Some Implications of the Latest International Tax Reforms

1. Background

One of the more unexpected announcements in the May 2005 Budget was the Government’s proposal to limit “the application of CGT [capital gains tax] to non-residents’ real property, and the business assets of Australian branches of a non-resident rather than the current wide range of assets.”  This measure, it was said, would “bring Australia’s … CGT rules and tax treaty practice into line with international standards.”  The ongoing cost of the measure was projected to be less than $65m per year, another surprising aspect of the announcement.

Legislation to enact this announcement (“the Bill”) was introduced into Parliament on the last sitting day of the winter session, 22 June 2006.  The legislation does not become operative until after the date of Royal Assent, which cannot occur before Parliament resumes in August this year but could well happen shortly thereafter.

The Bill builds on the many previous pieces of legislation already enacted as part of the Government’s so-called “NITA” project – to create Australia’s new international tax arrangements.  They are:

• the New International Tax Arrangements Act 2004 (NITA 1) which narrowed various aspects of the foreign investment funds rules;
• the New International Tax Arrangements (Participation Exemption and Other Measures) Act 2004 (NITA 2) which qualified Australian CGT where a resident disposes of non-portfolio shareholdings in a foreign company, expanded the tax exemption on non-portfolio dividends and foreign branch profits, and narrowed some aspects of the controlled foreign company rules;
• the New International Tax Arrangements (Managed Funds and Other Measures) Act 2005 (NITA 3) which dealt primarily with the CGT treatment of foreign residents investing in Australian fixed trusts;
• the New International Tax Arrangements (Foreign-owned Branches and Other Measures Act 2005 (NITA 4) which dealt with the taxation of dividends paid to the resident branches of non-resident companies and the Australian branches of non-bank financial institutions;
• the Tax Laws Amendment (Loss Recoupment Rules and Other Measures) Act 2005 (NITA 5) which enacted an expanded conduit foreign income regime; and
• the Taxation Laws Amendment (2006 Measures No 1) Act 2006 which enacted an exemption from Australian tax for temporary residents on their foreign source income and capital gains from offshore assets.

This Bill proposes three distinct measures:

• winding back the liability of non-residents to Australian CGT in some instances;
• expanding the liability of non-residents to Australian CGT in one situation; and
• re-expressing the rules dealing with the tax consequences of a change of residence.

The legislation replaces the current jurisdictional rules in Australia’s CGT.  Non-residents will now be liable to pay Australian CGT only where the asset involved is one of the 5 classes of “taxable Australian property”:

1. Australian real property owned by the non-resident;
2. an interest in Australian real property owned by the non-resident through holding a non-portfolio interest in an onshore company, trust or partnership where Australian real property and interests in real property represent at least one-half of the value of the company, trust or partnership.  (Rules which expand a non-resident’s liability in respect of an offshore company, trust or partnership are discussed at 4. below);
3. an asset used in carrying on business through a permanent establishment in Australia;
4. an option or right to acquire 1, 2 or 3; and
5. an asset owned by a non-resident who elected to defer Australian CGT on ceasing to be an Australian resident.

Among the obvious areas where the new rules will abandon CGT that is currently claimed are:

• gains made on the sale of shares in wholly-owned Australian subsidiaries will no longer be taxable unless the subsidiary is “land rich”;
• gains made on the sale of interests in resident unlisted trusts will no longer be taxable unless the trust is “land rich”;
• gains made on the sale of significant interests in listed companies and unit trusts will no longer be taxable unless the listed entity is “land rich”.

The sale of shares or units in “land-rich entities” is likely to prove the most common circumstance where a non-resident will be liable to pay Australian CGT.   Even it is unlikely to be common in practice; only in a handful of industries would a business have 50% of its assets as real estate.  The obvious analogy is to the “land rich” provisions in duties law – an area fraught with many difficulties.

The rules which impose tax on the sale of shares in land-rich companies and trusts are triggered where two tests are met:

• the non-resident is selling a non-portfolio interest in the entity (that is, at least 10%); and
• more than 50% of the value of the entity is represented by Australian real property.

Where the non-resident is selling shares or units in a holding entity which owns interests in a land-rich entity, the tests calculate the 10% proportion by multiplying the holdings at each layer.  So, for example, if a non-resident sells a 40% stake in a unit trust which has 20% of the shares of a land rich company, the non-resident has only an 8% interest and will not be liable to Australian CGT (unless of course the unit trust also happens to be land rich).  And there is no requirement to trace through an interest which is already less than 10% – for example, a 100% stake in a unit trust which has only 5% of the shares of a land rich company need not be examined.

Secondly, where the non-resident is selling shares or units in a holding entity which owns interests in a land-rich entity, the “50% of value test” is  diluted by non-land assets at each stage along the chain.  So, for example, if a non-resident sells units in a unit trust which has shares in a land rich company, the proportion of the value of the units being sold which represents Australian real property further down the chain is diluted by any non-land assets of both the company and the trust.

