Allens

Tax

Focus: ATO tax determinations on private equity investments

13 December 2010

In brief: The Australian Taxation Office has recently published four important determinations dealing with the treatment of private equity investments in Australian assets, including a significant acknowledgement that a tax treaty exemption may be available through fiscally transparent investment vehicles. Partner Larry Magid (view CV) and Senior Associate Thomas McAuliffe report.

How does it affect you?

  • The determinations demonstrate that the Australian Taxation Office (the ATO) will be inclined to regard gains realised by non-residents from private equity investments in Australian assets as subject to Australian tax, although ultimately that question will need to be determined having regard to the facts and circumstances of each particular case.
  • Where such a gain would otherwise be subject to Australian tax, the ATO has acknowledged that there may be circumstances in which the derivation of that gain by an interposed entity resident in a tax treaty country may not attract the operation of Part IVA where the ultimate investors themselves are residents of a tax treaty country.

Background

Two of the taxation determinations are final versions of drafts the ATO issued almost a year ago (please see our Client Update):

  • TD 2010/20 (the Part IVA determination) – Income Tax: treaty shopping – can Part IVA of the Income Tax Assessment Act 1936 apply to arrangements designed to alter the intended effect of Australia's International Tax Agreements network? (formerly TD 2009/D17); and
  • TD 2010/21 (the ordinary income determination) – Income Tax: can the profit on the sale of shares in a company group acquired in a leveraged buyout be included in the assessable income of the vendor under subsection 6-5(3) of the Income Tax Assessment Act 1997? (formerly TD 2009/D18).

The other two taxation determinations are drafts containing the ATO's views on issues not previously addressed by TD 2009/D17 or TD 2009/D18:

  • TD 2010/D7 (the source determination) – Income Tax: is 'Australian source(s)' in subsection 6-5(3) of the Income Tax Assessment Act 1997 (Cth) 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 private equity fund?; and
  • TD 2010/D8 (the fiscally transparent entity determination) – Income Tax: does the business profits article (Article 7) of Australia's tax treaties apply 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 entered into a tax treaty and the LLP is treated as fiscally transparent in the country of residence of the partners?

The ATO has invited comments on the source determination and the fiscally transparent entity determination by 28 January 2011.

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The Part IVA determination

The Part IVA determination considers the application of the general anti avoidance provisions to inbound investment schemes involving the interposition of a conduit entity resident in a country with which Australia has a tax treaty, where there are no commercial reasons for this interposition and the tax treaty shelters a gain that would otherwise be taxable in Australia. That is, a scheme involving the interposition of holding companies between an entity resident in a country that does not have a tax treaty with Australia (which we will assume to be the Cayman Islands) and an Australian holding company of the target assets may give rise to a tax benefit for the Cayman Islands entity in respect of an otherwise assessable Australian sourced business profit.

In a significant addition to last year's draft, the Part IVA determination states that a tax benefit may not arise if the Cayman Islands entity is an LLP. In such circumstances, the ATO will generally follow Organisation for Economic Co-operation and Development practice when the limited partners in the LLP are residents of a country with which Australia has a tax treaty and where that country treats the LLP as fiscally transparent for the purposes of its own tax system (this is dealt with in more detail in the fiscally transparent entity determination discussed below). 

In these cases, treaty benefits will be afforded to those limited partners resident in a tax treaty country where that residence can be verified, although there may be practical difficulties in tracing through such LLPs without their co-operation. If the relevant taxpayer is a limited partner resident in a tax treaty country because that country treats the Cayman Islands LLP as fiscally transparent, and that taxpayer would be entitled to relief from Australian tax under that treaty, the interposition of conduit entities located in tax treaty countries between Australia and the Cayman Islands should not give rise to a tax benefit, in which case Part IVA will not apply.

This is an important acknowledgement by the ATO, because it might have treated the transparent entity as the taxable entity and sought to apply Part IVA to the interposition of the treaty resident entity. However, it should be noted that the ATO does not accept, at least in the case of investors in the United States, that the appropriate alternative hypothesis for Part IVA purposes would be a direct investment from the United States in the target assets, rather than via a non-transparent Cayman Islands entity. The reason given is that it is said to be highly unlikely that alternative structures would be used, because of the different US tax consequences that such a direct investment would expose the ultimate investors to. 

The determination does not explain how the Cayman Islands entity would give rise to different US tax consequences if it were regarded as a fiscally transparent entity under US law. The non-acceptance of a direct investment as an alternative hypothesis would also appear to contradict statements ATO officers have made in recent media interviews that they have investigated some of the new arrangements private equity funds are using by investing directly from tax treaty countries such as the US, United Kingdom and Canada, and have been comfortable with them paying no Australian tax, as long as tax was paid in their home country.

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The ordinary income determination

The significance of the question this determination addresses is that if a profit made on the disposal of Australian assets is not ordinary income, then a non-resident would not otherwise be subject to Australian tax on a capital gain from the disposal of those assets if they are not taxable Australian property (ie very broadly, direct and indirect interests in Australian real property).

