Leasing Tax Guidelines
Because of the significance of its tax benefit transfer capacity, a regular issue over the years has been the definition of what constitutes ‘genuine leasing transactions for plant and equipment’. Unfortunately a starting point in this regard has often been what is referred to as IT28
– a 1985 Tax Office Ruling which reproduces a July 1960 Circular from the Commissioner of Taxation which aimed at distinguishing ‘an ordinary commercial lease entered into in the normal course of trade’ from an arrangement where the repayments were ‘in substance consideration for the sale of the goods purported to be leased.’
Several criteria were set down in this Circular to be included in a ‘genuine’ lease to evidence its ‘current’ (i.e. full amount of rentals tax deductible by the lessee) rather than ‘capital’ (i.e. lessee deducts only notional interest and depreciation) nature.
In certain respects however, these criteria differ from what is ordinarily included in a lease and these differences have on occasion confused policy and administrative discussion. This confusion first arose in November 1989 when a Taxation official cited the IT28 criteria as the benchmark for a ‘genuine’ lease. Subsequently a degree of uncertainty as to Tax Office approach arose when some commentators interpreted this citation as a major departure from the then existing tax treatment; that this was not the case was later confirmed by the Tax Office – however the differences and potential for confusion remained.
In October 1990, the Tax Office convened a working group comprising Treasury, legal, accounting and taxation professional groups, as well as Tax Office and Industry representatives to discuss the broader policy framework for leasing. At the conclusion of the meeting, AELA was asked to prepare an ‘omnibus’ draft ruling, bringing together the series of rulings on particular lease-related matters made in public and private rulings by the Tax Office over the previous thirty years. This was completed and was made available to provide a comprehensive basis for any further consideration of the lease product’s legal, taxation, accounting and commercial context as it has developed in Australia.
In this ‘omnibus’ draft ruling, AELA amongst other things reconciles IT28 with the commercial reality of the current lease product. In essence what occurred was that during 1961 the Tax Office issued further statements which qualified the earlier criteria. Had these changes been incorporated in IT28 when it was released in 1985, much of the confusion would have been avoided.
This has particularly affected two areas: residual value indemnities and the acceptable term of the lease. Contrary to IT28, most existing finance leases provide that the lessee cover any loss on sale of the equipment by way of a residual value indemnity. This has been an important commercial feature of the Australian market. Because of Australia’s geographic expanse and remoteness, second-hand equipment markets are generally more shallow. When added to high transport and other frictional costs, there is a much higher equipment risk domestically than would be the case in a lease of similar goods in major overseas markets. The costs and risks associated with retrieving and selling a particular item of specialised plant at the end of the lease, when the plant is located at a remote site in Central Queensland, is much greater than if it were occurring in Europe or North America.
But for the residual value indemnity, the cost of leasing such equipment would need to be significantly increased for the explicit pricing of this aspect of equipment risk which is not already bundled with the transaction’s credit risk. Whereas at present the lessee indemnity renders this risk implicit (and largely unpriced) any change would not only force up the cost of equipment financing to Australian business but to the extent that financiers could not accommodate the priced risk within their prudential objectives, it would also add to tax loss carry-forward distortions currently ameliorated by leasing’s tax benefit transfer capacity.
The reconciliation of this feature with IT28 as published, dates from November 1961 when the Tax Office advised that such indemnities were permitted subject to a number of conditions dealing with commerciality.
Similarly, also in 1961, the Tax Office revised its earlier position indicating that ‘no objection would be taken to the leasing of plant and machinery for the period of its estimated life’ provided always that the transaction was arms-length and commercial. This position was made less certain in March 1994 however when Tax Determination TD94/20 (now withdrawn) put the view that an acceptable lease should not be written for the whole or a substantial part of the asset’s useful life. As this is a common feature of the lease product, AELA requested the review of this matter; given the range of views taken on how effective or useful life is assessed, the Determination did not however present much practical difficulty. In this context, Income Tax Ruling TR2006:5, ‘Income Tax: effective life of depreciated assets’, notes the following at paragraph 62 under the heading of ‘Lease periods’: ‘Because effective life is, among other things, the period a depreciating asset can be used for the relevant purposes, it is unlikely that an asset could be leased for a period greater than its effective life. Consideration of this factor will, in many instances, suggest that the effective life of an asset is no shorter than the period it is leased’.
