Taxation of non-residents by Clint Harding, CTA, Partner, Arnold Bloch Leibler

Transcription

1 Taxation of non-residents by Clint Harding, CTA, Partner, Arnold Bloch Leibler Abstract: Non-Australian resident taxpayers are taxed only on their Australian-sourced income. The taxation of capital gains is an area that has been subject to much change over the last 10 years and continues to be an area focused on by governments which are seeking to address structural budget deficits and decreasing tax revenues, and yet are trying to make Australia an attractive place for investment. This article primarily considers the taxation of capital gains derived by non-residents. The article reviews the basic domestic taxing regime for capital gains for non-residents as it is affected by Australia s tax treaty network. As part of this review, the article addresses some of the concerns and issues that have come to light recently in this area and provides a brief examination of the government s latest proposal to impose a capital gains tax withholding tax on non-residents. Introduction In any discussion concerning the taxation of non-residents, it is a useful starting point to understand the policy settings that inform how Australia seeks to assert taxing rights over this category of taxpayers. Everyone will be familiar with the basic premise that non-australian resident taxpayers are taxed only on their Australian-sourced income, whereas resident taxpayers are taxed on their worldwide income. The taxation of non-residents, in the first instance, is therefore driven primarily by questions of source. In the absence of any real set of codified source rules, the source of any given item of income for Australian tax purposes will differ depending on characterisation of that income and any relevant deeming rules that may apply. Questions as to the determination of source are outside the scope of this article but there are plenty of good materials available to assist should you need it. 1 The focus on this article is primarily on the taxation of capital gains derived by nonresidents. The reason for this focus is that the taxation of capital gains is an area that has been subject to much change over the last 10 years and continues to be an area of focus for governments which are seeking to address structural budget deficits and decreasing tax revenues, and yet are trying to attract foreign investment. And therein lies the tension that makes for many an interesting dinner conversation. What follows below is an examination of the basic domestic taxing regime for capital gains of non-residents as it is affected by Australia s tax treaty network. As part of this review, the author will address some of the concerns and issues that have come to light recently in this area and will provide a brief examination of the government s latest proposal to impose a capital gains tax (CGT) withholding tax on non-residents. It should also be noted that the author has not considered the specific concessions available to certain non-residents under the investment manager regime contained in Subdiv 842-I of the Income Tax Assessment Act 1997 (Cth) (ITAA97). Under this regime, introduced only recently, certain income derived by widely held foreign funds is not subject to Australian income tax in circumstances where the foreign fund engages the services of an Australian intermediary (eg agent, manager or service provider) to exercise a general authority to negotiate and conclude contracts on its behalf in respect of certain financial arrangements. Subdivision 842-I achieves these objectives by disregarding, or treating as non-assessable non-exempt income, certain ordinary income and statutory income and by disregarding certain capital gains and capital losses. Policy settings for the taxation of non-residents Several significant issues were addressed as part of the Review of international taxation arrangements (RITA) consultation process which was conducted by the Board of Taxation in Some 10 years following the Board s recommendations, the objectives of RITA are still relevant in today s increasingly globalised marketplace. The guiding policy factor as it relates to the taxation of non-residents remains as follows: Australia s international taxation rules should not create distortions and impediments which could inhibit Australian companies from competing on the world stage with a strong Australian base. Such a statement obviously has an outwards focus, and it goes without saying that such distortions or impediments will potentially reduce the benefits which could flow to Australia through further integration into a global economy. Perhaps the flip side to the above statement, and the emphasis in ensuring Australian companies can compete on the world stage, is that Australia s international taxation rules are being increasingly required to promote Australia as a competitive destination for an international investor to place their funds, consistent with Australia s status as a net importer of capital. The Johnson Report in 2010 recommended a raft of policy changes aimed at building Australia as a sophisticated and advanced financial sector. Some of the recommendations were focused on ensuring Australia s taxation system did not deter foreign investment, for example the recommendations concerning funds management vehicles: The Forum recommends that the Treasurer request the Board of Taxation to review the scope for providing a broader range of tax flow-through collective investment vehicles. 200

2 There must always be a balance struck between encouraging investment and the flow of funds into Australia and maintaining the integrity of our CGT system. Often, this balance is difficult to achieve. Capital gains tax reforms were initially raised in RITA in the context of making recommendations focused on the removal of impediments to Australia becoming a regional financial services hub (echoing the sentiments found in the Johnson Report some 10 years later). In particular, the RITA report raised CGT reform for non-residents who invest in Australian-managed funds (usually in the form of a unit trust). The issue of tracing through interposed entities, especially where the interposed entities were non-resident, proved difficult to reconcile with the deliberate introduction of s 3A of the International Tax Agreements Act 1953 (Cth). While significant changes to the CGT treatment of non-residents was at first rejected by the government, eventually the government announced on 10 May 2005 that it would introduce Div 855 ITAA97 to address some of the issues that had been raised in earlier reports. It should be noted that issues with introduction and enforcement of policy settings concerning the taxation of non-residents are now being discussed in numerous jurisdictions. For example, the collection of CGT from non-residents in the United Kingdom is a hot topic following the revelation by Britain s Chancellor George Osborne in his 2013 autumn statement (and confirmed in March s Budget) that from April 2015, non-uk resident property owners will have to pay CGT. In India, the Vodafone case, involving the indirect sale of shares of an Indian company by upper tier non-indian corporations, focused attention on the extraterritorial reach of India s taxing power. The Supreme Court in that instance held in favour of the taxpayer; however, the decision resulted in the Indian government (in the Finance Act 2012) retrospectively amending Indian tax laws to address the issue of the indirect transfer of Indian assets. Australia is not the only jurisdiction grappling with these issues. PART I: NON-RESIDENTS AND CGT Outline of the operation of Div 855 Schedule 4 to the Tax Laws Amendment (2006 Measures No. 4) Bill 2006 inserted Div 855 and Subdiv 960-GP into the ITAA97. Division 855 applies to CGT events occurring on or after 12 December For CGT events occurring prior to 12 December 2006, a non-resident could only make a capital gain or loss if the relevant asset had the necessary connection with Australia. The rules for working out which assets had the necessary connection with Australia were found in former Div 136 ITAA97. The broad impact of the new Division was to narrow the range of assets on which a foreign resident would be liable for Australian CGT to Australian real property and the business assets (other than Australian real property) of a foreign resident s Australian permanent establishment. At the same time, the new regime sought to address several integrity concerns, perhaps most significantly by extending the regime to include foreign resident indirect holdings of Australian real property. The key operative provision is s (1) ITAA97 which provides: Disregard a *capital gain or *capital loss from a *CGT event if: (a) you are a foreign resident, or the trustee of a *foreign trust for CGT purposes, just before the CGT event happens; and (b) the CGT event happens in relation to a *CGT asset that is not *taxable Australian property. The three threshold requirements that are therefore required to enliven Div 855 are that there must be a foreign resident, a CGT event and a CGT asset that is not taxable Australian property. Foreign residents A foreign resident is a person who is not a resident of Australia for the purposes of s 6(1) of the Income Tax Assessment Act 1936 (Cth) (ITAA36). Temporary residents (as provided for in Subdiv 768-R ITAA97) are regarded as foreign residents for the purposes of determining whether they are entitled to disregard any capital gain under Div Division 855 also applies to a trustee of a foreign trust. A foreign trust for CGT purposes means a trust that is not a resident trust for CGT purposes (and as defined in s 995-1(1) ITAA97). Taxable Australian property Taxable Australian property (or TAP as it is often referred to), is defined exhaustively in s ITAA97 as: taxable Australian real property; an indirect interest in Australian real property; a business asset of a permanent establishment in Australia; an option or right to acquire any of the CGT assets in items 1 to 3; or a CGT asset that is deemed to be Australian taxable property where a taxpayer, on ceasing to be an Australian resident, makes an election under s ITAA97. Four of these five categories of TAP are fairly easy to navigate and do not in practice cause many issues. Taxable Australian real property is defined broadly in s ITAA97 as: (a) real property situated in Australia (including a lease of land, if the land is situated in Australia); or (b) a mining, quarrying or prospecting right (to the extent that the right is not real property), if the minerals, petroleum or quarry materials are situated in Australia. Real property for the purposes of para (a) above includes a leasehold interest in land. 3 Section 995-1(1) defines a mining, quarrying or prospecting right as follows: (a) an authority, licence, permit or right under an Australian law to mine, quarry or prospect for minerals, petroleum or quarry materials; or (b) a lease of land that allows the lessee to mine, quarry or prospect for minerals, petroleum or quarry materials on the land; or (c) an interest in such an authority, licence, permit, right or lease; or (d) any rights that: (i) are in respect of buildings or other improvements (including anything covered by the definition of housing and welfare) that are on the land concerned or are used in connection with operations on it; and (ii) are acquired with such an authority, licence, permit, right, lease or interest. Business assets used by a foreign resident in carrying on a business through a permanent establishment (branch assets) are self-explanatory, as are rights or options and deemed TAP assets. On 26 May 2014, Treasury released for consultation an exposure draft intended to fix a technical deficiency concerning the definition of a permanent establishment that is used in Div 855. THE TAX SPECIALIST VOL 17(5) 201

