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Home > Tax News > December 2009

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TAX NEWS - DECEMber 2009

Australia Tax: Australian Taxation Office (ATO) provides views on treaty shopping and capital versus revenue

The Australian Taxation Office (ATO) issued two draft Tax Determinations (TDs) on 16 December 2021 that are significant in relation to international tax (treaty shopping), and in respect of whether gains made by private equity investors are on income or capital account.

The TDs are entitled:

- TD 2009/D17: 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?
- TD 2009/D18: Income tax: can a private equity entity make an income gain from the disposal of the target assets it has acquired?

Both TDs are stated to have retroactive effect. Submissions can be made to the ATO on the TDs prior to their finalization.

A draft ruling was also expected to issue at the same time on the meaning of "beneficially owned" and "beneficially entitled" in the dividend, interest and royalties articles of Australia's tax treaties. This draft ruling has been deferred until January 2010.

The two draft TDs have been issued in the context of the recent IPO of a major Australian retailer, which had been largely owned by an international private equity investor. The ATO has sought to assess the private equity investor, and based on press reports and some publicly available court transcripts, did so on the basis that the general anti-avoidance rule (Part IVA) had application. The examples used in the two TDs are based on what we understand to be the actual facts in the case that the ATO is pursuing at present.


Treaty shopping and Part IVA

The example that forms the basis of the analysis in the draft TD is as follows:

- A group of investors (including persons resident in a country that has concluded a tax treaty with Australia and a private equity group) invest in a Cayman Islands investment vehicle;
- The Caymans investment vehicle invests in a Luxembourg company;
- The Luxembourg company owns a Dutch company;
- The Dutch company invested in Australia and later exited that investment at a profit. It is assumed that the profit is on income account and would be subject to tax in Australia. Australia's taxing rights would, however, be excluded where the business profits article of the Australia-Netherlands tax treaty has application.

The ATO accepts that there are valid reasons for the formation of an investment vehicle in the Caymans and consider that no adverse conclusions follow from that structure. However, the use of "more complicated structures" may attract scrutiny by the ATO.

Part IVA can be activated where a "tax benefit" is obtained and it is a sole or dominant purpose of a person to obtain such a tax benefit. Relevantly, the tax benefit identified by the ATO was the non-inclusion of the exit profit in the assessable income of the Caymans vehicle. That is, as a result of the interposition of the Dutch company, the exit profit was made by the Dutch company. In the absence of such a scheme, the ATO asserts that the exit profit would reasonably have been made by the Caymans vehicle and would have been subject to Australian tax as there is no tax treaty between Australia and the Cayman Islands.

The key conclusion of the ATO is that "Where an arrangement is put in place merely to attract the operation of a particular tax treaty in the context of a broader structuring arrangement, this may be a scheme or a part of a scheme which otherwise satisfies the terms of Part IVA, and any tax benefit obtained in relation to such a scheme may be cancelled".

The application of Part IVA will depend on a detailed consideration of all of the facts and circumstances in order to form a view as to whether the relevant tax benefit purpose is the sole or dominant purpose.

The ATO notes that in relation to the "complicated structuring," there may be "sound commercial reasons for creating this pattern of holding interests in a variety of jurisdictions. However, where none is apparent, it naturally requires consideration of why these interposed entities are there". The ATO concludes that "in the absence of any significant commercial activity in a treaty country by a company resident in that jurisdiction, the presence of a company in that jurisdiction in the context of a cross-border structure is normally to be explained by taxation considerations. The application of section 177D in Part IVA as a practical matter will therefore, in the absence of other relevant matters, depend on the presence or absence of non-Australian tax considerations and their weight, when considered in accordance with the section 177D factors. If there are relatively few, or no, advantages to be obtained from the presence of a company in the relevant jurisdiction other than the exemption from Australian tax, this will point to the conclusion that obtaining a tax benefit is the dominant purpose of one or more participants in the scheme." Further, the ATO states that where an interposed company is a "mere holding company," has little or no business activity and there are no regulatory reasons for such companies, "it is difficult to see any commercial purpose for the structure used."

