Foreign resident capital gains withholding and insolvency arena
WHO SHOULD READ THIS
- Insolvency practitioners, mortgagees or other secured creditors and their advisors.
THINGS YOU NEED TO KNOW
- Whilst the foreign resident capital gains withholding provisions (FRCGW) contain insolvency exceptions that exclude most asset disposal transactions undertaken in the insolvency area, it is important to recognise that not all insolvency transactions are excluded. Transactions by a mortgagee in possession may not be excluded.
WHAT YOU NEED TO DO
- Determine whether the FRCGW applies to your asset disposal, and if it does, engage with the ATO early to ensure that the withholding is managed appropriately.
The foreign resident capital gains withholding provisions (FRCGW) came into effect from 1 July 2016 and have changed the procedural way that disposals of Australian real estate are carried out.
Broadly, the FRCGW requires a purchaser who acquires certain Australian real estate assets from a foreign resident vendor to withhold and remit to the Australian Taxation Office (ATO) 10% of the market value purchase price paid. The FRCGW is a non-final withholding tax as a foreign vendor must still lodge an Australian income tax return in relation to the capital gain made on the disposal and may claim credit for the FRCGW already remitted to the ATO.
The FRCGW was enacted as a response to a concern that foreign residents may not be properly paying Australian income tax on capital gains they make on the sale of Australian real estate assets. However, the breadth of the FRCGW is wide. The provisions cover more than just Australian land and can apply to a 10% or more interest held in a company or unit trust whose majority of assets, by market value, comprises Australian land. Additionally, the FRCGW can adversely apply to an Australian resident vendor of Australian land who fails to obtain clearance certificate by settlement.
In this Focus Alert we explore briefly the operation of the FRCGW in the insolvency arena. Whilst the FRCGW contain exceptions for many insolvency transactions, the exceptions are not a blanket exception. Mortgagees in possession sales are not excluded. In such situations it is critical to work out how the FRCGW may apply to the transaction and whether certain actions can be taken to avoid FRCGW. Otherwise there is a risk that the purchaser may withhold and remit 10% of the purchase price to the ATO.
In situations of uncertainty a purchaser would prefer to withhold and remit as:
- the purchaser is liable to pay a penalty equal to the amount which should have been withheld, if they are wrong in their assessment of FRCGW, and
- there is a statutory provision which deems a purchaser to have paid the purchase price to the extent that the purchaser has withheld and remitted an amount of FRCGW to the ATO.
If FRCGW is imposed on a transaction when it should not have been (e.g. the vendor was actually an Australian tax resident) it is possible to seek a refund from the ATO. However, the process of obtaining such a refund is involved and time consuming. In the insolvency arena where the timing of payments to secured creditors is important (a secured creditor would want payment as a condition of their release of their security), ensuring that the FRCGW is appropriately managed can be critical to the final pay out amount received by a secured creditor.
What assets are caught by the FRCGW?
The FRCGW applies to:
- taxable Australian real property (TARP) i.e.:
- Australian land (including a lease of land)
- mining, quarrying or prospecting rights over minerals, petroleum or quarry materials situated in Australia
- an ‘indirect Australian real property interest’, or
- an option or right to acquire the property outlined above or an interest in such property.
A vendor holds an ‘indirect Australian real property interest’ if, at the relevant time (i.e. at contract settlement), they hold either alone or with associates:
- a 10% or more direct interest in a company or trust whose majority of assets, by market value, comprise TARP at the relevant time, or
- in a 12 month period within 24 months before the relevant time, an interest which formed part of a 10% or more direct interest in a company or trust and at the relevant time the company or trust had a majority of assets, by market value, comprising TARP.
Besides the Australian land sales, common transactions potentially caught by the FRCGW include the grant of options over TARP and the off market purchase of shares and units in companies and trusts whose majority of value comprises Australian land. Significantly, the ATO takes the approach that the FRCGW can apply to any change in legal title to an asset covered by the FRCGW. Whilst the technical correctness of the ATO’s approach is debatable its position means that transfers of assets on a change of trustee may be subject to FRCGW.
What transactions are specifically excluded from the FRCGW?
Transactions which are excluded from the FRCGW include:
- transactions involving TARP or a company title interest where the market value of the property is less than $2 million
- a transaction on an approved stock exchange or conducted using a crossing system
- an arrangement which is already subject to an existing withholding tax obligation
- securities lending arrangements, and
- transactions involving vendors who are subject to formal bankruptcy or insolvency arrangements – whether in Australia or overseas.
The insolvency exceptions to FRCGW are more specifically as follows.
Under section 14-215(1)(g), Schedule 1 to the Taxation Administration Act 1953 (Cth) (TAA) a transfer which arises from any of the following is excluded from the FRCGW:
- the administration of the estate of a bankrupt
- a composition or scheme of arrangement under Division 6, Part IV of the Bankruptcy Act 1966 (Cth) (BA)
- a debt agreement under Part IX of the BA
- a personal insolvency agreement under Part X of the BA, or
- circumstances that are, under a foreign law, the same or similar to those in any of the above situations.
Under section 14-215(1)(f), Schedule 1 to the TAA if the foreign resident vendor is a company and at the time of the transaction any of the following applies, then the transaction is excluded from the FRCGW:
- any of the conditions in section 161A(1)(a) CA are satisfied in respect of the foreign resident vendor, i.e.:
- the company is being wound up
- the company is under administration
- the company has executed a deed of company arrangement that has not yet terminated
- there is a managing controller of property of the company, or
- there is a receiver of property of the company, or
- the foreign resident vendor is, under a foreign law, in the same or similar position as outlined in the above situations.
