In its 2007 – 2008 Compliance Program, the ATO identified a number of "potential revenue risks" in relation to private equity. Amongst other things, these included the treatment of distributions to investors in unit trusts or other private equity investment vehicles, and whether the characterisation of those payments (revenue or capital) accords with the tax law.
More recently, on 30 October 2008, the Australian Financial Review reported that:
"[T]he taxation of private equity profits is under scrutiny by the Tax Office, which has expressed concerns about the legitimacy of operators claiming concessional tax treatment [CGT discount] on the sale of businesses".
"Private equity vehicles are under the microscope because they are in the business of buying and selling companies in a manner that the Tax Office views as similar to trading activity, and therefore not eligible for capital gains tax breaks."
It is regrettable that this issue still creates uncertainty in an environment where we are competing with other jurisdictions that provide more certainty in relation to capital inflows. One would hope that the ATO will assist in resolving the current level of uncertainty in this area to provide more certain outcomes for investors and ultimately create a level playing field in which Australia can compete for capital inflows.
In the absence of such assistance from the ATO, there are particular structures that may be utilised by private equity funds to provide more certainty regarding the characterisation of a gain as either capital or revenue.
As is explained in further detail below, for foreign funds, regardless of the characterisation of the gain as capital or revenue, provided that the entry point into Australia is structured correctly, both capital and revenue gains may be repatriated without being subject to Australian income tax.
What is the capital/revenue distinction?
Australian tax rules contain 3 parallel regimes that can affect the characterisation of gains and losses arising from the disposal of shares:
- capital gains tax (capital gains) – if the taxpayer's activities are not considered to be in the conduct of a business of share trading and the gains are not ordinary income, then the gains may be subject to capital gains tax. Losses would be regarded as capital losses to be offset against capital gains;
- ordinary income (revenue gains) – where assets are acquired by a taxpayer (and are not trading stock of the taxpayer – see below) , the profits (or losses) would be regarded as "ordinary income" (or deductions) if the gains (or losses) are realised in the course of carrying on a business of, for example, investment;
- trading stock – if a taxpayer is considered to be carrying on the business of share trading, the proceeds of sale of the shares may be subject to tax under the trading stock provisions. Under the trading stock provisions, outgoings and earnings of the taxpayer are accounted for as revenue gains (on a gross basis). Adjustments in value for trading stock on hand are made at the end of each financial year.
How do you determine whether a gain is a capital gain or a revenue gain?
At a very general level, the distinction between whether a gain is a capital gain or a revenue gain is determined primarily by reference to the purpose and intention of a taxpayer and the relevant activity which brings about the realisation of the gain. This requires one to undertake a "wide survey and exact scrutiny of the taxpayer's activities".
However, establishing tax outcomes by reference to the purpose and intention of a taxpayer in the context of the activities the taxpayer is carrying on is difficult and often exacerbated by the fact that the line between the business of trading in shares and a "business of investment" is a fine one.
In addition, in certain circumstances it is possible for revenue assets to change character to capital assets depending on the manner in which they were disposed of.
Taking all of these matters into account, it is not surprising that the capital/revenue distinction is the most litigated aspect of Australian taxation. Various judges have, on a number of occasions, made comments to the effect that "..the spin of a coin would decide the matter almost as satisfactorily as an attempt to find reasons".
The Managed Funds Industry – Same Issue as Private Equity?
As Australian private equity funds are usually established as unit trusts, the capital/revenue issue in the private equity space is generally the same as that in the managed funds area.
The difficulty in characterisation of gains as capital or revenue is exacerbated in the private equity space because, based on established case law, a strategy to maximise returns, even on long term assets, is regarded as generating revenue gains.
However, there is also case law that suggests that where a trustee (or manager on behalf of a trustee) invests funds in its capacity as trustee or manager, the investment activity of the trustee/manager is less likely to result in gains being characterised as revenue gains.
In simple terms, this case authority suggests that a trustee's fiduciary duty requires one to look at the objectives of the person for whom the investments are being made (i.e the investors in the fund) in determining the character of the gains. This can be contrasted with a situation where a company carries on activities in its own right – in which case it is the objective of the company (i.e. to maximise returns) that is considered and not the objective of each shareholder.
How does the capital/revenue distinction affect private equity investments?
The capital/revenue distinction and the way in which it may or may not affect private equity gains is dependant on the particular structure under consideration.
In relation to foreign private equity funds investing in Australia, there may be no distinction between tax outcomes based on the capital/ revenue characterisation depending on the structure used to invest in Australia. By way of example, if gains made on disposal of shares are capital, the capital gain is exempt from Australian taxation provided that the company is not "land-rich" for CGT purposes.
Similarly, if the gains are revenue gains, where the foreign fund is a resident of a country with which Australia has negotiated a comprehensive double tax agreement ("DTA") and the fund can obtain the protection of that DTA, then the revenue gains will be exempt from Australian taxation. If the foreign fund is not a resident of a DTA (or cannot obtain the benefit of the DTA), then the revenue gains will be taxable in Australia but only if the gains are Australian sourced.
It is also possible that offshore entities investing in Australia could be foreign hybrids for tax purposes. In these circumstances, determining the capital/revenue characterisation becomes more complicated. The effect of the capital/ revenue distinction for Australian private equity funds depends on whether the fund is investing in Australia or offshore.
Generally, for Australian private equity funds (unit trusts) investing in Australia, capital gains made by the fund from the disposal of shares will be taxable but may attract a discount of 50%. However, revenue gains made by the fund and distributed to Australian investors will be fully taxable without any discount.
The impact of the characterisation of a gain made by an Australian private equity fund investing offshore (as either capital or revenue) should be considered in the context of the application of the Australian foreign accruals regime (under the Controlled Foreign Company or Foreign Investment Fund rules) to that investment. This is important because if the fund is taxed under the foreign accruals regime, the impact of the capital/revenue distinction becomes less important.
To the extent that the gain is a capital gain, where accruals taxation arises, one of the key disadvantages is that even if the fund makes a capital gain on the disposal of the shares in the offshore target, Australian investors will not obtain the full benefit of the CGT discount.
This is due to the fact that tax has already been paid on some portion of the gains on an accruals basis (disregarding the discount).
Most common law jurisdictions have, at some stage in their development, grappled with the capital / revenue distinction. Some jurisdictions create arbitrary rules that are simple to apply and provide certainty, for example by determining if something is capital by reference to the period of time it is held.
Other jurisdictions, like Australia, provide a combination of subjective and objective tests – tests that seek to determine the purpose or motives of a taxpayer in the context of the activities that they carry on.
Amending our tax laws to create more certain outcomes for determining the capital/revenue characterisation of investment gains is long overdue. The review by the Board of Taxation into the taxation of Managed Investment Trusts is the best place to create some momentum for reforms in this area.
In the meantime, local and offshore private equity funds are left to grapple with these issues by minimising uncertainty through consideration of appropriate investment structures.
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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.