3 Where the fun really begins is with indirect interests in Australian real property. That is, Australian real property that is held through one or more interposed entities. Indirect interests in Australian real property The inclusion in the categories of TAP assets of indirect Australian real property interests was a deliberate move by the government to strengthen the application of Australia s CGT to non-portfolio interests in interposed entities (including foreign interposed entities), where more than 50% of the value of interposed entities assets are attributable, directly or indirectly, to Australian real property. Section ITAA97 provides that an indirect Australian real property interest exists where a foreign resident has a membership interest in an entity and that interest passes two tests: the non-portfolio interest test; and the principal asset test. These tests were primarily intended to reduce compliance costs for foreign residents, while maintaining consistency with Australia s taxing rights under tax treaty practice. 4 The non-portfolio interest test The non-portfolio interest test is set out in s ITAA97. An interest held by an entity (the holding entity) in another entity (the test entity) passes the non-portfolio interest test if the sum of the direct participation interests held by the holding entity and its associates in the test entity is 10% or more. A direct participation interest for these purposes is defined by s ITAA97 as the total interest that an entity directly holds in another entity. The non-portfolio interest test is satisfied if the interest passes the test either at the time of the CGT event or throughout a 12-month period beginning no earlier than 24 months before that time and ending no later than that time. The principal asset test Section (2) ITAA97 provides that a membership interest held by an entity (the holding entity) in another entity (the test entity) passes the principal asset test if: the sum of the market values of the test entity s assets that are taxable Australian real property exceeds the sum of the market values of its assets that are not taxable Australian real property. In other words, more than 50% of the value of the test entity s assets is attributable to taxable Australian real property. The test is done on a gross assets basis meaning that liabilities are not taken into account for the purposes of determining the market value of an entity s TAP and non-tap assets. Put simply, if a company borrows $100 to buy a piece of real property, the value of that asset used for the purposes of the principal asset test disregards any corresponding liability. Assuming that there are no other assets or liabilities, the market value of the shares in the company is $0 yet the test will recognise a TAP asset of $100. Section (4) imposes tracing requirements and provides guidance on determining the market value of TAP and non-tap assets in circumstances where the underlying assets are held through interposed entities. For the purposes of determining which underlying entity s tracing must be undertaken to include assets that are indirectly owned, Div 855 requires that both direct and indirect interests in the relevant underlying entity must exceed 10%. For underlying entities where the total participation interest of the holding entity exceeds 10%, a portion of the underlying assets of the test entity are directly included in calculating whether the holding entity itself passes the principal asset test. In circumstances where the holding entity has a less than 10% total participation interest in the test entity, the market value of the relevant shareholding (rather than Diagram 1 Entity B Australian real property $1,000,000 9% Australian real property $600,000 gross underlying assets) will be included in the calculation and will be treated as a non-tap asset. The differing treatment, based on the total participation interests, was designed to reflect that foreign residents with only portfolio participation interests will have access to the necessary financial information to ascertain the value of underlying assets. With the benefit of hindsight, the author does not think the manner of drafting has achieved the desired reduction in the compliance burden being placed on affected foreign resident taxpayers. It is often the case that affected foreign resident investors may struggle to obtain the market value information due to insufficient control in the interposed entity and therefore the ability to demand the production of such information. The tracing calculations required by Div 855 can become considerably complex. For example, consider the example in Diagram 1. 5 In this example, which highlights the different impacts of direct and indirect participation interests, Holding Entity s membership interest in Test Entity passes the principal asset test since more than 50% of the value of Test Entity s assets is attributable to taxable Australian real property. The detailed tracing calculations for the above example can be found in the explanatory memorandum to Div 855, but be warned, they require a cold towel and a clear head. If you are good at Sudoku puzzles, you should have no problem applying the tracing rules found in s Holding Entity Test Entity Entity A 100% 60% Other assets $200,000 20% Entity C Australian real property $500,

4 Valuation of assets The explanatory materials accompanying the introduction of Div 855 provided that assets should be measured at fair market value, being the amount that a willing purchaser, acting at arm s length to the seller, would pay for the asset. 6 Further, it was stated: 7 It would be expected that an entity would do all it can to arrive at a market valuation. If an entity is not required to prepare financial statements or it has not prepared financial statements then a market valuation would be required. When a taxpayer cannot get access to information, or the taxpayer does not have sufficient control to demand that a market valuation be undertaken, the taxpayer may use the value in the audited accounts of the entity only when the asset value is determined under the revaluation method ) ie, the fair value of the asset). These accounts would be expected to be prepared in accordance with the Australian equivalents of the International Accounting Standards. Asset values determined under the cost method do not represent an accurate value for the real property and may result in distortions in the calculation of whether the principal asset test is met. It is also possible for the market value of an entity s assets to be ascertained by reference to the market price of the shares in the entity. In some circumstances, the method adopted to value an asset may be determined by the nature of the asset itself. The issue of a suitable valuation method with respect to the value of mining information was considered by the AAT in AP Energy Investments Ltd and FCT 8 (AP Energy). The AP Energy case is discussed in more detail below. Further issues connected with the valuation of assets for the purposes of Div 855 have been ventilated in the Federal Court in FCT v Resource Capital Fund III LLP 9 (RCF), with the Full Federal Court recently overturning the decision of Edmonds J at first instance. The RCF case is also discussed in more detail below. Finally, readers should note that s (5) provides an integrity measure such that the market value of any asset acquired by the test entity or by any other entity is disregarded if the acquisition was done for a purpose (other than an incidental purpose) that included ensuring that a membership interest in any entity would not pass the principal asset test. The author is not aware of the ATO having relied on s (5) in any circumstances to date. Interpretation and application of Australia s tax treaties It is important to recognise that Australia s network of double taxation treaties can still have a role to play in determining the liability of non-residents to Australian tax on the disposal of assets. The interpretation and application of tax treaties is worthy of a separate article, and so the author has only broadly summarised the relevant principles that may apply in the context of the broader theme of this article. However, it is fair to say that the importance of tax treaties in determining the liability of non-residents to CGT has diminished following the introduction of Div 855 and the Federal Court decisions in Virgin Holdings SA v FCT 10 (Virgin Holdings) and Undershaft (No. 1) Ltd v FCT (Undershaft). 11 The first step when advising a non-resident on their liability to Australian tax remains, as has always been the case, to determine whether a liability to Australian tax exists under Australia s domestic taxing provisions. Such an exercise will necessarily entail an examination of the concepts of ordinary income and the provisions in the tax Acts dealing with the taxation of capital gains (including Div 855). Where a tax liability exists under Australian domestic legislation, the next step is to consider whether the position is altered by any applicable tax treaty between Australia and the foreign jurisdiction in question. In the event of inconsistency between Australia s domestic tax laws and the provisions of a double tax agreement (DTA), the latter prevails (subject to the application of the general anti-avoidance provisions contained within Pt IVA ITAA36, and the treaty override provision referred to below). 12 A tax treaty may, in some circumstances, overcome Australia s taxing rights arising from the provisions of the Australian tax Acts, including the CGT provisions. This article does not address the multitude of issues that can arise when determining what the appropriate treaty to apply is, and, assuming that the applicable treaty can be identified, whether a particular taxpayer is then able to rely on the terms of the treaty. 13 Such issues are still the subject of ongoing uncertainty as can be seen from the most recent decision of the Full Federal Court in RCF which dealt with the application of treaties in the context of foreign limited partnerships. Treaties and CGT Australia has entered into approximately 44 tax treaties with foreign nations that specifically deal with income taxes. While the treaties are all generally based on the uniform model treaty prepared by the OECD, the unilateral nature of the agreements means that an application of two treaties to the same set of facts and circumstances may not necessarily yield the same outcome from an Australian taxation perspective. The treaties in the existing network can be broadly divided into two groups: (1) those treaties which were negotiated and entered into post-1985 (the introduction of CGT) and which specifically allow Australia to tax capital gains made by non-residents on the disposal of Australian property (or interposed entities) through either; and (2) those treaties which were negotiated prior to 1985 and which do not directly address the CGT consequences for non-residents disposing of Australian real property. In any case, there are three questions you should be asking yourself as an adviser once you have established what the relevant treaty is. (1) Is CGT a tax covered by the treaty? (2) Does the business profits article in the treaty otherwise apply? (3) Are there any other operative articles (for example, specific articles dealing with the alienation of property) that may apply? These questions were first addressed by the ATO in TR 2001/12 in which the Commissioner considered, among other issues, whether Australia s tax treaties that were concluded prior to the introduction of CGT in 1985 denied Australia the right to tax the capital gains of enterprises of the other state in circumstances where the business profits article would otherwise apply to deny Australia taxing rights. The Commissioner s views on these issues, as set out in the ruling, were ultimately found by the Federal Court to be incorrect and the ruling was subsequently withdrawn. The Virgin Holdings and Undershaft decisions The agreed facts in both of these decisions were similar: a disposal of the shares by the non-resident taxpayer in the relevant Australian company triggered CGT event A1; THE TAX SPECIALIST VOL 17(5) 203

