Changes to Australian tax on gains of non-residents

by Graeme Cooper, Toby Eggleston, Ryan Leslie, Nick Heggart, James Pettigrew, Jinny Chaimungkalanont

The December 2023 Mid-Year Economic and Fiscal Outlook and the May 2024 Budget announced two changes to the rules for taxing gains made by non-residents:

• expanding Australia’s tax base to expose more assets owned by non-residents to Australian tax, and
•  strengthening the regime for reporting to the ATO when non-residents have made gains.

Treasury has released a Consultation Paper seeking submissions on the design of these measures and an Exposure Draft to lift the rate of CGT non-resident withholding to 15% from 1 January 2025 as previously announced. Our Tax Insight on the Budget announcement is available here and our podcast on the Paper and Exposure Draft is available here.

1. Expanding the tax base

Australia has toyed with the jurisdictional reach of the capital gains tax several times since 1985; the Discussion Paper proposes yet another revision. Existing investments are not grandfathered, and the current proposal does not include any transitional rules, which means many foreign residents may now face a tax impost on disposal of their investment that was not factored in at the time of investment.

1.1 Time of testing whether an entity is ‘land rich’

The proposals in the Discussion Paper involve two changes. One is relatively straightforward: to change the test for deciding whether a company or trust is ‘land-rich’ from a point-in-time test [… ‘[the] membership interest … passes the principal asset test … at that time’] to a period test: ‘if the underlying entity derives more than 50 per cent of its market value from TARP at the time of testing or at any time during the preceding 365 days …’  

This change looks like it would align with the period test in the ‘sufficient percentage of ownership’ aspect of the rule, but there are differences:

• the period test for finding a non-portfolio interest is, 10% held for any 12 months in the last 24 months;
• the period test for the principal asset test will be, 50% of the entity’s value at any time during the last 12 months.

Although the change appears simple, obtaining information to apply this test is likely to be difficult in practice especially for minority investors and the risk of valuation disputes seems very high.

1.2 Expanding the notion of Australian land

The other change is much more consequential and will undo some of the significant narrowing of the scope of the CGT legislated in 2006. The 2006 amendments were based on the recommendations in the Board of Taxation, Review of International Taxation Arrangements (2002) accepted by the Government.  The Government lauded the narrower CGT base in the Explanatory Memorandum to the 2006 changes:

The CGT and foreign residents measure will 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. More generally, the amendments will encourage investment in Australia by aligning Australian law more consistently with international practice. This results in greater certainty and generally lower compliance costs for investors.

The reference to the 2006 narrowing as ‘aligning Australian law more consistently with international practice …’ is more than a little ironic in light of the claim in the Consultation Paper that the proposed expansion, ‘… was announced to align Australia’s foreign resident CGT regime more closely with international tax practice.’ Given that the relevant passages in the OECD Model and Commentary have not changed significantly between 2006 and 2024, one of these statements must be wrong. The Discussion Paper describes the current reach of the CGT is ‘comparatively narrower than international tax practice.’

Real property, currently.  A key term in the rules is ‘real property …’  Non-residents are liable to Australian CGT if they sell, inter alia:

• ‘taxable Australian real property’ (which is defined to mean ‘real property situated in Australia’), or
• a non-portfolio interest in an entity the principal asset of which is ‘taxable Australian real property.’

Other specific provisions add leases over land in Australia (an extension which was probably unnecessary), and rights to explore for or extract minerals in Australia.

The term ‘real property’ is not defined in the tax legislation and so takes its meaning from Australian property law, both common law and State statutes, a position confirmed in the Explanatory Memorandum to the 2006 amendments: ‘real property, within the ordinary meaning of that term …’  For some reason, the Consultation Paper now doubts this: ‘However, it is not clear whether the ordinary meaning of “real property” is limited to its technical, legal meaning.’ Why this is now unclear is not explained. The Paper seems unwilling to concede the obvious – the meaning is very clear; it’s just that Treasury doesn’t like that meaning, especially since the meaning is moveable and can be changed by State governments and judicial decisions.

Interestingly, the Explanatory Memorandum to the 2006 changes took the curious position that, in the case of a non-resident who was resident in a treaty country, ‘real property’ took its meaning from the terms of the treaty:

4.29 Where an Australian tax treaty applies to a foreign resident in relation to a CGT event, in accordance with existing practice, the definition of real property should be read in conjunction with the definition as stated in the treaty. This outcome results from the application of section 4 of the International Tax Agreements Act 1953.

