Key Income Tax Developments In Australia - April 2019.

Legal News & Analysis - Asia Pacific - Australia - Tax

14 May, 2019

 

This bulletin outlines the key Australian income tax developments in the last month affecting your business, including a significant recent full Federal Court ruling concerning the tax treatment of limited liability partnerships. 

 

Top 5 developments in tax this month you need to know

 

RELEVANT AREA AT A GLANCE
Draft taxation ruling released regarding thin capitalisation arm's length test

The ATO has released a draft taxation ruling (TR 2019/D2) outlining the Commissioner's view on the use of the arm's length test for determining thin capitalisation limits. When finalised, it is intended that this ruling will replace the current TR 2003/1, which represents the Commissioner's current view on the arm's length test.

The ruling provides guidance on a number of technical issues, such as how to address the "two-limbed" nature of the test, how to apply the test where no debt instruments are entered into in a particular year, and how to construct the hypothetical "Australian business" used within the test.
Additionally, the draft ruling also considers record keeping obligations under the arm's length debt test, as well as interactions with the transfer pricing rules.

The Commissioner is also intending to release a Practical Compliance Guideline to accompany this draft ruling. It is notable however, that the Labor party has announced that if it is elected to the Federal Government, it will remove the arm's length and safe harbour tests from the thin capitalisation rules.

Law Companion Ruling released for hybrid mismatch targeted integrity rule 

The Commissioner has released a Law Companion Ruling (LCR 2019/D1) in respect of the hybrid mismatch targeted integrity rule in Subdivision 832-J of the ITAA97.

Broadly, the purpose of the targeted integrity rule is to prevent multinational groups  from replicating the benefits of "deduction/non-inclusion" structures by routing investment through jurisdictions with a tax rate of 10% or less. This is achieved by denying deductions for interest payments in Australia where such a structure is utilised for the principal purpose of (or a number of principal purposes including the purpose of) enabling a deduction in respect of a payment, and enabling foreign income tax to be imposed on the payment at a rate of 10% or less (or not at all).

This LCR provides guidance on a number of issues which arise in the application of this rule, including:

  • identification of the ultimate parent entity of a group;
  • determining the tax rate imposed by a jurisdiction; and
  • application of the "principal purpose" test.

It is important that entities wishing to reconsider their global structuring in light of the hybrid mismatch rules take the targeted integrity rule into account.

 ATO identifies six FBT issues "on its radar"

The ATO has updated its website to identify six FBT issues that are on its radar this year. These items are:

  • failing to correctly report motor vehicle fringe benefits;
  • mismatches between the amount reported as an employee contribution on an FBT return and the income amounts on an employer's tax return;
  • claiming entertainment expenses as a deduction but not correctly reporting them as a fringe benefit, or incorrectly classifying entertainment expenses as sponsorship or advertising;
  • incorrectly calculating car parking fringe benefits due to: significantly discounting market valuations; using non-commercial parking rates; and failing to provide adequate evidence;
  • not reporting fringe benefits on business assets provided for the personal enjoyment of employees; and
    failing to lodge FBT returns (or lodging them late) to delay or avoid payment of tax.

Employers should review their FBT processes having regard to these points.

Government announces extension of film offsets to digital platforms 

The Australian government has announced that the Post, Digital and Visual Effects (PDV) Offset and Location Offset currently available to producers of films and television series in Australia will be extended so as to be available to companies intending to host that content on online platforms such as Stan and Netflix.

The PDV Offset provides a 30% offset on qualifying Australian production expenditure (QAPE) relating to post, digital and visual effects production for a film. The Location Offset provides a 16.5% offset on all QAPE for film and television projections with QAPE of A$15m or more.

Additionally, the Australian government has announced that it does not intend to make any changes to eligibility for the Location Incentive. This is a merit assessed grant of up to 13.5% of the production's QAPE for productions which are eligible for the Location Offset.