5 the shares had the necessary connection with Australia; the shares were held on capital account; and the non-resident sellers were enterprises in their respective jurisdictions and did not carry on business in Australian through a permanent establishment. The court held in both decisions that Australian CGT was included in the definition of taxes covered (Swiss Treaty) or Australian income tax (Netherlands Treaty), notwithstanding the treaties were both pre-cgt treaties. Crucially, in relation to the effect of the business profits article in the treaty, the Federal Court held that the operation of the article was not limited to business profits or income according to ordinary concepts but should be extended to capital profits and capital gains. On that basis, art 7 applied to the capital gains made by the taxpayer and, in the absence of a permanent establishment in Australia, the Commissioner was denied the right to include the capital gain in the assessable income of the taxpayer. However, care should be taken when seeking to rely on these decisions as Australia continues to renegotiate a number of the tax treaties/dtas that were in force in 1985, including those with many of Australia s significant trading partners (eg the US, the UK, New Zealand, Canada). As further tax treaties are renegotiated, the potential impact of these decisions will lessen. It goes without saying that taxpayers resident in jurisdictions which do not have a tax treaty with Australia will not be in a position to avail themselves of any protection that could otherwise be offered in a treaty context. Australia s treaty override provision You might be forgiven for thinking that once you had navigated Australia s domestic taxing provisions, then identified and traversed the manner in which those provisions are affected by Australia s treaty network, you had advised your client in a diligent manner and that you were once again entitled to sleep at night. But alas, once these questions have been answered, then regard still needs to be had to Australia s domestic treaty override provision (s 3A of the International Tax Agreements Act 1953). Section 3A was introduced by Sch 1 to the Taxation Laws Amendment Act (No. 4) 2000 in direct response to the decision of the Full Federal Court in FCT v Lamesa Holdings BV 14 (Lamesa). In Lamesa, the taxpayer successfully argued that the alienation of real property article in the Australia Netherlands tax treaty should be restricted to the direct alienation of real property, and should not apply to an indirect alienation via an interposed entity. Section 3A extends the scope of Australia s taxing rights under the alienation of real property article in all of Australia s pre-1998 treaties to the sale of shares of a company that has a land rich subsidiary. Alienation of real property through interposed entities (1) This section applies if: (a) an agreement makes provision in relation to income, profits or gains from the alienation or disposition of shares or comparable interests in companies, or of interests in other entities, whose assets consist wholly or principally of real property (within the meaning of the agreement) or other interests in relation to land; and (b) this Act gave that provision the force of law before 27 April (2) For the purposes of this Act, that provision is taken to extend to the alienation or disposition of shares or any other interests in companies, and in any other entities, the value of whose assets is wholly or principally attributable, whether directly, or indirectly through one or more interposed companies or other entities, to such real property or interests. (3) However, subsection (2) applies only if the real property or land concerned is situated in Australia (within the meaning of the relevant agreement). (4) If, after the commencement of this section, this Act is amended so as to give the force of law to an amendment or substitution of a provision mentioned in subsection (1), this section ceases to apply to that provision from the time that the amendment of the Act takes effect. The heavy lifting that was formerly done by s 3A has now been assumed by Div 855 in a domestic sense. Division 855 is, however, broader in the sense that it applies to chains of interposed entities both inside and outside Australia. However, as can be seen by the following example, s 3A may still have work to do in circumstances where Div 855 does not apply. Case study The Glamrock Group (Glamrock) is a multinational group which carries on the core businesses of mining and the provision of mining equipment and associated services and is listed on the German DAX. Glamrock s Australian operations consist of a mining operation in Western Australia which owns and operates two mines in WA, and an engineering services business that provides consulting and engineering services to other entities within the group and to third parties. Glamrock s Australian operations sit within Red Rock Pty Ltd (Red Rock), a wholly owned subsidiary of Red Rock Holdings GmbH, which is itself a wholly owned subsidiary of the listed Glamrock Group AG. Red Rock also holds all of the shares in Indorock PT, which holds exploration rights in Indonesia and has recently established Glamrock s first mining operation there. The current market values of Red Rock s assets are as follows: Red Rock Oresome Mine 1 (WA) Red Rock Oresome Mine 2 (WA) Australian exploration licences Mining information and goodwill Shares in IndoRock PT IndoRock mines and rights Loan to IndoRock PT Other non-land assets A$100m A$100m A$300m A$100m A$250m A$300m A$50m A$5m The group structure can be represented by Diagram 2. Diagram 2 Germany Australia Indonesia Glamrock AG (listed) 100% Red Rock Holdings GmbH Red Rock Pty Ltd Indorock PT 100% 100% 204

6 Glamrock is considering a sale of its Australian operations and, based on current market values, it is expected that a disposal of the shares in Red Rock would result in a significant gain. Glamrock has asked you to advise as to whether the sale of the shares would be subject to tax in Australia. For the purposes of this example, it is assumed that Glamrock holds the shares in Red Rock on capital account such that any gain is not taxable as a revenue gain under s 6-5 ITAA97. Application of Div 855 Division 855 will determine whether Australia will seek to tax any capital gain arising on the disposal of the shares in Red Rock by Glamrock. As noted above, Div 855 will operate to disregard any capital gain made by a foreign resident in circumstances where the CGT event happens in relation to a CGT asset that is not taxable Australian property. The relevant question is therefore whether or not the shares in Red Rock are taxable Australian property for the purposes of Div 855. Looking at the categories of taxable Australian property set out in the table at s , the shares in Red Rock are clearly not taxable Australia real property, branch assets, options or rights or an asset covered by s (3) ITAA97. Accordingly, the only way in which the Red Rock shares will be regarded as taxable Australian property is if they meet the definition of an indirect Australian real property interest. On the basis that Glamrock owns 100% of the shares in Red Rock, the shares will pass the non-portfolio interest test in s (1)(a). The key issue then becomes whether Red Rock passes the principal asset test as set out in s As described in more detail above, the principal asset test will be satisfied if the market value of all of Red Rock s assets, which themselves qualify as taxable Australian property, exceeds the market value of all assets which are not taxable Australian property. Red Rock s assets that qualify as taxable Australian property are as follows: Red Rock Oresome Mine 1 (WA) Red Rock Oresome Mine 2 (WA) Australian exploration licences Total TAP A$100m A$100m A$300m A$500m For the purposes of this example, it is assumed that the Australian exploration licences have been granted under Australian law and meet the definition of a mining, quarrying or prospecting right provided by s 995-1(1) ITAA97. Red Rock s assets that do not qualify as taxable Australian property are as follows: Mining information and goodwill Indorock PT mines and rights Loan to Indorock PT Other non-land assets Total non-tap A$100m A$300m A$50m A$5m A$455m In relation to the shares held by Red Rock in IndoRock PT, it is necessary to trace through to the assets (assuming that this is possible) of Indorock PT to determine whether any of Indorock PT s assets should be directly included in calculating whether Red Rock will satisfy the principal asset test. This is on the basis that Red Rock has a direct participation interest (s ) of 100% in Indorock PT and therefore that item 2 in the table at s (4) applies. On the basis that Indorock PT does not own any Australian assets, it is appropriate to treat the non-tap assets of Indorock as nontaxable Australian property of the test entity. The inclusion of mining information and goodwill as a non-tap asset of Red Rock is also not free from doubt and this is explored later in the article. For the purposes of this example, it is not determinative of whether the principal asset test is satisfied, but should be noted by the reader as an issue warranting closer examination. The result of the application of the principal asset test is that the market value of Red Rock s TAP assets exceeds the market value of its non-tap assets and the test is satisfied. On that basis, the shares in Red Rock will represent an indirect Australian real property interest and Div 855 will not exempt any capital gain derived on the sale of such shares. Any gain made by Glamrock on the disposal of the shares in Red Rock will therefore be subject to Australian taxation under Australia s domestic taxing provisions. That is not the end of the story however. Application of the Australia Germany tax treaty Germany has been chosen as the jurisdiction for the holding company in this example for a specific reason. That reason is because the tax treaty between Australian and Germany (German DTA) is particularly unusual and serves to highlight how important it is to have regard to tax treaties in the context of advising non-resident clients. The German DTA was signed in 1972 and accordingly predates the introduction of CGT in Australia by some 13 years. The treaty defines Australian tax as meaning: tax imposed under the law of the Commonwealth of Australia, being tax to which this Agreement applies by virtue of Article 2. Article 2 provides that the taxes to which the German DTA applies are: (a) in Australia: the Commonwealth income tax, including the additional tax upon the undistributed amount of the distributable income of a private company. Furthermore, the German DTA does not contain an alienation of property article in the usual form. Article 21 of the German DTA deals with capital represented by real property and provides that such capital may be taxed in the contracting state in which the property is located. However, the author s view is that this article, when read with the restrictive definition of taxes in art 2, does not have the reach that a traditional alienation of property article may have when it comes to imposing Australian CGT on gain made from the disposal of the shares in a land rich entity such as Red Rock. Accordingly, in circumstances where Glamrock is deriving a capital gain on the disposal of shares in an Australian company, there would arguably be no specific provision in the treaty dealing with such gains and it may be open to Glamrock to rely on art 7 in the German DTA which states: The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the THE TAX SPECIALIST VOL 17(5) 205

