The RCF IV Case - a pyrrhic victory for taxpayers?

In Resource Capital Fund IV LP v FC of T [2018] FCA 41 (RCF IV case) a single judge of the Federal Court (Pagone J) dealt with two Cayman Islands Limited Partnerships – Resource Capital Fund IV LP (RCF IV) and Resource Capital Fund LF V (RCF V) (which have no separate legal personality under Cayman Islands law) – selling shares in Talison Lithium Ltd (Talison) a Toronto listed Australian company, at a profit. It was found by the Court to be a revenue profit with an Australian source under Australian domestic rules, but on the facts, not subject to Australian tax by virtue of Article 7 of the Australia US Double Tax Agreement (DTA).

Renowned expert and special counsel Paul O’Donnell outlines the practical implications of the court ruling and questions whether certain aspects of the decision will create separate taxable entities. This ruling will be of particular interest to private equity fund managers or those with Cayman Island Limited Partnership involvement.

The CEO of The Australian Private Equity and Venture Capital Association Limited (AVCAL) is reported in the Australian Financial Review as having said:

“What we cannot afford to have happen is for uncertainty around our tax laws [including the RCF IV case] to dampen…[offshore investors’] enthusiasm to allocate capital to this [Australian] market”.

Part of the uncertainty in the RCF IV case arises from the Court sanctioning a wider range of valuation methodologies which may be more appropriate than the one preferred by the Full Federal Court in the RCF III case, in relation to the alienation of (real) property article (Article 13(2) of the DTA).

Some uncertainty may also arise from the weighing of facts which led Pagone J to find that the profit from the sale of Talison shares by RVF IV and RCF V had an Australian source under Australian domestic rules.

Further uncertainty may arise because of the potential for the decision in the RCF IV case to give rise to double taxation of the same profit; for example, double taxation may arise if:

• the partners of RCF IV and RCF V were not protected by the business profits article in the DTA and were jointly and severally liable for the tax payable by the LP/company; and
• were also assessable on deemed dividends referrable to the partnership distribution without the benefit of dividend imputation (that is, where the LP/company and the partners are not Australian residents)

There are some further commercially relevant considerations noted below.

In the RCF IV case, RCF IV and RCFV sold shares in Talison pursuant to a scheme of arrangement under the Australian Corporations Act 2001 (Cth) in the 2012/13 year.

Talison held indirect interests in lithium mining businesses in Australia.

The Commissioner of Taxation (Commissioner) issued assessments to RCF IV and RCF V themselves in respect of the profit on sale, contending that

• Article 13 of the (DTA) authorised the taxing of gains from the alienation of real property; and
• section 3A of International Tax Agreements Act 1953 (Cth) (ITA) extended the operation of Article 13(2) to gains attributable to real property held through one or more interposed entities such at the subsidiary entities of Talison

After RCF IV and RCF V objected to the assessment in respect of the profits on sale of Talison shares, at the directions hearing, the general partners were given leave to be added as applicants in the appeal.

In the appeal, the general partner applicants argued that the partners in RCF IV and RCF V were taxable entities rather than the partnerships of RCF IV and RCF V themselves. Further, they contended that:

• Article 7 of the DTA (concerning business profits), rather than Article 13 of the DTA, governed Australia’s right to the tax the profit realised on sale of Talison shares; and
• public ruling TD 2011/25 bound the Commissioner to grant relief from Australian tax to the US resident partners in the fiscally transparent RCF IV and RCF V.

In the RCF IV case, Pagone J found that the US resident partners were not liable to Australian tax on their share of profits from RCF IV and RCF V because:

• Article 13 of the DTA and section 3A of ITA did not apply to those profits; and
• TD 2011/25 prevented the Commissioner from assessing those partners under Article 7 of the DTA because of a lack of a permanent establishmentof those partners assumed in TD 2011/25.

Pagone J also found that the partners in RCF IV and RCF V were the taxable entities rather than the partnerships themselves.

