The Australian Taxation Office appears confused about the nature of private equity. That, perhaps, isn’t surprising, since it appears it obtained its understanding of the sector from Wikipedia.
That isn’t a joke. The ATO today issued two draft determinations that relate to its attempt to prevent TPG from shifting the $1.5 billion of profits it made from the Myer Holdings float offshore and to tax those profits as income within the Australian tax system. The ATO referenced Wikipedia for its understanding of a typical private equity transaction. Seriously.
The core of the draft determinations are (a) that a private equity entity’s gain from selling assets can be treated as income for taxation purposes, although that “will depend on all the circumstances of the particular case” and (b) Australia’s anti-avoidance provisions can apply to arrangements designed to alter the intended effect of Australia’s international tax treaties.
As they apply to private equity, the two issues are related. If a private equity group is resident in a country with which Australia has a tax treaty, generally its profits won’t be taxed in Australia. However, if there were no commercial purpose for its ownership structure other than to obtain a tax benefit the anti-avoidance provisions could apply and the profits could be taxed within Australia.
The determinations are illustrated with hypothetical examples of an offshore company which acquires an Australian public company with the intention of restructuring it and re-floating it on the ASX.
The holding company for the Australian business is a Dutch company, which is in turn owned by a Luxembourg entity, which is itself owned by an entity resident in the Cayman Islands. Coincidentally, that hypothetical chain is exactly the structure TPG used for the Myer transaction.
At face value, one might look at the ATO’s determinations and agree with the conclusion that private equity is in the business of buying and selling companies for a profit and therefore its gains are income, not capital.
One might also look at its hypothetical corporate chain and conclude that the use of a Dutch company was to obtain the benefit of the tax treaty Australia has with the Netherlands as well as the tax exemption in the Netherlands for passive holding companies. That would enable a private equity firm to earn and the on-pass gains from Australian activities to tax havens.
That might appear to be the form, but it misstates the substance of private equity and its dealings. Private equity groups are essentially actively-managed collective investment vehicles. Had the ATO researched Wikipedia more extensively, it would have read that the investors in private equity are primarily institutional.
They aren’t in the business of buying and managing and ultimately selling assets – they are passive investors in the vehicles. They also tend to be dispersed around the globe – funds are channelled into the big private equity funds from the US, Europe, Asia and the Middle East.
The purpose of the structures used by private equity isn’t to help the end investors avoid or evade tax in their home jurisdictions but to provide, in effect, a clearing house for global collection and distribution of the investors’ funds and avoid paying a second layer of what would essentially be gratuitous transaction taxes tax as the investors’ funds are eventually repatriated.
That is precisely why the Future Fund, which is investing globally, has five subsidiaries in the Cayman Islands. There are, therefore sound commercial reasons for the use of such structures other than to avoid paying the taxes levied in the countries with which Australia has bilateral tax treaties.
The ATO presumably doesn’t actually believe that either all TPG’s investors live in the Cayman Islands or some other tax haven or are prepared to leave their capital in a tax haven in perpetuity. Pension funds and other institutions do have to service maturing liabilities and distribute earnings and therefore will at some point repatriate distributed funds and profits to their country of residence.
Overseas private equity firms operating in Australia have been using these structures routinely without ATO intervention in the past. Maybe it was the sheer size of the profit generated by the TPG investors that galvanised the ATO.
It is stated government policy that foreign investors should be exempt from capital gains tax on investments other than Australian real property. The policy is supposed to promote investment in Australia by foreign investment vehicles. The ATO’s actions are inconsistent with that policy.
The ATO’s shock interpretations will have a chilling effect on new investments by offshore private equity firms and other collective investment vehicles like infrastructure funds. It would also discourage new investments by Australian funds already subject to the local tax regime which now face a materially higher tax impost on their gains if they are to be assessed as income.
If they are rational – and private equity tends to be very unemotional — the foreigners will invest elsewhere.
One can conclude from the draft determinations that the new ATO stance doesn’t relate to some peculiarities of the TPG structure but represents a broader attempt to bring foreign private equity firms into the Australian tax net.
One would have thought that if there were to be a change of policy towards foreign private equity and, indeed, other types of foreign collective investment in Australia, it would be a matter for the federal government rather that the ATO.
There is an urgent need for the government to reveal whether it supports the ATO’s interpretations or not and, whichever way it leans, legislate to introduce some certainty.
This article first appeared on Business Spectator.
James was the editor and publisher of SmartCompany and LeadingCompany for five years. He is now the Australian Financial Review‘s companies & markets editor, and a former BRW editor.