It is worth noting that the outcome for the non-resident is all-or-nothing – Australian CGT is either payable in full on any gain made on the share sale or not at all.  There is no pro-rating of the gain between the land and non-land assets which might have contributed to it.  This can lead to unhappy outcomes.  For example:

• the gain on non-land assets can be taxed.  Assume the non-resident subscribes $100 for shares in the company; the company uses it to buy land for $80 and another asset for $20; the other asset appreciates in value to $70; and the non-resident sells its shares for $150.  The non-resident will be liable to CGT even though all of the gain is attributable to the growth in the other asset; or
• a gain can be taxed when there is actually a loss on the land component.  Assume the non-resident subscribes $100 for shares in the company; the company uses it to buy land for $80 and another asset for $20; the other asset appreciates in value to $50; the land depreciates to $55; the non-resident sells its shares for $105.  The non-resident will be liable to CGT even though there is a loss the land component; or
• a gain on foreign assets can be taxed.  Assume the non-resident subscribes $100 for shares in an offshore company; the company uses it to buy land in Australia for $80 and a local asset for $20; the other asset appreciates in value to $70; and the non-resident sells its shares for $150.  The non-resident will be liable to Australian CGT even though all of the gain is attributable to the growth in a foreign asset.

Needless to say, given that this rule is driven by the ratio of assets, there is also an anti-avoidance rule to prevent stuffing non-land assets into an otherwise land-rich company or intermediary in order to dilute the land value to less than 50%.

Where the asset is something that the non-resident used in carrying on business through a permanent establishment in Australia, there is a pro-rating regime if the asset was used only partly within the branch.

This is clearly a major departure from Australia’s current assertion of jurisdiction to impose tax on non-resident’s Australian capital gains.  Most obviously, non-residents should now rarely expect to have to pay Australian CGT on the sale of shares in private or listed companies.  This will apply whether the non-resident holds a minority interest in the company or even where the Australian company is a wholly-owned subsidiary of the offshore parent.  The principal exceptions will be non-resident taxpayers engaged in the mining and property development industries or dealing with infrastructure investments.

There is a beguiling simplicity to the language of the Bill – tax will still be imposed on capital gains made from the sale of “real property situated in Australia.”

Unhappily, the notion of “real property” is becoming more, not less, problematic in many industries as business practices evolve.  Property law is not always decisive in classifying items as real or personal property, nor are those categories immutable over time.  A non-resident who sells a parcel of vacant land will rarely face a difficult characterisation question; selling the benefit of a 99-year lease over an office tower would be less certain.  Modern commercial practice will raise issues where the principal asset of the company being sold is a put option over land or a right of pre-emption; a call option over land is separately included as taxable Australian property.  Other obvious instances where the question, is this real property or not, will arise would include infrastructure projects such as pipelines, transmission lines, tunnels and toll roads where the Crown retains ownership of the freehold, rights to airspace or transferable floor space which are (or are not) created by easement, rights of entry or use created by contract or covenant, demountable buildings constructed to contain workers’ amenities, whether assets are fixtures on land or fittings within buildings (and the value to be placed on each), and so on.  Any gain made from assigning the benefit of a contract to purchase real property in Australia is taxable, but under Item 4, not because the contract is real property.

In the property development and management industry, there will clearly be significant value attached to assets such as development agreements and management rights in addition to the real estate component of the business.  Such assets would appear not to be “real property” though they are inherently bound up with land.

For mining, there is an explicit extension to “mining quarrying or prospecting rights” where the minerals etc. are situated in Australia.  The definition of mining rights extends to prospecting and mining permits and licenses, leases over land which allow prospecting and mining to occur, and buildings and other improvements on land used in connection with mining.

Clearly this legislation will, when enacted, place a considerable premium on non-residents having the ownership of their Australian assets held directly by the non-resident rather than an Australian entity.  Companies considering entering the Australian market will undoubtedly want to plan their entry with this factor in mind.  It is likely to lead to relatively “flat” ownership structures into Australia – that is, any investment which involves multiple companies is more likely to have them each owned offshore, rather than onshore.

A further implication is that “MEC groups” (multiple entry consolidated groups) are likely to increase in attractiveness and frequency for fresh investments.  A flat structure will maximise the flexibility for selling the investment later tax-free, and using a MEC group means offshore owners will not need to sacrifice access to all the benefits of consolidation. 

Further, these rules are applied to “foreign residents” which is not an immutable concept.  One can envisage that some investments by Australians may in future be undertaken as out-in arrangements, where the investment into Australia is made via an offshore vehicle.  To put the same point another way, Australian law will now be less even-handed between residents and non-residents.  A resident who incorporates a company, exposes resources to risk and sells the shares in a successful company at a profit will be liable to Australian tax on the sale; a non-resident who takes on the same risk and succeeds will not be likely to pay Australian tax on the reward realised on selling the company.

For companies already operating in Australia with an existing ownership structure, there will undoubtedly be exploration of the options for re-organising unattractive structures.  Again, the flexibility of the consolidation system may be an advantage as it allows a degree of intra-group movement to occur tax free prior to exiting Australia.  Another option for re-organising an existing investment may be found within the various CGT rollover regimes.  The Bill does make a series of amendments to various rollovers and these amendments may constrain their availability as the means of re-arranging an unattractive existing structure in order to make a tax-free exit from the investment.

