The Federal Court has concluded that the profit made on disposal of shares in an Australian mining company by a private equity fund, formed as a Cayman Islands Limited Partnership, was not subject to Australian tax1. It found the shares in the Australian company were not taxable Australian property for capital gains tax purposes and the partners in the Limited Partnership who were US residents were entitled to relief from taxation under the double tax agreement between Australia and the US. When the judgment is reduced to these key propositions, it might be surprising that it has garnered so much commentary, some of which arguably reflects misunderstanding. That said, there are some conclusions in the judgment with potential implications for the conduct and management of investments by foreign residents in Australian companies that call for further reflection. Partner Craig Milner reports.
How does it affect you?
- When a foreign limited partnership, such as a Cayman Islands limited partnership (LP), makes a profit on the sale of shares in an Australian company, the LP is not taxable. Further, the limited partners of the LP should not be subject to tax if they are residents of countries with which Australia has a double tax agreement (DTA), provided that the Australian company's assets are not more than 50 per cent attributable to Australian land or mining rights.
- Private equity funds can demonstrate reliance on the Commissioner of Taxation's views in TD 2011/25 (to the same effect as described above) by undertaking action to determine the tax residency of its limited partners and obtaining advice about the application of the Commissioner's views to their circumstances.
- For private equity funds with substantial activities in Australia, including funds with Australian individuals who are directors of portfolio companies and who participate in Investment Committee deliberations and decisions, a profit on the exit from a portfolio investment is likely to have an Australian 'source' and potentially result in tax liabilities for foreign limited partners who are not resident in a DTA country.
- If a taxable gain arises (eg because the shares in an Australian company are taxable Australian property for capital gains tax (CGT) purposes or because the limited partner is not resident in a DTA country), contrary to the understanding in a previous judgment and the practice of the ATO, it may be that the limited partners are taxable, and not the LP itself. Past assessments may need to be reviewed.
Under a scheme of arrangement implemented in March 2013 for the acquisition of Talison Lithium Limited by private Chinese group Chengdu Tianqi Industry Group, two foreign limited partnerships formed under Cayman Islands law, Resource Capital Fund IV LP and Resource Capital Fund V LP (together RCF IV)2 ,made a profit on the disposal of the shares held in Talison Lithium, which at the time was an Australian company with interests in a lithium mine and processing operations in Western Australia and whose shares were listed on the Toronto Stock Exchange.
The Commissioner assessed RCF to tax on the profit by notice of assessment issued in the name of RCF and addressed to the General Partner of RCF. RCF lodged objections to the assessment and commenced proceedings. Subsequently the General Partner of the LP was added as a party to the proceedings.
The proceeding gave rise to the following issues:
- Whether the proper taxpayer was RCF or the partners of RCF.
- Whether the profit on the disposal was ordinary income.
- Whether the profit was derived from an Australian 'source'.
- Whether the DTA allocated taxing rights to Australia.
- Whether the Commissioner's views in TD 2011/25 were applicable and binding.
- Whether the shares in Talison Lithium were 'taxable Australian property' for CGT purposes that were permitted to be taxed by Australia under the DTA.
If the issues seem familiar, it is because the same issues, to a greater or lesser degree, were the subject of earlier proceedings, involving a different fund of the same private equity sponsor, in FCT v Resource Capital Fund III LP  FCAFC 37 (3 April 2014) and FCAFC 54 (2 May 2014) (RCF III).3
In RCF III, the Full Federal Court concluded that:
- The shares sold in the Australian mining company (St Barbra Mines) were taxable Australian property.
- RCF III itself, as a corporate limited partnership under the Income Tax Assessment Act 1936 (Cth), was liable to tax because, simply, RCF was not a US resident and, at :
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.
This conclusion had the further consequence that, at :
Though US law attributes to the partners the liability for any tax payable on the gain made by RCF, Australia attributes the liability for any tax payable to RCF. 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) … .
Leave to appeal the Full Federal Court judgment in RCF III to the High Court was refused.
In RCF IV, Justice Pagone concluded that the profit derived on the sale of the shares in Talison Lithium was not subject to tax in Australia, for various reasons that will be discussed in this article and, in substance, because:
- the shares in Talison Lithium were not 'taxable Australian property' for CGT purposes; and
- the profit on the sale was derived for the purposes of Australian tax law by the partners (and not by the limited partnership itself). As the partners were US residents, they were entitled to relief under the DTA and entitled to rely on the Commissioner's views in TD 2011/25.
