On 7 December 2006, the Australian Parliament passed the Tax Laws Amendment (2006 Measures No. 4) Bill 2006. The Act amends the capital gains tax (CGT) provisions of the Income Tax Assessment Act 1997 (Cth) as they relate to foreign residents. The changes take effect from the date of Royal Assent of the Act, which is expected to be on about 15 December 2006.

The principal effect of the amendments is to narrow the range of CGT assets of foreign residents that are subject to the CGT provisions. These measures attempt to further enhance Australia’s status as an attractive place for business and investment by addressing the deterrent effect for foreign investors of Australia’s current broad foreign resident CGT tax base.

However, at the same time, the Act will extend the scope of the Australian CGT provisions to a foreign resident’s indirect holdings of Australian real property (ie via interposed resident or foreign entities). This may result in some foreign residents being subject to CGT for a transaction which would not have been caught under the former provisions. Importantly, the Act can impose an Australian tax liability for a non-resident’s disposal of an interest in a non-resident entity which does not carry on business in Australia, or even directly owns any asset in Australia. This extension may raise difficult compliance issues in connection with transactions which, on their face, have no direct connection with Australia.

What was the previous position?

Prior to these amendments, a foreign resident was subject to the CGT provisions if a CGT event happened in relation to an asset of the foreign resident that had the “necessary connection with Australia.” There were nine categories of these assets, including land and buildings situated in Australia, shares in an Australian private company, a 10% or greater shareholding or unitholding in an Australian public company or unit trust, respectively, and assets used in carrying on a business through a permanent establishment in Australia.

What is the new position?

The amendments replace the concept of “necessary connection with Australia” with the concept of “taxable Australian property.” Under the new provisions, a foreign resident will be subject to the CGT provisions if they hold “taxable Australian property” as defined by the Act and a CGT event happens concerning that property.

Broadly, taxable Australian property includes:

• real property located in Australia;
• membership interests in resident or non-resident entities that directly or indirectly own real property in Australia (and which comprise 50% or more of their asset base, as calculated under a prescriptive test); and
• assets that are used in carrying on business in Australia via a permanent establishment.

Therefore, importantly, a foreign resident will not be subject to CGT when disposing of shares or units that it directly owns in an Australian public or private entity, provided that entity does not own real property in Australia which comprises 50% or more of its asset base. This represents a major win for foreign resident investors who directly invest in Australian securities.

What constitutes “taxable Australian property”?

There are five broad categories of assets that fall within this definition.

“Taxable Australian real property”: this includes real property situated in Australia and mining, quarrying or prospecting rights in Australia.

An “indirect Australian real property interest”: this includes interests (held through one or more resident or non-resident interposed entities) in taxable Australian real property. This will be satisfied when a foreign resident has a direct membership interest in a resident or non-resident entity and the interest passes two tests.

• A non-portfolio interest test: this will be satisfied where a foreign resident (together with associates) holds a direct interest of 10% or more in the entity being disposed of. Notably, this threshold can be triggered at the time of the disposal of the asset or for any 12 month period in the 24 months before the date of the disposal.
• A principal asset test: broadly, this will be satisfied when the entity in which the foreign resident has a direct membership interest is regarded as directly or indirectly owning taxable Australian real property with a market value of more than 50% of the assets of the entity (as calculated under a prescriptive test).

Importantly, as noted above, these tests can be satisfied in the case of a non- portfolio interest held by a foreign resident in a foreign entity which does not carry on business in Australia. Furthermore, the foreign resident may not be entitled to relief under any applicable double tax agreement or to any foreign tax credit for the Australian tax in its country of residence.

Business assets used in carrying on a business through a permanent establishment in Australia.

An option or right to acquire any of the above assets¹.

An asset covered by subsection 104-165(3): under this provision, on ceasing to be an Australian resident, a taxpayer can elect to disregard a gain or loss on assets. The amendment deems such assets to be taxable Australian property.

What does this mean for you?

Every time a foreign resident disposes of an interest in an entity (whether it is an Australian or foreign resident entity) which constitutes a non-portfolio interest, it must consider whether the disposal will constitute the disposal of “taxable Australian real property” (ie due to the entity directly or indirectly holding Australian land or Australian mining, quarrying or prospecting rights). Arguably this will increase compliance obligations and costs for certain foreign residents that would have not otherwise been subject to the Australian CGT regime, as demonstrated in the following example (assuming that the foreign resident has no other assets other than those shares noted in the diagram below):

If the foreign resident had disposed of its shares in Entity A prior to the Act coming into effect, it would have not been subject to CGT. Under the Act, the foreign resident will now be subject to CGT on the sale of these shares due to the following:

• the shares that the foreign resident holds in Entity A pass the non-portfolio test;
• the indirect participation interest that the foreign resident holds in Entity B will be 16% (ie in excess of a 10% threshold); and
• Entity A passes the principal asset test, as more than 50% of Entity A’s assets is attributable to taxable Australian real property (ie under the prescriptive test applicable in this case, we must look through to the underlying assets of Entity B in valuing the shares that Entity A holds in Entity B).

The application of the prescriptive test can be complex and can produce adverse results. You should always seek specialist tax advice.

Footnote

¹ It is arguable (although unsettled) that such an option will only constitute “taxable Australian real property” (in the event that it is an option to acquire interests in an entity) where the option gives the holder the right to acquire 10% or more of the interests in the entity. That is, you do not aggregate the existing interests that the taxpayer has in the entity with the rights conferred by the option.