7 other Contracting State through a permanent establishment situated therein. Following the decisions in Virgin Holdings and Undershaft, and the subsequent withdrawal of TR 2001/12, it may be open to Glamrock to rely on art 7 of the German DTA with the effect that any capital gains arising from the sale of the shares may not be taxable in Australia, notwithstanding the position arrived at under Div 855. For completeness, it is unlikely that Australia s tax treaty override provision (s 3A of the International Tax Agreements Act 1953) will apply in these circumstances as the section itself notes that it only applies if: a [treaty] makes provision in relation to income, profits or gains from the alienation or disposition of shares or comparable interests in companies, or of interests in other entities, whose assets consist wholly or principally of real property (within the meaning of the [treaty] or other interests in relation to land; As noted above, the German DTA does not specifically provide for income or gains from the alienation or disposal of interests in land rich entities. Accordingly, it would seem to follow that s 3A cannot apply to override the potential application of art 7 of the German DTA and on that basis, Glamrock should not be subject to Australian CGT on the disposal of its shares in Red Rock. Issues with Div 855 The author understands that there have been concerns raised at high levels within the ATO about the level of voluntary compliance with Div 855 since the time of its introduction. Such concerns are reflected in statements such as those included in the minutes of the November 2012 NTLG Losses & CGT sub-committee. In the minutes the ATO, when discussing the most recent CGT & losses compliance report, noted in respect of foreign residents that: [The ATO] was continuing to see low levels of voluntary compliance by foreign residents with respect to Division 855, with the bulk of CGT collections in this area arising from compliance activity by the ATO. We have a continued focus on identifying foreign resident companies that may be subject to Division 855 through monitoring media and other databases. We have been working with other Commonwealth and State agencies to improve our ability to identify transactions that may have a Division 855 consequence, and exploring options as to how education for foreign residents with taxable Australian real property can be best targeted. Valuation issues remain an area of concern, particularly in relation to the mining sector. In terms of valuing mining information, TR 98/3 was withdrawn on 11 July It would appear that the position has not materially changed since 2012, with Div 855 being identified as a current risk in the ATO large business income tax strategy for Consolidated groups generally One concern the ATO has is with the creation of intercompany debts within a consolidated group to bolster the assets of the lender, while the tax implications for the wider group remain neutral due to the income tax consolidation regime. This is reflected by the comments in the 2013 federal Budget announcement concerning the areas that will be the subject of scrutiny: The changes to the principal asset test comprise of two components. The first is to ignore intercompany dealings between entities within the same tax consolidated group for the purposes of determining whether the entity being disposed of passes the principal asset test. The principal asset test only looks at the assets of the entity being disposed of. It is currently possible to artificially inflate the gross assets of the entity being disposed of in order to fail the principal asset test and, therefore, come under the CGT exemption available under Subdivision 855-A. Diagram 3 100% Sub A Assets: Real property 150 Intra-group loan 100 For Co Head Co $ loan The issue potentially arises because the principal asset test is done on an entity-byentity basis (rather than on a consolidated basis) and the relevant asset valuations are taken on a gross assets basis, with liabilities effectively being ignored. The effect of this being, broadly, the duplication of assets. Diagram 3 illustrates a very simple example. In this example, the TAP assets would consist of the $150 of real property held by Sub A and the non-tap assets would be the $100 intragroup loan asset of Sub A and the $100 of cash in Sub B. The loan would be ignored for income tax purposes as it would be between two members of a tax consolidated group, yet the subsequent disposal of shares in Head Co would be exempt from Australian CGT on the basis that the principal asset test is failed and the exemption in Div 855 applies. In the absence of the loan, TAP assets would be $150 and non-tap assets $100. The government announced further changes addressing this issue with Div 855 in the federal Budget and, on the afternoon of 14 May 2014, released exposure draft legislation together with accompanying explanatory materials detailing the proposed changes. These changes are discussed in more detail below. MEC groups issues paper A separate issue, but still relating to the interaction between consolidated groups and Div 855, has been identified by the 100% Australia Sub B 100% Assets: Cash 100 Liabilities: Intra-group loan 100 Consolidated group 206

8 government and concerns certain tax advantages available to foreign-owned multiple entry consolidated (MEC) groups that are not available to Australian-owned consolidated groups. As part of reforms announced in the federal Budget to protect the corporate tax base from erosion and loopholes, the former Labour Government announced that the tax law would be amended to remove these advantages. Treasury subsequently released an issues paper in May 2013 titled Removing the tax advantages for multiple entry consolidated groups that identified the issue and outlined the process for implementing this measure: In many cases, MEC groups can undertake relatively simple restructuring to avoid CGT on the sale of non-taxable Australian real property (non- TAP) assets that are currently within the Australian tax net because they are owned by an Australianresident taxpayer. MEC groups can achieve this by moving assets to a tier-1 company and then selling the shares in the tier-1 company, rather than simply selling the underlying asset. As long as less than 50 per cent of the value of the tier-1 company is derived from TAP assets, the sale is eligible for the non-resident CGT exemption. In comparison, an ordinary consolidated group would not be able to receive the non-resident CGT exemption on the sale of the shares in a subsidiary, because the shares would be owned by the Australian-resident head of the group. As can be seen from the example in Diagram 4, if the MEC group wishes to sell Asset A (being one of many assets Diagram 4 Australia Indonesia Provisional Head Co Foreign Top Co Company A (Tier-1) Assset A (non-tarp) MEC group that Company A holds) and avoid a CGT liability in respect of any gains on the sale, the asset can be transferred to Empty Co, a tier-1 company in the consolidated MEC group owned directly by Foreign Top Co. The transfer will not attract any Australian income tax consequences as it is between members of a consolidated MEC group. The value of Empty Co is now derived entirely from non-tap assets and as a result, the shares in Empty Co can be sold without triggering Australian CGT courtesy of Div 855. The new measures outlined in the issues paper were stated to have effect from 1 July The current status of these reforms, as at the date of writing of this article, is not altogether clear. The Assistant Treasurer made an announcement on 14 December 2013 specifying which announced but unlegislated tax and superannuation measures would proceed. Item 77 on the table accompanying that announcement was on the list of measures that were effectively scrapped. Item 77 concerned amendments to the consolidation measures addressing minor technical deficiencies. It was noted in item 77 that issues related to MEC groups would be referred for consideration by the ongoing MEC group review. It is unclear at this stage whether these amendments identified in the Treasury issues paper will in fact be made and, if so, from what date they will take effect (whether that be from 1 July 2014 or otherwise). Empty Co (Tier-1) Step 1: Asset A is transferred to Empty Co, a Tier-1 company. Step 2: Empty Co, which owns Asset A, is sold by Foreign Top Co to Third Party Co. Because less than 50% of Empty Co s assets are TARP assets, Foreign Top Co pays no CGT. Third Party Co Empty Co Assset A (non-tarp) Mining information and goodwill Legislative changes addressing in part the issues raised by the AP Energy case were announced in the 2013 federal Budget. The thrust of the amendments is to take certain intangible assets, such as mining information and goodwill, which are currently not considered taxable Australian real property, and treat them as taxable Australian real property provided they are attributable to taxable Australian real property, such as the exploration and mining rights. According to the government s press release, a number of foreign-owned mining companies have been disposed of, and the foreign owner had not been taxed on the basis that the non-taxable Australian real property, including mining information, exceeded the value of the taxable Australian real property. In these cases, the principle asset test would be failed and the foreign owner would be exempt under Subdiv 855-A ITAA97. Under this example of the proposed amendments, the mining information will be included as taxable Australian property, which may result in the principle asset test being passed and, therefore, the Subdiv 855-A exemption would not be available. The consequence of the proposed is that the ability to separate out the value of the mining information (which is a non-tap asset) from the mining right itself (which is TAP as defined under s ) will no longer be possible. It was intended that these changes apply from the date of the announcement; however, at the time of writing, no draft legislation had yet been released. Valuation issues The issue of the valuation of mining information was raised in the AP Energy case. While the proposed changes will clarify whether or not mining information is to be regarded as TAP or non-tap, these changes will not necessarily resolve the difficult valuation issues that can arise. While most decisions on issues of valuation will likely be constrained to their specific facts and circumstances, the AP Energy and RCF cases do provide a window to the complexity and different views that can arise, and are thus themselves worthy of discussion. THE TAX SPECIALIST VOL 17(5) 207

