House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Treasurer, the Hon J. B. Hockey MP)

Chapter 3 - Improving the integrity of the foreign residents capital gains tax regime

Outline of chapter

3.1 Schedule 3 amends the Income Tax Assessment Act 1997 (ITAA 1997) to ensure that the foreign residents capital gains tax (CGT) regime operates as intended by preventing the double counting of certain assets under the Principal Asset Test.

3.2 A technical correction is also made to the meaning of 'permanent establishment' in section 855-15 of the ITAA 1997. The correction ensures that foreign residents are subject to CGT in relation to CGT assets that they have used in carrying on a business through a permanent establishment located in Australia.

Context of amendments

Australia's Foreign Resident CGT Regime

3.3 Australia's current foreign resident CGT regime was introduced in 2006, with the insertion of Division 855 into the ITAA 1997.

3.4 Consistent with international practice and Australia's international tax treaties, this regime promotes foreign investment in Australia. Subdivision 855-A operates to disregard a capital gain or capital loss made by a foreign resident provided the relevant CGT asset is not:

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a direct or indirect interest in Australian real property; or

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an asset used in carrying on a business through a permanent establishment in Australia.

3.5 All references in this Chapter are to the ITAA 1997 unless otherwise specified.

Permanent establishments

3.6 Section 855-15 of the ITAA 1997 provides that the term 'permanent establishment' has the same meaning as it does in section 23AH of the Income Tax Assessment Act 1936 (ITAA 1936).

3.7 The use of that definition was intended to apply any applicable treaty definition for permanent establishment. Alternatively, if no applicable treaty definition existed, the default meaning of permanent establishment in subsection 6(1) of the ITAA 1936 would apply.

3.8 Section 23AH, however, deals with outbound investment. The section 23AH definition applies in relation to 'listed or unlisted countries', which, by definition, are countries other than Australia. A strict application of this definition in the context of Division 855 precludes a CGT asset from ever being taxable Australian property. This outcome is clearly unintended as it would mean that part of the definition of taxable Australian property has no operation.

Indirect Australian Real Property Interests and the Principal Asset Test

3.9 The objects of the foreign resident CGT regime include ensuring that interests in an entity remain subject to Australia's capital gains tax laws if the entity's underlying value is principally derived from Australian real property (section 855-5).

3.10 This is achieved by ensuring that a capital gain realised by a foreign resident on an 'indirect Australian real property interest' (see section 855-25) cannot be disregarded.

3.11 An 'indirect Australian real property interest' includes a significant interest (generally a stake of 10 per cent or more) in an entity whose underlying value is principally derived from 'Australian real property'.

3.12 The Principal Asset Test in section 855-30 is used to determine whether an entity's underlying value is principally derived from Australian real property. The Principal Asset Test requires a comparison of the sum of the market values of the entity's taxable Australian real property (TARP) assets with the sum of the market values of its assets that are not taxable Australian real property (non-TARP) assets.

3.13 Sections 855-20 and 855-25 provide that a CGT asset is TARP if it is:

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real property situated in Australia (including a lease of land situated in Australia); or

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a mining, quarrying or prospecting right (to the extent that it is not real property), if the minerals, petroleum or quarry materials are situated in Australia.

3.14 If the sum of the market values of the entity's assets that are TARP exceeds the sum of the market values of the assets that are non-TARP, any capital gain or capital loss is not disregarded and may be included in the assessable income of the foreign resident.

3.15 The Principal Asset Test applies to the assets of the entity in which the foreign resident had a direct interest (the test entity). Where an asset of the test entity is an interest in another entity the test may operate to also assess the assets of those other entities. That is, the Principal Asset Test applies recursively to the assets of other entities in which the test entity has a significant interest, directly or indirectly, provided that the foreign resident has an indirect interest of at least 10% in that other entity.

3.16 This is achieved, under subsection 855-30(3), by converting the membership interests held by one entity in another as notional TARP and non-TARP assets according to the first entity's proportional stake in the other entity's underlying assets.

