This article was written by Jerome Tse, Scott Heezen, David Wood, Ari Rosenbaum and Mark Giuseppini
In Resource Capital Fund IV LP v Commissioner of Taxation  FCA 41, the Federal Court of Australia considered whether the sale of shares in an Australian company by two Cayman Islands limited partnerships (the Partnerships) should be subject to tax in Australia.
This judgment considers a number issues which are of considerable commercial importance to international investment in Australia (particularly in the context of private equity investment).
The Partnerships (Resource Capital Fund IV LP and Resource Capital Fund V LP) were formed as a means of attracting private equity investment in the Australian mining and minerals industry from the United States. The majority of the investors in the Partnerships were U.S. residents.
The Partnerships held shares in Talison Lithium Pty Ltd (Talison), a global producer of lithium with operations in, among other places, Australia. In March 2013, the Partnerships sold their interests in Talison and were subsequently assessed for the gains made on the sales of those shares.
In this case, the Court found that:
the Partnerships themselves were not separate taxable entities and therefore were not able to be assessed to tax;
the partners investing through the Partnerships were the relevant taxpayers for Australian tax purposes;
the profits from the sale of the shares had an Australian source given the amount of activity performed in Australia that ultimately led to the profitable disposal of Talison;
the US resident partners of the Partnerships were afforded the relief of the US-Australia Double Tax Agreement (DTA); and
in the context of determining whether an entity is land rich under the DTA and Division 855 of the Income Tax Assessment Act 1997, and based on the facts involved: (i) mining leases were taxable Australian property but general purpose leases and miscellaneous licences were not; and (ii) it is appropriate to distinguish between plant and equipment used in upstream and downstream operations when valuing taxable Australian real property (TARP).
Investment into Australia: This case confirms the applicability of treaty relief under the DTA to US investors that invest into Australia through limited partnerships. The Court concluded that the partners, rather than the Partnerships, were the proper taxpayers. The majority of offshore private equity investors use limited partnerships as the investment vehicle. Such structures are also common, for example, in the Agriculture and Infrastructure sectors. Investors in Australian assets should review their investment structures and the impact of this judgement on their tax compliance obligations, for example in relation to whether limited partners (and not the partnership itself) are now required to lodge income tax returns and account for tax on the profits of the vehicles they invest into, and whether treaty relief is available. One particularly important question is how the Australian legislative provisions which make partners jointly and severally liable for income tax liabilities otherwise payable by partnerships could be imposed on foreign limited partners whose liability is specifically limited under the relevant foreign laws. Clarification of these issues by the ATO will be extremely important.
Valuation: The ATO may also seek to argue that there should be no distinction between “upstream” and “downstream” assets and operations and therefore, the netback methodology should not have been accepted by the Court.
Record keeping: The large amount of evidence led by RCF to prove reliance on TD 2011/25 is also instructive and may lead other taxpayers to obtain similar evidence where they also seek to plead reliance on a binding tax ruling.
Determination of Australian sourced income: Offshore funds will also need to carefully review the Court’s findings in relation to ascertaining whether any gains made have an Australian source. In particular, the involvement of investors, their associates or contractors in investment decisions, investment committee meetings and on boards of the underlying investments, will need to be carefully considered, being factors that the Court took into account when making its decision.
A limited partnership is not a separate taxable entity for Australian tax purposes
Division 5A of the Income Tax Assessment Act 1936 provides that certain limited partnerships are to be treated as companies for tax purposes. According to the Commissioner, this meant that the Partnerships were to be treated as taxable entities and were able to be assessed to tax in that capacity. In support of this proposition, the Commissioner relied on the decision of the Full Court of the Federal Court of Australia in the earlier related case of Commissioner of Taxation v Resource Capital Fund III LP  FCAFC 37 (RCF III case). In the RCF III case, the Full Court proceeded on the basis that the relevant limited partnership (RCF III) was a taxable entity. A copy of our alert on the RCF III case may be found here.
In this case however, the Court had regard to the fact that the RCF III case had been conducted on the basis, without argument to the contrary, that RCF III was a separate taxable entity and able to be assessed for tax in its own capacity. The Full Court’s conclusions were therefore based on this position being correct. As the matter was not the subject of a legal conclusion, the Court in this instance found that it was not bound by the Full Court’s decision in the RCF III case.
In considering the matter, his Honour had regard to the text as well as the purpose of the relevant provisions and ultimately considered that the Partnerships were not separate taxable entities. In particular, his Honour noted that:
Division 5A treated a partnership as if it were a separate entity for tax calculation purposes only and not for the purpose of separate assessment or for an additional hurdle that might disentitle the partners to any relief that they might have under a provision of a treaty; and
the context and purpose of the relevant provisions is to ensure that the partners are those who bear the obligations and liabilities arising from treating the partnership as a company for fiscal purposes.
