Outbound investment tax issues

Outbound investment tax issues With the increasing prevalence of outbound investment from Australia, taxpayers should understand current tax developments impacting foreign investment. September 2017 Reproduced with the permission of The Tax Institute. This article first appears in Taxation in Australia, vol 52(3). For more information, see taxinstitute.com.au. In brief As investors search far and wide for improved returns from new markets and new asset classes, the deployment of Australian capital offshore is expected to continue to increase. One of the key income tax challenges with outbound investment is determining how Australian income tax principles should apply when overlaid with foreign vehicles and foreign income tax laws. Limited partnerships (which can include limited liability partnerships) are common foreign collective investment vehicles that can give rise to several complex questions when considered through an Australian income tax lens. Depending on the jurisdiction of formation, the number of Australian investors (including choices made by those investors), and the way a limited partnership is treated for foreign income tax purposes, it can be viewed as a company or a partnership for Australian income tax purposes. TR 2017/D4 is written in the context of limited partnerships that are treated as companies (corporate limited partnerships, or CLPs). It deals with the specific question of when an amount is deemed to be credited from a limited partnership for the purposes of determining when to recognise dividend income from CLPs. In addition to a discussion of TR 2017/D4, this article also touches briefly on other emerging issues to be aware of in the context of outbound investment. In detail TR 2017/D4 TR 2017/D4 intends to clarify the meaning of the term credits for the purposes of s 94M(1) of the Income Tax Assessment Act 1936 (Cth) (ITAA36). The question of when an amount is credited from a CLP is a pertinent question for Australian income tax purposes because investors in CLPs are required to find a way to recharacterise their returns from a limited partnership into those that are in the nature of returns received from a company (i.e. dividends and capital). www.pwc.com.au

Overview of the current tax treatment of CLP For context, it is important to understand the current provisions that govern the taxation of CLPs, which are contained in Div 5A ITAA36. These provisions broadly state that: 1) a CLP is treated as a company for Australian income tax purpose (other than CLPs that are treated as foreign hybrid limited partnerships under Div 830 of the Income Tax Assessment Act 1997 (Cth) (ITAA97)) 1 ; 2) subject to limited exceptions, a reference to dividends in the Australian income tax law includes a reference to a distribution made by a CLP to a partner in the CLP 2 ; and 3) if a CLP pays or credits an amount to a partner in a partnership against the profits or anticipated profits of the CLP or otherwise in anticipation of the profits of the CLP, the amount paid or credited is taken to be a dividend paid by the CLP to the partner out of profits derived by the CLP 3. TR 2017/D4 focuses exclusively on the third point, specifically when an amount is credited under s 94M(1). The Commissioner s view in TR 2017/D4 Under ss 94L and 94M(1) ITAA36, a deemed dividend can arise in relation to a CLP where an amount is distributed, paid or credited. Because the provisions specifically refer to three different scenarios, TR 2017/D4 contends that the term credits in the context of s 94M means neither paid nor distributed. The Commissioner s preliminary view is that a CLP credits an amount to a partner for the purposes of s 94M(1) if it applies or appropriates its resources to confer a benefit to that partner which: (1) is not subject to a condition precedent and is legally enforceable by the partner; and (2) is separate and distinct from the partner s existing interest in the CLP and its assets. TR 2017/D4 reasons that this approach is consistent with the purpose of Div 5A to tax the partners of a CLP as if they were shareholders in a company. Furthermore, to suggest that a mere accounting credit entry (in the absence of the above factors being satisfied) gives rise to a crediting under s 94M would align the tax treatment of CLPs with the tax treatment applicable to a normal partnership. This is inconsistent with how shareholders of a company are taxed, and would also mean that a partner of a CLP is taxed on amounts that they have no right to demand from the CLP, which they may never receive. Where a CLP has credited an amount, TR 2017/D4 indicates that this crediting holds true even if a future event occurs which requires the credited amount to be relinquished or returned to the partnership. For example, a circumstance could arise where a limited partner is entitled to an interim distribution, but, at the end of the year, if the CLP does not meet particular performance hurdles, the limited partner is required to repay the distribution, or the CLP s obligation to pay the distribution ceases. TR 2017/D4 suggests that it is possible in this scenario for the limited partner to be assessable on the interim distribution (assuming it is credited at that time), even if the limited partner has to repay the funds, or, potentially even if the limited partner never receives the funds. This risk of being taxed where no income is actually received should be carefully managed. 1 S 94J ITAA36 2 S 94L ITAA36 3 S 94M ITAA36 PwC Page 2