One manifestation of that issue is the way that branches will now be clearly less attractive as the vehicle for conducting business in Australia.  If a non-resident sells the assets of a local branch, Australian tax will be payable; if the non-resident sells the shares of a resident company which conducts the same business in Australia, Australian tax is unlikely to be payable. 

There are important issues that have to be managed about the interaction between the measures in the Bill and the measures for managed funds announced in NITA 3 enacted last year.

The NITA 3 measures currently operate to eliminate Australian CGT where a non-resident disposes of units in an Australian resident unit trust provided 90% of the trust’s assets are not taxable Australian property.  This aspect of NITA 3 has now been superseded by the measures in the Bill.  Under the version in the Bill, a non-resident who disposes of units in an Australian resident unit trust would be entitled to an exemption from Australian CGT in all cases except where the non-resident is selling a non-portfolio interest and the Australian real property component exceeds 50%.

In another respect, however, NITA 3 still has a role to play which has not been superseded by the Bill.  The CGT exemption in NITA 3 extended to the capital gains flowing through a resident trust for foreign resident investors because the trust has disposed of assets and triggered a capital gain.  The NITA 3 exclusion from CGT remains relevant here and has in fact been re-enacted in a modified form by the Bill. 

• Where a resident trust makes a capital gain to which a non-resident beneficiary is entitled, the non-resident will be liable to Australian CGT on their share of the gain if the underlying asset is taxable Australian property.  This affords the non-resident beneficiary an exemption from capital gains attributable to the sale of offshore assets and Australian assets that are not on the list.
• Where the resident trust makes its capital gain from selling an interest in another resident fixed trust, the non-resident beneficiary will be liable to Australian CGT on their share of the gain unless at least 90% the value of the trust is represented by property other than taxable Australian property. 

As usual, there is no guidance in the Bill or Explanatory Memorandum to it about how to apply the measures in the Bill to a consolidated group or MEC group. 

To take a simple example, assume non-resident shareholder sells 20% of the shares in Aust Co 1 which has no land, but is in a MEC group with Aust Co 2 which owns extremely valuable land.  Is the 50% land rich test applied to Aust Co 1 in isolation, or to the Aust Co MEC group as if a single entity?  The likely answer in this example is that the consolidation regime does not affect the Australian tax position of an entity (such as the non-resident) which is not a member of the group.

The report of Australia’s Review of Business Taxation in 1999 recommended that the Government should address issues arising from sales offshore where the immediate asset or underlying asset was within Australia’s CGT jurisdiction.  The obvious examples were the sale of Australian assets from one non-resident to another, and the sale of interests in offshore entities from one non-resident to another where the value of the offshore entity was largely represented by Australian assets.

The Bill addresses the second of these topics by creating a liability to Australian CGT on the sale of a non-portfolio interest in an offshore company, trust or partnership where Australian real estate represents at least one-half of the value of the company, trust or partnership.  Hence, a non-resident who sells more than 10% of the interests in an offshore entity will have a liability to Australian CGT if more than 50% of the value of those interests is represented by Australian real property.

This is a new liability to CGT which does not currently exist under Australian law.

It should be noted, however, that this liability may not survive scrutiny under Australia’s tax treaties.  The right to tax a non-resident on capital gains attributable to the sale of shares in a foreign company or trust will usually be allocated, at least initially, exclusively to the country of the non-resident.  While Australia’s treaties will generally permit Australia to tax the gain on such a sale where the value of the underlying assets of a company or trust is principally Australian real property, difficult issues can arise where that clause is limited or expressed in different terms, or other articles of the treaty would qualify Australia’s right to tax.

It is worth noting in passing that Bill does not seek to impose a liability to Australian CGT on the sale of a non-portfolio interest in an onshore or offshore company where the principal assets of the company were used to carry on business through a permanent establishment here.

It is also worth noting that the Bill does nothing to create a reporting regime, withholding regime or other administrative mechanism to ensure that the tax obligation is reported to the Australian tax authorities, and the tax owed by the non-resident is actually paid.  However, in a sign of things to come, another Bill introduced into Parliament on the same day proposes to enact machinery provisions to facilitate the cross-border collection of taxes on a reciprocal basis.  This machinery provision is being enacted to provide the legislative framework in domestic law for cross-border enforcement measures such as are now envisaged in Australia’s tax treaty with New Zealand and the new treaty with France.  But seeking help offshore to enforce a tax debt of which the Australian tax authorities are unaware must be considered highly problematic.

The final set of measures in the Bill re-write the current rules dealing with the tax consequences of the immigration of individuals, companies and trusts.  The Bill re-expresses the current rules that on arrival, offshore assets held by the taxpayer are deemed to be acquired on that date for their then market value.  In other words, gains accruing while the offshore asset was owned by a non-resident remain outside Australia’s claimed tax jurisdiction.

For further information, please contact,

Michael Moschner
61 2 9225 5969
michael.moschner@gf.com.au