25 September, 2018
INSIGHTS
A decision of the Federal Court of Australia has created significant uncertainty as to how Australia's income tax laws operate in relation to "limited partnerships".
Such partnerships had always been considered (by taxpayers and by the Commissioner of Taxation) to be "taxable entities" (that is, not transparent for Australian income tax purposes) and are a very common investment vehicle for foreign private equity investors to hold Australian assets.
In the decision at first instance, the primary judge found that limited partnerships were, in fact, transparent, with the possible outcome that all prior Australian assessments of tax issued to all limited partnerships were invalid (as they should have been issued to the partners).
An appeal to the Full Federal Court has just been heard.It is expected that the decision of the primary judge in this point will be overturned.If it is not, considerable administrative chaos could result which may require a legislative fix.
Aside from this, and far less dramatically, the judgment is also of interest in relation to a number of other issues – most notably, it provides guidance on the question of the source of income that will be of interest for foreign private equity investors (amongst others).
Introduction
Limited partnerships are a commonly used investment vehicle for a range of foreign private equity fund and hedge fund investors to make Australian investments. Cayman Islands limited partnerships are the most commonly used of these vehicles as they are particularly well understood by US tax resident investors and enable moneys sourced from various countries to be pooled in a stable jurisdiction that does not create an additional tax burden for the investors.
For Australian income tax purposes, the taxation of limited partnerships will generally fall to be dealt with under a separate regime in the tax law. Unlike general partnerships, which are essentially "transparent" for Australian income tax purposes, limited partnerships are treated as companies for most Australian income tax purposes.
Limited partnerships operating under the banner of the "Resource Capital" group (a US managed private equity fund manager) held, amongst other things, significant investments in Australian listed mining companies. Those limited partnerships have been involved in a number of Australian tax cases dealing with the profits realised from the sale of such shares, including the following:
- Resource Capital Fund III LP v FC of T (RCF III) – with a judgment delivered in 2013 by Edmonds J at first instance;
- FC of T v Resource Capital Fund III LP – with a judgment delivered by the Full Federal Court in 2014 on an appeal from the decision of Edmonds J; and
- Resource Capital Fund IV LP v FC of T (RCF IV) – with a judgment delivered in 2018 by Pagone J at first instance.
Each of these cases was heavily influenced by the challenge of providing Double Tax Agreement (DTA) relief where residents of a DTA country (in this case the US) derive profits in Australia through an entity, albeit not a separate legal entity, in a non-DTA country (in this case, the Cayman Islands) that is tax transparent for US tax purposes but is apparently opaque (that is, characterised as though it were a company) for Australian tax purposes.
As an administrative matter, the Commissioner of Taxation did not find that apparent mismatch challenging to deal with. In 2011, he issued a Tax Determination ("TD 2011/25") in which he directly addressed the issue. In essence, the Commissioner concluded in that Tax Determination that DTA protection could be afforded to US tax residents making Australian investments through a Cayman limited partnership, notwithstanding that the partnership is treated as though it were a company for Australian domestic income tax purposes.
The Commissioner's view was that the "business profits article" in the DTA still applies to the extent that the profits of the partners are treated as derived by them in their country of residence and do not fall to be dealt with otherwise than under the "business profits" article (for example, if they do not fall under the "alienation of property" article in the relevant DTA).
The Resource Capital cases arose because of the Commissioner's view that the relevant profits derived by the limited partnerships, being profits from the sale of shares in mining companies were not within the ambit of the business profits article (Article 7 of the US DTA). Rather, he considered that they were within the ambit of the "alienation of property" article (Article 13 of the US DTA) and that Australian taxing rights were therefore not restricted by the US DTA.
The Commissioner may well have anticipated that the resolution of this question would not generate much controversy and the Court would follow, in some manner, the approach he adopted in TD 2011/25.
He was wrong. The Resource Capital partnerships raised a number of interesting arguments for the Courts to consider and the Courts went in all directions in response in trying to deal with the problem of applying DTAs where there are misaligned entity characterisations (transparent versus opaque) between the relevant DTA countries.