(It is more than a little difficult to see how the drafting achieved this outcome; s. 4 of the International Tax Agreements Act 1953 does not achieve it.) The Consultation Paper then says the new types of assets to be covered ‘would qualify as “immovable property” or “property accessory to immovable property” under the OECD Model Tax Convention.’ If that is right, and the 2006 Explanatory Memorandum is right, we have been able to tax these assets since 2006 – and no change is needed. Again, the Paper seems unwilling to concede the obvious – the 2006 Explanatory Memorandum was just wishful thinking.

Proposed extensions.  A key passage in the Paper says –

… the concept of “real property” currently used in the legislation does not adequately capture the broad range of assets with a close economic connection to Australian land and/or natural resources, including, for example, tangible assets such as telecommunications or energy infrastructure and intangible assets such as water rights or pastoral leases.

The Paper refers to extending the CGT regime to ‘asset types with a close economic connection to Australian land and/or natural resources’ and then lists particular instances. It is not clear at present whether the legislation will express the general principle, the precise instances or both.

In either case, it seems likely the key expansions to the current definition will be:

• licences to use land situated in Australia (leases are already covered);
• agreements to use (probably, agricultural) land in a manner that gives rise to emissions permits;
• water entitlements;
• infrastructure and machinery installed on Australian land, including:

1. energy infrastructure assets such as wind turbines, solar panel arrays, batteries, transmission lines and sub-stations;
2. telecommunications infrastructure, particularly transmission towers;
3. water infrastructure assets, particularly pipelines,
4. transport infrastructure, such as rail networks, ports and airports; and
5. mining infrastructure, such as heavy machinery (eg, mining drills and ore crushers) installed on land use in mining operations.

Some of these items might be fixtures and so ‘real property’ already as a matter of property law, but a number of them are not, and least in some States, based on recent judicial decisions. The proposal in the Discussion Paper seems intended to:

• address the inconsistency in the treatment of assets as fixtures or chattels based on differences in State law;
• eliminate, for income tax purposes, the argument seen in State duty cases that the effect of State statutory severance legislation for power plants or water pipelines is to turn those severed infrastructure assets into goods. We have seen this issue play out in cases such as Shell and Conexa;
• potentially resolve the differences in the treatment of assets depending on whether they are located on owned or leased land. We have seen this issue play out in cases such as the ‘Ararat wind farm case’ and SPIC Pacific Hydro; and
• expand the notion of real property to cover some intangibles, in particular water entitlements.

The Paper singles out agriculture and insists it will not be affected by these changes: ‘it is not proposed to extend the jurisdiction to tax foreign residents on capital gains from the disposal of livestock and equipment used in agriculture and forestry, except to the extent that these assets are installed on land …’

There is no suggestion that the expansion of the ‘real property’ concept for non-resident CGT purposes will also be reflected in the concepts of ‘investing in land’ or ‘rent from land investment’ for the purposes of the managed investment trust rules.

Options.  There is an interesting passage in the Paper about handling sales of interests in a company or trust which owns an option or right to acquire real property.  Treasury’s concern lies in the disjunction between two definitions used in the current legislation: ‘taxable Australian real property’ and ‘taxable Australian property.’

Under the present definitions, the sale of a non-portfolio share- or unit-holding is taxable where the principal asset of the company or trust is ‘taxable Australian real property’. While a right or option over Australian land is ‘taxable Australian property’, it is not ‘taxable Australian real property’ and this produces the outcome which concerns Treasury: the sale of the option by the company or trust would be taxable, but the sale by the shareholder or unitholder of the company or trust which owns the option is not, even though the option might represent 100% of the value of the target entity.

Consequently, a new class of assets will be included: a non-portfolio membership interest in an entity where more than 50% of the underlying entity’s market value is derived from the expanded group of assets.

Mining information. The Paper notes a similar problem arises in relation to mining, quarrying or prospecting information because information might be ‘asset’ but it is not a ‘CGT asset’, a view which the ATO has accepted in the past.  

That position should cause a problem if a non-resident reveals mining information in exchange for a price. Information is not a ‘CGT asset’, and revealing information is not a CGT event; it is performing a service. The Paper does not examine this problem, probably because industry has decided to accept the ATO’s view that mining information is an ‘asset’ even if not a ‘CGT asset’.

Instead, the Paper is concerned about a non-resident shareholder or unitholder who sells a non-portfolio stake in an entity which holds such information. The problem was evident in AP Energy (although the case was fought on valuation issues) and in RCF III (although the case was largely fought on treaty interpretation issues).  The issue is, in deciding whether the company or trust is ‘land-rich’, the value of information would not feature anywhere in the calculation if it is not an ‘asset’ at all. But the parties in AP Energy and RCF III, and current industry practice, seems to accept that mining information is an ‘asset’ of the company, even though it might not be a ‘CGT asset.’ 