9 AP Energy Investments Ltd v FCT In AP Energy, a Chinese company was allowed to disregard the capital gain it made on the part disposal of its shares in an Australia company, Abra Mining Limited (Abra), pursuant to s (1). AP Energy is a Chinese registered investment company based in Beijing, China. On 7 December 2006, AP Energy entered into a share subscription and option issue agreement with Abra, an Australian incorporated company which is listed on the Australian Stock Exchange (AP Energy/Abra Agreement). Pursuant to the AP Energy/Abra Agreement, AP Energy: (1) subscribed for 9 million fully paid ordinary shares in Abra which were duly issued on 11 December 2006; and (2) was granted 9 million options to acquire Abra shares and a further 11 million options to acquire Abra shares. On 8 June 2007, AP Energy exercised its 9 million options, which resulted in AP Energy s shareholding in Abra increasing to 21.4%. On 3 December 2007, AP Energy disposed of 15,046,420 of its 18,000,000 Abra shares to Hunan Nonferrous Metals Holding Group Co Ltd (Hunan). On 12 September 2008, the Commissioner issued AP Energy with an assessment for the year ended 30 June 2008 for the amount of $1,805,240 (Assessment). The Assessment included a capital gain of AU$6,017,467 in respect of AP Energy s part disposal of its Abra shares to Hunan on 3 December On 6 October 2008, AP Energy objected to the Assessment (Objection) on the basis that the principal asset test was not satisfied at the time the shares in Abra were disposed of by AP Energy and it therefore followed that the shares in Abra were not themselves an indirect Australian real property interest. Accordingly, the shares should not have been considered TAP by the Commissioner and the capital gain made on the sale of the Abra shares should be disregarded pursuant to s Issue The main issue that was in contention was whether AP Energy was allowed to disregard the capital gain on the part disposal of its shares in Abra on 3 December 2007, pursuant to s (1). Relevantly, this required the tribunal to turn their mind to whether AP Energy s membership interest in Abra passed the principal asset test and, in particular, the market value of Abra s mining information, the resulting residual amount for Abra s mining rights and the intangible value created by Abra holding both mining information and mining rights. To the extent such non-tap assets exceeded the value of Abra s TAP assets, then AP Energy s membership interest in Abra mining would not pass the principal asset test and AP Energy would have been allowed to disregard its capital gain on the part disposal of the shares. Commissioner s contentions The Assessment and the Objection decision as issued by the Commissioner relied on the Australian Valuation Office (AVO) valuation of Abra. This particular valuation adopted a residual method approach to reach its conclusion that Abra passed the principal asset test. This methodology used by the AVO ascertained the market capitalisation of Abra as at 3 December 2007 and the market value of each of Abra s assets as at 3 December The difference between the market capitalisation value of Abra and the sum of the fair market value of each asset of Abra was then, according to the AVO valuation report, the value of any residual asset. The result of which in the Commissioners view meant that AP Energy s membership interest in Abra constituted an indirect real property interest as Abra had on balance a value ascribed to its TAP assets which exceeded its non-tap assets. Taxpayer s contentions On the other hand, in forming a view as to the correct valuation approach to take with respect to the assets of Abra and, in particular, the mining information and the mining rights, AP Energy relied on their own external valuation report. This report was, in part, consistent with the methodology adopted by the AVO report but differed in one respect, that being the way in which it ascribed a value to the mining information which was not a TAP asset for the purposes of Div 855. The taxpayer contended that: to obtain a fair snapshot of [the explorer s] underlying TARP for the purposes of the [principal asset test], the cost to a prospective arm s length purchaser of regenerating mining information, discounted for the use of relevant mining information publicly available, ought to be divorced from the intangible which may arise from mining information and attach to the mining right or real property. The consequence of this was that AP Energy contended that the correct value to attribute to Abra s mining information was $21,158,702 and not $10,000,000 (as alleged by the Commissioner and the AVO report) and therefore, on balance, Abra s TAP assets did not exceed its non-tap assets such that the principal asset test was not satisfied. Tribunal decision The issue before the AAT turned on expert opinion evidence as to the operation of the principal asset test and the value of the TAP and non-tap assets of Abra. Ultimately, the AAT accepted the valuation put forward by AP Energy s valuation expert and, accordingly, formed the view that the shares in Abra were not an indirect real property interest for the purposes of Div 855. The AAT stated: The Tribunal agrees with AP Energy s contention that Mr Longworth s valuation of Abra s mining information as at 3 December 2007 provides a reliable, conservative and independent expert assessment of the replication cost of Abra s mining information as at 3 December 2007 and that the residual of Abra s enterprise value picks up all the intangible value attracted to Abra s mining rights or real property by its exploration activity. In forming such a view, the AAT relied to some degree on guidance provided by Edmonds J in Resource Capital Fund III LP v FCT 15 (RCF) but ultimately distinguished that case on the basis that the relevant entity was a producer and not an explorer like Abra. Accordingly, the discounted cash flow method used in RCF may not have been reliable for an explorer where there was as yet no defined ore body of assessed economic significance. The AAT held that the appropriate basis for ascertaining market value was one which fairly arrived at that value. The sunk cost method adopted by Mr Longworth was therefore accepted by the tribunal as an acceptable proxy for market value. The author understands that the AP Energy decision is being appealed by the Commissioner. FCT v Resource Capital Fund III LP On 3 April 2014, the Full Federal Court issued its judgment in RCF overturning the Federal Court s judgment. 16 In RCF, the following issues were decided: 208

10 the US Australia tax treaty (US Treaty) did not prohibit the Commissioner from assessing Resource Capital Fund III LP (RCF), a Cayman Islands limited partnership (Caymans LP) that was treated as a fiscally transparent entity for US tax purposes but as a company for Australian tax purposes, on the capital gain in question; and the valuation methodology adopted by the Federal Court (Edmonds J) that required each asset to be valued separately for Div 855 purposes was incorrect. Instead, Div 855 requires the assets to be valued as if they were offered for simultaneous sale as a bundle of assets. The treaty issues addressed by the court in RCF are perhaps more interesting than the valuation issues. However, for the purposes of this article, the author has deliberately focused on the valuation issues that are directly connected with Div 855. Background During the year ended 30 June 2008 (the year of income), RCF sold shares in two parcels in St Barbara Mines Ltd (SBM). In 2010, the Commissioner issued RCF with a notice of assessment for the year of income including in assessable income a net capital gain in respect of the share sales of $58,250,000. The Commissioner also imposed an administrative penalty in respect of the tax liability. RCF objected against the assessment. The objection was deemed to have been disallowed by operation of s 14ZYA(3) of the Taxation Administration Act 1953 (Cth) and RCF appealed to the Federal Court. At all material times, RCF was a limited partnership formed in the Cayman Islands under the law of that jurisdiction. Its general partner was the Caymans LP and its affairs were managed by a limited liability company incorporated in Delaware, US. At all relevant times, SBM conducted a gold mining enterprise on mining tenements it owned in Western Australia, using plant, equipment, mining information and other assets. The mining tenements were taxable Australian property of SBM for the purposes of Div 855 but the other assets were not. SBM s fully paid ordinary shares were listed on the Australian Securities Exchange. There were two issues in the appeal. The first was whether the Commissioner could properly issue the assessment to RCF or whether he was precluded by the International Tax Agreements Act 1953, and more specifically, the US Treaty. The second issue was whether, if the assessment could properly be issued, any capital gain was required to be disregarded There must always be a balance struck between encouraging foreign investment and maintaining the integrity of our CGT system. under s For the purposes of this article, the second issue will be focused on as it applies to Div 855. Issues Full Federal Court decision The relevant focus of this article is on issues pertaining to Div 855. Accordingly, it is not the author s intention to undertake a detailed discussion as to the tax treaty issues that were also ventilated in the proceedings. The second issue addressed in the case, as already stated, concerned whether the capital gain derived by RCF (a non-resident taxpayer of Australia) on the sale of the shares in SBM was assessable to Australian income tax. As set out above, under Div 855, non-resident taxpayers may disregard capital gains to the extent they are considered to be non- TAP. Division 855 issue Under Australian tax law, and in particular Subdiv 855-A, foreign residents are subject to Australian CGT only where a CGT event, that happens on or after 12 December 2006, happens in relation to TAP, which includes direct or indirect interests in Australian real property and certain mining rights. Shares on their own will not be considered TAP. However, they may constitute an indirect Australian real property interest and in this regard for the purposes of s be deemed TAP. Accordingly, in RCF, the court was required to cogitate upon whether RCF s membership interest in SBM was an indirect Australian real property interest pursuant to s item 2(a); s and s ITAA97. In this regard, the court said that: RCF s membership interest (i.e. the SBM shares) was an indirect Australian real property interest if the membership interest passed the non-portfolio interest test (section ) and the principal asset test in section It was common ground that the nonportfolio interest test was passed and so the issue turned to whether the membership interest passed the principal asset test. That is, at the times that RCF sold its shares in SBM, the membership interest was passed where the aggregate of the market values of SBM s TAP assets exceeded the aggregate of the market values of its non-tap assets (s (2)). In the Federal Court decision, after reviewing expert valuation evidence, Justice Edmonds concluded that the aggregate of the market values of SBM s non-tap assets were greater than those of its TAP assets, and therefore the shares in RCF were not TAP and the capital gain could be disregarded. This conclusion was premised on the notion that the principal asset test in s requires a separate determination of the market value of each of the assets of the tested entity, not a valuation of groups of assets by class and not a valuation of all assets as a going concern. Edmonds J, went further and also stated (at para 96) that: the test further requires the classification of the company s assets into TAP or non-tap assets and finally that it requires the summing of the values in each class to determine whether the sum of the market values of the entity s TAP assets exceeds the sum of the market values of the entity s non-tap assets; only if it does, is the principal asset test passed. The Full Federal Court ruminated Edmonds J conclusions but ultimately rejected this argument and instead postulated that Div 855 requires the assets to be valued as if they were offered for simultaneous sale as a bundle of assets. In light of the statutory context and purpose, in our opinion it is implicit that to determine where the underlying value resides in SBM s bundle of assets, the market values of the individual assets making up that bundle are to be ascertained as THE TAX SPECIALIST VOL 17(5) 209