In FC of T v Resource Finance Capital Fund III LP (2014) FCR290 (RCF III case), a full bench of the Federal Court found that a profit on the sale of shares in certain mining companies was assessed in the hands of the partnership itself because such shares were indirect interests in taxable Australian real property for the purposes of the capital gains tax rules applicable to foreign residents and that the DTA did not apply to the RCFIII partnership itself.

In the RCF IV case, Pagone J explained that in the RCF III case, the Full Federal Court did not hear argument and had merely assumed that the partnership was the correct taxable entity rather than the partners themselves. In his Honour’s view, this enabled him not to follow the Full Federal Court on this point.

This departure in the RCF IV case from the position in the RCF III case represents a major change in market practice in relation to Australia income tax law and Cayman Islands limited partnerships investing in Australia. While it is understood the RCF IV case is on appeal to the Full Federal Court, we would suggest that the interpretation of whether the partners of a limited partnership or the limited partnership is the taxable entity under Division 5A of Part III of the Income Tax Assessment Act 1936 (Cth) (1936 Act) reveals itself as a vexed issue for the reasons noted below.

The comments reveal a difficulty with the current drafting of the definition of “limited partnership” in section 995-1 of the Income Tax Assessment Act 1997 (Cth) (1997 Act) and the drafting of Division 5A of Part III of the 1936 Act.

As noted above, initially, in the RCF IV case, the two Cayman limited partnerships were the parties to the tax appeal. This was not the case in relation to the Cayman limited partnership in the RCF III case. In the RCF IV case, leave was granted for the general partners in each of the Cayman limited partnerships to be joined as applicants, this enabled RCV IV and RCV V to make submissions, including that:

• no taxable entity, being the (corporate) limited partnership, is created by Division 5A of Part III of the 1936 Act; and
• by virtue of section 94U and 94V of the 1936 Act, only the partners are (jointly and severally) liable for income tax calculated under Division 5A; and
• the corporate limited partnership was not expressed to be liable to tax because it is not a legal personality separate from the partners, as is the case with “general” partnerships subject to the rules in Division 5 of Part III of the 1936 “general” Act.

While not discussed in the RCF IV case judgment, it is interesting to note that under section 94H and 94J of the 1936 Act, if a partnership is a “corporate limited partnership” in relation to a year of income, a reference to a “company” or a “body company” includes (subject to exceptions relating to the definitions of dividend and resident and some R&D provisions) a reference to the partnership. Further, under section 94K of the 1936 Act, a reference to a partnership in the income tax law (which includes the 1997 Act and the 1936 Act other than Division 5A of Part III) does not include a reference to the partnership.

Paragraph (b) of the definition of “limited partnership” in section 995-1 of the 1997 Act refers to certain venture capital limited partnerships which have a legal personality separate from the association of persons who form the partnership.

As noted above, the Cayman limited partnerships in the RCF IV case did not have a separate legal personality from the general partners or the limited partners. The Court found that those limited partnerships fell within paragraph (a) of the definition of “limited partnership” in section 995-1 of the 1997 Act which provides:

“An association of persons (other than a company) carrying on business as partners or in receipt of ordinary income or statutory income jointly, where the liability of at least of those persons is limited.”

Because the Cayman limited partnerships did not have a separate legal personality from the partners under Cayman law, the Federal Court in the RCF IV case looked in vain (in its view) for provisions in Division 5A of part III of the 1936 Act which created a separate taxable entity. By inference, the Federal Court believed it was insufficient to label the entity as a “company” for the purposes of the income tax law (as defined in section 94B of the 1936 Act).

The Federal Court looked at section 94U of the 1936 Act, which is headed “Incorporation” but found that a limited partnership (at least one without a separate legal personality) is only “taken” to be notionally incorporated where it was formed for the purposes of, among other things, its deemed residence under section 94T of the 1936 Act. The Federal Court also stated that section 94U “does not in form, effect or purpose create a taxable entity”. Such a statement is obviously not focusing on “limited partnerships” which have a separate legal personality and are referred to in paragraph (b) of the definition of that term.

The Federal Court then focused on subsection 94V(1) of the 1936 Act which provides, so far as relevant:

“The application of the income tax law to the partnership as if the partnership were a company is subject to the following changes:

(a) obligations that would be imposed on the partnership are imposed instead on each partner but may be discharged by any of the partners;

(b) the partners are jointly and severally liable to pay any amount that would be payable by the partnership; ….”

