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Cognition: Insight into the new sale and leaseback arrangements ruling

Feature Articles

Cite as: (2007) 81(6) LIJ, p. 68

A new income tax ruling on sale and leaseback arrangements resolves some concerns, but raises other issues.

By Julian Roberts

A new income tax ruling on sale and leaseback arrangements resolves some concerns, but raises other issues.
By Julian Roberts

On 1 November 2006 the Commissioner of Taxation (Commissioner) issued TR 2006/13 “Income tax: sale and leasebacks” (Ruling). The Ruling replaced TR 95/30 “Income tax: sale and leasebacks” as the ruling that governs the income tax treatment of sale and leaseback arrangements involving depreciating assets.

This article summarises the Ruling and explains some of the ways it differs from its predecessor. The article also discusses the main issues which arise out of the Ruling.

Scope of the Ruling

The Ruling discusses the application of Div 40 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) to sale and leaseback arrangements. To a lesser extent it discusses the application to sale and leaseback arrangements of Div 240 of the ITAA 1997 and Part IVA of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936).

According to para 2 of the Ruling, the income tax treatment of a sale and leaseback arrangement depends on its legal character. The Ruling goes on to discuss the income tax treatment of:

  • standard sale and leaseback arrangements: see Ruling, paras 10-17; and
  • sale and leaseback arrangements where the depreciating asset is a fixture: see Ruling, paras 25-33.

Standard arrangements

Paragraph 4 of the Ruling speaks of a standard sale and leaseback arrangement as comprising the sale of a depreciating asset by its owner (lessee) to a financier (lessor) and the leaseback of the asset by the lessor to the lessee. It is of course true that the leaseback component of a sale and leaseback arrangement might properly be called a bailment or licence agreement.[1] 

Balancing adjustment

On the sale, the lessee ceases to hold the depreciating asset under Item 10 of the table in s40-40 of the ITAA 1997, with the result that a balancing adjustment event occurs. Usually an amount will be included in the lessee’s assessable income or a deduction allowed to the lessee, depending on whether the termination value (that is, the sale price) is more or less than the adjustable value just before the asset was sold: see Ruling, para 11. In some cases a profit derived by the lessee on the sale may be income apart from the balancing adjustment provisions. This will be so if the circumstances set out in Federal Commissioner of Taxation v Myer Emporium Ltd[2] are satisfied:

“ ... the fact that a profit or gain is made as the result of an isolated venture or a ‘one-off’ transaction [does not] preclude it from being properly characterised as income ... The authorities establish that a profit or gain so made will constitute income if the property generating the profit or gain was acquired in a business operation or commercial transaction for the purpose of profit-making by the means giving rise to the profit”.

Deduction for depreciation

The lessor becomes the owner of the depreciating asset on its sale. The lessor holds the asset under Item 10 of the table in s40-40 of the ITAA 1997 and is entitled to deductions for the decline in the asset’s value: see Ruling, para 12. The lessor’s deductions are calculated according to the cost of the asset to the lessor (that is, the price which the lessor paid for the asset), not the typically higher cost of the asset to the lessee (that is, the price which the lessee originally paid for the asset): see Ruling, para 13.

At the same time the lessee ceases to own the asset. As a result, the lessee does not hold the asset for the purposes of Div 40 of the ITAA 1997, and is not entitled to deductions for depreciation.

Lease payments

The leaseback requires periodic payments by the lessee to the lessor. The lessee incurs and deducts these payments, whereas the lessor derives them as assessable income: see Ruling, para 14.

Proceeds of sale by lessor to lessee

Typically the lessor sells the asset back to the lessee at the end of the lease. In that case:

  • an amount will be included in the lessor’s assessable income if the termination value of the asset is more than its adjustable value just before it was sold; or
  • a deduction will be allowed to the lessor if the termination value of the asset is less than its adjustable value just before it was sold: see Ruling, para 16.

If at the end of the lease the lessor does not sell the asset back to the lessee but retains it, the lessor continues to hold the asset for the purposes of Div 40 of the ITAA 1997, and can continue to claim deductions for depreciation so long as the asset is still used for the purpose of gaining and producing assessable income: see Ruling, para 17.