11 if they were offered for sale as a bundle, not as if they were offered for sale on a stand-alone basis. The reference to the sum of the market values does not, even in its literal terms, require the ascertainment of the market value of each relevant asset separately, and then upon their ascertainment, an arithmetical calculation. The statutory criterion referred to in s (2) can still be applied by considering the matter on the basis of an assumed simultaneous sale of SBM s assets to the same hypothetical purchaser. In our opinion there is insufficient indication in the language and context of s to found what is, in our respectful opinion, the artificial conclusion for which RCF contended. It follows that the assets should be valued on the basis of an assumed simultaneous sale of SBM s assets to the same hypothetical purchaser, not as stand-alone separate sales. Conclusion As is made plainly clear, the valuation methodology adopted by the Federal Court (Edmonds J) that required each asset to be valued separately for Div 855 purposes was determined to be incorrect by the Full Federal Court. Instead, Div 855 requires the assets to be valued as if they were offered for simultaneous sale as a bundle of assets. Given the outcome, it is highly likely that RCF will seek special leave to appeal to the High Court. In the meantime, foreign resident investors should ensure that, subject to any appeal to the High Court, their valuation methodologies for Div 855 purposes are consistent with the Full Court s decision. The Budget announcements On 13 May 2014, the government announced as part of the Budget that it intended to further refine the integrity measures for the foreign resident CGT regime that were originally announced by the previous government as part of the Budget. It was announced that the changes to the principal asset test, aimed at preventing the double counting of assets, would extend to interests held by foreign residents in unconsolidated groups as well as in consolidated groups. Correctly, Treasury has realised that the potential duplication of assets issue extends beyond consolidated groups and can equally arise with respect to commercial arrangements between non-consolidated entities. The Budget also confirmed that the government would not be proceeding with changes to the MEC group rules on the basis that a view was formed that there was limited scope to address the inconsistencies without a reconsideration of broader international tax policy issues. The author is not sure the specific fix that would have been required to address the MEC group issue identified in the paper would have required such a reconsideration of broader international tax policy issues. Perhaps the risk to revenue presented by the MEC group issue may not have been significant enough to warrant an independent measure. Tax and Superannuation Laws Amendment (2014 Measures No. 3) Bill The exposure draft legislation for the proposed changes to the principal asset test, together with the accompanying explanatory materials, were released for comment on 14 May 2014, with submissions due by 9 June A copy of the exposure draft legislation is set out in Appendix 1. Valuation of mining information and goodwill While the exposure draft legislation addresses the changes to the principal asset test, the explanatory materials raise the issue of valuation of mining information and goodwill, and refer to the previous government s Budget announcement in this regard. The draft explanatory memorandum notes the recent Full Federal Court decision in RCF 16 and recognises that there are still matters before the courts in relation to the issue (presumably any appeal in RCF). In light of these judicial developments, the government has decided to defer the enactment of the amendment and to assess whether it is required once the present litigation is finalised. As set out above, my initial understanding was that the thrust of the proposed changes announced in the Budget were definitional in nature, that is, to ensure that mining information and goodwill was treated as TAP to the extent they are attributable to taxable Australian real property (TARP). With respect, the author is not sure the valuation issues at the heart of RCF add anything to the discussion on whether mining information and goodwill should be regarded as TAP or as a separate asset to the rights to which it attaches. The explanatory memorandum requests further feedback from taxpayers on this issue. Duplication of asset measures The anti-duplication measure, addressing the issue with the principal asset test referred to in the paper, will be contained in new s (4A) and will operate to disregard the market value of a non-tarp asset in circumstances where: the first entity and the other entity (as those terms are defined in s (3)) are parties to an arrangement; and the effect of the arrangement was to create the non-tarp asset, as an asset of one of those two parties, before the CGT event happened. Whether or not the asset was created as part of a genuine commercial arrangement between the parties is irrelevant. The policy intent behind disregarding genuine commercial arrangements between parties is unclear and any changes in this respect need to be considered with the utmost caution. The impact, as indicated in the Budget, is broader than simply transactions within consolidated groups and is intended to capture all entities within an economic group, and in some circumstances third parties. It is important to note that both entities referred to in the proposed s (4A) need to be caught within the requirements of the principal asset test. If one entity is not, then the new measures will not apply as there is no double counting. Example 1.2 in the draft explanatory memorandum demonstrates this as set out in Diagram 5. Diagram 5 13% Ardenia Capital 100% Bikra Mining Co Bridget 12% Khutai Capital Loan $100m In these circumstances, on a disposal of Khutai the other two companies do not need to be considered in applying the principal asset test to Bridget s interest in 210

12 Khutai. The same principal applies to a disposal of shares in Ardenia. The explanatory materials leave open the position in circumstances where Bridget disposes of both Ardenia and Khutai simultaneously. Paragraph 1.10 of the draft explanatory memorandum states that the amendments will not apply to a transaction involving the simple transfer of pre-existing assets between relevant entities on the basis that where no new asset is created, no potential for duplication arises. It is not quite that simple. Consider, for example, a scenario where Company A sells Company B a pre-existing asset and the purchase price is left outstanding as a debt owed by Company B. Presumably, the debt represents the creation of a new asset and so will be caught even if it is connected with the sale of a pre-existing asset. The explanatory materials also refer to the difficulties that the Commissioner perceives he faces in seeking to rely on the specific integrity measure already contained in s (5), particularly in circumstances where the arrangement arises through legitimate commercial arrangements. This, for example, may be the situation where any loan is placed on commercial and arm s length terms. No mention is made of the Commissioners ability to raise Pt IVA concerns with such arrangements. Sufficient interest tracing requirements You may recall from the paper that there is a requirement under s (4) to trace through to the assets of entities in circumstances where the foreign resident has a total participation interest of at least 10% and where the entity with the direct interest has at least a 10% direct interest. These new measures will not extend to entities (and newly created assets) where there is a less than 10% total participation interest or a less than 10% direct interest. This is on the basis that where neither of those two thresholds are satisfied, the principal asset test assesses the market value of the membership interests in that entity. Application For consolidated groups or MEC group members involved in the creation of new non-tarp assets, the measures apply from 7.30 pm on 14 May For all other entities, the measures will apply from 14 May 2014, being the date on which the exposure draft was released for public consultation. PART II: CGT and Withholding Tax The previous government announced on 14 May 2013 that it would introduce a 10% non-final withholding tax to support the operation of the foreign resident CGT regime effective from 1 July The new government has announced it will proceed with this measure confirming its intention that the new regime apply from 1 July Under the proposal, where a foreign resident disposes of certain taxable Australian property, the purchaser will be required to withhold and remit to the ATO 10% of the gross proceeds from the sale. It has been stated that the new withholding regime will not apply to residential property transactions valued under $2.5m, ensuring that the vast majority of private house sales will be unaffected by this measure. While the withholding regime will protect the integrity of the foreign resident CGT regime discussed in the first part of this article, it will equally apply where the disposal of the Australian real property asset by a foreign resident is likely to generate gains on revenue account and, as a result, be taxable as ordinary income, rather than as a capital gain. The government has agreed to consult publicly on the design and implementation of the regime in an attempt to minimise the impact on taxpayers in terms of potential future compliance costs. It is intended that any consultation will include exploring options to provide certainty about when obligations arise, pre-payment of tax liabilities by the seller, removing the withholding obligation where it can be shown that no gain will arise, and streamlining any payments required, including through the use of intermediaries. Treasury was scheduled to release a detailed discussion paper outlining the proposed design of the withholding regime by the end of As at the date of writing, no discussion paper has yet been issued, however the proposal to introduce a CGT withholding tax survived the cull of announced, yet unenacted, measures by the new government that took place at the end of The imposition of such a withholding will have implications for transactions, both in terms of costs and possibly even the timeframe in which transactions take place. Some of the big picture issues that immediately spring to mind are as follows. A withholding tax of 10% levied on gross sales proceeds avoids issue of purchaser having to determine how much tax is payable by vendor but what if the property is being sold at a loss? How might a secured lender or a mortgagee in possession exercising their right of sale feel about that? Will we see some aggressive vendors attempt a gross-up obligation in the same manner as is commonly encountered with respect to withholding on interest and royalty payments to non-residents? How will a purchaser determine the residence? How will the provisions work with regard to the disposal of interests in interposed land rich entities (the shares of which are indirect interests in TAP for Div 855 purposes)? Who would assume risk of compliance with Div 855? How will the withholding obligations interact with Australia s tax treaties? Who will actually be liable to withhold? The seller s agent? The seller s solicitor who holds the funds in trust? At what point would it be remitted to the revenue? What will be the penalties or sanctions placed on a purchaser in circumstances where they have failed to withhold and remit the appropriate amount if tax? Perhaps the biggest question is how the government intends practically to operate the new regime. Australia is not the first jurisdiction to impose a non-resident CGT withholding tax and so it is useful to look outside our borders for a glimpse of what might be to come. The author believes it is likely that Australia will move to some form of tax clearance certificate system similar in operation to those examined below. Ireland Ireland provides for a tax clearance certificate (TCC) system. Essentially, s 980 of the Irish Taxes Consolidation Act, 1997 obliges the purchaser of certain assets to withhold 15% of the purchase price of that asset from the vendor and remit it to the Irish revenue authorities, unless the vendor holds a general TCC or a CG50A. Broadly speaking, the Irish CGT withholding requirements apply to assets over 500,000 in value (from 2003 onwards) THE TAX SPECIALIST VOL 17(5) 211