What is clear from the cases, is that, even if mining information is an ‘asset’, it is not ‘taxable Australian real property’ and so the sale by the shareholder or unitholder of the company or trust which owns such information is not taxable, even though the information might represent 100% of the value of the target entity.  The Paper presents this as a valuation issue: ‘it is possible for foreign residents to manipulate the value of assets, such as shares in a company that owns … mining information [which] may lead to the avoidance of taxation on the sale of’ shares or units, but the problem is more profound.

Synthetic sales. The Paper also ruminates on the need for rules to counter, ‘selling economic interests in TARP, or rights to future income over TARP, instead of selling the TARP asset directly [for example] by creating a ‘total return swap’ …’  The Paper notes that Part IVA might apply to these arrangements but also hints at future, ‘additional integrity rules … to ensure the policy intent of the reforms is achieved …’

Treaty issues. The Paper is well aware that expanding the range of assets brought within Australia’s CGT net under Australian domestic income tax law will require co-ordination with Australia’s bilateral income tax treaties.  It makes little sense to legislate an expand range of assets to be treated as ‘real property’ if our treaties do not also treat the assets as ‘immovable property.’ And there is the further complication of the impact of the Multilateral Instrument on the subset of our treaties that are Covered Treaties for those cases where our treaty partner agrees with Australia’s choice about whether and how to implement article 9 of the MLI into the bilateral treaty.

The proposals in the Paper focus on taxing transactions with these assets (either direct sales of the assets or share and unit sales in entities holding these assets), rather than taxing the income from those assets. This suggests the proposals must survive scrutiny under Article 13 of the relevant treaty, rather than Article 6, but Article 13 will often incorporate definitions found in Article 6, and so both Articles need to be considered. But it is worth noting, in the case of the US and UK treaties and some other treaties, surviving Article 13 poses few difficulties as the treaties deliberately allow each Contracting State to tax capital gains in accordance with domestic law.

There are two different issues lurking beneath this proposal which the Paper does not tease out.  The first is, can these changes be made in tax law, or do they require amendments to property law?  The second is, will they require a treaty over-ride?

The definitions used in the real property articles in our treaties vary quite markedly between treaties, and there can be differences between the terms used in Article 6 (income from real property) and those in Article 13 (gains from alienating real property) within the same treaty. But it is often the case that Article 13 will start from the definition of real property in Article 6. Many of our treaties follow the design of Article 6 of the OECD Model in that there is both a core meaning and an expanded meaning.  The core meaning starts from the domestic law of the country where the land is located. For example, the UK treaty says, ‘the term "real property" shall have the meaning which it has under the law of the Contracting State in which the property is situated’. It is generally accepted that this core meaning is the one found in the property law of the Contracting State, not the tax law of the Contracting State.  This means, amending the definition of ‘real property’ in the Assessment Act would be futile in the case of UK investors. For treaties where amending tax law definitions would be ineffective, either the States would need to amend their property law to accommodate the Commonwealth (which seems unlikely) or else the Commonwealth might decide to make the amendments in the Agreements Act and override our treaties (as was done in 2000 in the amendments to overturn the Lamesa decision) and see how our treaty partners react.

But that is not the end of the story.  The Commonwealth might be able to side-step this difficulty if the expanded range of assets falls within the expanded meaning used in the treaty. Article 6 of our treaties will have an expanded meaning for real property which deems certain types of income to be income from real property regardless of what the domestic property law, or tax law, says.  Again, the expanded meaning used in Australia’s treaties differs, though we will usually include as real property mining and exploration licenses and mineral royalties.

The expanded meaning in Article 6 of the OECD Model deems these items to be ‘immovable property’ –

• property ‘accessory to immovable property’;
• livestock and equipment used in agriculture and forestry (although the Paper insists Australia’s amendments will not extend to livestock nor to farming equipment unless a fixture);
• rights to which the provisions of general law respecting landed property apply;
• usufruct of immovable property (usufruct is the right to enjoy the benefits of property owned by another, akin to the rights of a lessee or life tenant); and
• rights to variable or fixed payments as consideration for the working of, or the right to work, mineral deposits, sources and other natural resources.

The Paper takes the position that the expanded range of assets are, ‘types of assets [which] would qualify as “immovable property” or “property accessory to immovable property”.’ This is the language of the OECD Model, but our treaties rarely use the same language as the OECD Model. For example, in the US treaty we expand article 6 to include only exploration and mining rights (but there is no expanded definition of “property accessory to immovable property”), and in article 13 we add interests in land-rich companies, partnerships and trusts.

All of this suggests enacting these measures is going to be a complex dance unless done by a treaty override. Wind turbines or pipelines, for example, might be real property but if severed under State property law, might be ‘property accessory to real property’. It is hard to see how transferable water entitlements or mining information could be captured under either the core meaning or the expanded meaning.

