On 21 July 2017, the Exposure Draft Housing Tax Integrity Bill 2017: Capital Gains Tax changes for foreign residents was released by Treasury in order to implement the following Federal Budget proposals:
to affected membership interests subject to CGT Events (e.g. sale contracts/asset transfers) from 7:30 pm AEST on 9 May 2017 (see below for details).
“Foreign Resident” is broadly defined in s.995-1 ITAA 1997 as any individual or entity which is not a resident as defined in s.6 ITAA 1936. As such, a foreign resident is effectively a non-resident for income tax purposes.
The Main Residence Exemption changes will primarily affect individuals who are non-residents (see below for details and some further inclusions) whereas the Indirect Australian Real Property Membership Interest changes may be potentially relevant to any type of entity.
Importantly, unlike the foreign resident reduction/removal of the CGT Discount (introduced in 2013 by changes to Subdiv 115-B ITAA 1997) these proposed foreign resident CGT changes do not specify that they will apply to temporary residents as defined in s.995-1 ITAA 1997. As a consequence, many citizens of foreign countries (including New Zealand) who reside in Australia on a long-term basis will be unaffected, provided that they are residents and/or temporary residents for Australian tax purposes at the CGT Event time.
TIP – The ATO document “Work out your residency status for tax purposes” details current ATO views regarding tax residence status for individuals. Separate rules apply when determining trust or company residence, with company residence currently the subject of a Draft Ruling which remains subject to consultation (see TR 2017/D2). At the time of publication these ATO resources reflect current legislation and are likely to be changed to reflect the new law when enacted.
As illustrated below, where a capital gain is made regarding an interest in a dwelling which could otherwise qualify for a full or partial CGT exemption due to the property’s use (e.g. as a family home) then either:
As noted in the diagram below, the above effect will generally apply where the CGT Event occurs from 1 July 2019 onwards (unless the dwelling interest was acquired from 7:30 pm on 9 May 2017 in which case scenario B below would have immediate application).
The impact of the scenario shown at B above will be significant if it applies. If, for example, an individual had been a resident (or temporary resident) for income tax purposes during the majority of their ownership of their main residence but was unfortunately unable to finalise a contract for the property’s sale until just after they had relocated overseas and become a non-resident, then no main residence exemption could apply. If the total capital gain was, for example, $300,000 then this timing would result in at least a $150,000 net capital gain being included in the individual’s assessable income in the year of the CGT Event (possibly more if the individual’s CGT Discount was reduced under Subdiv 115-B ITAA 1997 based on their acquisition date and/or non-resident or temporary resident days during ownership).
If the same individual had instead successfully signed a contract of sale just before becoming a foreign resident for income tax, then no CGT would have applied to the sale of their main residence (assuming conditions for the full main residence exemption were satisfied under Subdiv 118-B ITAA 1997).
The above changes will increase the importance of understanding both:
Determining whether or not membership interests in an entity (e.g. shares, units or partnership interests) are Indirect Australian Real Property, and therefore Taxable Australian Property (TAP) under s.855-25 ITAA 1997, is important to determine whether:
Membership interests will satisfy TAP status only if both of the following tests are passed:
The Draft Legislation proposes to expand the operation of the Principal Asset Test with backdated effect for CGT Events arising from 7:30 pm AEST 9 May 2017 where the entity in which membership interests are being sold/transferred by the vendor/holding entity (i.e. the Higher Entity illustrated in the diagram below) itself holds membership interests in one or more other entities (i.e. a multi-tiered structure involving the Lower Entity shown below).
The difference between the existing legislation and the proposed Principal Asset Test is illustrated in the following example where the provisions are applied to an identical set of facts, but with different outcomes for Indirect Australian Real Property status of the shares sold by the Foreign Resident Vendor/Holding Entity in its subsidiary “Higher Entity”. Note that the s.960-195 ITAA 1997 non-portfolio interest test is passed by the vendor’s Higher Entity shareholding under both scenarios, with no change proposed to this test.
