By Peter Madden, Mark Goldsmith, Alyson Rodi, Mark Hadassin, Vik Khanna, Claudio Cimetta and David Watkins (US)

On 26 October 2011, the Australian Tax Office (ATO) released two final Tax Determinations (TDs):

• TD 2011/24 considers the source of profits made in a private equity leveraged buy-out (LBO); and
• TD 2011/25 addresses, in respect of Australian-source business profits, the availability of double tax treaty benefits to limited partners in treaty countries where their investment into Australia is structured through a non-Australian limited partnership (LP).

Both TDs were released in draft form in December 2010, and the release of the final versions has been keenly awaited by the private equity investment sector.

This alert summarizes the key points from each of the final TDs, highlights some of the key differences from the draft versions and outlines some of the key implications.

Source of private equity LBO profit

In Australia, nonresidents generally are taxed on their ordinary income derived directly or indirectly from Australian sources and statutory income from all Australian sources.

Final TD 2011/24 sets out the factors the ATO will consider when determining the source of income arising from the sale of shares in an Australian company acquired in a LBO by a private equity fund. Essentially, the Commissioner maintains the view expressed in the draft version of the TD (TD 2010/D7) that the source of income does not depend solely on where purchase and sale contracts are executed; rather, source is determined having regard to all the facts and circumstances of the particular case.

The final TD states that the Commissioner will consider the following when determining source in an LBO arrangement:

• The activities undertaken by the fund, or on the fund’s behalf, in making any improvements to the Australian corporate group;
• Where those activities are undertaken;
• The nature of any agreements between the entities;
• The extent and nature of any control or involvement in the management of the Australian corporate group;
• Where the purchase contracts and sale contracts are executed; and
• The form and substance of the purchase payments.

Unlike the draft version of the TD which expressed the view that the case of Thorpe Nominees Pty Ltd v Federal Commissioner of Taxation (88 ATC 4886) was authority for the importance of looking at the substance of the transaction as a whole rather than adhering to rules about certain transactions in determining the source of income, the final TD accepts that a number of court cases have determined that the source of the income was the particular contract. However, according to the TD, this is because the courts in those cases ruled that the particular contracts either created or embodied the rights giving rise to the income and were determinative of geographical source, and in the Thorpe case, the court did not consider that the contract executed in Switzerland was determinative. Instead, it held that the legal acts performed in Switzerland were merely part of a pre-arranged plan to avoid tax in Australia.

In the case of an LBO undertaken by a private equity fund, the Commissioner does not accept that the contracts effecting the initial purchase and ultimate sale of the target company alone give rise to the profit resulting from the sale. The Commissioner, therefore, rejects the principle that the source of that profit is the place where the contracts are executed. The Commissioner takes the view that, in an LBO arrangement, the private equity firm, as the general partner, either actively undertakes or causes to be undertaken a number of activities as part of a pre- determined strategy to derive profits. According to the TD, the Commissioner will examine the significance of such activities undertaken in Australia relative to the profit. Where everything but the execution of the purchase and sale contracts is conducted in Australia, by or at the direction of the private equity firm acting as general partner of the fund, the Commissioner takes the view that the source of the profit is Australia.

The Commissioner understands that in many cases, an Australian advisory entity (associated with the general partner) also may have a role in the transaction. The Commissioner warns that whether the arrangement with the advisory entity creates a permanent establishment (PE) in Australia of the general partner or the limited partner will depend on all of the facts and circumstances.

Interestingly, unlike the draft version, the final TD contains no discussion of the possible application of the general anti-avoidance provisions of Part IVA of the Income Tax Assessment Act 1936 where the taxpayer had successfully structured the arrangements in such a way so as to require the conclusion that profit did not have an Australian source.

Tax treaty “look through” for investment structured through limited partnership

Australia’s right to tax Australian-source income may be limited by the application of one of Australia’s tax treaties. Very broadly, under the business profits article (generally article 7) in Australia’s tax treaties, if there is no PE in Australia, or the profits of the enterprise are not attributable to the PE, Australia has no right to tax the profits.

It should be noted that some of Australia’s tax treaties contain specific provisions that deal with certain fact patterns involving fiscally transparent entities (for example, the treaties with Japan, New Zealand and the U.S.). TD 2011/25 is focused on tax treaties that do not address fiscally transparent entities.

