account (rather than just the interest held in respect of the non-treaty partners).
In the 2013-14 Federal Budget, the former Federal Government announced proposed changes to (among other things) the principal asset test in Division 855, presumably in response to the first instance decision in RCF. Those changes were proposed to apply from 1 July 2016.
In particular, for the purpose of the principal asset test, intangible assets connected to mining, quarrying or prospecting rights (which are TARP) - notably mining, quarrying or prospecting information and goodwill - will be treated as part of the rights to which they relate (and therefore as TARP). It does not appear that this will apply to tangible assets such as plant and equipment.
The following changes were also announced in the 2013-14 Budget (also to apply from 1 July 2016):
The current Federal Government has said it will proceed with these proposed changes.
Conclusion
The TARP Issue may have more limited ongoing significance in light of the proposed changes to the principal asset test referred to above, if enacted.
However, the Full Federal Court's decision in relation to the Treaty Issue could create considerable uncertainty for foreign investors investing in Australian assets through foreign LPs (particularly capital investments in mining or other land-rich companies). While there may have been some flaws in the judgment at first instance on this Issue, the outcome under that decision did make some practical sense.
The potentially significant implications of the decision on the Treaty Issue may be relevant for RCF in deciding whether to seek special leave to appeal to the High Court.
1 In Resource Capital Fund III, L.P. v Commissioner of Taxation [2013] FCA 363. Readers are also referred to earlier articles by this author on that decision.
2 Middleton, Robertson and Davies, JJ
3 That is, the Income Tax Assessment Act 1936(Cth) and the Income Tax Assessment Act 1997(Cth) (together the Assessment Act).
4 That is, the International Tax Agreements Act 1953(Cth) (Agreements Act), which enacts the DTAs into Australian law and is to be read with the Assessment Acts (see below).
5 As the Treaty Issue was the ratioof his Honour's decision, it was not strictly necessary to decide the TARP Issue (although, with respect, arguably the TARP Issue is the primary issue as the Treaty Issue is only relevant if the gain is otherwise taxable under the Assessment Act).
6 While the Commissioner had argued at first instance that RCF was a US resident for the purposes of the DTA, he accepted for the purposes of the appeal that it was not a US resident.
7 At paragraph 29 of the judgment.
8 Paragraphs 29-30.
9 See last paragraph at [69] of Edmonds J's judgment.
10 As laid down in Spencer v Commonwealth(1907) 5 CLR 418 (Spencer)
11 Based on the approach in Commissioner of State Taxation (WA) v Nischu Pty Ltd(1991) 4 WAR 437 (Nischu). This case dealt with whether the sale of shares in a company that had an interest in a mining joint venture attracted stamp duty because the value of the mining tenement was 80% of the value of all of its property. The company's other assets were documents and other chattels that contained the mining information, which the WA Court of Appeal said did not form part of the value of the mining tenements. The Court therefore held the tenements were to be valued by deducting the value of all the company's property the cost of reproducing the information, including the lost cash flow for the 2 years it would take to do so. The Full Federal Court in RCFheld that Nischuwas distinguishable because it concerned a different statutory scheme, requiring the valuation of the tenements alone, whereas s 855-30(2) of the Assessment Act, based on its statutory context and purpose, requires the valuation of allthe company's assets on the basis of a simultaneous sale to a single purchaser.
12 Paragraph 51.
13 At paragraphs [55] to [60] of his Honour's judgment.
14 As noted below (see footnote 16), it appears that Edmonds J contemplated that the US partners would be subject to Australian tax on the gain in their hands, although he may not have considered the application of this test.
15 See ATO response to issue 4 in TD 2011/25EC.
16 It is clear that an important consideration in Edmonds J's decision was that the DTA's objective of preventing double taxation of the capital gains would not be achieved if Australia was authorised under Article 13 to tax the gain to the LP, as the US resident partners would be liable to US tax on the capital gain without credit for the Australian tax, which would be avoided if the gain were taxed in the hands of the partners, who could then rely on Article 22(1) to obtain credit in the US for the Australian tax payable by them (see last paragraph of [69] of the judgment). However, this assumes that the partners were actually subject to US tax, which some or all of them may not have been, as they may be tax exempt in the US.
17 As noted, only 97% of the partners of RCF were US residents - it is not clear what the status of the other 3% of partners was. Edmonds J nevertheless held, in relation to the Treaty Issue (which was the ratiofor his Honour's decision), that RCF was not taxable on anyof the capital gain, without adverting to the 3% interest of the non-US partners.
18 Under s 260-5 of Schedule 1 to the Taxation Administration Act 1953(Cth) and s 255 of the Administration Act, respectively.
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