Asset Duplication

3.17 The Principal Asset Test only has regard to the market value of the assets of the relevant entities (it does not have regard to the liabilities or the source of the assets). Where the assets of multiple entities are assessed under the Principal Asset Test, and those entities have assets and liabilities arising out of transactions between themselves, this can affect the outcome of applying the Test in that the value of certain non-TARP assets can be effectively duplicated.

3.18 Transactions between these entities may create assets that lead to certain assets of the group effectively being valued multiple times, once in the hands of each entity. The issue is best illustrated by way of example.

Example 3.1 : Asset duplication under the current law

Emily, a foreign resident, wishes to dispose of her 15 per cent interest in Mineral Dynamics International (MDI).

MDI owns 100 per cent of the shares in Regular Resource Industries (RRI), a mining company with operations in Australia.

MDI also has $100 million cash on hand (all examples in this Chapter use amounts denominated in Australian currency). RRI's only asset is a mining licence with a current market value of $150 million.

If Emily were to sell her shares when these were MDI's only assets, the Principal Asset Test would be satisfied as the test entity, MDI, would have a TARP asset worth $150 million (derived from the mining licence held by RRI) and a non-TARP asset worth $100 million.

Before Emily sells her shares, MDI loans $100 million to RRI on commercial terms. MDI thereby acquires a right to receive funds under the loan agreement. This right has a market value of $100 million. Under the arrangement, RRI uses the funds advanced to purchase non-TARP assets, equipment worth $100 million.

The same underlying store of economic value, the $100 million, is effectively counted twice under the Principal Asset Test, once as a loan asset in the hands of MDI and again as equipment in the hands of RRI.

As a result, the sum of the market values of MDI's non-TARP assets equals $200 million (derived from the loan asset of MDI and the equipment in the hands of RRI) and exceeds the value of the TARP asset ($150 million derived from RRI's mining licence). The Principal Asset Test is not satisfied. Therefore, any capital gain or capital loss that Emily would make on the disposal of her shares in MDI would be disregarded. The underlying value of MDI, however, has not changed.

3.19 Subsection 855-30(5) is an integrity rule that provides that the market value of an asset acquired with a purpose of failing the Principal Asset Test is disregarded. This integrity rule will not operate to prevent all instances of asset duplication, which may arise through legitimate commercial arrangements.

3.20 The treatment of inter-company loans under the Principal Asset Test is discussed in ATO Interpretative Decision 2012/14 . The potential for the Principal Asset Test to result in asset duplication is discussed in Taxpayer Alert 2008/20 .

Announced Changes to the Principal Asset Test

3.21 On 14 May 2013, the previous government announced amendments to the Principal Asset Test in the 2013-14 Budget. The amendments, as announced, would:

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value mining, quarrying or prospecting information and goodwill together with the mining rights to which they relate; and

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remove the ability to use transactions between members of the same consolidated group to create and duplicate assets.

3.22 On 4 November 2013, the Government announced that it would proceed with the changes to the Principal Asset Test.

The valuation of mining information and goodwill

3.23 The previous government's announcement of the valuation amendment appears to be a response to issues arising from the decision of the Federal Court in Resource Capital Fund III LP v Commissioner of Taxation [2013] FCA 363, which was handed down on 26 April 2013.

3.24 Following additional judicial consideration, the courts have recently provided their final decision in relation to this issue (see in particular the decision of the Full Federal Court in Commissioner of Taxation v Resource Capital Fund III LP [2014] FCAFC 37 (3 April 2014)). The Government has decided to defer the enactment of the amendment until the effect of the decision has been analysed.

The scope of the anti-duplication amendment

3.25 The amendments to address asset duplication, as announced by the previous government, focused on interactions between members of a consolidated group or Multiple-Entry Consolidated (MEC) group.