13 and, usually, though not exclusively, arise in context of land/property sales. The CG50A CGT clearance certificate is applied for on a specific application form. A copy of the relevant form can be found at Appendix 2. While it is still possible to use the CG50 procedure, the following can also be accepted by the purchaser (in lieu of the CG50) as sufficient authority to make the payment for the asset without deduction of the 15%: (1) a current tax clearance certificate issued under the normal tax clearance schemes; (2) a certificate of authorisation (C2 certificate); or (3) a tax clearance certificate issued specifically for the purposes of s 980 (deduction from consideration on disposal of certain assets). An Irish resident seller will be able to obtain a certificate without difficulty. A seller which is not resident in Ireland will need to compute the gain, make a return to the Irish Revenue Commissioners and pay the resultant tax in order for a certificate to issue. It is interesting to note that an Irish agent for a foreign seller can be held liable to pay the seller s CGT arising on the sale. The author s understanding is that an agent will, as a result, generally retain sufficient funds to cover the estimated tax until satisfied that it has been fully discharged. Canada Broadly speaking, when taxable Canadian property (TCP) is acquired from a non-resident, the purchaser is required to withhold 25% of the gross proceeds for non-depreciable capital property (50% of gross proceeds for inventory and depreciable property) unless the purchaser has taken steps to establish that the vendor has paid the tax or provided security for the tax. To provide the purchaser with evidence to eliminate or reduce his or her withholding obligation, the vendor will have to apply to the Canada Revenue Agency for a Section 116 Certificate of compliance by filing form T2062, Request by a non-resident of Canada for a certificate of compliance related to the disposition of taxable Canadian property. Form T2062A, Request by a non-resident of Canada for a certificate of compliance related to the disposition of Canadian resource or timber resource property, Canadian real property (other than capital property), or depreciable taxable Canadian property also has to be prepared and filed for the disposition of depreciable TCP. A copy of form T2062 can be found at Appendix 3. Forms T2062 and T2062A require the non-resident vendor to state the name and address of the purchaser, the date of the transaction, a description of the property, and the expected gain and recapture of capital allowances as a result of the disposition. The request may be made in advance of the transaction or no later than 10 days after the transaction. Before the Canadian revenue authorities will issue a certificate of compliance, the non-resident vendor is required to make payment or post security on account of tax. The amount of payment/security for capital gains is equal to 25% of the capital gain. Failure to comply with s 116 may result in a penalty plus any applicable interest, and/or imprisonment. A tax return must be filed for the year of disposition to report the amount of the actual capital gain from the disposition and some non-residents may also have to file a s 216(1) return to report the amount of CCA recapture from the disposition and any rental income earned from TCP during the year. Simplified procedures have been introduced for transactions other than those involving real estate and provide that the requirement to withhold tax and obtain a clearance certificate will be eliminated where: the purchaser has made reasonable efforts to determine that the vendor is a resident of a country that has a tax treaty with Canada; the gain on the disposition is exempt from tax under a tax treaty with Canada; and a notice setting out the particulars of the transaction is filed with the CRA by the purchaser within 30 days of the disposition. This notice obligation can be satisfied by submitting form T2062C, Notification of an acquisition of treaty-protected property from a non-resident vendor. The United Kingdom It is perhaps interesting to note that the United Kingdom Government has recently announced that it will also be introducing significant reforms in the area of CGT and non-residents. On 28 March 2014, the UK Government published its consultation paper describing the extension of the UK CGT regime to gains made by non-residents disposing of UK residential property. Interestingly, the discussion paper contains no suggestion that the UK Government will seek to tax non-resident individuals on gains from the disposal of shares in companies holding UK residential property. The collection mechanism for the new tax is yet to be decided but all indications are that it will be by some form of withholding. Clint Harding, CTA Partner Arnold Bloch Leibler This article was originally presented at The Tax Institute s 7th NSW Tax Forum held in Sydney on 22 May References 1 See C Hillier, An introduction to Australia s international taxation system how is source determined, The Tax Institute International Masterclass, 18 August S ITAA97. 3 TD 2009/18. 4 Para 4.30 of the revised explanatory memorandum to the Tax Laws Amendment (2006 Measures No. 4) Bill Example 4.7 of the revised explanatory memorandum to the Tax Laws Amendment (2006 Measures No. 4) Bill Para 4.79 of the revised explanatory memorandum to the Tax Laws Amendment (2006 Measures No. 4) Bill Paras 4.81 and 4.82 of the revised explanatory memorandum to the Tax Laws Amendment (2006 Measures No. 4) Bill ATC [2014] FCAFC [2008] FCA [2009] FCA S 4(2) of the International Tax Agreements Act See, for example, the limitation of benefits article in the US Treaty which may apply with the result that certain US taxpayers will not be in a position to rely on the treaty. 14 [1997] FCA [2013] FCA Reported at [2013] FCA Reported at [2013] FCA

14 Appendix 1 EXPOSURE DRAFT EXPOSURE DRAFT Inserts for Tax and Superannuation Laws Amendment (2014 Measures No. 3) Bill 2014: foreign resident CGT integrity measures Commencement information Column 1 Column 2 Column 3 Provision(s) Commencement Date/Details Schedule?? The day this Act receives the Royal Assent THE TAX SPECIALIST VOL 17(5) 213

15 Appendix 1 (cont) EXPOSURE DRAFT Schedule?? Foreign resident CGT integrity measures Income Tax Assessment Act After subsection (4) Insert: (4A) For the purposes of subsections (2) and (4), disregard the * market value of an asset that is not * taxable Australian real property if: (a) the parties to an * arrangement included the first entity and the other entity, or included: (i) the first entity or the other entity; and (ii) an entity that is a first entity or other entity for the purposes of a related application of subsection (3) and table item 2 in subsection (4); and (b) an effect of the arrangement was to create the asset, as an asset of one of those 2 parties, before the * CGT event happened. 2 Application of amendment (1) Subsection (4A) of the Income Tax Assessment Act 1997 (as inserted by this Schedule) applies in relation to a CGT event if: (a) in a case where those 2 parties were members of the same consolidated group or MEC group at the time the asset was created the CGT event happens after the budget time; and (b) otherwise the CGT event happens on or after [insert day the exposure draft is released to the public]. (2) For the purposes of this item, the budget time is 7.30 pm, by legal time in the Australian Capital Territory, on 14 May

16 Appendix 2 Form CG50 Application for certificate under Section 980(8) Taxes Consolidation Act 1997 You should read the explanatory notes when completing this form. Incorrectly completed forms will be returned for correction. To Revenue Office 1 Application is hereby made by/on behalf of the vendor(s) 2 named overleaf for a certificate that a notice, under Section 980(9) TCA 1997, need not be given to the Revenue Commissioners and that the deduction specified in Paragraph 4 of the Section should not be made out of the consideration arising on the disposal of the asset described hereunder. Description of Asset 3 Address of Asset 3 Consideration 4 Date of acquisition 5 Market value of asset at date of acquisition,,,.00 D D M M Y Y Y Y / /,,,.00 Tick the appropriate boxes Was the asset being disposed of acquired by way of gift? Was gift tax paid in respect of the asset? Was the asset being disposed of acquired by way of inheritance? Was inheritance tax paid in respect of the asset? Is/are the purchaser(s) connected with the vendor(s) for the purposes of the Taxes Acts? Yes Yes Yes Yes Yes No No No No No Date of disposal on contract 6 D D M M Y Y Y Y / / Page 1 THE TAX SPECIALIST VOL 17(5) 215

17 Appendix 2 (cont) Vendor 2 Name Name Address Address Tax Reference No. Name Tax Reference No. Name Address Address Tax Reference No. Tax Reference No. Purchaser 7 Name Name Address Address Name Name Address Address Vendor s Declaration I Declare that I am/the above named is the person making the disposal and the grounds of the application are as follows (Tick the appropriate box) a) I/we/the above named am/are resident in the State. 8 b) No amount of Capital Gains Tax is payable in respect of the disposal. 9 c) The Capital Gains Tax chargeable for the year of assessment for which I/we/the above named am/are chargeable in respect of the disposal of the asset and the tax chargeable on any gain accruing in any earlier year of assessment on a previous disposal of the asset has been paid. 9 Signature 10 Signature 10 Date D D M M Y Y Y Y / / Capacity in which application is made 11 Page 2 Date D D M M Y Y Y Y / / 216

18 Appendix 2 (cont) Form CG50B Certificate of Deduction of Capital Gains Tax from Purchase Consideration under Section 980(4)(a)(i) Taxes Consolidation Act 1997 Section 980(4)(a)(i) Taxes Consolidation Act 1997 Deduction of tax from purchase consideration I certify that on payment of the consideration, agreed at for the acquisition of the asset(s), namely, (gross), to (the Vendor) of (Address) I deducted, in accordance with the provision of Section 980(4)(a)(i) Taxes Consolidation Act 1997, in respect of Capital Gains Tax. I further certify that the said sum has been paid by me to the proper officer for the receipt of taxes who has issued to me Receipt No. dated in the sum of I / the company / the trust submit(s) tax returns to the Revenue Office Tax Reference No. Name (Block Capitals) Address the sum of Date Signature Capacity in which this Certificate is given (e.g. Co. Secretary, Individual on own behalf, etc.) Full name of Company, trust, etc. acquiring the asset For Official use only RPC003279_EN_WB_L_1 THE TAX SPECIALIST VOL 17(5) 217

