The ATO has issued two draft Determinations that may result in many non-resident private equity investors being caught under the Australian tax net.
The Determinations follow the unsuccessful attempt by the ATO to freeze the proceeds of sale from the Myer float when assessments were issued against special purpose vehicles resident in the Cayman Islands and Luxembourg. These were established by the Texas Pacific Group as part of its holding structure for its interest in Myer.
The ATO has now advised that:
- non-resident investors that engage in 'treaty shopping' by interposing holding companies through which to have an entry point into Australia will be engaging in a tax avoidance scheme, unless there are clear commercial reasons for this holding structure
- profits derived by non-resident private equity investors may be of an income nature, depending on the circumstances.
Treaty shopping considered tax avoidance
Where non-resident private equity investors interpose holding companies in countries with which Australia has entered into a Double Taxation Agreement (DTA) for no good commercial reason the ATO will regard this holding structure as a tax avoidance scheme.
The effect of having a shelf company interposed in a country with which Australia has a DTA is that the profit on the sale of equity in the Australian target will generally be eligible to be taxed only in that other country. For example, if a shelf company established in the Netherlands makes a business profit on the sale of an Australian investee company, that profit will be taxed in the Netherlands, pursuant to the Australia-Netherlands DTA. As Australia is a high-tax jurisdiction, this may be a very desirable outcome, particularly as the Netherlands domestic law contains a tax exemption for holding companies.
In contrast, if the holding company is resident in a country with which Australia does not have a DTA, the 'source' rules would determine the taxing jurisdiction, resulting in an Australian tax liability in respect of profits that are on revenue account derived in Australia.
The ATO recognises that there may be 'sound commercial reasons' for creating a multi-tiered holding structure. However, the absence of any 'significant' commercial activity in the country with which Australia has a DTA will strongly indicate a tax avoidance scheme. If an entity interposed in a treaty country is a mere holding company that has little or no business activity, and there is no other reason for the company to be there, the ATO considers it will be difficult to see any commercial purpose for the structure used.
Gains on disposal of target assets on revenue account
In 2006, the capital gains tax (CGT) rules were amended to exempt non-residents from CGT unless the asset disposed of was 'taxable Australian real property', an interest in a company or trust whose assets consist predominantly of Australian real property or assets used in conducting a permanent establishment in Australia. When a non-resident disposes of a capital asset that does not constitute a real property interest, the disposal is exempt from Australian CGT. If however, the asset is held on revenue account rather than capital account, the non-resident does not obtain the benefit of this exemption.
The ATO considers that non-resident private equity investors may make an income gain from the disposal of the target assets they have acquired. The ATO considers that a typical private equity acquisition involves the acquisition of interests (such as shares) in the target by the non-resident entity, the holding of those interests for a period during which operational improvements are usually made to improve the value of the target, and the subsequent sale of the target's assets.
It is considered that returns on a typical private equity investment depend on three factors: cash flow from operations, operational improvements to increase earnings over the life of the investment, and disposing of the shares of the target for a higher amount than was originally paid.
In determining whether the realisation of private equity assets will be ordinary income, the ATO will consider the relative importance of these three factors driving returns, the investment strategy devised by the parties prior to acquiring the target, and the legal form and substance of the arrangements.
The view of the ATO that business activities of non-resident private equity investors will give rise to an income gain is significant, as it has been the general view that such profits were, in most cases, on capital account. Additionally, the application of the anti-avoidance provisions to private equity structures will have significant tax and penalty consequences for non-resident investors involved in existing structures together with those proposing future investments.
The Determinations will have retrospective effect once finalised. It is essential that non-resident private equity investors obtain advice as to how the ATO view will impact their structures, and ascertain whether any detrimental consequences can be mitigated.
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.