This determination states that a profit made by a private equity entity resident in a non-tax treaty country from the disposal of shares in an Australian company acquired for the purpose of profit making by sale in a commercial transaction (such as a leveraged buyout with a short to medium term time frame) will constitute ordinary income. The relevant profit-making purpose is that of the non-resident private equity entity itself, not the ultimate non-resident investors that invest in that entity.

Critical to this conclusion is the ATO's understanding of private equity leveraged buyout acquisitions, which is set out in the determination, subject to the caveat that whether the profit from the realisation of private equity assets will be ordinary income will depend on the circumstances of each particular case. This will require a weighing up of the relative importance of each of the factors driving returns, the investment strategy the parties agreed to before acquiring the assets, and the legal form and substance of the arrangements and structures used to implement these strategies.

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The source determination

A gain made by a non-resident investor that is ordinary income (as opposed to a capital gain) will only be subject to Australian tax if that gain has an Australian source. The source determination addresses this question by stating the well-known proposition that the source of income for tax purposes is determined by having regard to all the facts and circumstances of the particular case – it is not dependent solely on where purchase and sale contracts were executed.

The source determination states that there are a number of steps and activities undertaken during a leveraged buyout arrangement, all of which contribute in some way to the realisation of the ultimate profits, including:

  • undertaking preparatory activities, including those pertaining to factors such as assessments of profitability and risk;
  • sourcing and negotiating the funding;
  • executing the purchase and sale contracts;
  • actively managing the investment in the target entity and making operational improvements such as streamlining the target entity's activities and financing to improve the investment return; and
  • undertaking business plan development and management support activities during the period of investment in the target entity.

The source determination states that some of these factors are typically undertaken in conjunction with a local advisory company in Australia that is an associate of the offshore private equity sponsor. 

The ATO states that when determining the source of profits, the relative weight to be given to each element will be a question of fact in every case. However, the Commissioner considers that the key factors increasing or impacting on the profit are:

  • the business ability in assessing suitable target enterprises;
  • the making of operational improvements; and
  • the steps making the acquisition of the business possible (such as arranging finance).

Where these activities are undertaken in Australia, the ATO will regard the source of the profits as being in Australia. The ATO states that it understands these activities are undertaken in Australia in a typical leveraged buyout arrangement. Whether that is in fact the case for a particular leveraged buyout arrangement will depend on a thorough analysis of which entity performs these activities (eg the Australian holding company itself, the Australian advisory company associated with the offshore private equity sponsor, or the offshore private equity sponsor itself), and on whose behalf and where those activities are carried out. As evidentiary matters, some of these may be difficult to prove (or disprove).

Interestingly, the assertion that the question of source is not dependent solely on where purchase and sale contracts were executed is contrary to the position the ATO has taken on trades of ASX-listed shares by offshore hedge funds. The distinction may arise from the comparatively passive nature of investments made by hedge funds, in contrast to private equity leveraged buyout arrangements involving the elements listed above. However, even passive investments involve research and analysis of the performance and prospects of the investee company and market conditions at the time of acquisition, as well as when that investment is reviewed from time to time to ascertain the optimal time for the sale of the relevant shares. Where all such investment and sale analyses and decisions are conducted and made offshore, any resulting gain should arguably be regarded as not having an Australian source, notwithstanding that the share trades are executed on the Australian Securities Exchange.

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The fiscally transparent entity determination

An LLP is generally treated as a company for Australian tax purposes and therefore a taxable entity in its own right. However, as alluded to above in relation to the Part IVA determination, the ATO will recognise limited partners that are resident in a tax treaty country as the relevant taxpayers where the profits of the LLP are liable to tax in the hands of the limited partners under their home country's income tax law because that law (as opposed to Australian law) treats the LLP as fiscally transparent. In those cases, the profits derived by those limited partners through the LLP may qualify for exemption from Australian tax under the relevant tax treaty.

As a practical matter, this will require the LLP's co-operation, and that the limited partners verify their identities and their places of residence. In the absence of such verification, the ATO may seek to collect Australian tax from the relevant profits before they are paid offshore. Where the ATO is subsequently satisfied that the limited partners are resident in a tax treaty country, and that the treaty benefits are available to them, a refund of the Australian tax collected could be sought. Given that that process may involve a significant administrative burden for the relevant limited partners, it would seem to be in the interests of investors resident in a tax treaty country for them, as well as the investment vehicle located in the non-tax treaty country, to co-operate with the ATO to verify their residence and entitlement to the benefits of the relevant treaty before the proceeds from the sale of the Australian assets are remitted offshore.

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Conclusion

Even where a gain made on the sale of Australian assets (that are not taxable Australian property) is considered to be ordinary income with an Australian source, the ability of private equity investors resident in tax treaty countries to obtain relief from Australian tax where their country of residence treats the investment vehicle that would otherwise be subject to Australian tax on the gain as fiscally transparent is an important acknowledgement by the ATO. However, this will necessarily require a degree of co-operation from that investment vehicle and the relevant investors in establishing to the ATO's satisfaction that such treaty relief applies.

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