Proposed Changes to Foreign Resident CGT Regime: Implications for M&A Transactions

In brief

• Australian Treasury has just released a consultation paper outlining significant proposed changes to the capital gains tax (CGT) regime for foreign residents.
• These changes aim to broaden the foreign resident CGT rules, with potential major implications for cross-border mergers and acquisitions involving Australian infrastructure assets. The changes will apply to any sale occurring on or after 1 July 2025
• The proposed changes to Australia's foreign resident CGT regime have the potential to significantly impact cross-border M&A activity and will introduce new complexities and compliance burdens for transaction parties.
• As the consultation process unfolds, stakeholders should closely monitor developments and consider making submissions on practical implementation issues.

Background

On 24 July 2024, the Australian Treasury released a consultation paper outlining significant proposed changes to the capital gains tax (CGT) regime for foreign residents. These changes, announced in the May 2024 Federal Budget, aim to broaden the foreign resident CGT rules, with potential major implications for cross-border mergers and acquisitions involving Australian infrastructure assets. This note examines the key proposals and their potential impact on M&A transactions.

Currently, foreign residents are only subject to CGT on disposals of "taxable Australian property" (TAP), which includes:

• Taxable Australian real property (TARP)
• Indirect Australian real property interests (IARPI), being in summary where:
  • The vendor holds a 10% or greater interest in a company or unit trust; and
  • more than 50% of the market value of the assets of the company or trust are attributable to TARP (the Principal Asset Test or PAT)
• Assets used in carrying on business through an Australian permanent establishment

Broadening the CGT Asset Base

The most substantial proposed change is a clarification and broadening of the types of assets that will be subject to CGT for foreign residents. The consultation paper proposes expanding the definition of TAP to capture a wider range of assets with a "close economic connection to Australian land and/or natural resources." This would include:

• Leases or licenses to use Australian land (e.g. pastoral leases)
• Australian water entitlements
• Infrastructure and machinery installed on Australian land (e.g. wind turbines, solar panels, telecommunications infrastructure, rail networks, ports);
• Options or rights to acquire the above assets; and
• Non-portfolio interests in entities deriving more than 50% of their value from such assets.

This broadening of the asset base would significantly expand the scope of Australian CGT for foreign residents.

For M&A transactions, it means a wider range of asset and share sales could potentially trigger CGT liabilities for foreign vendors. Buyers will need to conduct more extensive due diligence on whether target assets or entities fall within the expanded TAP definition. Importantly there is no mention of grandfathering existing assets. Rather the changes will apply to any sale occurring on or after 1 July 2025.

Changes to the Principal Asset Test

For indirect interests in Australian assets held through companies or trusts, the "principal asset test" (PAT) determines whether a 10% or greater membership interest constitutes an IARPI subject to CGT. Currently, this test looks at whether more than 50% of the entity's market value is attributable to TARP assets at the time the membership interest is sold.

The consultation paper proposes changing this to a 365-day testing period. An interest would be an IARPI if the greater than 50% threshold is met at any time in the 365 days preceding the CGT event. This aligns with the OECD Model Tax Convention and aims to prevent manipulation of asset values around transaction dates. Australia already has a ‘anti-stuffing’ integrity rule designed to prevent the concerns about manipulation which are raised, so it is unclear why this change is required.

For M&A deals, this change would require a longer look-back period when assessing potential CGT implications of share sales. Sellers may need to review historical asset compositions and valuations of target entities.

New ATO Notification Requirement

A significant new compliance obligation is proposed for high-value transactions. Foreign resident vendors disposing of membership interests exceeding $20 million in value would be required to notify the ATO in advance if they intend to provide a declaration to the purchaser that the interest is not an IARPI.

This notification would need to be made in an approved form prior to a set review period before the earlier of the CGT event (typically signing of a sale agreement) or settlement. The ATO would then have an opportunity to review and potentially challenge the vendor's position before the transaction completes.

For major M&A deals involving foreign sellers, this new requirement could introduce timing uncertainties and potential delays. Deal timetables may need to factor in the ATO notification and review period, and the impact if the ATO disagrees with a vendor’s declaration.

The notification requirement will not apply to on-market sales but will apply to acquisitions under schemes of arrangement or off market takeovers.

The consultation paper seeks feedback on the appropriate threshold (currently proposed at $20 million) and notification timeframe by 20 August 2024. As the consultation process unfolds, stakeholders should closely monitor developments and consider making submissions on practical implementation issues.

Practical Considerations for M&A Transactions

• Deal Structuring: The expanded asset base for foreign resident CGT may influence transaction structuring decisions.
• Due Diligence: More extensive tax due diligence will be required, particularly for infrastructure assets, natural resource projects, and real estate portfolios. Historical asset compositions and valuations will need closer scrutiny given the proposed 365-day PAT.
• Pricing and Valuations: The expanded CGT base may impact pricing negotiations and valuations, particularly for assets newly brought into the regime like infrastructure. Buyers may seek to factor in latent CGT liabilities.
• Timing and Processes: For high-value deals, transaction timetables will need to accommodate the proposed ATO notification process. Conditions precedent and completion mechanics may need to address potential ATO interventions.
• Tax Warranties and Indemnities: More robust tax warranties and indemnities may be sought to address expanded CGT exposures, particularly around the classification of assets as TAP.
• Withholding Obligations: Buyers will need to carefully assess withholding obligations, which may apply to a broader range of transactions. Processes for obtaining and verifying vendor declarations will be crucial.