Foreign Resident CGT Main Residence
Indirect Australian Real Property Membership Interest
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:
- removed access to the Capital Gains Tax (“CGT”) main residence exemption on sale of an interest in a dwelling (regardless of prior use or tax residence status) where the seller is a foreign resident for income tax purposes at the CGT Event time (e.g. sale contract date) – generally for CGT Events occurring from 1 July 2019 but with immediate effect for dwellings acquired since 7:30 pm AEST on 9 May 2017 (see below for details); and
- increased application of the complex Indirect Australian Real Property status to some membership interests (generally closely held shares, units or partnership interests held in entities which in turn hold membership interest in lower level entities of a multi-tiered structure) held by foreign residents by applying the Principal Asset Test in s.855-30 ITAA 1997 on an associate inclusive basis. This change may result in increased and backdated application of both:
- CGT; and
- the 12.5% asset withholding tax (see our related Tax Astute Snapshot of 26 June 2017 at this link),
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).
Who or what is a “foreign resident” affected by these changes?
“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.
Main Residence Exemption Removal for Foreign Residents
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:
- a full or partial main residence exemption will remain available under Subdiv 118-B ITAA 1997 without any change if the seller is an Australian tax resident at the time of the CGT Event (e.g. contract date) regardless of prior residence status while holding the interest in the dwelling (see A below); or
- no main residence exemption will be available under Subdiv 118-B ITAA 1997 if the seller is a foreign resident (i.e. a non-resident for income tax) at the time of the CGT Event (e.g. contract date) regardless of prior residence status or use as a main residence while holding the interest in the dwelling (see B below).
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).
- For purposes of the above diagram, treat the term “resident” as including a “temporary resident” as defined in s.995-1 ITAA 1997.
- The above treatment will also broadly apply to Div 128 ITAA 1997 CGT Events and concessions applying to the former main residence of a deceased individual who was a foreign resident for income tax at the time of their death, although more complex issues and some differences apply when dealing with deceased taxpayer scenarios and/or main residence issues for special disability trusts. Tax Astute clients should review their forthcoming training sessions and client notes and recordings for more details.
- Unlike the existing foreign resident reduction/removal of the CGT Discount provisions in Subdiv 115-B ITAA 1997 (the effect of which may vary based upon the proportion of tax resident vs non-resident/ temporary resident days) the proposed foreign resident CGT main residence exemption removal applies on an “all or nothing” basis with application of A or B above based solely upon foreign residence status or otherwise on the specific CGT event date as shown above.
- The Draft Legislation confirms that the above treatment can also apply to involuntary CGT Event scenarios such as a compulsory acquisition of all or part of a foreign resident’s main residence or some CGT events following the death of a foreign resident owner (see note above for more information).
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:
- the timing issues surrounding an individual’s tax residence or non-residence status; and
- keeping records of non-deductible costs of main residence ownership (e.g. non-deductible interest, rates, repairs or insurance incurred during ownership) which may increase element 3 of the dwelling’s cost base under s.110-25(4) ITAA 1997 if CGT ultimately applies to its sale.
Principal Asset Test changes for Membership Interest Indirect Australian Real Property Status
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:
- a foreign resident vendor is subject to CGT on the membership interests’ sale (or other transfer); and
- up to 12.5% asset withholding tax may need to be withheld by the membership interest’s purchaser (subject to a withholding tax exception or variation applying – see our related Tax Astute Snapshot of 26 June 2017 at this link).
Membership interests will satisfy TAP status only if both of the following tests are passed:
- the non-portfolio interest test in s.960-195 ITAA 1997, whereby a > 10% membership direct “participation interest” (broadly the membership interest held but more specifically defined in Subdiv 960-GP ITAA 1997) is held in the company, unit trust or partnership by the vendor on an associate inclusive basis (for 12 of the past 24 months before the CGT event); and
- the membership interests sold/transferred at the CGT event time satisfy the Principal Asset Test in s.855-30 ITAA 1997 whereby > 50% of the company, unit trust or partnership’s underlying value comprises Taxable Australian Real Property (including interests in Australian land and buildings and broader real property concepts such as leases and mining, quarrying and prospecting rights as defined in s.855-20 ITAA 1997).
