The Federal Treasurer’s press release of May 2005 echoed the Government’s strategic thinking to make Australia a hub for investment in the Asia Pacific. It was announced that the proposed removal of capital gains tax on sale of shares in Australian companies held by non-residents was 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 capital gains tax base.”
The proposal has now become law in the Tax Law Amendment (2006 Measures No.4) Act 2006.
Removal of CGT liability for non-residents in certain circumstances
Accordingly, effective from December 2006 capital gains tax (CGT) liability was simplified for non-residents by amendments made to Australian tax law. CGT considerations were previously more complex for non-residents.
From December 2006, a non-resident person will be subject to CGT in Australia only where either:
- there is a direct or indirect interest in Australian real property; or
- the asset is used by the non-resident person in carrying on a business through a permanent establishment in Australia.
It is undoubtedly a welcome change to the law since after December 2006 no CGT liability arises unless:
- the asset is Australian real property (which includes mining, quarrying or prospecting rights); or
- the permanent establishment condition is satisfied.
However, there are at least two traps to which we now turn.
Trap no. 1: potential CGT liability due to indirect interests
A CGT liability will arise if a foreign resident disposes an indirect interest in Australian real property via an Australian or foreign company. To expand on that, indirect interest in Australian real property may occur when a person holds a non-portfolio interest (at least 10% interest) in an entity (test entity), which passes the principal asset test. The test entity in which the foreign resident has a non-portfolio interest can be either a resident or non-resident entity.
The test entity passes the principal asset test if more than 50% of the value of its assets are attributable to Australian real property. This scenario is illustrated in the accompanying diagram. Assume the foreign resident intends to sell its shares in Company 3 and the question arises – will there be CGT liability?
In the diagram the Foreign Resident has the following interests in Foreign Company 3:
- Direct participation Interest in Company 3 of 9%
- Indirect participation interest in Company 3 of 100% x 20% + 80% x 100% = 1%
Therefore the foreign resident has a non-portfolio interest in Company 3.
The next question is to find out whether Company 3 satisfies the Principal Asset test. Company 3 has a 60% direct participation interest in the Australian company. Therefore:
- its interest in Australian real property is 60% of $600,000 ($360,000),
- its interest in all assets is 60% of $(600,000 + 200,000), which is $480,000, and
- $360,000 / $480,000 is 75%.
Therefore more than 50% of the value of the its assets are attributable to Australian real property.
If the membership interests in Company 3 are sold by the foreign resident there will be potential CGT liability.
Trap no. 2: business through a “permanent establishment” in Australia
CGT will arise if the interest sold relates to an asset used by the non-resident in carrying on a business through a “permanent establishment” in Australia.
The “permanent establishment” trap applies if the non-resident uses the asset in carrying on a business in Australia.
In contrast, if a non-resident person licenses his or her intellectual property (IP) to an Australian company for use in the Australian company’s business, then the IP will not be subject to CGT when it is eventually sold.
Due to the traps discussed above in the new CGT rules applicable to non-residents in future business structuring matters the percentages of shareholding in companies and ownership interests in Australian real property should always be carefully reviewed.