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Finance and Investment Division 250 Working Group minutes - 2 December 2008 |
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Meeting details
Venue: |
Australian Taxation Office | ||
Date: |
2 December 2008 | ||
Start: |
10.00am |
Finish: |
12.45pm |
Chair: |
John Smith | ||
Contact and Secretariat: |
Robin Halls |
Contact phone: |
(03) 9275 2551 |
Attendees
Brett Andersen |
Australian Financial Markets Association |
Michael Anderson |
Institute of Chartered Accountants in Australia |
John Bardsley |
Institute of Chartered Accountants in Australia |
John Bills |
Australian Equipment Lessors Association |
Julian Cheng |
CPA Australia |
Patricia Day |
Tax Office |
Jacinta Fitton |
Tax Office |
Paul King |
Taxation Institute of Australia |
Richard Krone |
Tax Office |
Dudley Heywood |
Investment and Financial Services Association |
David Lynch |
Australian Financial Markets Association |
Max Persson |
Property Council of Australia |
Steven Vrontis |
Law Council of Australia |
Peter Woods |
Tax Office |
Apologies
Mike Davidson |
Australian Council for Infrastructure Development |
Steven Economides |
Australian Council for Infrastructure Development |
James Loughhead |
Australian Bankers Association |
Tony Regan |
Treasury |
Professional bodies represented on this NTLG sub-group working group
Australian Bankers Association |
ABA |
Australian Council for Infrastructure Development |
AUSCID |
Australian Equipment Lessors Association |
AELA |
Australian Financial Markets Association |
AFMA |
CPA Australia |
CPAA |
Institute of Chartered Accountants in Australia |
ICAA |
Investment and Financial Services Association |
IFSA |
Law Council of Australia |
LCA |
Property Council of Australia |
PCA |
Taxation Institute of Australia |
TIA |
Agenda items
Disclaimer
Please note: National Tax Liaison Group (NTLG) agendas, minutes and related papers are not binding on the Tax Office or any of the other bodies referred to in these papers. The responses contained in this agenda are the preliminary responses of the Tax Office based on the agenda items supplied. These papers reflect the position prior to discussion in the meeting and readers should note that the position on any issue may subsequently change.
1. Chairman's welcome
The Chair welcomed members of the working group and thanked them for submitting issues. He said that he thought the forum would provide a good opportunity for the issues to be discussed and would assist the Tax Office in considering an appropriate response to those issues.
He advised that Treasury was unable to attend the meeting but had expressed interest in the issues and in attending future meetings of the working group.
He suggested that the issues would need to be better understood and prioritised and consideration would then be given to the appropriate form in which each issue might be addressed.
He noted that Practice Statements might be used to address issues relating to administration and that Taxation Determinations might be appropriate for discrete interpretative issues. He said that Taxation Determinations (TD) would usually enable more timely advice of formal Tax Office views than Taxation Rulings because a Ruling often covers a number of interpretive issues and entails lengthier work and approval processes.
It was anticipated that the working group would meet every three months, and it was likely that the next meeting would be in late February 2009 – the date will be set to facilitate Treasury’s attendance.
He reminded attendees that the activities of the working group and its members are governed by the working group’s terms of reference and the NTLG Finance and Investment Sub-group’s charter.
The chair said that Jacinta Fitton would undertake the responsibilities of Chairperson and Richard Krone would undertake the role of Secretariat at future meetings of the working group.
The Chair opened up the meeting for a discussion of the issues.
The Property Council of Australia's (PCA) member initially referred to agenda item 2.2 – the issues listed in Attachment B to the agenda. He suggested that some of these issues might be addressed by administrative or interpretative approaches and others might require a change in the law. He confirmed after enquiry by the chair that no discussion with Treasury had occurred on the issues to date.
He then referred to agenda item 2.1 and spoke on the issues set out in Attachment A to the agenda.