19 Appendix 3 REQUEST BY A NON-RESIDENT OF CANADA FOR A CERTIFICATE OF COMPLIANCE RELATED TO THE DISPOSITION OF TAXABLE CANADIAN PROPERTY INSTRUCTIONS All legislative references are to the Canadian Income Tax Act. When and How to file the Form Use this form if you are a non-resident of Canada to give notice of the proposed disposition of, or the completed disposition of, certain taxable Canadian property. Taxable Canadian property is property described in subsection 248(1) of the Act. A disposition of taxable Canadian property includes any interest or option for such property, whether or not the property exists. Use Form T2062A for proposed or completed dispositions of Canadian resource or timber resource property, Canadian real property (other than capital property), or depreciable taxable Canadian property. However, when disposing of depreciable taxable Canadian property, use this form to report the gain on the disposition and Form T2062A to report the recapture of capital cost allowance or terminal loss. If both forms T2062 and T2062A are required for a disposition, the forms must be filed together. File a separate T2062 for each disposition or proposed disposition. However, if you are disposing of, or proposing to dispose of, several properties to the same purchaser at the same time, only one T2062 is required for all the properties. A separate T2062 must be filed by each person indicating an interest in a joint tenancy, tenancy in common, or co-ownership. If you file a request for a proposed disposition under subsection 116(1) and the completed disposition complies with the requirements of subparagraphs 116(3)(d), (e), and (f), you do not have to file a separate request under subsection 116(3) for the completed disposition. We issue a certificate of compliance after tax is paid or security acceptable to the Minister is submitted in respect of the proposed or completed disposition. Final settlement of the tax liability is made when you file your Canadian income tax return. You have to file an income tax return to report the disposition of the property listed on this form. Failure to attach this certificate to your income tax return may result in a delay in processing. Penalties for Not Filing If you are giving notice of a completed disposition under subsection 116(3), you must send this form to us by registered mail not later than 10 days after the date of disposition. The penalty, under subsection 162(7), for failing to file or submit a notice on time is $25 a day. There is a minimum penalty of $100 and a maximum penalty of $2,500. Send this notice along with all supporting documents (see list attached), to the tax services office for the area where the property is located. An incomplete notification will delay the issuance of a Certificate of Compliance. Completing the Form Country of residence Indicate the country where you normally, customarily, or routinely live. Identification number Enter the appropriate identification number. This will ensure that security or payment made for tax is credited to the correct account. Identification numbers must be used when filing your Canadian income tax return and on all correspondence with us. Social insurance number (SIN) applies if an individual was formerly a resident or a deemed resident of Canada. Individual Tax Number (TTN) is a number assigned to a non-resident individual who filed a Canadian income tax return in previous years. Subsidiary ledger number is a number assigned to a non-resident individual who has made a remittance but does not have a Canadian tax account number. Business number (BN) is a registration number for businesses such as corporations, partnerships, and sole proprietorships. Trust account number is a number assigned to a trust that filed a Canadian income tax return in previous years. If you do not have a SIN or ITN, please complete Form T1261, Application for a Canada Revenue Agency Individual Tax Number (ITN) for Non-Residents, available on the Internet at Include the completed form with your T2062. Applying for a BN Complete Form RC1, Request for a Business Number (BN). Form RC1 and our pamphlet called, The Business Number and Your Canada Revenue Agency Accounts, are available on the Internet at: Send the completed RC1 with a copy of the certification of incorporation to the tax services office where you filed the Form T2062. Details of property If a disposition includes more than one property, attach a piece of paper providing the details for each property. All amounts must be in Canadian dollars. Property jurisdiction include the municipality/city, province/territory, and postal code for the street address requested below in "Description of property". Description of property Land or buildings Business property Shares Partnership property Trusts Designated insurance property include the following details: street address, plan number, lot number, registration number, municipal value, and use of property (e.g., personal residence, rental or business property). identification of business assets, business name, and street address. name and street address of corporation, number of shares, certificate numbers, and par value or stated capital. name, street address, and identification number of partnership. name and address, if any, of trust; otherwise name(s) and street address(es) of trustee(s). identification of insurer's business asset, business name, and street address. Exemption If you are claiming an exemption from tax, such as under a tax convention or a principal residence exemption, enter the exempt portion in column (4). Attach a note detailing the calculation of the exempt amount. Note: You cannot claim outlays and expenses related to the disposition of property, including real estate commissions, brokerage fees, and legal and notary fees, when you file this form. However, you can claim these amounts when you file your Canadian income tax return. More information You can get more information about residency status in Canada from Interpretation Bulletin IT-221, Determination of an Individual's Residence Status, or by contacting our General Enquiries line as follows: From inside Canada or the United States (for non-resident individuals and trusts) or (for non-resident corporations), From outside Canada or the United States (for non-resident individuals and trusts) or (for non-resident corporations). You can also visit our website at You can also get information from: Information Circular Procedures Concerning the Disposition of Taxable Canadian Property by Non-Residents of Canada Section 116 Interpretation bulletins: IT 171 Non-Resident Individuals Computation of Taxable Income Earned in Canada and Non-Refundable Tax Credits IT 176 Taxable Canadian Property Interests in and Options on Real Property and Shares IT 419 Meaning of Arm's Length T2062 E (08) (Ce formulaire existe en français.) 218

20 Appendix 3 (cont) Supporting Document List When you send us your completed Form T2062, you must attach supporting documents so we can process your request. To help you, we have provided the following reference list. You can tick ( ) the boxes that apply to you. Transactions Sale of land or buildings If you sell land or buildings, include copies of: the offer to purchase (proposed disposition); the sales agreement (actual disposition); the purchase agreement (when property was acquired); the registered deeds on purchase; and the registered deeds on sale. Principal residence If the property is your principal residence, also include: Form T2091(IND), Designation of a Property as a Principal Residence by an Individual (Other than a Personal Trust); and Form T2091(IND)-WS, Principal Residence Worksheet. Personal use property If you sell other personal use property, include: a letter describing the use of the property for the ownership period; and a list of adjustments to the adjusted cost base. Rental property If you sell rental property, include: capital cost allowance (CCA) schedules for all years; copies of your Canadian income tax returns and notices of assessment for the last three years; documents to support the allocation of the proceeds between land and building; documents to support subsection 21(1) and (3) elections regarding capitalization of interest; and a completed Form T2062A, Request by a Non-Resident of Canada for a Certificate of Compliance Related to the Disposition of Canadian Resource or Timber Resource Property, Canadian Real Property (other than Capital Property), or Depreciable Taxable Canadian Property. Leases If you grant an interest in property, or dispose of an interest in property, include copies of: the right-of-way agreement; the surface lease agreement; or the leasehold interest agreement. Vendor takes back mortgage If the vendor takes back the mortgage include: a copy of the mortgage agreement. Mortgage foreclosures and power of sale If the transaction is a result of a mortgage foreclosure or power of sale, include copies of: the power of sale or court order; and the mortgage agreement. Sale of business assets If you sell business assets including but not limited to accounts receivables and prepaid expenses, include copies of: the sale agreement (actual disposition); the most recent financial statements; and if the proceeds are included in a bundled payment, ensure that the proper value has been attributed to assets; the offer to purchase (proposed dispositions). Sale of depreciable property (other than rental property) For this type of transaction, include copies of: the sales agreement; the capital cost allowance (CCA) schedules for all years; documentation to support the cost amount; and a completed Form T2062A. Sale of shares If you sell shares, include copies of: the share certificate or section of the minute book showing the number of shares owned; the shareholder register showing the number of shares owned; the original purchase agreement documenting the adjusted cost base; the corporate resolution concerning the sale; the most recent financial statements of the corporation whose shares are sold; the most recent financial statements of any subsidiary corporations; the sale agreement (actual disposition); and the offer to purchase (proposed disposition). Sale of partnership property If you sell partnership property, include copies of: the sale agreement (actual disposition); the listing of partners; the partnership agreement; and the offer to purchase (proposed disposition). Partnership interest If the property is a partnership interest, include: a calculation of the adjusted cost base (ACB); a copy of the partnership capital account balance; and the purchase agreement (if interest was originally acquired from another partnership). Partnership residual interest If the property is a partnership residual interest, include: a calculation of the ACB. Partnership continuing income right If the property is a continuing income right, include: a calculation of the ACB; and documents to support the partner's share of income. Capital Interest in a Canadian Trust If you are disposing of a capital interest in a Canadian trust, include: Name and account number of the trust; Sale documents if interest was sold; FMV of any property received from the trust in settlement of the capital interest including any evaluations; and A calculation of proceeds and adjusted cost base. Claims for exemptions under tax conventions If you are claming an exemption under a tax convention, you have to give us proof of residency. Individuals should include: copies of their most recent income tax returns from the treaty country; and a letter from the tax authority in the treaty country confirming their residency status. THE TAX SPECIALIST VOL 17(5) 219