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International tax complexity for Australian investments: a real-world example

Accounting, Accounting, Audit & Payroll, Audit, Blog, Business Practices, Checkpoint, Corporations, Financial Institutions, Financial Planning, International Reporting & Compliance, International Traders, International Traders, News, ONESOURCE, Organisations, Tax March 6, 2018

Following the US tax reforms in December 2017, Australia is feeling the pressure to reduce its own corporate tax rate to maintain international competitiveness against the US rate of 21% (down from 35%). The debate on reducing Australia’s standard corporate tax rate of 30% has largely bogged down on the extent to which it may flow through in the form of higher wages for workers. This debate is further complicated by the fact that Australia competes for resources and capital in a dynamic world economy.

Exactly how global businesses may respond to the US tax reforms in terms of their investment decisions is a complex process and remains to be seen. Tax is only one of many factors in any business decision, albeit a very important one. Rather than getting lost in the competing economic models that attempt to predict the impact of a corporate tax cut on the broader economy, it is perhaps more useful to look at real-world examples of the role tax can play in cross-border investments. Understanding the mindset of key offshore investors in Australian assets gives an insight into the impact of the corporate tax rate.

US private equity investors

US private equity is an important sector to consider in terms of inbound Australian investments. The US accounts for a quarter of all foreign investment in Australia, with $A860bn of cumulative stock invested in Australia. Therefore, it is wise to consider the implications of the change to the US corporate tax rate from the perspective of this important sector.

The complexity faced by US private equity was highlighted in the recent case of Resource Capital Fund IV LP v FCT [2018] FCA 41, reported in Thomson Reuters Weekly Tax Bulletin (Issue 5, 9 February 2018). What these investors appear to crave above everything else is tax certainty. Highly-skilled advisers have developed entities and structures that seek to navigate both Australian tax law and the US double tax agreement (DTA) to deliver “look through” treatment for the purposes of US tax law. This essentially enables such US investors to limit their tax considerations on certain investments to their domestic US tax law obligations.

If US investors were adopting a look-through tax structure when the US corporate tax rate was 34%, there now appears to be an even greater incentive with the US rate cut to 21%. The prevailing Australian corporate tax rate also appears to be largely irrelevant for certain inbound investments from the US that are relieved from Australian tax under the DTA.

The investment vehicle of choice in the Resource Capital Fund IV LP case was a limited partnership incorporated in the Cayman Islands. This vehicle was chosen for a number of reasons, including:

  • partnerships (in contrast to corporations) avoid entity-level tax for US federal income tax purposes;
  • capital gains earned by a partnership retain their character as capital gains rather than becoming dividend income paid to shareholders;
  • incorporating the partnership outside the US enabled the partners to be taxed according to their proportionate interest. That is, the partnership itself would be “looked through” for the purposes of US tax law; and
  • the Cayman Islands imposes no additional tax burden on the partnership in addition to its obligations to pay US taxes and allows it to be regulated by US securities law.

The Court observed that the treatment of partnerships for US tax purposes was therefore broadly the same as for Australian purposes. That is, that the taxable entities were the partners rather than the association they comprised.

Case study – Investment in Australian mining company

In Resource Capital Fund IV LP, the Federal Court was called upon to rule on the tax treatment of substantial profits made by the US private equity investors on the sale of their shares in an Australian mining company. The case raised many complex questions of fact and legal construction in terms of the application of the US DTA and its relationship with provisions of the ITAA 1997 dealing with taxable Australian real property.

The investments had been structured in a way to attract private equity investment from the US by attempting to maintain flow through tax treatment to give the investors tax certainty. Therefore, the issues decided by the Court were of considerable commercial importance for both the taxpayers and others involved in international investment in Australia.

Fact situation

The taxpayers, Resource Capital Fund IV LP (RCF IV) and RCF V, were established as limited partnerships in the Cayman Islands by a private equity firm. The management company for the partnerships was incorporated in Delaware and based in Denver, Colorado. In March 2013, the taxpayers received C$198m and C$112m respectively under a scheme of arrangement for their shares in the Australian mining company, Talison Lithium Limited.

The Australian Tax Commissioner issued notices of assessment for RCF IV and RCF V for taxable incomes of A$117m and A$62m, respectively. The taxpayers submitted that the partners (not the partnerships) were the appropriate taxable entities and that those members of the partnership who were US residents, were entitled to relief from taxation by reason of Art 7 of the US DTA.

Decision

In allowing the taxpayer’s appeal, the Court ruled that the partners carried on an enterprise by their activities as partners in those partnerships. As the tax relief provided under the DTA extends to an “enterprise of a Contracting State”, the Court said the enterprise able to seek relief is the activity of the partners constituting the partnerships. Accordingly, the Court ruled that the relief provided by the US DTA was available to the partners in the partnerships who were US residents.

Having found that the profits from the sale of the shares were ordinary income with an Australian source, the Court then rejected the ATO’s claim that the DTA permitted Australia to tax the US residents on such income from the indirect disposal of real property situated in Australia (being the shares in the land-rich mining company).

The Court determined that the mining company’s taxable Australian real property (TARP) assets did not exceed the relevant 50% threshold test for CGT purposes under Div 855 of the ITAA 1997. In this respect, the Court ruled that the value of the assets for Div 855 purposes do not include the value of the general purpose mining leases and plant used by Talison Lithium. The Court also accepted the detailed expert evidence on the asset valuations to find that Talison Lithium did not trigger the 50% TARP threshold.

Conclusion

Subject to any appeal by the Australian Tax Office, US private equity investors appear to have found an investment structure that can deliver “look through” tax treatment to restrict their obligations on certain Australian investments that do not trigger the 50% TARP threshold for CGT purposes. The dramatic cut to the US corporate tax rate is likely to increase demand by US investors for such tax structures that achieve a look through tax status. Where this outcome is achieved, the Australian corporate tax rate appears to be irrelevant for such inbound investments.

Of course, international tax law is constantly evolving and advisers need to keep one step ahead of emerging issues. Navigate the international tax landscape with Thomson Reuters Australian Income Tax 1997 Commentary, Australian Double Tax Agreements and Checkpoint World – International tax planning and research.

For practical software solutions for the increasingly complex tax world, see Thomson Reuters ONESOURCE.