Under the Existing Principal Asset Test, it is necessary to determine whether the majority of Higher Entity’s value comprises Taxable Australian Real Property (TARP) assets using both:
Current s.855-30(4) ITAA 1997, table item 1 provides that the value of Higher Entity’s interest in Lower Entity will be deemed to be only a non-TARP asset (regardless of Lower Entity’s actual asset holdings) where either:
As these conditions are met under this scenario (because the interest held by the Vendor’s Associate interest is ignored) the total of Lower Entity’s assets (shown at A and B below) is multiplied by 9% to arrive at a $144,000 Deemed Other Asset Value for Higher Entity (see C below). As a consequence, the Existing Principal Asset Test is failed as shown at F because the majority of Higher Entity’s actual and deemed assets comprise Other Assets which are not TARP (see F below for full calculation).
Consequently, the shares sold in Higher Entity are not Indirect Australian Real Property under the Existing Principal Asset Test and therefore generally not subject to either:
NOTE – Key changes between the above approach and the Proposed Principal Asset Test are denoted with an “*” in the diagram below and further explained in the text below and in our Tax Snapshot Recording.
Under the Proposed Principal Asset Test, it is once again necessary to determine whether the majority of Higher Entity’s value comprises Taxable Australian Real Property (TARP) assets using both:
Proposed new s.855-30(4) ITAA 1997 table item 1 provides that the value of Higher Entity’s interest in Lower Entity will be deemed to be only a non-TARP/Other asset (regardless of Lower Entity B’s actual asset holdings) only where the sum of total direct and indirect participation interests held by both:
in Lower Entity is < 10%.
As shown and asterisked below, these conditions are not met under this scenario (because the 1% interest held by the Vendor’s Associate is now included). As a consequence, Lower Entity’s assets (shown at G and H below) are separately multiplied by the 10% (associate-inclusive) interest held by Higher Entity to arrive at:
As a consequence, the Principal Asset Test is passed as shown at M because the majority of Higher Entity’s actual and deemed assets now comprise TARP assets (see M below for full calculation).
Consequently, the shares sold in Higher Entity are Indirect Australian Real Property/TAP and therefore generally will be subject to both:
The above example provides one illustration of how the proposed new Principal Asset Test is likely to impact membership interest transactions involving multi-tiered structures. There are numerous other more complex scenarios (e.g. structures with more than the 2 tiers shown above) which may also be impacted by the change, subject to the particular amounts and circumstances involved.
The Draft Legislation’s Explanatory Memorandum provides a further example (Example 3.1) of a lower entity in which the Vendor/Holding entity holds an indirect participation interest of > 10% in a land rich Lower Entity via its 2 directly held (Higher Entity) subsidiaries, each of which holds an interest of 9% and 7% respectively. Under the Current Principal Asset Test the interests in the Lower Entity would be deemed Other (non-TARP) assets of each Higher Entity subsidiary, reducing the chance of Passing the Principal Asset Test. This would occur because (under the current/existing test in s.855-30(4) ITAA 1997 table item 1) the value of the Higher Entities’ interests in Lower Entity will be deemed to be only a non-TARP/Other asset (regardless of the land rich Lower Entity’s actual asset holdings) where either:
In this case, the above requirement is satisfied and the Existing Principal Asset Test is more likely to be failed. By contrast, the New/Proposed Principal Asset Test would instead consider the Vendor/Holding Entity’s total direct and indirect participation interests [i.e. the combined 9% and 7% held through both 100% owned Higher Entity subsidiaries results in a 16% (i.e. > 10%) interest under the new provision]. In this case an associate-inclusive approach was not relevant to passing the new Principal Asset Test.
The Draft Legislation will also add an anti-double counting rule in proposed s.855-30(4A) ITAA 1997 such that an interest already counted under the general direct or indirect participation interest rules will not be counted a second time because an entity involved in is also an associate under s.318 ITAA 1936.
In addition to details available at www.taxastute.com.au, Tax Astute clients receive more information and specific details, questions and answers underlying the brief snapshot summary above as a part of their:
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