When applying the principles in TR 2017/D4, the Commissioner recommends that the questions in Table 1 are asked. The application of the principles in Table 1 are demonstrated by seven examples in TR 2017/D4. The examples consider a wide range of scenarios and principles which are summarised briefly in Table 2. Table 1. Questions to ask when determining whether an amount has been credited by a CLP Relevant question Has the CLP, in substance, applied or appropriated its resources to confer a benefit on one or more of its partners? Comments This benefit can be any type of right, as long as it is legally enforceable. Examples noted in TR 2017/D4 include: an act or transaction that creates an irrevocable and legally enforceable debt owing from the CLP to the partner; a legally enforceable forgiveness by the CLP of a debt owed to it by one of its partners; and where permitted by the relevant partnership law, a limited partner giving up a right to receive a distribution of profits from the CLP: o o in return for a legally enforceable discharge of their unpaid obligation to contribute to the CLP s partnership liabilities; or as a means of making an additional contribution. Is the benefit conferred on the partner legally enforceable? Is the benefit conferred on the partner subject to a condition precedent? Is the benefit conferred on the partner separate and distinct from the partner s existing interests in the CLP and its assets? Consideration will need to be given to the relevant limited partnership agreement, as well as the laws governing the partnership and the benefit in question. If it is, it will not be credited until the condition precedent is satisfied and the benefit becomes legally enforceable. Examples noted in TR 2017/D4 include a new interest in the partnership and its profits, or the extinguishment of a debt owing. PwC Page 3

Table 2. Summary of the examples in TR 2017/D4 Example number Example 1 Example 2 Example 3 Example 4 Example 5 Example 6 and 7 Brief summary A mere credit entry in a CLP s accounts does not of itself constitute a credit for the purposes of s 94M(1). Foregoing a distribution in exchange for additional capital in a CLP can be considered a credit, assuming it is in accordance with the relevant law that applies to the CLP. Where the finalisation of accounts creates a debt unconditionally payable on demand to the partner, the relevant amount will be considered a credit. Where a general partner has a right to retain profits, this will be a condition precedent and any credit will not occur until after the condition precedent has expired or been waived. Where rights of a partner to draw an amount are partly exercised, the unpaid balance will only be credited if there is an unconditional and legally enforceable obligation to pay it under the limited partnership agreement. Where partnership profits are applied to discharge debts owed by a partner to the CLP, this can constitute a credit. Observations regarding TR 2017/D4 In the authors view, TR 2017/D4 provides helpful clarity regarding when an amount is credited for the purposes of s 94M. However, it also should prompt Australian investors in limited partnerships to consider whether their method for recognising dividends from a CLP aligns with the methodology outlined in TR 2017/D4. This is likely to require a review of existing limited partnership agreements as well as discussions with custodians/administrators as relevant. Where the taxpayer s approach has differed to the approach outlined in TR 2017/D4, consideration should be given to whether amendments are required to prior period calculations. For taxpayers that have historically treated mere credits as assessable, they should consider whether amended assessment periods have closed, and whether there is any risk of double taxation when amounts are subsequently credited in accordance with TR 2017/D4. An assessment of whether there is any historical impact on the utilisation of foreign income tax offsets should also be undertaken. The discussion regarding the term credited may also be relevant for other parts of the income tax law (for example, the term is also used with reference to dividends, and in the context of withholding taxes). TR 2017/D4 is silent on its application to other parts of the income tax law. Other limited partnership issues to consider As part of this process, taxpayers may also wish to revisit or reconfirm the positions that they have taken in relation to other practical and technical nuances associated with the taxation of limited partnerships. These include: distinguishing between returns of capital and dividends, including the level of analysis of underlying information that is required to make this assessment; PwC Page 4