Overview of the effect of the RCF judgements
The results of the cases to date have been very unsatisfactory and can be summarised as follows:
- In RCF III, Edmonds J sought to resolve the misalignment by following OECD guidelines for dealing with these problems through DTAs, even though the relevant entity causing the problem (the Cayman Islands limited partnership) was not within the ambit of the US DTA – with the outcome from his approach being that DTA relief was potentially extended well beyond its previously understood limits (too much DTA relief!);
- In the RCF III appeal, the Full Federal Court focused on avoiding the issue entirely on the basis that the relevant question that would bring the issue forward for their consideration was not asked – so that the potential DTA overreach problem from the decision at first instance was overcome, but taxpayers and the Commissioner were then left in a situation where they had no certainty as to whether, in fact, any DTA relief would be available in misalignment scenarios; and
- In the RCF IV case, Pagone J sought to resolve the issue by showing that there was, in fact, no misalignment on the basis that corporate limited partnerships are, in relevant respects, transparent for both Australian and US tax purposes – with the potential outcome that the apparently well understood tax treatment of limited partnerships in Australia was wrong and all tax assessments issued on the basis of that treatment were invalid.
Pagone J's observations on whether the limited partnership in the RCF IV case was a taxable entity caused a considerable stir – the headline in the Australian Financial Review following the judgment read "Private equity shaken by shock tax verdict" with the text indicating that "lawyers are stunned by some aspects of the decision".
Key points from the RCF IV decision
The most significant conclusion reached by Pagone J in RCF IV was that, despite the apparently clear design intent of the rules dealing with limited partnerships, those rules did not make limited partnerships "taxable entities".
Although it is not clear exactly what the term "taxable entity" means, it seems to follow from this that the partners and not the "partnership" must be treated as deriving the relevant profit. This has certainly not been the practice in Australia since the introduction of the limited partnership rules in the 1990s. The practice of the Commissioner (which reflected a generally understood and non-controversial position) was that the general partner of the partnership was assessed as a company and tax was imposed at the company tax rate on the taxable income so assessed.
The conclusion reached by Pagone J creates the possibility that all prior assessments issued to limited partnerships (both foreign and Australian) were outside the power of the Commissioner (being issued to the wrong taxpayer) and therefore invalid.
This would create administrative chaos for limited partnerships and for the Commissioner.
However, when the judgment is read closely, it is apparent that the judge did not conclude that the assessments he was considering were invalid. Rather, he was prepared to conclude that they should be treated as within power, being addressed to the correct taxpayers through the agency of the limited partnership. So it is possible that the case could be read as not leading to the invalidation of most limited partnership assessments.
The case was also notable for a number of other points, with the judge reaching the following conclusions:
- that the profits from the shares sales were income of the partners rather than a capital gain (this was uncontroversial, given the particular fact pattern before his Honour);
- that the profits had an Australian source;
- that tax relief was potentially available under the US DTA (because the limited partnership was transparent, as discussed above);
- that the Commissioner's Tax Determination was binding on the Commissioner to the extent that limited partnerships derive profits dealt with by the business profits article in a DTA, and so could be relied upon by those partnerships in determining their Australian income tax position; and
- that (in a part of the case dealing with complex valuation issues) various assets are not "taxable Australian property" for Australian capital gains tax purposes.
The conclusions reached by the judge in relation to the source of the profits will be of potential significance to a range of foreign investors. In this regard, while the share sale transaction giving rise to the profit was executed outside Australia (on the Toronto Stock Exchange), the judge did not give this much weight in determining the source of the profit. Instead, he found the following facts more persuasive in deciding where the source of the profit was located:
- the business strategy included substantial business activities in Australia by agents of the limited partnership;
- an management entity for the limited partnership maintained an office in Australia with Australian employees and those employees played an active role in the initial investment, its management and ultimate disposal and assisted the non-Australian Investment Committee of the limited partnership to make the relevant investment decisions;
- those Australian employees were active on the boards of the investee companies in Australia; and
- the shares were sold pursuant to a scheme of arrangement carried out in Australia pursuant to the Corporations Act and under the supervision of the Federal Court of Australia.
Foreign investors should take note of the judge's focus on where the business activity takes place in relation to the both initial investment, the ongoing management and the disposal of Australian assets. Moreover, in considering whether the source of particular profits is from Australia or not, the approach of the judge suggests an almost binary analysis: there does not appear to be room in the analysis for some apportionment between Australian and foreign sources. Foreign investors may therefore wish to restrict the level of activities in Australia as far as possible.
The case on appeal
Not surprisingly, the Commissioner appealed the decision of the primary judge to the Full Federal Court. That appeal was heard recently (in early August this year).
While anything is, of course, possible, we think it likely that the Full Court will overturn the most contentious part of the decision of the primary judge and conclude that limited partnerships should be characterised as a "taxable entity" for Australian income tax purposes. This should ensure that prior assessments to such partnerships are not invalidated. Whether it also means that DTA relief is not available where investors invest through such partnerships remains to be seen.
Please click here to download the full report (3.16MB).
For further information, please contact:
Peter McCullough, Partner, Ashurst
peter.mccullough@ashurst.com