3.26 However, the potential for assets to be effectively duplicated is not restricted to assets being created from transactions between members of a consolidated group; rather it arises from the operation of the Principal Asset Test itself.

Summary of new law

3.27 Part 1 of Schedule 3 amends the law to prevent the double counting of certain non-TARP assets that can distort the application of the Principal Asset Test.

3.28 Where the assets of two or more entities are included in the Principal Asset Test, the market value of new non-TARP assets arising from certain arrangements between those entities will be disregarded for the purposes of the Principal Asset Test.

3.29 If the group has consolidated financial accounts, the asset would not be recognised because it would be offset by the existence of the liability in the other entity. The amendments are necessary because the corresponding liability is not included in the Principal Asset Test calculations.

3.30 These amendments are broader than those announced by the previous government. In particular, the scope of the amendments is not restricted to entities that are members of the same consolidated group or MEC group.

3.31 Part 2 of Schedule 3 makes a technical correction to section 855-15. This amendment ensures that, in determining whether an asset is 'taxable Australian property', the test in respect of CGT assets that are used in carrying on a business through a permanent establishment in Australia is applied appropriately.

3.32 This change replaces the reference to a permanent establishment within the meaning of section 23AH of the ITAA 1936 with specific tests. Consistent with section 23AH, these tests take into account an entity's status as a resident of a country with which Australia has an international tax agreement in determining whether it has a permanent establishment in Australia.

Comparison of key features of new law and current law

Detailed explanation of new law

Part 1: Principal Asset Test Amendments

3.33 Part 1 of Schedule 3 prevents the double counting of non-TARP assets when applying the Principal Asset Test. [Schedule 3, item 4, subsection 855-32(1)]

The entities to which the amendments apply

3.34 The amendments apply to any assets arising from transactions between entities that have their assets valued for the purposes of the Principal Asset Test as a result of a CGT event occurring to a foreign resident. [Schedule 3, item 4, subsection 855-32(3)]

3.35 The amendments can apply to all entities within an economic structure regardless of whether the entities are members of the same consolidated group or MEC group for tax purposes.

3.36 The amendments bring entities within the scope of the provision is two ways. Where one of the parties to the arrangement has a direct interest in the other (see Example 3.1), paragraph 855-32(3)(a) will apply. Where there are entities interposed between the two parties but the parties are still within the same relevant ownership chain, paragraph 855-32(3)(b) will apply. [Schedule 3, item 4, subsection 855-32(3)]

3.37 In applying the Principal Asset Test, arrangements involving related parties and group members that result in the creation of new assets will not be affected if the assets of only one of the parties to the arrangement are taken into account in applying the Test. See the following example involving multiple chains of ownership.

Example 3.2 : Groups with multiple chains of ownership

Bridget, a foreign resident, has interests in two investment firms. One of the firms, Ardenia Capital finances an Australian mining company, Bikra Mining Co, through the purchase of shares. The other, Khutai Capital, makes an investment by way of a loan agreement with Bikra.

If Bridget disposed of her interest in Khutai Capital, the amendments would not apply to the loan asset created in the hands of Khutai Capital. This is because the assets of Bikra are not taken into account for the purposes of applying the Principal Asset Test in relation to Bridget's disposal of the membership interests in Khutai Capital.

Similarly, if Bridget were to dispose of her interest in Ardenia Capital, the amendments would not apply to the cash asset in the hands of Bikra because Khutai Capital's loan asset would not be assessed under the Principal Asset Test.

If Bridget were to sell both interests contemporaneously, she had significant control over the affairs of each entity, and both entities had significant TARP assets, it may be necessary to consider whether the loan asset was acquired for a purpose that satisfies the condition in subsection 855-30(5). The present amendments, however, would not apply.

3.38 The amendments will also only apply to entities in which the foreign resident has a sufficient interest. Table item 2 of subsection 855-30(4) only applies to entities in which the foreign resident has a total participation interest of at least 10 per cent and where the entity with the direct interest has at least a 10 per cent interest.

