Edited version of private advice

Authorisation Number: 1051909090776

Date of advice: 16 November 2021

Ruling

Subject: Disposal of shares by non-resident

Question 1

Will any gain on the disposal of the shares in AusCo be included as assessable income of the Partnership under subsection 6-5(3) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes, subject to the application of the business profits article (Article 7) of the relevant tax treaties.

Question 2

Will any capital gain on disposal of the shares in AusCo be disregarded by the Partnership under subsection 855-10(1) of the ITAA 1997?

Answer

Yes.

Question 3

Does the business profits article (Article 7) of each of the three relevant DTAs (the DTAs) apply to the disposal of the shares in AusCo by the Partnership such that the amount is not subject to tax in Australia to the extent the profits are treated as the profits of the partners in the respective treaty country?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 20YY

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The Partnership

1. The Partnership is a limited partnership governed by the Limited Partnership Agreement (the LPA).
2. The partners in the Partnership (the Partners) are:
   • Partner 1 as the Managing General Partner. It is a company and tax resident in Treaty Country 1.
   • Partner 2 as a General Partner. It is a company and tax resident in Treaty Country 2.
   • Partner 3 as a limited partner. It is a company and tax resident in the Country 1.
   • Partner 4 and Partner 5 are individuals who are limited partners and tax residents of Treaty Country 1.
   • Partner 6 is an individual who is a limited partner and a tax resident of Treaty Country 3.
3. Per the LPA, the Managing General Partner has the exclusive responsibility for the operation of the Partnership, and shall use reasonable business judgment and due care in carrying out their duties. Further, the General Partner has authority to make investment decisions upon consulting the Investment Committee. The LPA states the Partnership's purpose.
4. The Limited Partners have no role in the Partnership's operation.
5. The Partnership is not treated as an association taxable as a corporation.
6. The Partnership is treated as a fiscally transparent or flow-through entity for tax purposes in each of the three Treaty Countries.
7. Neither the Partnership nor any of the Partners have a permanent establishment in Australia.
8. The activities of the Partnership consist of making long term investments in high risk early stage companies. These investments are put together within a portfolio in the Partnership, to balance the inherent risk of the investments across the markets, maturity and timeframe of the respective underlying businesses.
9. The Partnership has acquired several investments as minority shareholder, some of which it continues to hold, and some of which have been sold. The Partnership is never a controlling shareholder in its investments and does not make management decisions for the companies or decide when the company shares will be sold.
10. The Partnership does not have any predetermined strategy for determining when investments should be disposed of.
11. The investments form part of a long term strategic market sensing activity for an entity related to one of the partners.

AusCo

12. The Partnership was a shareholder in AusCo.
13. AusCo is a company resident in Australia.
14. AusCo does not currently, and did not prior to completion of the sale, have a direct or indirect interest in taxable Australian real property (TARP).
15. The Partnership held an interest of between 10% and 20% of AusCo.
16. The Partnership did not receive any dividends from AusCo.
17. No gearing or debt was involved in the Partnership's acquisition of its shares in AusCo.
18. One of the individual partners was a board member of AusCo and provided customary governance and strategic advice expected of a board member. Their role on the board was primarily for the purpose of protecting the Partnership's investment in AusCo.
19. The sale of the Partnership's investment in AusCo was part of a sale of shares in AusCo by all shareholders to one purchaser. The Partnership based its decision to sell upon the recommendation from the AusCo Board of Directors, which will have taken into account the future prospects for the company under all scenarios.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section100-20

Income Tax Assessment Act 1997 section104-10

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section855-10

Income Tax Assessment Act 1997 section 855-15

Income Tax Assessment Act 1997 section995-1

Reasons for decision

Question 1

Will any gain on the disposal of the shares in AusCo be included as assessable income of the Partnership under subsection 6-5(3) of the ITAA 1997?

Detailed reasoning

Subsection 6-5(3) of the ITAA 1997 states:

If you are a foreign resident, your assessable income includes:

(a)    The *ordinary income you *derived directly or indirectly from all *Australian sources during the income year; and

(b)    Other *ordinary income that a provision includes in your assessable income for the income year on some basis other than having an *Australian source

If, on an assessment of all the facts, the disposal of the investment is a normal operation in the course of carrying on a business of investment, any gain will be income according to ordinary concepts (London Australia Investment Co Ltd v. Federal Commissioner of Taxation (1977) 138 CLR 106; 77 ATC 4398; (1977) 7 ATR 757).

Based on the specific circumstances of the Ruling, the Commissioner considered that the gain on the disposal of shares in AusCo by the Partnership is ordinary income and that the gains are made on revenue account.

The Partnership is a foreign resident. As such, to the extent there is Australian sourced ordinary income made on the disposal of the shares in AusCo, the Partnership would prima facie be required to include the amount in their assessable income under subsection 6-5(3) of the ITAA 1997. However, this is subject to any limitations imposed on Australia's right to tax that income by any DTAs.