We might decide this is all too hard without a treaty override, or we might end up with a scenario in which Australia amends the domestic tax law, we allow our bilateral treaties to operate according to their terms, and we see where the chips fall in each case.

Transition. There is no discussion in the Paper about the date from which the new measures will apply. One might hope that the legislation would leave unaffected those non-residents who invested in Australia on the basis of the law as it stood prior to the announcement, but there is nothing in the Paper to suggest how existing investments will be handled.

2. Strengthening reporting protocols

The Taxation Administration Act 1953 sets up a preventative, tentative, gross-basis tax collection process when non-residents (and inattentive residents) make capital and revenue gains on off-market transactions involving various classes of assets connected to Australian real-estate.

For Australian resident vendors, the legislation sets up a collection regime but, in practice, it is really a reporting regime.  Collection is not meant to happen. Instead, the regime is designed to ensure the ATO is made aware of upcoming sizeable transactions in the expectation that vendors, knowing the ATO now knows, will follow the stipulated assessment and payment processes. In practice, collection does not occur because resident vendors obtain an ATO Clearance Certificate as a result of which the tentative collection process is not enlivened, and the buyer can pay the contract price in full, without withholding.

For share or unit sales, there is also a parallel regime under which vendors give a declaration to buyers that the asset in question is not within the collection regime (meaning typically that the sale is a portfolio interest in the company or trust, or the entity is not land-rich). Where the vendor provides the declaration to the buyer, the declaration turns off the buyer’s collection obligation unless the buyer knows the declaration to be false. The vendor is exposed to penalties if the declaration is incorrect.

2.1 Changes to the collection regime

The December 2023 MYEFO announcement proposed two changes to the current regime:

• the withholding rate of 12.5% will be increased to 15% of the payment made to the vendor, and
•  the current materiality threshold of $750,000, below which the regime does not apply, will be removed.

This announcement represents the second tightening of these rules. Between 2016 and 2017, the withholding tax rate was 10% and the materiality threshold was $2m.

Where the new rules are triggered, the changes will apply to payments (whenever made) in respect of “acquisitions” of affected assets occurring from 1 January 2025. Typically that will mean, payments occurring under contracts entered on and after 1 January 2025.

Treasury is seeking submissions on the Exposure Draft by 5 August 2024.

2.2 Revised vendor declaration regime

The Consultation Paper proposes changing the current parallel regime of vendor declarations. At present, the vendor provides a declaration to the buyer that a share sale is not within the regime (it is not, ‘an indirect Australian real property interest’) but the ATO is not involved in this process. The 2024 Budget proposal, now outlined in the Consultation Paper, gives the ATO a role.  The measure would apply where –

• a foreign resident proposes to dispose of membership interests for $20m or more, and
• the vendor gives the buyer a declaration that the sale is ‘not an indirect Australian real property interest’

In that case, the vendor must notify the ATO of the transaction in the approved form prior to the date of contract. The ATO then has a finite period (the Paper hints at 28 days but also contemplates up to 60 days) during which to review the proposed transaction. The Paper does not explicitly prohibit the vendor from completing the transaction during the period, but that consequence can’t be ruled out in the next iteration of this policy. Instead, the Paper says, if the ATO is dissatisfied with what it sees, ‘the ATO can make a recommendation to the vendor and the purchaser that the vendor declaration be withdrawn …’ and if need be, ‘the ATO can … apply existing powers as appropriate, including issuing a special assessment to the vendor; or applying for a freezing order in relation to the purchase price or assets to support the relevant tax owed.’

Another unknown is, what will be what is the consequence of a non-resident providing a declaration to the buyer but not having had it approved by the ATO? Presumably the buyer will be required to withhold unless the buyer has both a declaration and at least a receipt from the ATO that the declaration has been lodged with the ATO.

Treasury may also take the opportunity to expand the reporting obligation will be expanded to cover non-residents holding through resident custodians, which are currently not covered by these provisions.

The Consultation Paper describes this as ‘a compliance measure … to ensure the ATO has visibility over … vendor declarations … addressing an information asymmetry and compliance risk that exists under the current settings.’

At first glance, the proposal seems plausible in theory, but it is likely to prove unworkable in many common scenarios, such as:

• private sales where contract and settlement happen on the same day, and
•  large public company transactions undertaken by off-market takeover or  by scheme of arrangement. Requiring all non-residents holding a greater than $20m parcel to apply to the ATO to obtain pre-sale clearance from the ATO at least a month in advance seems impractical, particularly where the company is clearly not land rich or the non-resident holds a less than 10% interest in the company. It also seems to run contrary to the policy of the IMR exemption.

The net result may end up being that those non-residents end up selling on-market where no such obligation applies.

Treasury is seeking submissions on the Consultation Paper by 20 August 2024.