3.39 The amendments do not apply to entities that do not meet the interest thresholds because the Principal Asset Test assesses the net market value of these interests (and includes this in the value of the non-TARP assets) (see table item 1 in subsection 855-30(4)).

The arrangements to which the amendments apply

3.40 The amendments only apply to arrangements that result in the creation of new non-TARP assets and corresponding liabilities. [Schedule 3, item 4, subsection 855-32(2)]

3.41 The amendments are not designed specifically to target aggressive tax planning techniques but rather to overcome shortcomings in the existing regime. Accordingly, the amendments are not punitive but may apply to long-standing and legitimate commercial transactions.

3.42 The amendments apply where a new asset is created, for example, a financial asset or a new interest in a pre-existing asset of another entity. The amendments ensure that, where a new asset is created and its market value is derived from a liability owed by another relevant entity, the market value of the new asset is disregarded. Assets acquired by the entity with the corresponding liability, however, are not affected.

Example 3.3 : Application of the amendments

Further to Example 3.1, the amendments would apply to disregard the loan asset in the hands of MDI for the purposes of the Principal Asset Test. The corresponding liability is RRI's liability to repay the loan.

The underlying equipment asset will be valued in the hands RRI. The equipment and the corresponding liability to repay the loan are both held by RRI, which does not satisfy paragraph 855-32(2)(b).

3.43 The liability must be a 'corresponding liability' to satisfy subparagraph 855-32(2)(b)(ii). The corresponding liability will ordinarily be the liability that, in substance, requires the payment of the receivable, for example, the liability to repay a loan. A liability that bears no commercial relationship to the asset, or that is merely a contingent liability, is not a corresponding liability if another corresponding liability can be identified.

3.44 The amendments will not apply to a transaction involving the simple transfer of pre-existing assets between relevant entities. Where no new asset is created or where there is no corresponding liability in another party to the arrangement, no potential for duplication arises.

Third Parties

3.45 The amendments also apply to arrangements that involve third parties, provided at least two of the parties to the arrangement meet the conditions outlined above.

Example 3.4 : Arrangements involving third parties

Daniel, a foreign resident, is disposing of his interest in Glee Capital Ltd.

Glee Capital's assets consist of its interest in its wholly-owned subsidiary, Kurtz Coltan Pty Ltd, and a $100 million loan asset.

The loan asset arose from an arrangement whereby Glee Capital lent funds to an unrelated third party, Loris Finance Group, which on lent the funds to Kurtz Coltan. Kurtz Coltan's liability to repay the loan to Loris is the corresponding liability to Glee Capital's loan asset. The amendment will apply to ensure that the market value of the loan asset in the hands of Glee Capital is disregarded for the purposes of applying the Principal Asset Test in relation to Daniel's disposal of his membership interests.

Intra-group membership interests

3.46 The amendments will also not apply to membership interests that relevant entities hold in one another. The market value of these assets is never taken into account due to the operation of subsection 855-30(3).

3.47 Rather, the membership interest asset becomes two notional TARP and non-TARP assets based on the underlying assets of the subsidiary. It is not intended that the amendments should apply to these notional assets directly, although their market value may be reduced (even to nil) because certain underlying assets were disregarded.

Limitation where only partial duplication exists

3.48 In the context of wholly-owned groups, assets may be fully duplicated. In these circumstances, it is appropriate to disregard the entire market value of the new asset. Where the arrangement involves parties that are not wholly-owned, however, it is appropriate that the effect of the amendments be limited to reflect the partial duplication of an asset.

3.49 Accordingly, the amendments only apply to disregard the market value of the new asset to the extent of the test entity's total participation interest in the entity in which the corresponding liability is created. [Schedule 3, item 4, subsection 855-32(4)]

3.50 Consistent with the operation of the Principal Asset Test, the relevant total participation interest is assessed at the time of the CGT event occurring for the foreign resident.

