Australia's capital gains coup

As foreign private equity investors look at Australia with greater interest, the country's new tax laws will provide welcome encouragement.

On 7 December 2006, the Australian parliament finally passed the Tax Laws Amendment (2006 Measures No. 4) Bill 2006. The Bill achieved Royal Assent on December 12th and became law.

The Bill includes amendments to narrow the range of assets on which a foreign resident will be liable to Australian capital gains tax (CGT). Foreign private equity investors will benefit from the changes as Australian CGT will no longer be payable on the sale of shares in an Australian company (or units in an Australian unit trust) to the extent that the entity does not have significant Australian real property interests.

The Bill has had a long and, at times, difficult gestation period. The Australian government announced that it would amend the CGT rules for foreign investors in the May 2005 Federal Budget. After introduction of the Bill in June 2006, it was then subject to review and public hearings before the Senate Economics Legislation Committee.

At first it seemed that the Bill would enjoy a smooth passage through Parliament as it had both government and opposition support. However, in an 11th hour bid, a dissenting senator from the ruling coalition, together with members of several minor parties, challenged the Bill on the grounds that the new rules will give foreign investors an unfair advantage over Australian investors.

Given government and opposition support, there was little doubt that the Bill would pass. However, the issue did give rise to public debate about private equity and foreign investment in Australia. In one particularly memorable quote, Senator Joyce of Queensland commented that ?[the Bill] means a person in Pyongyang has more rights to exemption from capital gains tax than a person in Sydney.?

Ultimately, the debate about providing a CGT exemption for foreign investors should be seen in the light of recent high-profile private equity plays for well known Australian companies. Examples include: the $18.2 billion bid by a consortium led by Kohlberg Kravis Roberts (KKR) for Coles Myer, one of Australia's largest supermarket chains (which ultimately did not proceed); the acquisition by CVC of a 50 percent interest in the media assets of one of Australia's largest media companies, Publishing and Broadcasting Limited (and KKR's similar deal with the Seven television network); as well as the recent move by a private equity consortium to takeover Australia's flagship airline, Qantas.

The prior position
Prior to the Bill, a foreign resident was liable to CGT on the disposal of an asset that had the ?necessary connection with Australia?. Broadly, this included:

  • ? land and buildings in Australia
  • ? assets used in carrying on a business through a permanent establishment in Australia
  • ? shares in an Australian private company
  • ? a 10% or greater shareholding in an Australian public company
  • ? a 10% or greater unitholding in an Australian unit trust;
  • ? an option or right to acquire one of the above.
  • The old CGT net was therefore cast very wide and in a manner which was generally inconsistent with international best practice. In fact, the Bill states that the objects of the amendments are ?to improve?:

  • (a) Australia's status as an attractive place for business and investment; and
  • (b) the integrity of Australia's capital gains tax base.?
  • For foreign private equity investors, the broad scope of the old rules meant that any successful investment in an Australian private company (whatever the size of the holding) was subject to CGT at the rate of 30 percent. Likewise, successful investments in Australian listed companies were also subject to CGT where the investor had a share holding of 10 percent or more of that listed company.

    The new position
    The Act just passed replaces the old concept of an asset that has the ?necessary connection with Australia? with the new concept of ?taxable Australian property?.

    Broadly, ?taxable Australian property? includes:

  • ? ?taxable Australian real property? (i.e. real property in Australia and mining, quarrying or prospecting rights)
  • ? an ?indirect Australian real property interest? (i.e. an interest held through an interposed entity or entities whether located in Australia or offshore)
  • ? assets used in carrying on a business through a permanent establishment in Australia
  • ? an option or right to acquire one of the above.
  • While the treatment of assets used in a permanent establishment remains essentially the same, the focus going forward is very definitely on land.

    The new rules will benefit those who invest in shares in Australian companies (and units in Australian unit trusts), where the Australian entity does not hold significant Australian real property interests. Basically, the sale of shares in an Australian company will not be subject to any Australian CGT unless the company is ?land rich?.