Legislation passed by Parliament in April

 The following legislation passed Parliament in April and has received or is awaiting Royal Assent:

  • Treasury Laws Amendment (Increasing the Instant Asset Write-Off for Small Business Entities) Bill 2019 – Implementing policies announced in the Federal Budget, this bill extends access to the instant asset write-off to businesses with an annual turnover of up to $50m, and will increase the asset value threshold to A$30,000. This write-off will be available for assets first used, or installed ready for use from 2 April 2019 to 30 June 2020.
  • Treasury Laws Amendment (Making Sure Foreign Investors Pay Their Fair Share of Tax in Australia and Other Measures) Bill 2019 ; Income Tax (Managed Investment Trust Withholding Tax) Amendment Bill 2018 ; Income Tax Rates Amendment (Sovereign Entities) Bill 2018 – together these bills make a number of changes, including increasing the MIT withholding rate on non-concessional fund payments, modifying the thin capitalisation rules, limiting the withholding tax exemption for superannuation funds for foreign residents, and limiting the scope of the sovereign immunity tax exemption.
  • Treasury Laws Amendment (Design and Distribution Obligations and Product Intervention Powers) Bill 2018 – this bill introduces new disclosure and distribution obligations for entities offering financial products, and gives the ASIC new powers to regulate and ban financial products where there is a risk of significant consumer detriment.
 

What you need to know

 

  • The Full Federal Court issued its judgment in the controversial case: Commissioner of Taxation v Resource Capital Fund VI LP (RCF IV).  The lengthy judgment dealt with seven complex issues and, unless overturned by the High Court on appeal, is likely to be the source of guidance on a range of general interpretative issues. The case is of particular relevance to foreign private equity investors holding Australian assets.
  • The case confirms that corporate limited partnerships are liable to tax as though they were companies and that the corporate limited partners are the legal entities who can be sued in debt for the limited partnership's liability to tax.
  • This brings the law back into line with the original understanding of how the taxation of corporate limited partnerships works.
  • The case is also notable for concluding that, contrary to the (now) concessional position taken by the Commissioner of Taxation in Taxation Determination TD 2011/25, under the US Double Tax Agreement (US DTA) protection is only available for foreign limited partnerships that are themselves US residents for US tax purposes.  Thus, commonly used Cayman limited partnerships will not qualify for such protection unless they are also considered to be US tax residents.
  • At the same time, the Court accepted that US tax resident partners could still potentially claim US DTA protection from Australian tax in recovery proceedings if the Commissioner was suing for the tax debt imposed on the partnership.  
  • As a result of this, some additional administrative processes may need to be established with the ATO to allow US partners in Cayman (and other non-US) corporate limited partnerships to more readily obtain US DTA protection.
  • The judgement also contains decisions of importance dealing with the source of income that will be of particular relevance to private equity investors, as well as guidance as to when mining leases give rise to taxable Australian real property (TARP) interests and how such TARP interests are to be valued. 

 

The Full Federal Court Decision in Commissioner of Taxation v Resource Capital Fund IV LP

 

Background

 

RCF IV (along with a sister fund RCF V) was a Cayman Islands limited partnership that acquired and subsequently disposed of shares in an Australian resident mining company (Talison Lithium Ltd) for a significant profit.  At issue in the case was whether and, if so, how Australia could tax that profit.

 

The appeal in RCF IV was heard by five judges of the Federal Court (Besanko, Middleton, Davies, Steward and Thawley JJ), with Davies J issuing a dissenting judgement in respect of one of the issues that arose for consideration (whether DTA relief can be claimed by limited partnerships) and declining to offer a view as to some of the other issues in dispute, which were not the subject of argument by the parties. The decision of the Full Court is (subject to any appeal to the High Court) potentially the final decision in a number of cases that have involved RCF funds.  

 

The case deals with some fundamental matters of importance in relation to the Australian taxation treatment of foreign limited partnerships. Limited partnerships, whether formed in a low tax jurisdiction or in the US or UK, are a common pooling entity for foreign investors in a private equity fund and such funds are frequent investors in Australian businesses. 