As per Question 3, each of the Partners are from treaty countries, and the relevant DTAs apply to prevent Australia from taxing such income. Where satisfactory evidence has been provided of the applicability of Article 7 of the relevant DTAs and the Partners' rights to treaty benefits, the Commissioner will make arrangements to ensure that the treaty obligations have been met.

Question 2

Will any capital gain on disposal of the shares in AusCo be disregarded by the Partnership under subsection 855-10(1) of the ITAA 1997?

Detailed reasoning

Subsection 855-10(1) of the ITAA 1997 provides that a foreign resident can disregard a capital gain or capital loss arising from a capital gains tax (CGT) event, provided that the CGT event happens in relation to a CGT asset that is not 'taxable Australian property'.

Section 108-5 of the ITAA 1997 provides the meaning of a CGT asset to include any kind of property, including shares in a company. The Partnership's interest in AusCo shares are CGT assets.

Section 100-20 of the ITAA 1997 provides:

(1) You can make a capital gain or loss only if a CGT event happens.

Subsection 104-10(1) of the ITAA 1997 provides:

CGT event A1 happens if you dispose of a CGT asset.

There are five categories of CGT assets that are taxable Australian property. The categories are set out in the table in section 855-15 of the ITAA 1997 as follows:

In relation to the Partnership's sale of their interest in the shares of AusCo, Items 1, 3, 4 and 5 contained in section 855-15 are not considered in more detail as:

• the shares do not represent a direct interest in taxable Australian real property (TARP) (Item 1)
• the shares were not used at any time in carrying on a business through a permanent establishment in Australia (Item 3)
• the shares do not represent an option or right to acquire a CGT asset (Item 4), and
• section 104-165(3) only applies to individuals who choose to disregard a gain covered by CGT event I1 (Item 5).

Consequently, Item 2 in section 855-15 of the ITAA 1997 is considered in detail below.

Item 2 - Indirect Australian real property interest

Subsection 855-25(1) of the ITAA 1997 broadly provides an indirect Australian real property interest will exist if the membership interest held passes:

        •      the non-portfolio interest test (per section 960-195), and

        •      the principal asset test (per section 855-30).

Non-portfolio interest test

Section 960-195 of the ITAA 1997 explains the non-portfolio interest test will be passed where:

An interest held by an entity (the holding entity) in another entity (the test entity) passes the non-portfolio interest test at a time if the sum of the direct participation interests held by the holding entity and its associates in the test entity at that time is 10% or more.

Direct participation interest is defined in section 960-190 of the ITAA 1997 as the direct control interest that the first entity holds in the other entity. Section 350 of the ITAA 1936 provides that a direct control interest includes the percentage an entity holds in another entity of the total paid-up share capital or the total rights of shareholders to vote.

As the Partnership had a direct participation interest of greater than 10% in AusCo the non-portfolio interest test is satisfied.

Principal Asset Test

According to subsection 855-30(2) of the ITAA 1997, the principal asset test will be satisfied if the sum of the market values of the test entity's assets that are TARP exceed the market values of the test entity's assets that are not TARP.

The market value of AusCo's TARP assets does not exceed the market value of AusCo's non-TARP assets. As a consequence, the principal asset test contained in section 855-30 of the ITAA 1997 is not passed and Item 2 of section 855-15 will not apply to limit the application of Division 855 of the ITAA 1997 in respect of the sale of shares in AusCo by the Partnership.

Based on the reasons above, section 855-15 of the ITAA 1997 does not apply to limit the application of Division 855. Accordingly, as the Partnership is a foreign resident, Division 855 of the ITAA 1997 will apply to disregard the gain made by the Partnership in relation to the sale of the shares in AusCo.

Question 3

Does Article 7 of each of the three relevant DTAs apply to the disposal of the shares in AusCo by the Partnership such that the amount is not subject to tax in Australia to the extent the profits are treated as the profits of the partners in the respective treaty country?

Summary

Article 7 of each of the DTAs does apply to the disposal of the shares in AusCo by the Partnership because:

-       the gain on the disposal of the shares is treated as the profits of the Partners (and not the LP) for the purposes of the taxation laws of the country of residence of the partners,

-       the profits are not dealt with under another Article of the Treaty (such as Article 13); and

-       the Partners are considered to meet the applicable tax treaty requirements.

Detailed reasoning

Article 7 of the DTAs - Business Profits

Under Article 7 of the DTAs, the business profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in Australia through a permanent establishment situated in Australia. If it does, so much of the profit of the enterprise that is attributable to the permanent establishment in Australia may be taxed in Australia.

Tax Determination TD 2011/25 Income tax: does the business profits article (Article 7) of Australia's tax treaties apply to Australian sourced business profits of a foreign limited partnership (LP) where the LP is treated as fiscally transparent in a country with which Australia has entered into a tax treaty (tax treaty country) and the partners in the LP are residents of that tax treaty country? (TD 2011/25) considers how the Commissioner applies and administers Article 7 to treaty residents participating in a fiscally transparent entity that have Australian sourced business profits. TD 2011/25 provides that Article 7 generally applies to the profits of foreign limited partnerships (provided the profits are not dealt with under another article of the DTA and the resident partners meet all the other applicable treaty requirements) when:

-       the LP is treated as fiscally transparent by a DTA country,

-       the partners in the LP are reside in a country Australia has entered into a treaty with that country, and

-       the business profits are treated as the profits of the partners (and not the LP) for the purposes of the taxation laws of the country of residence of the partners.