    Indirect Australian real property interests
    The new rules seek to tax a foreign resident on the disposal of an interest in a foreign entity that holds a direct or indirect interest in Australian real property. This is not the case at present and raises interesting enforcement issues.

    The treatment of indirect interests is somewhat similar to the treatment of ?land rich? entities for stamp duty purposes.

    An ?indirect Australian real property interest? that is liable to CGT will exist where a foreign resident has a membership interest in an entity which passes both:

  • ? a non-portfolio interest test
  • ? a principal asset test.
  • Non-portfolio interest test
    A foreign resident will hold a non-portfolio interest in an entity if the direct or indirect interest of the foreign resident together with its associates is 10 percent or greater.

    It is worth noting that the entity in which the foreign resident and its associates hold a membership interest may be either an Australian resident or a foreign resident.

    Note also that the 10 percent threshold may be triggered either at the time of the CGT event or throughout a 12-month period during the 24 months before the CGT event. The second limb is aimed at the staggered sell-down of an interest.

    Principal asset test
    A membership interest will pass the principal asset test where an entity's underlying value is principally derived from Australian real property.

    The test is whether or not the market value of the entity's taxable Australian real property is more than 50 percent of the market value of all the entity's assets.

    One of the difficulties with the new rules is that they are absolute, there is no partial or pro-rated exemption. For example, where the real property assets of a company are equal to 49 percent of the market value of the company, the rules will have no application. However, where the real property assets of a company are equal to 51 percent of the market value of the company, 100 percent of any gain arising in respect of the sale of the shares in the relevant company will be subject to Australian CGT.

    Similar to stamp duty, the market value of all the entity's assets excludes assets acquired for the purpose of manipulating the principal asset test. This is an integrity measure to prevent avoidance through the acquisition of liquid assets in the lead up to the CGT event.

    In practice, investors should continue to monitor the relative value of real property vis-à-vis other assets on an ongoing basis to ensure that they understand their CGT position. Of course, this will be particularly important where the real property assets of the company are close to the 50 percent threshold.

    Change of residence
    It is worth noting that special CGT rules continue to apply where:

  • ? an Australian resident becomes a foreign resident; and
  • ? a foreign resident becomes an Australian resident.
  • Date of effect
    The new rules will apply to CGT events occurring on or after the date of Royal Assent.

    Note that a CGT event generally occurs at the time of entry into a contract (as distinct from settlement or completion of the contract). This needs to be borne in mind by investors hoping to take advantage of the amendments.

    Tax-efficient private equity investment
    The new rules are likely to provide further stimulus for foreign private equity investment into Australia.

    These amendments are likely to be particularly attractive when considered in terms of traditional private equity investment structures through offshore financial centres.

    From the date of Royal Assent, any capital gain arising in terms of the sale of shares in an Australian company, or units in an Australian unit trust, will be exempt from Australian CGT (unless the entity has significant Australian real property interests).

    It is worth noting that the new rules do not include any changes to Australia's dividend withholding tax (DWT) rules. The rate of Australian dividend withholding tax on an unfranked dividend when paid to an investor located in a country that does not have a double tax agreement (DTA) with Australia is 30 percent. The rate of DWT is significantly lower when Australia has a DTA with the investor's home country (generally 15 percent, but potentially lower for UK, US and New Zealand investors among others). Where a dividend is franked, no DWT is payable when the dividend is paid to the foreign investor. DWT is relevant in terms of dividend income received during the life of the investment, and where an exit strategy is structured as the sale of a business, in which case the sale proceeds will be delivered to the investor by way of a dividend.

    The new rules represent a significant reform of Australia's international tax arrangements. They should have a positive impact on foreign investment (particularly in the private equity space) and provide a stimulus to crossborder merger and acquisition activity.

    Jonathon Leek is a partner and Paul Argent is a senior associate at Corrs Chambers Westgarth in Sydney