A further area of tax guidelines for the Australian lease product relates to residual values. The July 1960 Circular (later published as IT28) set a range of residual values which the Tax Commissioner considered to be reasonable and realistic. The schedule derived from historical depreciation rates for particular types of equipment and had its RVs set at 75% of the relevant prime cost written down value, in recognition that lessees are likely to inflict more wear and tear on the equipment than owners. The schedule was subsequently confirmed in January 1981 through IT174, and in July 1993, via TD93/142, it was recast in terms of underlying effective life rather than prime cost depreciation rate.
The Determination notes that residual values lower than those outlined in the guideline may be used where a well-considered and fair estimate of the likely market value of the item at the end of the lease warrants this. AELA supports this commercially realistic approach. Following the Government’s adoption of the RBT recommendation to fund most of the Revenue foregone in dropping the company tax rate from 36% to 30% by removing the acceleration in the broad-banded safe-harbour depreciation regime, the Commissioner of Taxation was charged with revising his determinations of safe-harbour effective lives of a wide range of assets. Taxpayers continue to have the option to self-assess the effective life of an asset as an alternative to adopting the Commissioner’s schedule, or where they are in existence to apply statutory caps.
In the first round of revisions, from 1 July 2002 the Commissioner increased the effective life of aircraft from 8 to 20 years, of offshore oil/gas platforms from 20 to 30 years and of motor vehicles from 6.67 to 8 years. In the case of aircraft and offshore platforms, the Government legislated statutory caps of 10 and 20 years respectively, considerably ameliorating or removing the impact of the Commissioner’s change. Recourse to statutory caps of course, does not mean that the revised effective lives are incorrect, rather they are to address competitive factors in particular markets.
For motor vehicles, the variation did not present a significant concern at the time, but in the recent period the second-hand market for cars has demonstrated considerable fragility. The Commissioner proposed, as from 1 January 2004, to increase the effective life determinations from generally 6.67 to 12 years for light commercial vehicles and 15 years for trucks. As these increases were considerably greater than that for motor cars, the determination potentially had a much more dire consequence for the resulting safe-harbour residual value and hence equipment and credit risk.
In response, AELA developed a co-ordinated approach to assist members in addressing these impacts, which incorporated the following elements: a request to the Tax Office to delay implementation of the revised determinations; a request to the Government to introduce statutory life caps for these assets; the development of a methodology consistent with the Tax Office framework to enable lessors to confidently self-assess an effective life shorter than the Commissioner’s determinations; and the assembly of independent data on the market value of light commercials and trucks for common end-lease periods, as a basis for members to adopt more realistic minimum residual values, and also to support the introduction of statutory caps and effective life self-assessment.
In the event the Tax Office twice deferred the revised determinations, initially to 1 July 2004 and then to 1 January 2005. In the meantime the Government announced (in August 2004) that statutory effective life caps would be introduced for light commercial vehicles, trucks, buses (7.5 years) and truck trailers (10 years) effective as from 1 January 2005. This issue is covered in more detail later in this Review in the section dealing with ‘Trucking and Transport Issues’, but in brief the statutory caps have resulted in depreciation allowances for these assets more in line with the fall in their value.
AELA has subsequently again written to the Commissioner of Taxation in relation to the impact of the substantial increase in his determinations of effective lives of assets on ‘safe-harbour’ minimum residual values in leases. These are resulting in very high ‘safe-harbour’ residual values, presenting an unacceptable credit risk for financiers, in that the asset at the end of the lease is likely to be worth considerably less than the safe-harbour residual value pursuant to the revised effective lives.
AELA is not suggesting that the Commissioner’s revised determination is not an accurate reflection of the ‘effective life’ of an asset, but rather that an asset’s value does not depreciate in a ‘straight-line’ over the effective life and in the early years the depreciation is disproportionately high. That such straight-line depreciation does not provide an accurate reflection of an asset’s loss of value in its early years has been recognised by the Government in recent times in two ways. Firstly, the introduction of statutory effective life caps (first introduced in January 2002), and the 2006 Commonwealth Budget announcement that the diminishing value (DV) rate of depreciation would increase from 150% to 200%. In announcing this measure, the Treasurer stated that it would ensure that depreciation deductions for income tax purposes more closely reflected an asset’s decline in actual value. AELA accordingly requested that lessors should be given similar ability to use effective life caps (when in place) and DV depreciation in utilising the safe-harbour residual value methodology, but at the time of writing the Commissioner has not acceded to this request.
