Australia's domestic laws limit the liability of foreign residents to Australian capital gains tax (CGT) to instances involving direct and indirect interests in land – but what is "land"? A recent landmark decision in the Federal Court has held that "land" does not encompass more than has previously been thought, which will have important implications for anyone investing in Australian assets, particularly in the energy and resources sector. This decision is relevant for non resident multinational and private equity investors alike. (Commissioner of Taxation v Resource Capital Fund III [2013] FCA 363; Clayton Utz acted for the successful taxpayer).
The decision also gives important guidance in the operation of double taxation treaties;and the fiscal transparency of foreign limited partnerships.
Background and Division 855
Broadly, the Australian income tax system taxes Australian residents and non-resident recipients of Australian-sourced income. Fortunately for foreign residents who own Australian property, the CGT regime limits the taxation of foreign residents to gains derived from "CGT events" happening to "CGT assets" that are, by-and-large, interests in real property (that is, land).
These rules (in Division 855 of the Income Tax Assessment Act 1997) do this by providing that only CGT assets that are "taxable Australian property" give rise to a CGT liability for foreign residents. "Taxable Australian property" broadly translates into land (a definition which includes leases and mining tenements) but also includes non-portfolio shares or units held in companies and trusts that themselves own land, where the sum of the market values of the various Australian "land" assets of the company or trust exceeds the sum of the market values of the discrete "non-land" (or non-Australian land) assets (referred to in the Act as "TARP" and "non-TARP" assets respectively (for "Taxable Australian Real Property")).
Division 855 was enacted in 2006, replacing (former) Division 136, effectively narrowing the CGT exposure of foreign residents (Division 136 contained a greater category of assets which were "caught" than does Division 855) and follows Recommendation 21.7 of the Ralph Review, which called for legislation dealing with the avoidance of Australian CGT by foreign residents, who would dispose of interposed entities holding Australian assets rather than the assets themselves.
It is notable (in light of the recent developments alluded to below) that in making the recommendation, the Review emphasised that the focus was on countering avoidance arrangements rather than on penalising commercial transactions. Indeed, section 855-5 of the Act states that one of the objects of the rules is "to improve Australia's status as an attractive place for business and investment".
The ATO's view of what sorts of gains come within the ambit of Division 855 appear to have developed considerably in recent times.
When is land "land"?
In 2010 the Federal Court granted the ATO's requested orders freezing the Australian assets of Resource Capital Fund III LP (RCF), on the basis that RCF had derived income in Australia in the 2007 and 2008 income years in the order of some $58 million.
The basis of the ATO's claim was RCF's acquisition and disposal of 100 million shares in St Barbara Mines Ltd, a company which, the ATO argued, satisfied the test to be an "indirect Australian real property interest" (in other words, a TARP or "land" asset).
The taxpayer disagreed. RCF argued that its shares in St Barbara were not TARP because the sum of the market value of St Barbara's assets that were not real property exceeded the sum of the market value of assets that were real property.
The Commissioner, conversely, argued that a majority of the market value of St Barbara's assets were based in real property.
St Barbara Mine's shares are not a "land" interest
Justice Edmonds agreed with RCF's analysis that the shares in St Barbara were not an "indirect Australian real property interest."
More generally, Justice Edmonds' judgment is useful in illuminating the method of valuation for the purposes of Division 855, following on from the law surrounding the valuation of such things as mining information and goodwill expounded in the decisions (in the context of stamp duty) of Nischu and Alcan cases.
Relevant entity under the double taxation treaty
As a limited partnership established under Cayman Island Law consisting almost entirely of partners resident in the USA, RCF argued that pursuant to the US/Australia international tax treaty for the avoidance of double taxation (DTA), any tax on the transaction is payable by its partners in the USA.
In any event, consistent with the DTA, RCF argued that the ATO should not have assessed the Limited Partnership as the relevant entity; instead, the ATO should have applied the DTA at the level of the partners.
Justice Edmonds held that the limited partnership is fiscally transparent in Australia and the ATO could not issue assessments to it.
Recent developments - cause for concern?
This decision has to be seen in the context of the ATO's willingness to seek orders freezing the Australian assets of a foreign entity on the basis of a capital gain arising from the entity's disposal of shares, claiming that a majority of the market value of the company's assets stem from "land" interests (FCT v Regent Pacific Group Limited & Ors [2013] FCA 36, 23 January 2013).
Under the Federal Court Rules, the Court may make a freezing order if it thinks a debt will be unsatisfied because the assets of the debtor (or another person) will either be removed from Australia or disposed of, dealt with or diminished in value.
Such an order can be made even though there is no positive intention to remove assets from Australia and the debt is not yet due. In Regent Pacific, for example, the debt was not payable for some 11 months.
A freezing order, like the garnishee and security procedures, does, however, require a "debt". This may explain the ATO's apparent move towards an "assess first, ask questions later" approach – establish a debt well before any payment liability would arise and then obtain a freeze of the assets in Australia.
Foreign investors are accordingly at risk of being dealt with differently from their Australian registered peers – having debts established before the end of the tax year and being subjected to extreme orders freezing their assets, demanding third parties to pay over funds realised from sale of assets or coming under an obligation to provide securities that no Australia company would ever be asked to provide in favour of the Commissioner.
It will also be interesting to see if the Commissioner appeals the decision. If not it is likely the decision will cause the Commissioner to take a different approach on whether such transactions represent a "land" interest thus affecting his ability to issue special assessments and seek freezing orders or issue security or garnishee notices.
What can / should you do?
These developments are worrying for foreign taxpayers who maintain "non-portfolio" interests (ie. greater than 10%) in companies or trusts which hold "land" assets, where the market value of the "land" assets is approaching (even moderately) the market value of the "non-land" assets.
In these circumstances, where a disposal of interests is contemplated (or even a possibility) foreign investors should:
- assume that the ATO will be aware of the transaction and contact advisors about the possibility of liaising with the ATO prior to entering into it; and
- engage with the (Australian) entity about the possibility of accessing information enabling the investor to ascertain market values of "land" and "non-land" assets to substantiate its own position.
Australian entities the subject of changes in interests held by non-portfolio interest-holders should be aware of the possibility of their assets being subject to a valuation process and develop strategies to manage confidential material, while being mindful of their legal obligations to provide such information.
Establishing the relevant taxable entity under Australian DTAs in the context of private equity limited partnerships has proved problematic. This decision clarifies the fiscal transparency of limited partnerships and the position of partners resident in treaty countries.
Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this bulletin. Persons listed may not be admitted in all states and territories.