 

Prior to the decision at first instance in RCF IV, the Australian income tax treatment of limited partnerships (whether Australian or foreign) was considered straightforward – that is, they are broadly treated for income tax purposes as companies.  

 

The antecedent to the RCF IV case was the decision by the Full Federal Court in Commissioner of Taxation v Resource Capital Fund III LP (RCF III) from 2014. In that case, the Full Federal Court concluded that Article 13 of the US DTA did not apply to prevent the Commissioner taxing a Cayman limited partnership on the disposal of TARP. The Court also concluded that TD 2011/25 did not protect the taxpayer as it only bound the Commissioner in relation to profits dealt with under Article 7 (the "business profits" Article) of the US DTA, rather than Article 13 (the "real property" Article), which was the applicable Article in that case. At no point did the Full Federal Court in RCF III indicate that it considered that the limited partnership in that case was not to be treated as a taxable entity for Australian tax purposes.

 

Despite the decision in RCF III, the first instance judge in RCF IV (Pagone J) decided the Full Federal Court decision in RCF III did not create a precedent which bound him to treat a limited partnership as a taxable entity for income tax purposes. This was on the basis of his view that the Full Federal Court had assumed, for the purposes of its decision in RCF III, that a limited partnership is a taxable entity without considering the matter.  

 

Pagone J went on to find, amongst other matters, that Division 5A did not make a limited partnership a separate taxable entity. Rather, his Honour concluded that the appropriate taxpayers were the general and limited partners who are jointly and severally liable for the debts of the limited partnership.

 

This key point, along with a number of other matters were the subject of the appeal to the Full Federal Court. 

 

The issues

 

There were in fact seven separate issues that the Full Court was required to deal with in this case:

 

  1. Whether or not limited partnerships are liable to tax;
  2. Who in this case had been assessed to tax;
  3. Whether the imposition of the tax on limited partnerships is constitutionally invalid (as being "incontestable");
  4. What was the source of the gain from the sale of the shares in Talison Lithium;
  5. Whether the RCF funds could claim protection from Australian tax under the US DTA;
  6. Whether the funds could rely on TD 2011/25 to claim protection from Australian tax (that is, was the determination binding on the Commissioner in relation to the funds);
  7. Whether the approach of Pagone J to the valuation evidence (as to whether the shares in Talison Lithium constituted TARP) was correct.

 

Are limited partnerships liable to tax?

 

The Court concluded that when one has regard to the text and context of the limited partnership provisions in Division 5A of the Income Tax Assessment Act 1936 (ITAA 1936) it is apparent that a limited partnership is to be treated as an "entity" that is liable to pay tax – that is, as an entity on which tax may be assessed.

 

The Court noted that Parliament, in designing Division 5A, did not intend to give limited partnerships actual legal existence.  Such partnerships are, if created under Australian law, not separate legal entities from their partners (it is conceivable that a limited partnership created under foreign law could be a separate legal entity, but such a limited partnership would as a result be more likely to be characterised as a company for Australian tax purposes).  Having no legal existence they cannot, for example, be sued. 

 

This limitation is, in fact,acknowledged in one of the limited partnership provisions in Division 5A: section 94V provides that "obligations that would be imposed on the partnership are imposed instead on each partner…".  

 

This wording (in particular the use of the words "would be") was in fact taken by Pagone J as meaning that Division 5A should be interpreted as not making limited partnerships liable to tax.  

 

However, the Full Court held that when one has regard to:

 

  • the overall approach to characterisation of limited partnerships taken Division in 5A,
  • the broader statutory context in which Division 5A sits in the Tax Acts, and
  • the contrasting wording that has been used by Parliament in treating general partnerships as not being liable to tax,

that it must be concluded that the words "would be" should be understood as meaning "is".  As a result, all relevant wording in the Tax Acts points to the conclusion that limited partnerships are liable to tax: that is, the limited partnership is to be considered an entity for the purposes of being capable of being issued an assessment for income tax, albeit that the Commissioner would need to sue the partners for the debt created by the issuance of the assessment because the limited partnership is not itself a legal entity capable of being sued.