Example 3.5 : Partial duplication

Simon, a foreign resident, owns a significant stake in Blaze Capital. Blaze Capital owns 25 per cent of the membership interest in Hello! Telecommunications.

To finance its operations, Hello has secured a $100 million loan from Blaze Capital.

Simon wishes to dispose of a portion of his interest in Blaze Capital. Under the current law, the original $100 million would be valued, to the test entity, Blaze Capital, 1.25 times or as $125 million.

Under the amendments, the market value of the loan asset in the hands of Blaze Capital is reduced proportionally to Blaze Capital's interest in Hello (by 25 per cent). This outcome reflects the underlying value of the group, which is comprised of Blaze Capital's interest in the advanced funds ($25 million) and a receivable with respect to the loan advanced to the non-owned portion of Hello ($75 million).

3.51 Where the relevant liability is created in the test entity, the market value of the new asset is disregarded entirely. [Schedule 3, item 4, subsection 855-32(4)]

Sequencing of provisions

3.52 The amendments apply at the start of each application of subsection 855-30(3) and table item 2 in subsection (4). This means that relevant assets are disregarded prior to those assets contributing to the value of notional TARP and non-TARP assets created under subsection 855-30(3).

3.53 This is consistent with the operation of the existing integrity rule in subsection 855-30(5).

Example 3.6 : Sequencing of Provisions

Further to Example 3.5, the outcome in that example is achieved through the following mechanical steps in sections 855-30 and 855-32.

The first step is to consider the assets of the lowest tier company, Hello (see Note 1 to subsection 855-30(4)).

Hello's only asset is the $100 million advanced under the loan. It is necessary to consider whether either integrity rule (subsection 855-30(5) or section 855-32) applies to disregard the market value of the asset. Neither rule applies to the asset.

Next, subsections 855-30(3) and (4) apply to Blaze Capital's (the first entity) membership interest in Hello (the other entity). The membership interest is valued as a non-TARP asset with a market value of $25 million ($100 million × 25%) and a TARP asset valued as nil (Hello does not have any TARP assets).

It would then be necessary to consider whether either integrity rule applied to the other assets of Blaze Capital. As outlined in Example 3.5, $25 million of the market value of Blaze Capital's loan asset would be disregarded.

Part 2: Permanent Establishment Amendments

3.54 Part 2 of Schedule 3 makes a technical correction to the definition of taxable Australian property. A CGT asset is taxable Australian property if it is used at any time in carrying on a business through a permanent establishment in Australia.

3.55 To ensure the definition of taxable Australian property applies as originally intended, these amendments replace the reference to the section 23AH definition of permanent establishment with an equivalent test that applies in respect of Australian permanent establishments. Consistent with the section 23AH definition, this new test applies any applicable treaty definition of permanent establishment.

3.56 In determining whether a CGT asset is taxable Australian property of a kind that is used in carrying on a business through a permanent establishment in Australia, the residency status of the entity that uses the CGT asset determines the way in which the permanent establishment is defined.

3.57 Where an entity is a resident in a country with which Australia has an international tax agreement that contains a permanent establishment article, the definition of permanent establishment in the agreement is used in determining whether the entity has a permanent establishment in Australia. [Schedule 3, items 6 and 8, section 855-15, paragraph (a) of the cell at table item 3, column headed 'Description' and subsection 855-35(1)]

3.58 An international tax agreement is defined in subsection 995-1(1) as an agreement within the meaning of, and given the force of law by, the International Tax Agreements Act 1953. To ensure that this aspect of the test is appropriately targeted, these amendments also introduce a definition of 'permanent establishment article'.

3.59 A permanent establishment article is defined as Article 5 of the UK convention, or a corresponding agreement of another international tax agreement. [Schedule 3, items 7 and 9, section 855-16 and definition of 'permanent establishment article' in subsection 995-1(1)()]

3.60 Article 5 of the UK convention sets out the definition of permanent establishment for the purposes of that convention. An article in another agreement that has the same effect for the purposes of that agreement is also a permanent establishment article. This approach to defining permanent establishment articles is consistent with the definitions of associated enterprises article, business profits article, and residence article, which each refer to the corresponding article in the UK Convention.