The Court held that its interpretation was consistent with case law and the explanatory memorandum to the bill introducing Division 5A, which made clear that the Division was intended to treat a limited partnership as a company, but not that there was an intention to expressly create a new legal person or a new taxable entity. This finding, by itself, is likely to result in the Commissioner seeking an appeal of the decision to the Full Federal Court.
Partners’ liability to tax
As the Partnerships were not themselves taxable entities, Pagone J then considered who should have been (and was in terms of the matter before the Court) assessed for tax. His Honour concluded that the partners themselves should be assessed for tax. Despite the Commissioner issuing amended assessments to the Partnerships (rather than the partners), his Honour considered that the assessments and the other procedural steps taken should be understood as assessments to, and as steps undertaken by, the partners by reference to their partnership name.
As non-Australian residents, the US resident partners of the Partnerships would, subject to the application of the DTA, only be subject to tax on:
It was therefore then necessary to determine the character of the gains made by the partners in the Partnerships.
The gains made by the partners were Australian sourced income
His Honour found that the profitable realisation of the investment by disposal was always an objective of the investment by the Partnerships. Therefore, the amounts received by the Partnerships on disposal of their shares was income according to ordinary concepts.
The Court acknowledged that the more difficult aspect of the application of the relevant taxing provisions is whether the income was derived from an Australian source. The Court held that the factors that are relevant in answering this question will vary from case to case, and will vary as between different kinds of income. Nonetheless, his Honour noted that the place of the performance of services is likely to be significant to determine the source of income derived from personal exertion, the location of the property will be significant when the income is derived from property and the place where a taxpayer has performed income earning operations will be significant where the income is derived from a service of operations.
In the current circumstances, all decision making, negotiations, monitoring and payments in respect of the investment in Talison (and its disposal) took place offshore. However, his Honour considered that the gains had an Australian source because the ultimate profit from the disposal was part of the entire business strategy which included substantial activity in Australia. His Honour noted that the fact that the business and assets were in Australia might not of itself be sufficient to make Australia the ultimate source of the gain, but the location in Australia of the business and assets, and the nature and extent of the business and assets, occasioned substantial activities in Australia that were an integral part of the investment, its management, and its ultimate profitable disposal. For example, Australian resident associates of the Partnerships:
played an active role in the management of the investment;
played an active role in the disposal of the investment;
frequently participated in, and prepared material for, investment committee meetings; and
were representatives on the board of Talison.
His Honour also held that the fact that the shares were sold pursuant to a scheme of arrangement carried out in Australia under the Corporations Act and the supervision of the Federal Court might similarly, by itself, be insufficient to conclude that the source of the gain was Australia, but it was an essential aspect of the sale as it ultimately proceeded, adding something to that conclusion.
Investors should take note of the above when analysing whether their investments may give rise to a gain that has an Australian source with the approach of the Court giving rise to potential ramifications for existing investment structures and the use of Australian managers and other expertise.
Tax relief under the DTA for the US partners
Despite the gains having an Australian source, the partners could be entitled to relief from taxation having regard to either or both of Article 7 (Business Profits) of the DTA and TD 2011/25. The Court ultimately held that the Partnerships had evidenced their reliance on TD 2011/25, in which the ATO confirmed that treaty relief under Article 7 would apply in near identical circumstances to those of the Partnerships unless Article 13 (Alienation of Property) applied.
After lengthy submissions by the parties, the Court found that Article 13, as supplemented by section 3A(2) of the International Tax Agreements Act 1953, was broad enough to encompass the tax effected by Division 855. Accordingly, the issue then became whether Division 855 applied to subject the partners to Australian tax.
Valuing and identifying TARP assets
In determining whether the gain was taxable under Division 855 (and Article 13) and therefore whether the relief under Article 7 was, or was not, available, the Court considered whether Talison’s underlying assets were TARP and how they should be valued.
Notably, the Court found that, on the facts of this case:
the plant and equipment used in the processing operations, which occurred after extraction of the ore by mining, did not come within the meaning of TARP under Division 855 – the Court noted a distinction between mining operations (which required a mining lease) and mineral processing (which did not);
the general leases and a miscellaneous licence, which did not give rights to the buildings or other improvements on the land, were not TARP;
the residual value of a mining lease after it expires should be valued as a non-TARP asset; and
the netback method was a valid valuation methodology to determine the value of the ore once it had been mined and severed from the ground.
On the basis of the above, the Court held that the partners should not be assessed for tax under Division 855. Therefore the protection under Article 7 applied.