 

This important part of the decision will presumably (subject to the High Court having other views) eliminate the considerable uncertainty arising from the decision at first instance on this point.

 

Who was assessed?

 

It followed from the Court's decision as to whether an assessment could be issued to a limited partnership that the assessments to the RCF funds were correctly issued to the respective limited partnerships.

 

Pagone J had concluded that he could apply the decision in Prestige Motors to treat the relevant assessments as having been issued to the partners despite being addressed to the partnerships.  While strictly not required to, the Full Court went to some trouble to disagree with this conclusion, deciding that there was no basis for treating the notices as having been issued to the partners.

 

The point here is that Prestige Motors will not provide a great deal of leeway for the Commissioner to issue assessment notices to the attention of the wrong party. The Commissioner's compliance obligations in this respect will therefore continue to be evaluated by the Courts on a reasonably strict basis.

 

Are the limited partnership provisions unconstitutional?

 

The Court concluded in short order that the taxation treatment of limited partnerships was constitutional. The taxpayer assessed (the limited partnerships) had a right to contest the decision of the Commissioner.  The collection of tax from the partners merely dealt with the outcome of such contest.

 

The source of income

 

The Full Court decision in this case will potentially be of some importance in the future in relation to the application of the principles for determining the source of income from the disposal of shares. Pagone J decided that the profit from the sale of the shares in Talison Lithium was Australian sourced income of the funds. The determination of the source of particular items of income is a question of fact – a point confirmed by the Full Court here and the taxpayer on appeal did not challenge the test applied by Pagone J to determine the source of the income. 

 

Rather, the taxpayer contended that his Honour misapplied the test, because, while his Honour recognised that many of the actions that had contributed to the profit being realised were undertaken in Australia, he did not take into account the many other actions that were undertaken overseas.

 

The Court concluded that Pagone J had not misapplied the test – a not particularly controversial position given that a judge is naturally given considerable leeway in applying his judgment to what is essentially a factual question. 

 

But the Court then went to some trouble to further validate the conclusions reached by Pagone J. This is interesting and potentially of importance for other foreign investors holding Australian assets in two respects:

 

  • Neither at first instance nor on appeal did the Courts consider that some apportionment of source was appropriate even though it would seem on its face to be a reasonable way to deal with the particular facts. This indicates that an "all-or-nothing" approach to the determination of the source of profits obtained from the disposal of assets will often naturally be adopted by the Courts.
  • The Full Court placed considerable weight on the place where the sale transaction occurred (it took place by way of a scheme of arrangement in Australia) in determining the source of the profit.

 

In this regard, the Full Court commented that:

 

"A proximate origin of the profits here was thus the scheme of arrangement and the location of the scheme is analogous to the place where the contract was made in Tariff Reinsurances…."

 

The Court has thus shown a willingness to place considerable weight on the place where the sale contract is made as determinative of the entire source of a gain from the sale. This seems to give more weight to the purely "formal" aspects in determining source, as opposed to all the other activities that took place in relation to the making of the profit from the sale.  This may make it important for non-residents who would otherwise be taxable on Australian sourced income from the sale of assets to, if possible, have the sale contract made outside Australia.  It should be noted that this formalistic approach to determining the source of income from the disposal of shares appears to be, at least to some extent, at odds with the Commissioner's views expressed in TD 2011/24. In TD 2011/24 the Commissioner rejects the view that the place of contract is determinative of the source of profits in private equity transactions in favour of a more holistic approach which determines source on the basis of all of the relevant activities undertaken to realise the profit.

 

Finally, it is also worth noting that the Full Court also felt that the activities in Australia of employees of a company controlled by the funds could appropriately be considered, as a "practical" matter, relevant to determining the source of profits. This view could potentially affect the determination of source in a wider range of situations than may first meet the eye – effectively piercing the corporate veil in considering the source of income.    

 

Was US DTA protection available to the funds?