At the outset, the conclusion – based on the expert valuation evidence admitted in the proceeding in RCF IV – that the shares in Talison Lithium were not 'taxable Australian property' for CGT purposes is the key distinguishing feature when compared with RCF III and, in our view, ultimately may be the foundation on which the result in RCF IV prevails if any appeal proceeds from Justice Pagone's judgment. Arguably this result would follow notwithstanding the analysis and conclusions of His Honour on the other issues, in respect of which the first issue below is bound to be the most contentious.
The Full Federal Court in RCF III stated early in its judgment that, at :
The analysis must start with a consideration of RCF’s tax status in Australia. RCF is a corporate limited partnership, and in Australia corporate limited partnerships are taxed as companies: s 94H of the Income Tax Assessment Act 1936 (Cth). This means that RCF is a taxable entity for Australian tax purposes and liable for any tax on the capital gain from the share sale.
The reference to 'taxable entity' is not a term with any technical meaning under the tax law of Australia. It might be inferred as a short-hand reference to the legislative provisions in Division 5A of the 1936 Act that certain corporate limited partnerships (which would include RCF) are 'to be treated as companies for tax purposes', though there is no elaboration of the intended meaning of 'taxable entity' when used in the Full Federal Court's judgment in RCF III.
In RCF IV, on the basis of Justice Pagone's finding that, at :
at no stage had it been contended by either party in the RCF III proceedings that Division 5A did not constitute or contemplate RCF III to be a limited partnership able to be taxed as a taxable entity separately from the partners,
His Honour concluded that, at :
from the way in which the issue of RCF III as a taxable entity was considered in RCF III, … the view in RCF III that the partnership in that case was a taxable entity is not binding in these proceedings.
In Justice Pagone's view, it followed that the effect of Division 5A, in its application to a corporate limited partnership, was not to create a new legal person or expressly provide for there to be a new taxable entity and that, at :
The partnership is treated as a company for the purposes of determining how the income tax law is to apply, but the factual and legal reality remains that the partnership is not a company and that any obligations and liabilities must fall upon the individual partners. The context and purpose of s 94V is to ensure that the partners are those who bear the obligations and liability arising from treating the partnership as a company for fiscal purposes.
In the result, Justice Pagone concluded that the questions of 'who has been assessed' and 'who is before the court' should be answered as follows, at :
The assessments and the other procedural steps taken in this proceeding should similarly be understood as assessments to, and as steps undertaken by, the partners by reference to their partnership name. [emphasis added]
Accordingly, the further issues in the proceeding were considered on the basis that the 'partners' were the taxpayers whose assessment and objection thereto were under consideration by the court.
Notwithstanding the reasoning and analysis applied to consider this issue in a way that side-stepped the result in the Full Federal Court in RCF III, the conclusion that a corporate limited partnership cannot be made the subject of an assessment of tax under the tax law will undoubtedly cause difficulties to the way in which the Commissioner has administered the law to date. Whether or not the observation of Justice Pagone that RCF III was conducted on the unchallenged premise of a corporate limited partnership being a 'taxable entity' will be sufficient for a differently constituted bench of the Full Federal Court to agree with him will be a matter to be followed with interest if the Commissioner pursues an appeal.
We include some observations at the end of this article on the potential implications of the conclusion on this first issue.
It is a trite point that the assessable income of a foreign resident includes the ordinary income derived by the foreign resident from all Australian sources (s6-5(3) of the Income Tax Assessment Act 1997 (Cth) (the 1997 Act).
In respect of the profit on the sale of the shares in Talison Lithium, Justice Pagone reviewed the circumstances of the formation of the RCF IV fund and its investment in Australia. Applying the well-established principles from the cases (eg FCT v Myer Emporium Ltd  HCA 18), His Honour concluded that the amounts received by the RCF partners were income according to the ordinary concepts (at ) because, at :
Profitable realisation of the investment by disposal was an objective of the investment by the RCF partnerships from the beginning.
