Many participants in the New Zealand private equity market will have been aware of the brouhaha across the Tasman last year when the Australian Taxation Office (ATO) asserted that A$452M of Australian tax was owed on the sale of shares in Myer Group by a fund managed by TPG.
The latest chapter in the saga contains some interesting reading on cross-border issues, but little of note on the capital/revenue distinction.
Final and draft determinations
Early this month, the ATO released two final and two draft determinations on private equity taxation issues, all of which are relevant to TPG's sale of its Myer stake.
- TD 2010/21 rules that the profit on sale of shares in a company acquired in an LBO can be income under ordinary principles.
- TD 2010/20 rules that the Australian anti-avoidance provision can over-ride a claim to tax treaty benefits, where a treaty country resident is inserted in an ownership chain for no reason other than to obtain those benefits.
- TD 2010/D7 rules that a gain on sale of an Australian company can have an Australian source (and therefore be subject to Australian tax in the hands of a non-resident) even where the contracts to sell the company are entered into outside Australia.
- TD 2010/D8 deals with the granting of treaty benefits to non-residents who hold interests in Australian assets through limited liability partnerships (LLPs).
Capital/revenue issue
TD 2010/21 gives two examples of sales of shares. In the first, which is no doubt intended to bear a strong resemblance to the Myer facts, the gain is taxable. In the second, it is not.
FIRST EXAMPLE: GAIN IS ORDINARY INCOME
The first example involves a PE fund undertaking an LBO of an Australian public company with the intention of taking the company private, restructuring it, and then refloating it within three years. During the restructuring period the investment will generate low or negative returns because of interest costs and management expenses.
The ATO concludes that the gain on the refloating of the company by the PE fund is ordinary income. Given that the example assumes an intention to re-sell within three years, and no or negative returns until re-sale, it would have been staggering had the ATO reached any other conclusion. On the facts set out in the example, it would be difficult for even the most optimistic manager to find a reason to come to a different view in New Zealand. Of course, the facts will often be quite different.
SECOND EXAMPLE: CAPITAL GAIN
The second example is perhaps more interesting. It involves an investment trust whose members are mostly superannuation and pension funds. It acquires a controlling interest in an Australian infrastructure holding entity. The trust is open ended. It does not directly participate in the management of the infrastructure entity. There is no pre-conceived plan to sell the investment. However, after a period of time not specified in the example, the investment trust sells its interest to meet redemptions and in recognition of the increase in the cost of capital as a result of the GFC. In this case, the ATO concludes that the gain is on capital account.
The treatment of gains in the kind of situation referred to in this second example was a topic of uncertainty in New Zealand for some years. Under pressure from the IRD, many unit trusts took the conservative position that all equity gains were on revenue account, other than for passive funds. The position was clarified for most unit trusts by the introduction in 2007 of the PIE regime and the new FIF regime, which provide rules that are not dependent on individual facts and circumstances.
Cross-border issues
The examples discussed above both involve offshore funds, and therefore raise issues as to the applicability of tax treaties. Such issues are considered both in TD 2010/20, and in the other final and draft rulings released at the same time.
SOURCE OF GAINS
Non-residents are only subject to Australian tax on Australian sourced income. This raises the question of when gain from selling shares in an Australian company is Australian sourced.
TD 2010/D7 considers the example of an LBO acquisition and subsequent sale, by a non-resident fund. The contracts for sale of shares in the LBO vehicle are entered into outside Australia. The draft ruling holds that the gain on sale has an Australian source, despite the contracts for sale being entered into outside Australia. That is because the:
- initial assessment of the target
- arranging of acquisition financing
- making of operational improvements
all take place in Australia. These activities are obviously integral to making the gain. This conclusion is not surprising.
APPLICATION OF THE BUSINESS PROFITS ARTICLE TO LLPS
If a gain from sale of an LBO investment is taxable as ordinary income in the source country (ie the country where the LBO investee is located), that source country taxation can be eliminated if the vendor fund
- is resident in a country which has a tax treaty with the source country, and
- has no physical presence (technically, no "permanent establishment" or PE) in the source country.
This is by virtue of the "business profits" article.
TD 2010/21 comes to an interesting conclusion on the application of the business profits article where the fund is a limited liability partnership (LLP). It says that if a partner in the fund:
- is resident in a country which has a tax treaty with Australia
- is treated by that country as earning the gain on sale directly,
then Australia will allow them the benefit of the business profits article on their share of the gain on sale of an Australian company, regardless of whether the LLP itself would be entitled to that benefit. This is not pursuant to any specific "look-through" legislation, but rather is an application of general OECD practice. This issue is considered in more detail in TD 2010/D8.
The IRD may have had an unofficial practice of giving similar relief, and has certainly been happy to include such relief specifically in treaties (see for example Article 1(2) of the new NZ/Australia Treaty). It should perhaps feel emboldened by Australia's stance to go further in this direction, and release some kind of generally applicable interpretation statement.
TAX TREATIES AND TAX AVOIDANCE
Treaty issues are further analysed in TD 2010/20. This determination concludes that in some situations, the use of special purpose companies to obtain treaty benefits such as the one referred to above can be tax avoidance. In that case, the benefit of the treaty can be denied under Australian anti-avoidance legislation. Australian law explicitly provides that the anti-avoidance provisions over-ride treaties.
There is no equivalent provision in New Zealand, and the outcome is accordingly less certain.
The information in this article is for informative purposes only and should not be relied on as legal advice. Please contact Chapman Tripp for advice tailored to your situation.
