In one of the most radical changes to Australia's capital gains tax since it was introduced in 1985, amendments enacted in late 2006 (with immediate effect) have significantly narrowed the application of the capital gains tax regime to all foreign residents. The reforms have major implications for all investors into Australia, whether individual, corporate or trustees of trusts.
Making Australia more attractive to foreign investors
The legislation aims to make Australia a more attractive place for business and investment by limiting Australian capital gains tax so that it applies only where a foreign investment transaction involves Australian real property, branch assets, or interests in an entity whose "underlying value" is derived from Australian real property. The reforms apply to all foreign residents (individual and corporate) and to the trustees of foreign trusts.
Fewer types of assets potentially subject to CGT
A key change is the reduction in the categories of assets potentially subject to Australian capital gains tax where a disposal or other taxable event occurs. Shares or units in private companies/trusts and holdings of 10% or more in public companies/trusts held by foreign investors will no longer be subject to capital gains tax, whether or not the companies own any Australian real property.
Is it taxable Australian property?
Under the new regime the critical question for a foreign resident is whether the transaction involves an asset that falls within the revised definition of "taxable Australian property". Transactions affecting assets that are not taxable Australian property are disregarded.
There are now four main categories:
- taxable Australian real property (essentially real property (ie. land) and things assimilated to land (eg. mining rights) in Australia);
- an indirect interest in Australian real property;
- an asset held and used in carrying on business through a branch (permanent establishment) in Australia (not otherwise covered); and
- an option or right to acquire any of the above.
A special fifth category applies in connection with the rules applicable to outbound individuals.
In relation to share or unit investors, in general no Australian capital gains tax will be incurred by a non-resident investor who disposes of shares in an Australian company that does not directly or indirectly principally own land in Australia (ie. more than 50% of total asset values).
A foreign business will generally only be subject to Australian capital gains tax for assets other than direct or indirect interests in Australian real property, where it disposes of assets that have been used in carrying on business through a branch (permanent establishment) in Australia.
Two categories of Australian real property interests
The first category of "taxable Australian real property" (TARP) is relatively straightforward. However, the second category, indirect Australian real property interests, is likely to require closer scrutiny. This category in fact broadens the reach of Australian capital gains tax in certain circumstances.
Under this category, a "membership interest" held by a foreign resident in an entity at a particular time is an "indirect interest in Australian real property" at that time where the interest passes two tests:
- a "non-portfolio interest" test; and
- a "principal asset" test.
The non-portfolio interest test
In essence, where the relevant entity is a company, a non-portfolio interest is a 10% or greater "direct participation interest", or control interest, in the company. The key elements are the rights held by a shareholder to vote, or to receive distributions of capital or dividends.
The non-portfolio interest test is applied at the time of the relevant taxable event and over a 12 month period that begins no earlier than 24 months before the relevant taxable event.
The principal asset test
The principal asset test is satisfied where a foreign resident (the holder) holds a membership interest in an entity (the test entity) and more than 50% of the market value of the test entity’s assets is attributable to taxable Australian real property. This requires a valuation to determine the total market value of any TARP owned or deemed to be owned by the test entity, and the total market value of assets not attributable to TARP. In applying the test, the assets that are taken into account include:
- directly held taxable Australian real property;
- directly held assets other than TARP;
- membership interests (eg. shares) in other entities - that is, interests held by the test entity in other entities through one or more intermediate entities - based on calculations of direct and indirect "participation interests".
In the case of a company, this means that no tracing of indirect real property interests is required if a foreign shareholder holds a direct participation interest in an Australian company of less than 10%, or if the foreign shareholder holds a total participation interest (direct and indirect) in a company of less than 10%.
However, where the foreign resident shareholder holds a direct participation interest in a company (the intermediate entity) of at least 10% and the intermediate entity has a total participation interest (direct and indirect) of at least 10% in one or more other entities, there are sufficient interests held in the other entities to trace through them to determine whether the shares held in the intermediate entity pass the 50% principal asset test.
For example, if a US shareholder disposes of 20% of a US company, the US shareholder's interest is a non-portfolio interest at the time of the disposal (being above 10% - and taking account of a 12 month period over the previous 24 month period). If the US company owns less than 50% - say 40% - of an Australian land owning company (and no assets other than the shares in the Australian company), the shareholder's total participation interest (direct and indirect) in the underlying Australian company would be 8% (20% x 40%). Therefore, it would not be necessary for the US shareholder to test whether or not the shareholding interest in the US company is an indirect Australian real property interest that passes the "principal asset" test.
However, if the US company had a shareholding in the Australian company of more than 50%, say 60%, it would be necessary to test the assets of the Australian company as the US shareholders' total participation interest would be 12% (20% x 60%). The market value of the shares held by the US company, to the extent treated as TARP assets, would be greater than the market value of its assets treated as non-TARP assets. This would cause the principal asset test to be passed and the disposal by the US shareholder would be taxable in Australia (irrespective of the precise extent to which that gain is actually attributable to the Australian land assets of the Australian company, and whether or not the gain is taxable in the US.)
There is no specific statutory link between the amount received from the sale of the US company shares and the market values of the underlying assets of lower tier entities. For example, if the US company shares were sold at a premium to net tangible assets (eg. for management goodwill), this would not ordinarily be taken into account in determining the market value of the assets of, or the interests in, a lower tier company, in this case the Australian company.
Further issues are likely to arise concerning methods of valuation of the assets of entities affected. Although some guidance has been offered concerning reliance on financial accounts, many issues remain unresolved.
While the reduction in the categories of taxable Australian property provides significant benefits for foreign investors, the tracing of indirect interests in Australian real property may give rise to many practical difficulties.
Are investments through managed funds and other trusts an indirect interest?
The same reduced list of categories of taxable Australian property applies to all foreign residents, including the holders of trust interests and the trustees of foreign trusts. As for corporate investors, foreign investors in trusts will need to determine whether or not their trust interests constitute an indirect interest in Australian real property.
The amendments restate the reforms introduced in 2004 relating to trust investments by foreign investors through Australian resident trusts, including managed funds. The 2004 changes sought to align the tax treatment of such a foreign resident investor with the treatment that would apply to a direct investment in the assets of the trust, in Australia or overseas. This treatment has been maintained, but with the narrower definition of "taxable Australian property".
A capital gain or loss on an interest in a fixed trust made by a foreign resident will be disregarded where the gain is attributable to a CGT event affecting a trust asset that is not taxable Australian property. Where the trust asset is an interest in another fixed trust, the condition applies that at least 90% by market value of the trust assets, directly or indirectly through other fixed trusts, must not be taxable Australian property.
The narrower definition of taxable Australian property significantly broadens the scope of these exclusionary rules but maintains the alignment of indirect trust investment with the treatment applicable to direct investment in taxable Australian property.