 

The key issue for consideration here was whether the funds could, despite being Cayman Island entities, qualify for protection under the US DTA on the basis that the partners in the funds were US tax residents.

 

This question in turn depended on whether the definition of a "resident of the United States" in the US DTA first requires that a partnership must itself be a resident of the US for US domestic tax purposes. If so, then US DTA protection would be available to such US tax resident partnership, but only to the extent that the income of the partnership was subject to tax in the US in the hands of a partner because that partner is considered under US law to be US tax resident.

 

The Court concluded that US residency of the partnership was a precondition for US DTA protection to be claimed. As far as could be established, the RCF funds were not US tax resident entities.  As a result, the RCF funds could not claim US DTA protection. This would be the case even if all of the partners in the funds were US tax residents who were subject to tax in the US on the income of the funds.

 

It was on this issue that Davies J dissented. Her Honour held that US residency of the partnership does not operate as a qualification to when a person is a resident of the United States for the purposes of its tax but rather operates to identify when a partnership is to be treated as a resident of the US for the purposes of its tax. In her Honour's view, this meant that a Cayman limited partnership could be a resident of the US for the purposes of the DTA to the extent its limited partners were US residents.  Although the text of the US DTA is not well drafted, there is force to this logic. The US does not have a concept of "residence" for partnerships (US partnerships are "domestic partnerships"). There is also no distinction under US tax law between US and foreign partnerships that are fiscally transparent for US tax purposes and it might be thought unlikely the DTA intended such a distinction to be drawn.

 

The Court did, indicate that the US partners could claim protection under the US DTA; however they could not dispute an assessment issued (as the Court found is required by Division 5A of the ITAA 1936) to the partnership. Rather, the Court suggested that the partners could claim such protection in an appropriate forum, such as where the Commissioner was trying to enforce the tax payable from the assessment to the partnership against the partners. 

 

This analysis of the effect of the US DTA was in line with (and explicitly acknowledged) the judgment of Edmonds J in one of the earlier cases involving an RCF fund.

 

This means that a Cayman limited partnership with US tax resident partners will not be able to claim US DTA protection in objecting to an assessment issued to it under Division 5A: rather, it will need to legally respond by seeking some form of declaratory relief from a Court or through the expedient of resisting a debt claim by the Commissioner.  

 

Importantly, the Court indicated in this regard that a claim for relief from the tax could also potentially extend to a situation where the Commissioner sought to collect the tax from a third party who owes an amount to the partner (a garnishee claim under section 255 of the ITAA 1936, which authorises the Commissioner to collect funds from a resident to pay tax owed by a non-resident). Thus, a US tax resident limited partner could potentially challenge a section 255 notice issued to the general partner of the limited partnership, who would normally hold funds due to the various limited partners.

 

In addition, the Court noted that a US tax resident partner could, "in an appropriate case", seek declaratory orders concerning that partner's share of the profits of the partnership.

 

This confirmation of the legal constraints imposed by the US DTA (first explained by Edmonds J in 2014) will thus determine how US tax resident partners in non-US established funds will need to respond to assessments issued to such funds by the Commissioner.

 

Finally, while the prospect of relying on DTA relief in debt recovery proceedings might provide some assistance to limited partnership investors, it does not assist investors in other types of fiscally transparent entities. For example, members of non-US limited liability companies that are treated as partnerships for US tax purposes (eg, Cayman exempted companies) will not have this avenue available to them because Division 5A does not apply to these entities and in any event these entities have legal personality (and can therefore be sued in their own right for the tax). Again, there is no logical reason from a US tax perspective for this difference in treatment and the difference would not appear to arise under Davies J's decision on this issue. This outcome would lend further support to Davies J's construction of the residence article for partnerships.

 

Was the Commissioner bound by TD 2011/25?

 

The lengthiest part of the judgment by far was devoted to this relatively innocuous question. The key part of the question was answered in a straightforward way – and in conformity with a similar question raised in other cases: provided the Determination is on point, the Commissioner is bound by the Determination.  