3.61 Where an entity is not a resident in a country with which Australia has an international tax agreement, the general definition of permanent establishment in subsection 995-1(1) is used in determining whether the entity has a permanent establishment in Australia (this definition refers to the definition in subsection 6(1) of the ITAA 1936). [Schedule 3, item 6, section 855-15, paragraph (a) of the cell at table item 3, column headed 'Description']

3.62 These amendments apply only to the way in which a permanent establishment is defined, and do not otherwise affect the test for whether a CGT asset is taxable Australian property.

Consequential amendments

3.63 Two notes are inserted into section 855-30 to inform the reader that, under section 855-32, certain asset may be disregarded for the purposes of the Principal Asset Test. [Schedule 3, items 1 to 3, section 855-30]

Application Provisions

Part 1: Principal Asset Test Amendments

3.64 Where the entities involved in the creation of the new non-TARP asset are members of the same tax consolidated group, or MEC Group, the amendments in Part 1 of Schedule 3 apply to CGT events that occur after 7.30pm on 14 May 2013 (Budget Night).

3.65 For all other entities, the amendments will apply to CGT events occurring on or after 13 May 2014. [Schedule 3, item 5]

3.66 The application dates reflect the dates on which it was announced that the amendments would apply to particular entities.

3.67 The retrospectivity of these amendments to the date of their announcement is warranted as the amendments correct a defect in the operation of the Principal Asset Test that would otherwise prevent it from operating as intended. The amendments also ensure greater integrity for Australia's foreign resident CGT regime.

Part 2: Permanent Establishment Amendments

3.68 The amendments made by Part 2 of Schedule 3 apply from the commencement of Division 855. [Schedule 3, item 10]

3.69 These changes are of a technical nature and do not affect any other aspect of the definition of taxable Australian property. They do not negatively affect any taxpayer because the scope of the definition of taxable Australian property aligns with the intention of the original provisions.

3.70 Division 855 was introduced in the Tax Laws Amendment (2006 Measures No. 4) Act 2006 and applies to CGT events that happen on or after 12 December 2006, which aligns with the commencement of Division 855.

3.71 Applying the amendments to Division 855 made by this Schedule from the commencement of Division 855 ensures the references to an Australian permanent establishment in the Division apply as originally intended.

STATEMENT OF COMPATIBILITY WITH HUMAN RIGHTS

Prepared in accordance with Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011

Tax and Superannuation Laws Amendment (2014 Measures No. 4) Bill 2014 - Improving the integrity of the foreign residents capital gains tax regime

3.72 This Schedule is compatible with the human rights and freedoms recognised or declared in the international instruments listed in section 3 of the Human Rights (Parliamentary Scrutiny) Act 2011.

Overview

3.73 This Schedule amends the Income Tax Assessment Act 1997 (ITAA 1997) to ensure that the foreign residents capital gains tax (CGT) regime operates as intended by preventing the double counting of certain assets under the Principal Asset Test.

3.74 A technical correction is also made to the meaning of 'permanent establishment' in section 855-15 of the ITAA 1997. The correction ensures that foreign residents are subject to CGT in relation to CGT assets that they have used in carrying on a business through a permanent establishment located in Australia.

Human rights implications

3.75 These amendments improve the integrity of Australia's foreign resident CGT regime. This ensures that foreign residents cannot obtain favourable treatment that is not justified under the regime's policy framework. This promotes the rights to equality and non-discrimination in Article 26 of the International Covenant on Civil and Political Rights and the International Convention on the Elimination of All Forms of Racial Discrimination.

Conclusion

3.76 This Schedule is compatible with human rights as it promotes, but does not inhibit, the fulfilment of human rights.