The view that a profit on the disposal of an investment in a portfolio company by a private equity fund is income according to ordinary concepts aligns with the general views of the Commissioner about divestments by private equity funds in Taxation Determination TD 2010/21. In our experience, it is also consistent with the disclosures included by some private equity sponsors in offering documents, such as a private placement memorandum, prepared for the purpose of seeking capital from potential investors in a new fund.
While the conclusion on the second issue accords with the position adopted by some private equity funds, Justice Pagone's conclusion that the profit made by the RCF partners had an 'Australian source' has not been reflected as commonly in the positions adopted by some private equity funds.
His Honour concluded that the ultimate profit from the disposal was part of a business strategy that included 'substantial activity' in Australia (at ). The following factors were influential:
- Talison Lithium was an Australian company and its assets were in Australia, though neither factor alone would be determinative of Australian source;
- moreover, the above matter occasioned substantial activities in Australia that were an integral part of the investment, its management and its ultimate profitable disposal' (at );
- RCF Management Australia maintained an office in Australia from which the investments were managed;
- there were employees living in Australia who played an active role in the management, including the ultimate disposal, of the investment, such as frequently participating from Australia in Investment Committee meetings, preparing the papers for consideration and decision by the Investment Committee and occupying positions on the boards of the Australian investee company; and
- the shares were sold under a scheme of arrangement carried out in Australia, though that factor itself is not determinative.
It is not uncommon for some private equity funds to adopt a view that a profit made on the disposal of an investment in Australian investee company may not have any Australian source if certain actions, particularly associated with the implementation of the sale transaction, occur outside Australia. While each case will depend on its facts, Justice Pagone's conclusion points to an Australian source for a profit made by a private equity fund which manages its investment in a similar way to RCF IV's management of the Talison Lithium investment.
The evidence in the proceeding was that:
- there were 77 limited partners in RCF IV of which 73 were resident in the US (at ); and
- there were 137 limited partners in RCF V of which 130 were resident in the US (at ).
Based on the conclusion in respect of the first issue that the partners are the relevant persons which derived the income on the sale of the shares, in our view, the application of the DTA was determined under a conventional application of the business profits article (Article 7), at :
The application of Article 7(1) requires identification of the business profits of an enterprise. In the present case the enterprises in question are the partners to the RCF [partnership]. … The partners of [the partnerships] carried on an enterprise in that sense by their activities as partners in those partnerships. The relief from taxation provided by Article 7 extends to an “enterprise of a Contracting State”. The enterprise able to seek relief under Article 7 is the activity of the partners constituting the [RCF] partnerships and, accordingly, the partners of each of the [RCF] partnerships are able to claim relief under Article 7 of the United States Convention. Neither [RCF] partnership is a separate taxable entity to be taxed separately from the partners and their agents. The taxable activity in each case was an investment in Talison Minerals and Talison Lithium which was carried out on their behalf by their respective General Partners.
In relation to an interpretative issue about whether a 'partnership' is a 'person' that could be a US resident under the DTA, Justice Pagone said, at :
Article 4 does not provide, and does not warrant a construction, that a partnership should be treated as a separate person with a separate residence. … The terms of Article 4(1)(b)(iii) do not suggest that a partnership was intended to be included as a person separate from, and in addition to, the partners who comprised it … .
Accordingly, His Honour concluded that the US resident partners in the RCF partnership were entitled to relief under Article 7(1) of the DTA, unless another provision of the DTA gave taxing rights to Australia (see the sixth issue below).
In TD 2011/25, the Commissioner answers 'yes' to the question of whether Article 7 of Australia's tax treaties apply to Australian sourced business profits of a foreign limited partnership where the LP is treated as fiscally transparent in a country with which Australia has concluded a double tax treaty and the partners in the LP are residents of that country. The Ruling section of TD 2011/25 contains an example of a US resident partner in a Cayman Islands Limited Partnership. The views in TD 2011/25 will be familiar to private equity funds and investors.
Evidence in the RCF IV proceeding established that the person in the role of 'Vice President-Legal' for RCF in Australia was acutely aware of TD 2011/25 and sought external tax advice. RCF also undertook work to substantiate the residency of its limited partners and obtained expert advice on the best process for doing so – in reliance on statements made by partners in completing IRS issued 'W' forms – with a view to applying the views in TD 2011/25.