 

This will be the case even if the Determination does not correctly apply the law. The decision of the Full Court in relation to the lack of protection afforded Cayman Island limited partnerships by the US DTA means that the Commissioner's position in TD 2011/25 does not correctly apply the law.  In the Determination the Commissioner concluded that Cayman Island partnerships can claim US DTA protection to the extent that US resident partners are subject to tax in the US on the income of the partnership.

 

Nevetheless, the Court made it clear that the Commissioner is, while the Determination remains on foot, bound to follow it.

 

The question that involved far more analysis in the judgment was whether the Determination applied to the funds. This in turn depended (in broad terms) on whether the assets of the funds principally consisted of TARP as defined in the Australian domestic tax law.  

 

The Court noted that, technically, this was not the question that it should have been considering – rather the correct question was whether assets of the fund principally consisted of "real property" in Australia as defined in Article 13 of the US DTA. However, the Court proceeded on the basis that it would answer the case put by both sides and consider whether or not the shares in Talison Lithium were TARP.  (While the two definitions are similarly worded, the Court noted that they were not identical and thus the conclusion of the Court as to the meaning to be given to the definition of TARP would not be determinative if the correct question – the meaning of "real property" in Article 13 – is raised in another case in the future.)

 

In determining whether or not the shares were TARP, the key issue on which the Court devoted the main part of its judgment was whether some of the "leases" held by Talison Lithium were "real property" as defined for TARP purposes (a matter not raised by either party but put into play by the Court itself) and/or "mining, quarrying or prospecting rights" in relation to the relevant TARP definition.  

 

The judges undertook an extensive analysis of the law and principles governing the characterisation of various rights to mine and associated ancillary rights, that will no doubt be of particular use for some taxpayers holding mining interests. However, it is beyond the scope of this article to discuss this part of the judgment in any detail other than to point out that it provides a rich source of analysis of the law on this question.

 

Having traversed the authorities and considered the available facts (complaining that they in fact had insufficient facts in front of them), the judges concluded that the underlying assets were solely or predominantly within the definition of TARP.  

 

As a result of this, the Commissioner was not bound by his ruling which, as we noted above, applied only to profits dealt with under the business profits Article, not the real property Article of a DTA.

 

Was Pagone J correct in his approach to the valuation evidence?

 

The final matter for consideration was one that took up a very large part of the judgment of Pagone J at first instance and involved concepts and analysis that, to the lay reader, were very difficult to comprehend.

 

To a large extent, however, the conclusion that the underlying assets were TARP made the valuation evidence preferred by Pagone J not relevantly applicable to the facts of the case, as that valuation proceeded on the basis that significant parts of the assets of Talison Lithium were not TARP.

 

However, the Full Court still felt it necessary to comment on the valuation methodology that Pagone J adopted – a complex valuation approach called the "net back method".

 

The Court indicated that it had strong reservations about the appropriateness of this method to value the assets in the case at hand: indicating that it should generally be used as a last resort and concluding that "the methodology employed in this case …. could at best only accidentally happen upon the [market value of the assets]".

 

The outcome

 

The overall result of the conclusions of the Full Court on these seven matters was that the funds' objections to the assessments issued to them were denied.  

 

This leaves the US tax resident partners in limited partnerships having to determine how to claim protection under the US DTA. It also leaves investors in non-limited partnership funds that are fiscally transparent for US tax purposes with potentially no avenue to claim to relief under the US DTA. In addition, the clear suggestion by the Court that TD 2011/25 does not correctly apply the law indicates that it will eventually need to be withdrawn by the Commissioner.  Changes to TD 2011/24, dealing with the source of income from private equity activities, would also need to be considered.

 

Subject to there being an appeal, the case itself clearly resolves a number of very complex issues involving private equity fund investments in Australia, interpretation of the US DTA, the nature of mining rights and the meaning of TARP.  It therefore warrants close consideration by foreign investors looking at, or holding, Australian investments.

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For further information, please contact:

 

Vivian Chang, Partner, Ashurst

vivian.chang@ashurst.com