On 5 February 2018, the Federal Court set aside the Commissioner’s assessments, issued to two limited partnerships, for profits they made on their respective investments in the shares of an Australian mining company: Talison Lithium Limited (Lithium Co).
In 2007, two limited liability partnerships: Resource Capital Fund IV LP (Resource IV) and Resource Capital Fund V LP (Resource V) bought shares in Lithium Co and in 2013, by Scheme of Arrangement, they disposed of their shares, to a Canadian based purchaser, for C$198m and C$112m respectively.
The limited partnerships were established in the Cayman Islands. Investment decisions were made by an Investment Committee meeting in the US, while various management companies conducted the day-to-day operations.
One selling their shares, the Commissioner issued notices of assessment to Resource IV and Resource V, sending the notices of assessment to the General Partner of each partnership.
- The assessment for RCF IV ascertained a taxable amount of A$116,835,066 with tax payable thereon (at 30%) of A$35,050,519.
- The assessment for RCF IV ascertained a taxable amount of A$61,577,787 and tax payable thereon of A$18,473,336.
- The ATO correspondence referred to the disposal of taxable Australian property, indicating that the ATO proceeded on the basis that the taxable amount was a capital gain (and not an ordinary income gain).
- The assessments were issued in the name of the limited partnerships, relying on Division 5A of Part III of the ITAA36 (Div 5A), which deems limited partnerships to be companies (or at least, that’s the common perception of what these provisions do).
The Limited Partnerships were not the relevant ‘taxpayer’
The ATO argued that Resource IV and Resource V (the Funds) were “taxable entities” with standing to the tax appeal. However, the Court held that the Funds were not separate taxable entities and the correct correct parties to assess were the partners, not the partnership. It accepted expert evidence that the Funds were not separate legal entities under Caymans law and the proper parties to sue and be sued were the actual partners. It also relied on the fact that the Funds were tax transparent in both the US and the Caymans.
In the end Div 5A did not achieve this. It modified the tax law, so that the definition of ‘company’ was to include limited partnerships (in s94J of the ITAA36) that the word ‘company’ would include the limited partnership. This was because the section attempted to include (in the definition of ‘company’) something that had no separate existence.
Would Australian domestic law tax the gain (on what basis)?
The Commissioner appeared to have assessed the gain, under our CGT provisions, on the assumption that the limited partnership was non-resident, but assessable on the shares because they were ‘Taxable Australian Property’ under Div 855 of the ITAA97 (which is to say: the shares were an ‘indirect Australian Real Property interest’, under the ‘principal asset test’ in s855-30, which determines whether the ‘principal [underlying] assets’ are Taxable Australian Real Property/TARP – a kind of ‘land rich’ test).
The Court, however, found that the gain was ‘ordinary income’ and that it had an Australian source – meaning the Australian domestic law could tax the gain (noting that CGT takes ‘back seat’ to other assessing provisions under s118-20 of the ITAA97).
Hence, the issue all came down to whether the Australia-USA Double Tax Agreement (DTA) gave relief to the preponderance of US resident limited partners.
Access to Australia-US Double Tax Treaty
The Commissioner already accepted that a foreign limited liability partnership could have access to relevant double tax agreements. He had issued a binding public determination: TD 2011/25, to that effect. It said this would be the result “to the extent 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“. The Court held that the Commissioner was bound by this public ruling.
However, taxpayers fought and won the point, that the relevant taxpayers were each of the relevant partners, providing an alternative way of ensuring they could access the benefits of the DTA. The DTA applies to ‘enterprises of [the USA]’ and the individual US limited partners plainly answered that description.
Relief under Article 7 of the DTA as ‘business profits’
Article 7 of the DTA, is in standard form, and gives the US the sole right to tax US enterprises, on their business profits, unless that enterprise was carrying on business in Australia, through a permanent establishment. The Court ruled these were ‘business profits’ and the limited partners did not carry on their business through a PE in Australia. On the face of it, Australia was excluded from taxing the gain, subject to one potential exclusion.
Article 7(6) gave priority to other provisions of the DTA that “deal with [items of income] separately”. This gave rise to the possibility that Article 13, regarding ‘Alienation of Real Property’ could apply. Article 13 would give Australia back the right to tax, here, as it allowed the state, in which the real property was ‘situated’ to tax that income.
The possible application of Article 13 – ‘Alienation of real property’
The first limb of Article 13 didn’t apply, because it was shares (not real property) that was sold. But Article 13 also applied to alienation of “shares … in a company, the assets of which consist wholly or principally of real property in Australia”.