Subject to the sixth issue, and subject to contrary arguments by the Commissioner (which were tied to the sixth issue), Justice Pagone comfortably concluded that the Ruling in TD 2011/25:
 binds the way in which the Commissioner is to apply the legislation, namely, to grant relief under Article 7 of the United States Convention to the partners of the RCF IV and RCF V partnerships unless the profit from the disposal of the shares and interests is to be assessed under Article 13 by reason of Article 7(6).
Sixth issue: whether the shares in Talison Lithium were 'taxable Australian property' for CGT purposes
Article 13 of the DTA permits Australia to tax US residents on income or gains from the alienation of or disposition of real property in Australia. The definition of real property includes shares in a company whose assets consist wholly or principally of real property in Australia.
After analysing the interpretative issues about Article 13 of the DTA, Justice Pagone concluded:
- real property for the purposes of all items in Article 13 includes 'rights to exploit or to explore for natural resources' (at );
- Article 13, as extended in operation by s3A(2) of the International Tax Agreements Act 1953 (Cth), contemplated taxing rights for Australia in respect of capital gains from the sale of shares in a company the value of whose assets is wholly or principally attributable, whether directly, or indirectly through one or more interposed companies or other entities, to real property or interests; and
- Article 13, as extended in operation by s3A(2) above, is 'broad enough to encompass the tax effected' (at ) on a capital gain from a CGT event in relation to a CGT asset that is 'taxable Australian property', for the purposes of Division 855 of the 1997 Act.
Accordingly, the sixth issue boiled down to whether or not the shares in Talison Lithium were 'taxable Australian property' for the purposes of Division 855. Relevantly, this definition includes an Australian mining, quarrying or prospecting right (s855-20) and includes the shares in a company whose taxable Australian real property (including mining rights) is more than 50 per cent of the market value of all its assets if the shareholding of the taxpayer is 10 per cent or more.
In the longest part of the judgment, Justice Pagone sets out the various expert valuation evidence that was relevant to determining this question. It is beyond the scope of this article to consider this evidence in any detail. Essentially, His Honour drew a distinction between assets that were 'taxable Australian real property' (TARP) on the basis of mining or 'downstream' operations and assets that were non-TARP on the basis of post-extraction or 'upstream' operations.
Having regard to the classic Spencer test, Justice Pagone preferred the evidence of the expert whose valuation was based on a methodology that more appropriately allocated value between these two asset classes. On the valuation preferred by Justice Pagone, the TARP assets were 46.5 per cent or 34.0 per cent (depending on alternative assumptions) of the total market value of all assets and, as such, the shares were not taxable Australian property for the purposes of Division 855.
As is evident from the above survey of the various issues in the judgment, there is a lot of ground to cover and not all of it is covered on paths travelled by the courts before. Possibly for this reason, and as happens from time to time with tax cases, the RCF IV judgment caught the attention of the media and attracted some excited commentary (for example, see 'Private Equity shaken by shock tax verdict', The Australian Financial Review, 12 February 2018.)
With the benefit of further time for reflection, we consider that the RCF IV judgment should be viewed principally through the prism of Justice Pagone's conclusions on the sixth issue. This conclusion provides the critical distinction between the outcome in RCF IV and RCF III. Based on His Honour's finding that the shares in Talison Lithium are not taxable Australian property for CGT purposes, the result that the profit on sale was not taxable is not surprising. Whether this conclusion is reached by way of reasoning that the partners are the relevant taxpayers (as Justice Pagone concluded, differently to the position in RCF III) or that the Commissioner is bound by his views in TD 2011/25 is probably neither here nor there in the final result. In this regard, if it was determined conclusively as a preliminary issue that the shares in Talison Lithium were not taxable Australian property in circumstances where the relevant taxpayer was a US resident, it would seem unlikely that the Commissioner would take the case any further, based on his published views in TD 2011/25.
Where that leaves us now is a matter that may be speculated on with some interest:
- Public ruling: The potential for the judgment to be interpreted as Justice Pagone concluding that the Commissioner has not applied the views in his ruling to relevant facts may place pressure on the Commissioner, particularly from a reputational perspective, to appeal the judgment specifically to address this point.