Taxation Determination TD 2010/21 -- Income tax: can the profit on the sale of shares in a company group acquired in a leveraged buyout be included in the assessable income of the vendor under subsection 6-5(3) of the Income Tax Assessment Act 1997? (TD 2010/21) explains how DTAs generally treat limited partnerships:

19. ... We will follow, broadly speaking, Organisation for Economic Co-operation and Development practice in this regard when the limited partners are residents of a country with which we have a Double Tax Convention and which treats the partnership as fiscally transparent for the purposes of its tax system. Treaty benefits will be afforded those limited partners where their residence can be verified. Practical difficulties in this regard will need to be overcome. Where information enabling the verification of residence is not disclosed, the LLP will be assessed to tax...

TD 2011/25 provides further information:

21. The Commentary on Article 1 of the OECD Model provides for the source country to acknowledge how income arising in its jurisdiction is treated in the country of residence of persons claiming the benefits of the Convention. In applying the relevant tax treaty, Australia recognises that the domestic tax law of treaty partner countries may require flow-through tax treatment to Australian sourced income derived through an interposed fiscally transparent entity.

22. The effect of the principle outlined at paragraph 6.3 of the Commentary on Article 1 of the OECD Model is expressed at paragraph 6.4 which states:

Where... income has 'flowed through' a transparent partnership to the partners who are liable to tax on that income in the State of their residence then the income is appropriately viewed as 'paid' to the partners... Hence the partners, in these circumstances, satisfy the condition, imposed in several Articles, that the income concerned is 'paid to a resident of the other Contracting State'. Similarly the requirement, imposed by some other Articles, that income or gains are 'derived by a resident of the other Contracting State' is met in the circumstances described above... Following from the principle discussed in paragraph 6.3, the conditions that the income be paid to, or derived by, a resident should be considered to be satisfied even where, as a matter of the domestic law of the State of source, the partnership would not be regarded as transparent for tax purposes, provided that the partnership is not actually considered as a resident of the State of source.

23. Accordingly, in relation to profits of an enterprise that have 'flowed through' a transparent partnership to its partners, application of the principle in paragraph 6.3 of the Commentary on Article 1 of the OECD Model means that such profits are treated as the profits of the partners.

...

35. ... where the partners of a LP are resident in different countries (and Australia may not have a tax treaty with all those countries), treaty benefits only arise for partners resident in tax treaty countries. Again, it is a practical matter of ascertaining residence and the appropriate proportion of business profit which is to be taxed in accordance with the relevant tax treaty.

...

39. As a consequence, the onus must be on the general partner of any involved LP to demonstrate that a limited partner is a resident of a tax treaty country. The OECD was alert to the problem of tracing and conceded the difficulty of affording treaty benefits where the residence of partners was obscure. Like all member countries, Australia considers it inappropriate to afford tax treaty benefits under the Business Profits Article where the residence of the partners cannot be determined. Countries with which Australia has a tax treaty have no single methodology available to easily discern the residence of partners in these kinds of cases. Necessarily, it will therefore be a matter for the general partner (fund manager) to discuss their circumstances with the Commissioner on a case by case basis.

It is therefore necessary to consider the above and the facts of this case to determine whether Article 7 of the DTAs will apply in respect of the gain on the disposal of the shares in AusCo by the Partnership.

The Partnership disposed of its shares in the company AusCo in 20XX.

The Partnership is a limited partnership. The Partnership is treated as a fiscally transparent or flow-through entity for tax purposes in the three Treaty Countries such that profits it derives are treated as having been made directly by the Partners themselves.

Neither the Partnership nor any of the Partners have a permanent establishment in Australia.

The residency of each of the Partners is situated in one of the three relevant Treaty Countries.

In each of the relevant DTAs, the DTAs apply to persons who are residents of one or both of the relevant Contracting States (Article 1 of the DTAs). The Commissioner has been provided with evidence of the residency status of the Partners as part of the Ruling process. Further, the Commissioner considers that the profits arising from the disposal of the shares are not dealt with under another Article of any of the relevant DTAs (such as Article 13) and the Partners are considered to meet the applicable tax treaty requirements.

Therefore, as the Partnership is treated as fiscally transparent in the three Treaty Countries and all the Partners are residents of one of those tax treaty countries, the Commissioner accepts that Article 7 of each of the three respective DTAs apply to the disposal of the shares in AusCo by the Partnership. As a result of this, the Commissioner accepts that the gain made by the Partnership on the disposal of its shares in AusCo is not subject to tax in Australia to the extent the profits are treated as the profits of the partners in the respective treaty country.

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