Consistent with the OECD Commentary on the Model Treaty, the Commissioner accepts that Australia-source business profits of a non-Australian LP will be eligible for treaty benefits under the treaty between the country of residence of a limited partner investor (ultimate investor) and Australia to the extent that:

• The business profits are treated as the profits of the partners (and not the LP) under the tax laws in the ultimate investor’s country of residence. In other words, the LP is treated as “fiscally transparent”;
• The business profits are not attributable to a PE in Australia;
• The ultimate investor is a resident of a country with which Australia has a tax treaty; and
• The ultimate investor meets any other applicable tax treaty requirements.

In addition, in a welcome expansion from the earlier draft, TD 2011/25 clarifies that treaty benefits under the business profits article also may be available to the extent a limited partner in a LP (the deriving LP) is itself a LP (the interposed LP) and limited partners in the interposed LP are residents of a tax treaty country.

TD 2011/25 also confirms that the above principles will apply where a limited partner is a tax exempt organization that qualifies as a resident for the purposes of the relevant tax treaty. This was unclear under the draft where the language required that the ultimate investor was “liable to tax.”

TD 2011/25 unfortunately states that it does not apply where the fiscally transparent entity is not a partnership. The ATO takes the view that the above principles are to be applied only where the entity is regarded as a partnership for the purposes of the “applicable commercial laws” of the ultimate investor’s country of residence. Thus, if the fund vehicle, or an upstream feeder vehicle, is an entity, such as a Cayman Islands company or a U.S. limited liability company (LLC), it seems that the Commissioner does not intend to apply the principles in TD 2011/25 (although the applicable commercial laws would need to be reviewed). For example, where U.S. resident ultimate investors invest via a Cayman company that is disregarded for U.S. tax purposes (effectively treated as a partnership for U.S. tax purposes), the Commissioner does not intend to apply the same look through principles if the Cayman company is not viewed as a partnership under applicable commercial laws in the U.S.

The above principles are largely to be welcomed, but will present challenges for fund managers in practice. As mentioned above, one of the prerequisites for the availability of treaty benefits under the business profits article as set out in the TD is that the partners are residents of a treaty country. In the TD, the Commissioner states that the onus is on the general partner of the LP to prove that a limited partner is a resident of a tax treaty country. According to the TD, this will be done through discussions with the Commissioner and provision of relevant information as regards the ultimate investors on a case by case basis. The Commissioner suggests that fund managers should assemble as much information as is available to them as soon as practicable after an acquisition has been made and discuss the matter with the Commissioner. Once the residence of the ultimate partners has been determined, the Commissioner will advise the fund manager as to what arrangements will need to be put in place to ensure treaty obligations have been fulfilled.

In the absence of sufficient identifying information as to the residence of the partners, the TD indicates the Commissioner will, where appropriate, issue notices to third parties to secure the debt on any subsequent assessment. The Commissioner will also consider other available remedies, if necessary.

The TD notes that if the Commissioner is subsequently satisfied that the partners in a LP are resident in a tax treaty partner country and tax treaty benefits are available, a refund of the tax collected can be sought.

Some points to note:

• It is not necessary for the LP to be organized in a tax treaty country for treaty benefits to be available to the partners, provided the partners reside in a tax treaty country, and the LP is treated as fiscally transparent in the treaty country (i.e. the income is treated as that of the partner, not the LP itself).
• Although not expressly addressed, we consider that the above principles will be applied where different ultimate investors are resident in different countries with which Australia has a tax treaty.
• One of the examples makes clear that where one ultimate investor is resident in a tax treaty country and the other ultimate investor is resident in a non-tax treaty country, treaty benefits will be applied only to the extent the income is attributable to the ultimate investor in a treaty country.
• The TD addresses the question of the application of the business profits article in Australia’s tax treaties. It does not address the application of flow-through benefits under other articles of Australian tax treaties. For example, it does not consider the application of the dividend article in a tax treaty where an unfranked dividend is paid to a fiscally transparent entity.
• The onus is on the general partner to establish the residence, according to the applicable Australian treaty, of the partners in the LP and forward that information to the Commissioner. According to the TD, “it is envisaged that in nearly all cases fund managers will be aware of the details of the residence of their ultimate investors.” However, as a matter of practice, gathering the relevant data sufficient to trace through to all ultimate investors is often a difficult process. The Commissioner does not contemplate any safe harbor or de minimis rule and so seems to want complete information on all ultimate investors.
• In circumstances where the Commissioner subsequently becomes satisfied that partners in a LP are resident in a tax treaty partner country and that treaty benefits are available, TD 2011/25 indicates that a refund of the tax collected can be sought. However, no details have been provided regarding how this will be administered in practice.