Guidance is also provided for practices on trade-ins and in relation to balloon payments. This is via TR98/15 which states that where a previously leased asset is traded-in on a replacement asset, the trade-in credit is taken into account in determining the lessee’s taxable income, notwithstanding that the proceeds are not paid to the lessee but are used to reduce the cost of the replacement asset or the lease payments that would otherwise be payable. The Ruling also specifies when balloon payments are deductible.
In the equipment finance area of hire purchase, the Government in February 1998 announced that it would formalise the long-standing (October 1951- IT 196) administrative practice whereby taxpayers acquiring assets by hire purchase are treated as owners for eligibility to depreciation and other capital allowances. Coincidentally a Federal Court decision in Bellinz v Commissioner of Tax, found that a lessee (in this instance, a leveraged lease partnership) with an unexercised purchase option, held insufficient ownership rights to be regarded as the owner for the purposes of claiming depreciation. Given the legislative amendments by way of Division 240 of the Income Tax Assessment Act 1997, this decision has not had major consequences for regular hire-purchase transactions, however AELA has continued to monitor developments to ensure no unforeseen outcomes.
A number of other areas of the Commonwealth taxation framework affect leasing.
In May 1994 the Tax Office issued Draft Taxation Ruling TR94/D26 on depreciation of fixtures. The legal principles discussed in this ruling would, in some instances, preclude the availability of depreciation, not because of limits on tax benefit transfer, but because of the general law of property. Representations were made by AELA and on 11 June 1996 the Federal Treasurer announced that legislative amendments would be introduced to ensure that lessors retain entitlements to depreciation where leased equipment is a fixture on someone else’s land, and where the lessor has an effective right to remove the equipment. In April 1997 legislation was introduced to ensure that lessors retain this right to claim depreciation.
In August 1995 the Tax Office issued Taxation Ruling TR95/30 on Sale and Leasebacks. The Ruling addressed many of the concerns raised in AELA’s submission on the draft, and states that where an arrangement is legally characterised as a sale and leaseback then generally the lessor is entitled to claim depreciation and other deductions, and the lease payments are deductible to the lessee. A draft ruling TR2006/D5 was issued in April 2006, which revised and updated TR95/30, and was issued in November in final form as Tax Ruling TR2006/13. This Ruling confirms the general tax treatment for sale and leaseback described in TR95/30.
In relation to the tax treatment of software, the 1998 Budget provided for software to be depreciated over 2.5 years. An immediate deduction is available for software spending of $300 or less and for undeducted spending where software development projects are abandoned. An immediate deduction was also available on software expenditure for Y2K compliance. The amendments generally apply to software spending incurred after 11 May 1998.
In February 1999 the Tax Office issued Tax Ruling TR1999/3: Depreciation of Second-hand Luxury Cars. The ruling states that the cost of a second-hand car for depreciation purposes is the purchase price, and will be subject to the luxury car Depreciation Limit where this exceeds the Limit. Section 42-90 of the Income Tax Assessment Act 1997 provides a discretion to the Commissioner to limit the cost of previously depreciated property; the ruling notes that the fact a car has previously been subject to the luxury car Depreciation Limit would not, of itself, cause the Commissioner to exercise this discretion. A further area in which Tax Office rulings have been relevant is that of novated leases. These leases involve an employee leasing a vehicle (often as part of a salary package) from a leasing company, with the obligation to make the repayments novated (i.e. taken over) by the employer for the term of employment.
Following the August 1996 changes to the Luxury Vehicle Depreciation Limit (i.e. lessee becomes owner for tax purposes), some confusion arose as to the tax consequences for lessees under ‘partial novations’; subsequently TR 1999/15 was released which ensured no tax implications for lessees, provided that the conditions in the Rulings are met and AELA welcomed this outcome.
In May 2001 the Government introduced legislation for the recommendations of the Ralph Review of Business Taxation to unify the various Capital Allowance regimes. The ‘second hand plant rules’ are part of the Uniform Capital Allowance (UCA) regime, and apply from 9 May 2001. Generally, when calculating tax deductions for depreciable assets the taxpayer can choose either the diminishing value or the prime cost method, and choose either the Commissioner’s safe-harbour determination of effective life or self-assess the effective life of the asset. However, under the ‘second-hand plant rules’ these choices are restricted.
The new holder of the asset (being the person entitled to depreciation deductions under the UCA regime) is required to use the same method and same effective life used by the former holder. Where the new holder does not know and cannot readily find out which method and/or effective life the former holder was using or the former holder did not use a method and/or effective life, the second hand plant rules provide a default rule, being the use of the diminishing value method and/or the Commissioner’s determination of effective life. This seems to be the general outcome in practice.
|