The implication of the draft TD is that where there is a tax benefit and seemingly little commercial (non-tax) purpose for the structure, the ATO would seek to apply Part IVA. This would effectively mean that the interposed entities are to be disregarded and the ATO would assess the Caymans vehicle as if it had made the profit. As there is no treaty with the Caymans, Australia would have taxing rights over any such income gain (assuming the gain had a source in Australia - this issue is not addressed in the draft TD).


Implications

The draft TD is very much a response to the recent issues involving the specific private equity disposal. However, the draft TD has significantly broader ramifications for all inbound investment into Australia. The ATO is flagging that it considers that the general anti-avoidance rule is an effective weapon against treaty shopping. The ATO is clearly concerned by structures that have features such as mere holding companies, companies with little or no other business activity and an "unnecessary hierarchy of holding companies."

International investors into Australia will need to have careful regard to their holding structures into Australia where such structures potentially provide benefits under tax treaties.

A further issue addressed by the draft TD (albeit indirectly) is whether an ultimate investor, who is resident in a country that has concluded a tax treaty with Australia, can seek to rely on that treaty where the investment is made through some form of fiscally transparent vehicle. For example, the issue arises where a foreign investor invests into Australia through a tax transparent partnership (such as a U.S. limited partnership).

The ATO has previously issued some public views accepting that investors investing through certain tax transparent vehicles may be able to rely on the tax treaty between Australia and their country of residence. In the facts considered in the draft TD, the ATO is somewhat vague about the investment vehicle, and describes it as, "for example, a limited liability partnership or company in a tax haven country." The ATO states that "this would put the taxation ramifications of the transaction beyond the terms of the tax treaty Australia might have with the investor's country of residence." Further, the draft TD refers to the "intended absence" of the application of the investor's home country tax treaty with Australia. In other words, the ATO seems to imply that the use of such a collective investment vehicle will necessarily prevent an ultimate investor relying on a tax treaty. While this may be the case in some fact patterns, it is submitted that this will not always be the case. The Commentary to the OECD Model Treaty makes it clear that in certain cases, an ultimate investor investing through a partnership is able to rely on the investor's home country tax treaty with Australia. Further, the ATO has publicly applied these OECD principles to entities other than partnerships.

This matter is one that we hope will be clarified before the TD is finalized.


Suggested next steps

Affected taxpayers should consider the following steps:

- Review existing inbound structures and carefully review the function and substance of any interposed companies;
- Assess the impact of a potential ATO attack on such structures having regard to the overall tax profile of the group; and
- Consider the potential opportunity for restructuring.
 

Capital versus revenue distinction

A nonresident of Australia that sells shares in an Australian company will generally not be subject to Australian capital gains tax (CGT) as a matter of Australian tax law (the exception being a disposal of non-portfolio interests in Australian land-rich entities). However, where such a gain is an income gain, it will be subject to tax where the source is in Australia (subject to the operation of a tax treaty, where applicable).

TD 2009/D18 considers whether a private equity entity makes an income gain from the disposal of the target assets it has acquired. The ATO states that "Whether the profit from the realisation of private equity assets will be ordinary income will depend on the circumstances of each particular case. These circumstances will include a weighing up of the relevant importance of each of the three factors driving returns [being cash flows from operations, operational improvements to increase earnings and disposing of the shares of the target entity for a higher amount than was originally paid], the investment strategy agreed to by the parties before acquiring the assets and the legal form and substance of the arrangements and structures used to implement these strategies."

Again, whilst this draft TD is framed in the context of a nonresident private equity investor, it will also be relevant to Australian private equity investors and to nonresident non-private equity investors. The critical revenue versus capital distinction that underpins Australian tax law continues to be subject to considerable uncertainty.

We also note that the ATO makes no comments about the "source" of income or gains in either of the TDs.


Conclusion

The two TDs and the expected draft ruling on beneficial ownership in the dividend, interest and royalties articles of Australia's tax treaties represent a multi-pronged strategy on the part of the ATO. The ATO is seeking to critically assess whether benefits should be available under Australia's treaties and whether gains are more appropriately to be characterized as income gains rather than capital gains.

Nonresidents with Australian investments will need to carefully consider the impact of the draft TDs on their investments and monitor the ongoing discussion in Australia on these issues.
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