Companies whose assets are subject to a mortgagee in possession arrangement may not necessarily be excluded from FRCGW since there may be no managing controller. Consider the situation were a mortgagee has taken possession of a passive rental property which is managed by an external real estate agent. In that situation, whilst the mortgagee’s agent is a controller they carry out no management activities and consequently the company has no managing controller. A sale of such a rental property would not be excluded from FRCGW. A mortgagee in possession may be excluded from FRCGW if it does undertake management activities such that it is classed as a managing controller.
Who is a foreign resident vendor for the purposes of the FRCGW?
FRCGW only applies to a transaction where the vendor is ‘foreign’. The question of whether a vendor is an Australian resident for income tax purposes is a question of fact based on weighing up a number of relevant factors. Since it is often difficult (if not impossible) for a purchaser to determine a vendor’s income tax residency since they require information that only the vendor would know, the FRCGW outlines special rules to determine residency.
TARP and company title (occupancy) shares – clearance certificates
A vendor of TARP and company title (occupancy) shares will be regarded as Australian residents if the vendor does not provide an ATO issued clearance certificate to the purchaser by settlement of the transaction. The clearance certificate represents the ATO’s assessment of whether the vendor is a resident for Australian income tax purposes based on its records and publicly available information. The clearance certificate assessment is only relevant for FRCGW and no other tax purpose.
Where a vendor does not provide such a clearance certificate, they are deemed to be foreign for the purposes of the FRCGW. This is so even if the vendor is actually an Australian income tax resident. The consequence of this deeming is that it is now standard conveyancing practice for an Australian resident vendor’s solicitor to order a clearance certificate as part of the initial standard searches used to compile the sale contract.
In the insolvency context it is relevant to note that only the legal title owner can apply for a clearance certificate. This can be problematic for mortgagees who choose not to take the legal title to the property, but instead either direct the mortgagor to sell the property or take possession of the property to sell under a power of sale. In such situations only the mortgagor (being the legal title owner) can apply for a clearance certificate and such a mortgagor may not be very co-operative in providing the mortgagee such assistance. Mortgagees in these circumstances are more likely to manage their FRCGW obligations by applying for a variation notice (see discussion below).
Indirect Australian real property interests (other than company title or occupancy shares) – declarations
A vendor of indirect Australian real property interests (other than company title or occupancy shares) can avoid FRCGW if it makes a written declaration that either:
- it is an Australian resident for Australian income tax purposes, or
- the shares or units being sold are not indirect Australian real property interests.
A purchaser can rely on such a declaration provided they do not know that the declaration is false.
It can be difficult to assess whether or not the shares or units being sold are indirect Australian real property interests, since it depends on relative market values of real estate owned by the relevant company or trust. Consequently, it is more common in practice for a vendor to make an Australian residency declaration.
Since a written declaration only lasts 6 months the general contractual practice is to require a vendor to make such a declaration both at the time of exchange and then at completion to ensure that the declaration still applies.
The ATO has the power to vary the amount of FRCGW payable (this can be to nil) by issuing a variation notice in situations where:
- the vendor can show that:
- they will not make a taxable capital gain (e.g. capital loss or CGT rollover), or
- they will not otherwise have an income tax liability (e.g. prior year capital or revenue losses), or
- a secured creditor can show that the FRCGW will adversely affect the creditor’s ability to recover their debt from the vendor.
Either a vendor or purchaser can apply for a variation notice, but it is likely that a vendor would apply since they have the relevant information. The ability for secured creditors to apply for a variation notice is helpful since it remedies a situation where an uncooperative mortgagor is unwilling to apply for a clearance certificate or to make the required written declaration to prevent FRCGW applying.
Obtaining a variation notice in itself is not enough to prevent FRCGW. The variation notice must be provided to the purchaser at settlement for it to operate to reduce FRCGW.
Whilst the turnaround time to obtain a clearance certificate is relatively quick, obtaining a variation notice generally takes longer because it is essentially a formal submission to the ATO on why the FRCGW should not apply. Insolvency practitioners should be aware that the ATO may not always vary the FRCGW to nil and instead may either:
- reduce the FRCGW only to a partial extent on the basis that sale proceeds may be enough to pay out a secured creditor and partially pay FRCGW, or
- the ATO may defer the time when FRCGW is payable to a time other than settlement of the transaction. For instance, in Law Companion Guideline LCG 2016/5 the ATO indicates that in a foreclosure situation where a bank seizes the legal title to a property, the ATO may choose not to vary the FRCGW to nil if the market value of the property indicates that the proceeds receivable on a disposal of the property will be sufficient to cover both the bank’s secured debt and the FRCGW arising on the change of legal title to the bank’s name. In such a situation the ATO may instead defer the time the bank is required to remit FRCGW to the time of the sale of the property.
In auction situations where the sale price is unknown, the ATO may issue conditional variation notices. That is, FRCGW may not be required to be withheld and remitted if the sale price is below a set figure but above a set figure withholding is required.
Whilst the FRCGW contains insolvency exclusions which mean that many insolvency transactions are exempt from FRCGW it is important to recognise that not all insolvency transactions are covered by these exclusions. Notably a mortgagee in possession who does not manage the subject property may not be exempt from FRCGW and must manage their situation appropriately (e.g. by obtaining a clearance certificate, written declaration or variation notice) to ensure that cash flow issues do not arise as a result of the FRCGW applying.
This publication covers legal and technical issues in a general way. It is not designed to express opinions on specific cases. It is intended for information purposes only and should not be regarded as legal advice. Further advice should be obtained before taking action on any issue dealt with in this publication.