Arrangements where asset is a fixture

On the sale of a depreciating asset that is a fixture, the lessor becomes the equitable owner of the asset; the lessee remains the legal owner because the asset is a fixture to the lessee’s land: see Ruling, para 25.[3] 

Division 40 of the ITAA 1997

As for Div 40 of the ITAA 1997, the following happens:

  • On the sale, the lessor commences to hold the asset under Item 6 of the table in s40-40 of the ITAA 1997. The lessee ceases to hold the asset under Item 10 because usually it applies only if none of the other items apply: see Ruling, para 27.
  • On leaseback, the lessor ceases to hold the asset under Item 6, because the lessor no longer has the right to possess the asset immediately. The lessor commences to hold the asset under Item 4, which provides that the lessor of a depreciating asset that is a fixture to land, who has the right to recover the asset, holds the asset, but not to the exclusion of any other holder, including a holder under Item 10. As such, the lessee also commences to hold the asset, as its legal owner under Item 10: see Ruling, para 27.
  • Where (as here) more than one person holds the asset, s40-35 of the ITAA 1997 provides that Div 40 applies as if each interest in the asset were itself the asset. The result is that both the lessor and lessee are entitled to deductions for depreciation. In practice, the lessee will not claim any deductions because the cost of the asset to the lessee is zero. That is, the lessee makes no payments to hold the asset save the non-capital lease payments, which are excluded from cost by s40-220 of the ITAA 1997: see Ruling, para 29.
  • The lessee is entitled to claim deductions for the lease payments. The lessor must return the lease payments as assessable income: see Ruling, para 30.

Where asset affixed to third party’s land

Where a depreciating asset is a fixture to land owned not by the lessee but by a third party, the lessor’s right to recover the asset may be limited or even excluded. In such cases the lessor might not hold the asset for the purposes of Div 40, and might not be entitled to deductions for depreciation: see Ruling, para 32.

Where the lessor’s right to recover the asset from the third party’s land is not limited or excluded, the lessor holds the asset under Item 4 of the table in s40-40 of the ITAA 1997. The third party also holds the asset, as its legal owner under Item 10. As more than one person holds the asset, s40-35 of the ITAA 1997 applies to entitle both the lessor and the third party to deductions for depreciation proportionate to the cost of the asset to them.

Part IVA of the ITAA 1936

The Ruling begins by acknowledging that Part IVA of the ITAA 1936 does not generally apply to sale and leaseback arrangements: see Ruling, para 37.[4] It goes on to discuss the elements of Part IVA, namely scheme, tax benefit and dominant purpose: see Ruling, paras 84-102.

Scheme

In most cases the scheme will be the sale and leaseback arrangement in its entirety: see Ruling, para 86.

Tax benefit

In most cases the counterfactual (that is, what would or might reasonably have been the position if the scheme had not been entered into) will be that the asset would not have been sold and the lessee would have secured funds by entering into a loan or some other finance arrangement. The result of such a counterfactual is that the deductions for depreciation and for the lease payments would not have been obtained if the scheme had not been entered into: see Ruling, para 89.

In cases where the lessee would have been entitled to deductions other than for the lease payments (for instance, for interest paid on a loan) if the scheme had not been entered into, presumably the tax benefit equals the difference between the deductions for the lease payments and the deductions that would have been obtained if the scheme had not been entered into. In such cases the lessee might argue that no tax benefit has been obtained because the counterfactual has the same tax consequence as the scheme. Of course, while the overall tax consequence might be the same, the immediate tax consequence in a given income year is not. An argument along these lines is therefore unlikely to succeed.

Dominant purpose

Paragraph 95 of the Ruling states that the choice of a sale and leaseback arrangement in place of a loan or some other finance arrangement may sustain a finding of a dominant tax purpose where the only benefit to either party appears to be that a tax benefit has been obtained. It is suggested that this statement is problematic because it assumes that a tax benefit is the only advantage of a sale and leaseback arrangement over and above the advantages associated with loans and other finance arrangements. The error of this assumption was highlighted by Lee J in Eastern Nitrogen Ltd v Federal Commissioner of Taxation,[5] who pointed out that the sale and leaseback arrangement in that case:

  • enhanced the taxpayer’s balance sheet structure;
  • meant that the taxpayer could be deprived of its asset if it defaulted in payment; and
  • transferred ownership in the asset, making the taxpayer a lessee.