As noted by the Federal Court:

“Nothing in s.94V, or any other provision of Div 5A, authorises the Commissioner to impose any obligation or liability on any person other than a partner, and if there had been any doubt where the liability and obligation fell, the doubt was expressly removed by s.94V.”

It is relatively clear why section 94V is necessary for a paragraph (a) limited partnership with no separate legal personality (such as the ones in the RCF IV case), but it is less clear in relation to paragraph (b) venture capital limited partnerships which have a separate legal personality.

What the Federal Court did not refer to in the RCF IV case is section 94L and section 94M of the 1936 Act. These provisions generally deem distributions of corporate limited partnerships and drawings from such partnerships to be dividends paid by a company out of profits of the company and to be assessable as dividends under section 44 of the 1936 Act, or subject to or exempted from dividend withholding tax under Division 11A of Part III of the 1936 Act.

There is an obligation on the Commissioner to avoid double taxation in section 94M dealing with drawings. However, subsection 94M(3) limits this obligation to cases where there are further partner distributions after drawings and where the drawings may have anticipated future profits.

What is not covered in Division 5A expressly is the scenario where a partner, who is jointly and severally liable for the corporate limited partnership’s income tax liability, receives both:

• an assessment; and
• a deemed dividend from a distribution or drawing from the partnership.

For Australian resident corporate limited partnerships and partners, the partnership is a “corporate tax entity” which can generally frank dividends. Hence double tax is partly or wholly dealt with in the above circumstances.

However, for non-resident corporate limited partnerships and partners, double taxation may arise if the RCF IV case is correct. This appears to be a surprising result in that it re-introduces the classical system (double taxation of the same profit) for taxing companies and shareholders for foreign residents and in the case of a non-resident partner assessed on the whole of the partnerships taxable income, multiple taxation of that profit.

On the assumption that the decision of Pagone J in the RCF IV case is not overturned on appeal, one issue may arise as to whether or not the general partner or limited partner of a limited partnership similar to the RCF IV limited partnership may need to consider the permanent establishment provisions in the DTA (including the deemed permanent establishment provisions for fiscally transparent entities in Article 7(9) of the DTA, and (potentially) the MAAL provision in section 177DA of the 1936 Act).

Generally, under existing arrangements, the market view appears to be that the general partner of such a partnership does not carry on business in Australia itself and does not use a dependent agent to do so on its behalf. Rather an Australian related entity of the foreign fund manager provides services to the limited partnership for a fee. Such arrangements may have been assumed to be in place in light of TD2011/25.

Alternatively, if in relation to a Cayman limited partnership:

• Article 13 of the DTA authorises the taxing of a profit realised on sale of shares that are an indirect interest in Australian real property; and
• the corporate limited partnership (or rather its partners) are liable to tax in Australia; and
• the general partner does not have sufficient funds to meet an assessment,
• then the Commissioner may issue assessments to the limited partners in the Cayman limited partnership.

The NSW, Victorian and South Australian Partnership Acts (specifically, section 68 of the Partnership Act 1898 (NSW), section 64 of the Partnership Act 1958 (Vic) and section 62 of the Partnership Act 1891 (SA)) recognise the limitation of liability of certain foreign limited partnerships in their respective states.

However, certain Cayman limited partnership which have no separate legal personality (such as RCF IV and RCF V) are not listed in the regulations to enable such recognition. As such, these Partnership Acts would have no effect if the Commissioner was to commence recovery proceedings in the Australian Federal Court to collect tax from the limited partners.

However, even if these Partnership Acts applied, Australian federal law is unlikely to be impeded by State recognition of limited liability. Hence, subject to recognition of judgment debts in foreign jurisdictions, such as those in the USA, the Commissioner may be able to recover Australian tax debts from limited partners.

If you would like to discuss further the implications of this decision to you or your clients, please contact Paul at paul.odonnell@nortonrosefulbright.com.au or +61 2 9330 8903.