Friday Letter Clear as mud

Australia's determination this week that private equity profits may – in certain circumstances – be taxed as income rather than capital gains has left more questions than answers. 

On Wednesday, the Australian Taxation Office (ATO) released its long-awaited final determinations on the tax treatment of private equity proceeds.

The rulings were not good news for foreign firms and their investors. Yes, the ATO said, private equity proceeds generated from the sale of Australian assets can be taxed as income, rather than as capital gains. And yes, private equity structures involving offshore holding companies can be assessed under Australia’s anti-avoidance tax provisions to ensure they are not “treaty shopping”.

Though striking a blow to Australia’s offshore private equity community, the ruling on income tax was likely no surprise. Since the ATO first handed TPG Capital a tax bill of A$452.2 million ($422.7 million; €282.3 million) based on the firm’s A$1.58 billion profit from the flotation of Myer Group at the end of last year, the tax body’s agenda was pretty clear.

The decision to consider private equity gains as income liable to be taxed in the country of source (i.e. Australia) means the country is now out of step with practices in Europe and the US. It also means it has seemingly backtracked on legislative changes made in 2006 that allowed private equity returns, as capital gains, to be taxed in the home jurisdiction of the end investor, in line with OECD standards. However, it is not completely out in left-field – New Zealand and Singapore are two other Asian countries which do the same.

More concerning to investors is the seemingly arbitrary nature with which the ATO intends to review – and subsequently tax – private equity investments. While returns on investments made by foreign private equity firms in Australia can be liable for income tax, the ATO has said its decision to levy such a charge will depend on a number of factors specific to each individual deal and investor base. 

“Lack of certainty is the real problem here. No one knows where the tax office will draw the line,” said one senior tax advisor to private equity clients, adding that the outcome of case-by-case assessment is made even less predictable by the country’s notoriously unclear anti-avoidance framework.

“The Australian anti-avoidance rules are ones where two people can come to different conclusions based on the same set of facts – and both can be reasonable,” the source explained.

“The repeated warnings in these tax office rulings that their application will often turn on the particular circumstances of the transaction at hand, are a reminder that there is still a compelling case for the government to legislate to address the inherent uncertainty in the general law as to whether an investment activity produces a return on capital or income account,” Andrew Rothery, chairman of the Australian Private Equity & Venture Capital Association, wrote in a letter to The Australian newspaper in response to the ATO rulings.

Whether or not investors will get clarity on this point remains to be seen: the ATO rulings are open to comment from the industry until 28 January.

In the meantime, many will be keen to gauge the reaction of the large global firms for which these tax rulings are intended. Kohlberg Kravis Roberts, TPG, The Carlyle Group and Cerberus Capital Management have all either been involved in an Australian transaction or linked to high-profile bids on Australian companies in the last few months.

Whether their interest levels in the market will remain the same in the face of such uncertainty remains to be seen. If so, how to go about investing in Australia is the next question that will need to be addressed.