considering the application and overlap with other provisions of the law (including the capital gains tax provisions, ss 45B and s 94M(2)) ITAA36) to ensure that distributions from a CLP are not double taxed at the partner level; and considering whether the foreign hybrid limited partnership rules could have application, and if possible, whether there are any benefits to electing into these rules. 4 Other outbound investor issues to consider In addition to investments in limited partnerships, there are a myriad of alternate offshore investment structures, each of which can raise distinct Australian income tax complexities which should be considered on a case-by-case basis. The authors have briefly highlighted below some other emerging and existing tax issues to consider when investing in offshore structures (including limited partnerships). Managing the risk of the CFC rules applying Where the controlled foreign company (CFC) rules apply, attributable Australian taxpayers could be subject to tax on an attribution basis (rather than a receipts basis) in relation to the investment. As the central definition for CFC purposes looks to control held by Australian residents and their associates, a foreign company can be regarded as a CFC although no Australian entity has substantial influence or holds a controlling direct or indirect interest in the foreign company. It can be very difficult for an Australian entity to apply the CFC rules correctly if it is not in a position of control to allow it to extract the relevant information it requires. It should also be noted that the ATO has recently published its views regarding when control arises in the context of Div 6C ITAA36 5. The ATO s position is that in certain circumstances, veto rights held by minority shareholders could constitute control for the purposes of Div 6C. While this view is provided in the context of infrastructure and property investments held through trust structures (and the language of Div 6C differs from the CFC provisions), any further developments or views put forward by the ATO regarding the definition of control should be monitored in case they seek to apply a similar approach to the CFC provisions. Ensuring investments in foreign structures do not result in the foreign entity inadvertently becoming an Australian tax resident The residence of foreign investments should also be considered, particularly in light of the TR 2017/D2. This draft ruling was issued following the decision handed down in Bywater Investments Ltd v FCT; Hua Wang Bank Berhad v FCT 6. On the same day, the ATO withdrew the previous ruling on the central management and control test set out in TR 2004/15. Of particular note, TR 2017/D2 provides that it is not necessary for any part of the actual trading or investment operations from which a company s profits are made to take place in Australia, as the central management and control of a business is factually part of carrying on that business. This is a notable 4 The foreign hybrid limited partnership rules broadly treat limited partnerships as partnerships (not corporate entities) for Australian income tax purposes. 5 Australian Taxation Office, Draft privatisation and infrastructure Australian federal tax framework, January 2017. 6 [2016] HCA 45 PwC Page 5

change from TR 2004/15 and could potentially treat a wider range of foreign entities as Australian tax resident (and therefore subject to Australian corporate income tax on their worldwide income). For example, trading entities whose central management and control was in Australia may have argued previously that they could not be Australian tax resident on the basis that they did not carry on business in Australia. Under TR 2017/D2, this argument may no longer be valid as central management and control in Australian should of itself indicate that business is also carried on in Australia. The finalisation of TR 2017/D2 should be closely monitored to identify any changes or clarifications in the ATO s views regarding residency. The ability to flow capital gains through foreign trusts The rules relating to the taxation of foreign trusts are complex. The recently issued TD 2016/D4 and TD 2016/D5 deal with the interaction of the non-resident capital gains tax exemption, foreign trusts and s 99B ITAA36. In these draft tax determinations, the ATO puts forward the view that non-taxable Australian property capital gains (non-tap gains) derived by foreign trusts should be disregarded under Div 855 ITAA97. The ATO argues that, as a consequence of this, when the gains are distributed to investors, they should be assessable under s 99B. This outcome would effectively recharacterise non-tap capital gains derived by a foreign trust as ordinary income in the hands of Australian resident beneficiaries. This would prevent Australian investors in foreign trusts from claiming the capital gains tax discount, or the ability to utilise investor level capital losses against capital gains distributed from the foreign trust. In the authors view, the interpretation of the law put forward by the ATO would be contrary to the policy intent (being for investors in trusts to access capital gains treatment in relation to underlying investments). Australian taxpayers that invest in foreign trusts should monitor developments in relation to the draft determinations closely. Foreign income tax offset planning Given the use it or lose it nature of foreign income tax offsets (FITOs), it always pays to perform planning regarding when FITOs are likely to arise, and whether sufficient foreign income will be generated from foreign investments in the relevant year. Typically, the level of planning and structuring with respect to FITOs will come down to a question of how significant the FITOs may be, compared to the costs and risks of seeking to access them. Let s talk For a deeper discussion of how these issues might affect your business, please contact: Mark Edmonds, Sydney +61 (2) 8266 1339 mark.edmonds@pwc.com Rohit Raghavan, Melbourne +61 (3) 8603 0699 rohit.raghavan@pwc.com 2017 PricewaterhouseCoopers. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers a partnership formed in Australia, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. This publication is a general summary. It is not legal or tax advice. Readers should not act on the basis of this publication before obtaining professional advice. PricewaterhouseCoopers is not licensed to provide financial product advice under the Corporations Act 2001 (Cth). Taxation is only one of the matters that you need to consider when making a decision on a financial product. You should consider taking advice from the holder of an Australian Financial Services License before making a decision on a financial product. PwC Page 6 Liability limited by a scheme approved under Professional Standards Legislation.