That is not to say that Part IVA will never apply to a scheme involving a sale and leaseback arrangement. It is clear that Part IVA will apply if there is inserted into a sale and leaseback arrangement a step whose dominant purpose is to obtain a tax benefit: see Ruling, para 95. But here it is not the sale and leaseback arrangement that is impugned by Part IVA so much as the inserted step.

Old Ruling TR 95/30

As stated above, the Ruling replaced TR 95/30 “Income tax: sale and leasebacks” (Old Ruling): see Ruling, para 44. There are a number of differences between the two.

In the Old Ruling, which dealt with the former depreciation regime, it was said that the person who owned (not held) the asset was entitled to deductions for depreciation: see Old Ruling, para 7. In the case of a standard sale and leaseback arrangement, this makes no practical difference. The reason why is that on the sale of the asset, the lessor owns it and is entitled to deductions for depreciation calculated according to the cost of the asset to the lessor. In contrast, the lessee does not own the asset and is not entitled to deductions for depreciation: see Old Ruling, paras 7-8; compare Ruling, paras 12-13.

Paragraph 16 of the Old Ruling rejects the notion that a fixture to the lessee’s land can be the depreciating asset under a sale and leaseback arrangement. The result is that the lessee is entitled to deductions for depreciation as the owner of the land to which the asset is a fixture: see Old Ruling, para 17.

In the Ruling, the Commissioner accepts that a fixture to land can be the depreciating asset under a sale and leaseback arrangement. The legal effect is that the lessor becomes the equitable owner of the asset while the lessee remains its legal owner. Both the lessor and the lessee hold the asset and are entitled to deductions for depreciation proportionate to the cost of the asset to them: see Ruling, paras 25-29.[6] 

While the Commissioner’s view on the application of Part IVA to sale and leaseback arrangements has not changed (see Old Ruling, paras 21-27; compare Ruling, paras 84-102), it does need to be considered in light of the decisions in Eastern Nitrogen Ltd v Federal Commissioner of Taxation[7] and Federal Commissioner of Taxation v Metal Manufactures Ltd.[8] 

Main issues

The Ruling gives rise to two main issues:

  • The sale of the asset by the lessee to the lessor at the commencement of the lease. According to para 22 of the Ruling, where no recognised market exists for a major asset, the Commissioner requires evidence as to the appropriateness of the sale price in the form of an independent valuation by a recognised valuer. While it may be prudent for the lessee to obtain an independent valuation to support its income tax return, the Commissioner’s view is questionable, as there is no such requirement in the ITAA 1997. Moreover, the agreed sale price would, in the case of arm’s length dealing, usually represent the market value, so there should be no need for an independent valuation.
  • The Commissioner’s continued insistence that a sale and leaseback arrangement, in place of a loan or some other finance arrangement, may attract the application of Part IVA of the ITAA 1997. As stated above, this is doubtful because a tax benefit is not the only advantage of a sale and leaseback arrangement over and above the advantages associated with loans and other finance arrangements. Also, some of the examples of transactions likely to raise concern are questionable. For instance, it should not be relevant that the lessor intends to assign the right to income for the term of the arrangement if Part IVA is being applied in respect of the lessee: contrast Ruling, para 37.
  • from these issues and some other minor ones, it appears that the Ruling accurately reflects the changes that have been made to the law since the Commissioner issued the Old Ruling.

JULIAN ROBERTS is a lawyer working in the revenue group at Corrs Chambers Westgarth.


[1] See Federal Commissioner of Taxation v Citibank Ltd (1993) 44 FCR 434 at 436; Harrington v Harrington Services (In Liq) [2002] 55 NSWLR 618 at 621-622.

[2] 87 ATC 4363 at 4367.

[3] Eastern Nitrogen Ltd v Federal Commissioner of Taxation 2001 ATC 4164 at 4173; Federal Commissioner of Taxation v Metal Manufactures Ltd 2001 ATC 4152 at 4163.

[4] See also Eastern Nitrogen Ltd v Federal Commissioner of Taxation, note 3 above.

[5] Note 3 above, at 4180-4181.

[6] Eastern Nitrogen v Federal Commissioner of Taxation, note 3 above; Federal Commissioner of Taxation v Metal Manufactures Ltd 2001 ATC 4152.

[7] Note 3 above.a

[8] Note 6 above.

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