- Tax status of a CLP: Although it is not critical to the result in the proceeding, the conclusion on the first issue – that the rules in Division 5A of the 1936 Act do not result in taxation of the corporate limited partnership – are probably the most problematic from the perspective of certainty about the application and administration of the tax law. At a time when both taxpayers and the Commissioner are still grappling with the implications for the Single Entity Rule of the decision in Channel Pastoral Holdings Pty Ltd v Commissioner of Taxation  FCAFC 57, in RCF IV, Justice Pagone demonstrates once again the difficulties that can arise when the legislation relies upon statutory fictions. That said, if Justice Pagone's conclusion is correct:
- In circumstances where a capital gain is made on disposal of a CGT asset by a corporate limited partnership, and the relevant CGT asset is taxable Australian property, the Commissioner's apparent practice of assessing the limited partnership (presumably by issuing the assessment to the GP) would be contrary to law. The limited partners should be assessed to tax, which may not align with the management and discharge of obligations under a Limited Partnership Agreement and practices of private equity funds, which would usually contemplate the GP discharging tax obligations on source income of the fund.
- In circumstances where the sale of a CGT asset results in ordinary income of a corporate limited partnership, and there are foreign limited partners resident in non-treaty countries, again, the limited partner should be assessed to tax and the same concern as stated above would arise.
- Assessments issued in the past on the basis of the corporate limited partnership (or GP) being taxable would be contrary to law and should be capable of being set aside on objection and, if necessary, appeal, though there would be interesting issues regarding assessments that ordinarily would be out of time for objection.
- For Australian resident corporate limited partnerships, it is unclear how the deeming provision for dividends in s94L of the 1936 Act can operate, assuming as it apparently does, that the distribution of profit can constitute the payment of a dividend by a corporate limited partnership to a partner. On a related point, it is unclear how a corporate limited partnership could operate a franking account or frank a distribution if it is not a taxable entity, being matters assumed to be capable of a corporate tax entity within the meaning of s960-115 of the 1997 Act.
- The non-portfolio interest test for TAP: Another matter of interest arises under Justice Pagone's views about looking through the corporate limited partnership to the limited partners. If it is correct to look through the Cayman Islands LP in RCF IV, then assuming (contrary to the actual finding) that the assets of Talison Lithium were more than 50 per cent attributable to taxable Australian real property, it raises an issue that is not resolved in the judgment. The shares would only be taxable Australian property if, in addition to passing the principal asset test, they pass the non-portfolio interest test which relevantly requires that the relevant person holds a 10 per cent or greater shareholding, on an associate inclusive basis. In RCF IV, at , it was:
accepted, and it was common ground, that they passed the nonportfolio interest test in s 960-195 for the purposes of s 855-25(1)(a) because, at the relevant time, the partners in RCF IV held 23.1% of the ordinary shares in Talison Lithium and the partners in RCF V held 13.1% of the ordinary shares in Talison Lithium. The direct participation interest of each therefore exceeded the prescribed 10% referred to in s 960-195..
If it is correct to identify the limited partner itself as making the capital gain, it would seem relevant to test the non-portfolio status of the shareholding at the level of the individual partner. Based on the large number of limited partners in each of RCF IV and RCF V, it seems unlikely that any single limited partner would hold a 10 per cent or more interest in Talison Lithium. Then, it would be an issue of whether each limited partner would be an 'associate' of each other. The critical test is in s318 of the 1936 Act, which contains different rules for testing associates in the context of a 'company' and a 'partnership'.
In summary, a shareholder of a company is not necessarily an associate of each other shareholder of the same company but a partner generally would be an associate of each other partner in the partnership. Under Division 5A of the 1936 Act, a reference to a company includes a reference to a corporate limited partnership (s94J) and a reference to a partnership does not include a corporate limited partnership (s94K). A reference in the income tax law to a shareholder includes a reference to a partner in a corporate limited partnership (s94Q). The question of which associate test – company or partnership – to apply to the partners of a corporate limited partnership may be an issue for another day.
- Resource Capital Fund IV LP v FCT  FCA 41 (5 February 2018) (RCF IV).
- We use 'RCF IV' to distinguish from the previous proceeding involving 'RCF III', as described below.
- See our previous Focus: Capital gains tax and foreign partnerships on the judgment at first instance, a judgment that was subsequently overturned in the Full Federal Court.