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:
- its actual TARP assets and other assets (excluding the shareholding in Lower Entity B) (see D & E below); and
- its deemed assets under existing s.855-30(4) ITAA 1997 table item 1, which reflect its interest in Lower Entity (see C below).
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:
- Higher Entity a holds a < 10% participation interest in Lower Entity; or
- the Vendor/holding entity holds a < 10% participation interest in Lower Entity.
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:
- Australian CGT to the foreign resident Vendor on the sale of interests in Higher Entity (subject to rare exceptions in cases where the vendor was a former resident and CGT Event I1 or I2 was previously available but not applied); or
- a 12.5% asset withholding tax obligation, provided that a Vendor Declaration is made and provided by the Foreign Resident Vendor, broadly stating that the shares sold are not Indirect Australian Real Property, due to failing the Principal Asset Test (see our related Tax Astute Snapshot of 26 June 2017 at this link).
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:
- its actual TARP assets and other assets (excluding the shareholding in Lower Entity) (see K & L below); and
- its deemed assets under proposed new s.855-30(4) ITAA 1997, table item 1 which reflect its interest in Lower Entity (see I and J below).
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:
- the Vendor/holding entity; and
- its “associates” (as defined in s.318 ITAA 1936),
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:
- a $120,000 Deemed TARP Asset Value for Higher Entity (see J and asterisk below).
- a $40,000 Deemed Other Asset Value for Higher Entity (see I below).
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:
- Australian CGT to the foreign resident vendor on the sale of interests in Higher Entity (because the shares are now TAP assets due to their Indirect Australian Real Property status from passing both the Non-Portfolio Interest and Principal Asset Tests); and
- a 12.5% asset withholding tax will apply (unless a specific asset withholding tax Variation or other exception applies - see our related Tax Astute Snapshot of 26 June 2017 at this link). This is once again because the shares are now TAP assets sold by a foreign resident due to their Indirect Australian Real Property status from passing both the Non-Portfolio Interest and Principal Asset Tests.
- Review our Tax Snapshot Recording (below) to assist your understanding of these complex provisions.
- When applying the new Principal Asset Test provisions to multi-tiered structures (including those with more than the two tiers shown above), a “bottom-up” approach should be taken to determine deemed TARP and Other Asset status of the next entity in the structure (which in turn may be relevant to determining the deemed TARP assets of the next entity above and so on).
- If the vendor/holding entity in the above diagram was instead a Resident for Australian Income Tax purposes, then the above calculations would not be required because:
- the vendor/holding entity would automatically be subject to CGT on the shares (as they would on all of their CGT assets as a tax resident, barring some other CGT exemption or concession); and
- any 12.5% asset withholding tax issue could be resolved by a valid Vendor Declaration stating that they are a tax resident (assuming that there are no doubts about the vendor’s residence status – see our related Tax Astute Snapshot of 26 June 2017 at this link).
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:
- Higher Entity a holds a < 10% participation interest in Lower Entity; or
- the Vendor/holding entity holds a < 10% participation interest in Lower Entity.
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.
- The Principal Asset Test, s.318 ITAA 1936 “associate” definition and tax residence provisions can be complex in nature and structures owned by foreign residents should be carefully reviewed where required in practice. As shown in the above example, the test continues to rely heavily on accurate market valuations of all assets at each tier of a structure.
- Existing s.14-200(1)(c) TAA 1953 provides that a 12.5% asset withholding tax obligation may arise regarding a membership interest acquired if, at the time of acquisition (e.g. contract date or asset transfer for some related party transactions), it is Indirect Australian Real Property. Because the new Principal Asset Test is proposed to apply retrospectively (to CGT Events from 7:30 pm on 9 May 2017), it is unclear at the time of publication what withholding tax administrative approach the ATO may take to membership interest sales by foreign residents which might become subject to withholding tax due to the change. To the extent that the Vendor is a tax resident (and able to make a Vendor Declaration of residence) or some other withholding tax solution such as an ATO Variation may be available, such alternative solutions should be implemented wherever possible to manage asset withholding tax issues – see our related Tax Astute Snapshot of 26 June 2017 at this link.
WANT MORE DETAILS?
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:
- Tax Astute Training Session;
- Tax Astute Final Reference Notes; and
- Tax Astute Detailed Multimedia Recording.
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