Various subsidiaries of Lithium Co had mining rights and leases over property on which processing plants were built. There was, therefore, the potential for Article 13 to apply, depending on what the “principally of real property in Australia” meant. But interpreting this phrase was difficult.
- In 1997, the Full Federal Court held that the equivalent Article, in our Netherlands Agreement, only permitted an enquiries into the real estate assets of the company, whose shares were sold – without looking deeper into the its subsidiary’s assets: Lamesa  FCA 785.
- As a result of this case, the Australian Parliament later attempted a unilateral, retrospective, amendment to its bilateral double tax agreements, by inserting a new s3A into our International Tax Agreements Act 1953. It purported to extend these words as if they said: “principally attributable, whether directly or indirectly, through one or more interposed companies or other entities, to such real property or interests”.
- The Court wrestled with the capacity of the Act to, both give effect to a bi-lateral treaty (which can’t be changed without agreement) whilst also purporting to unilaterally extend it. It held that this reduced to a task of trying to reconcile two domestic laws (albeit in the one statute). [para 85]
- Without going through all the twists and turns, the Court concluded that the competing provisions could be reconciled on the basis that the s3A amendment, was measured, and did not undermine the force and effect of the DTA. In particular, it did not undermine Article 13, which made separate provision for Australian real property. The Court held that they could be reconciled, to the extent that s3A sought to enable the Australian domestic tax law to apply to companies whose “assets [that] are … principally .. real property”.
- Australian CGT applies to non-residents, on the sale of shares the ‘principal asset(s)’ of which are Australian real property: Div 855 of the ITAA97. So the Court was prepared to apply the ‘principal assets test’ in Div 855 as a proxy for what this DTA provision meant (in the light of the s3A purported ‘extension’).
Did Article 13 apply (via a Div 855 proxy)
This question of whether Article 13 applied, to allow Australia to tax the gain, turned on whether or not the value of Lithium Co’s underlying assets, that were taxable Australian real property (TARP) was more than the value of those that were not TARP assets – s855-30(1). Very broadly, TARP comprises all interests in land, mining and exploration interests and certain buildings and improvements.
This issue required very technical and specialised analysis by appropriately qualified valuation experts. A core aspect of the Funds’ valuation evidence was the use of the “Netback method”, which was a methodology for separating values of Lithium Co.’s mining and processing activities (being TARP and non-TARP, respectively). It operated on the assumption that the mining leases’ value could be struck by a discounted cash flow of the lithium ore severed from the ground, as it then became a chattel that the miner could own. They then worked from the known price of selling processed lithium, back to the value of the unprocessed ore, by subtracting all the costs of processing, plus a profit margin.
The Court preferred and adopted this approach, under which it found that the value of Lithium Co’s underlying TARP assets were less than the value of its non-TARP assets.
In accepting the Funds’ expert valuation evidence, the Court found as follows:
- the “netback method” used by the Funds’ experts, which is a method for separately valuing the mining and processing operations, was acceptable, reasonable and reliable;
- certain leases and licences that allow processing (but not mining operations) are not TARP and the value of those leases and licences, as well as processing plant and equipment, are non-TARP;
- value attributable to the period after expiry of the current mining leases should be valued as a non-TARP asset; and
- intercompany loans were to be valued on a gross, not net basis.
Final result (not final)
Finally, the Court allowed the appeal and set aside the Commissioner’s objection decisions.
However, the Court also remitted the matter back to the Commissioner for reconsideration, subject to the experts undertaking some recalculations to reflect some of the findings and conclusions.
It also scheduled further hearings to finalise orders.
(Resource Capital Fund IV LP v CofT  FCA 41, Federal Court, Pagone J, 5 February 2018).
Study questions (answers below*)
- Was the result, in this case, that the profits made, by two Cayman Islands limited partnerships, from selling their shares in an Australian mining company, were not taxable in Australia?
- Did the Commissioner issue assessments, to the limited partnerships (treating them as a company in line with Div 5A of the ITAA36)?
- Was he correct?
- Did this matter (in terms of accessing the Australia-US Double Tax Treaty)?
- Could Australian domestic tax law have taxed the gain (ignoring the DTA)?
- Did the DTA ultimately prevent Australian tax apply?
- Did Article 7(1) relating to business profits apply?
- Did Article 13 (about alienating Australian real property apply)?
- Did Australia’s unilateral attempt to vary a prior agreement (by inserting s3A into the International Tax Agreements Act) affect the meaning of the previous agreement?
- Was this result because the underlying TARP asset values exceeded the non-TARP assets.
- Was this result achieved by applying a valuation basis known as ‘Netback’?