2. Agenda Items submitted by members
2.1 Practical application of Division 250 to investments in real estate
The PCA's member spoke on the five issues illustrated in Attachment A. The issues and notes of the discussion on each are as follows:
- Identification of the relevant asset
The issue is ‘what is the relevant asset’ put to a tax preferred use? As outlined in example 1, in a multi-storeyed office building with one floor leased to a tax exempt end user and the remaining floors leased to taxable entities, the member said that the preferable approach would be that the relevant asset is the floor of the building that is subject to tax preferred use, and not the entire building. This interpretation was consistent with the intent of the legislation being that the provisions would apply to the asset that is subject to tax preferred use. - Testing each depreciating asset separately
The member requested that the aggregation of depreciating assets should be permitted when testing for the purposes of section 250-135. The compliance cost of separately testing each depreciation asset is very onerous, and this cost justified a de minimis grouping approach of assets and application of the test based on one effective life. - Determination of market value of relevant asset
The member spoke about the requirement to determine market value of the asset for the purposes of section 250-135, which in the example was taken to be the floor leased to the tax preferred end user. He noted that this is not required for any purpose other than to satisfy the requirement under Division 250. The member suggested that lettable floor space as a percentage of the value of the building or percentage of rental income would be preferred approaches.
Jacinta Fitton suggested that one type of allocation might not suit all projects – for example where higher floors in a large development might be of different value than lower floors, or retail space of a similar area. The member referred to market valuation guidelines under tax consolidation rules. A member commented that the approach should not be too prescriptive.
The PCA's member said he would come back to the Working Group with proposed methodologies for consideration.
A member queried why Division 250 would apply if only one floor of a 20 storey building was leased to a tax preferred end user.
Another member suggested the limited debt exclusion in subsection 250-115(5) might apply; this provision anticipated that the asset was the building rather than the floor.
Ms Fitton commented that the exclusion would not extend to section 250-135.
A member questioned the appropriate treatment where additional expenditure was incurred during the course of the arrangement, and asked whether there should be a separate calculation for the additional expenditure or the expenditure would be added to the existing loan so that a principal and interest calculation would be performed from the adjusted loan?
A member commented that this might raise a problem and create distortions, especially for an infrastructure project, where it would be preferable to test the expenditure separately.
Ms Fitton said that the test occurs at the start of the arrangement based on what is expected over the arrangement, and payments streams would anticipate replacement expenditure over the course of the arrangement.
A member said that modelling would generally solve this. He did not think it was worth spending too much time on the issue and noted that under Division 16D a reasonable allocation had applied.
- Determination of expected financial benefits in relation to the relevant asset identification of a short cut of financial benefits to particular assets.
The PCA's member suggested a shortcut being a pro-rata allocation of the financial benefit to particular assets based on the proportion of market value of the asset compared with the market value of all assets, or another method provided the method is reasonable and consistently applied.. A member said that in infrastructure this would be based on cost rather than on value.
Ms Fitton said that different project types may lend themselves to different methodologies.
- Determination of discount rate.
It was suggested that the methodology for the determination of the discount rate prescribed in legislation is not appropriate in a property lease context. The PCA's member stated that the first tenancy will not recoup costs of acquisition/construction, and this will result in an internal rate of return (IRR) that is nonsensical (for example a negative IRR). The life of the building will nearly always exceed the term of the first lease.
The chair suggested that Treasury would need to provide advice.
The action items arising from this agenda item are as follows.
D250-021208-2.1-1
| |
Responsibility |
Tax Office |
Due date |
On the call for agenda items for the next meeting |
D250-021208-2.1-2
| |
Responsibility |
PCA |
Due date |
On the call for agenda items for the next meeting |
2.2 Register of issues requiring clarification by the Tax Office and/or Treasury
(See Attachment B to the agenda). The PCA's member addressed the items proposed for a register of issues.
Issue 2.01 This issue was discussed earlier as issue 1 in agenda item 2.1
Issue 2.02 Limited Recourse Debt Test
Ms Fitton noted the difference between section 51AD and section 243-20 in the terms and meaning. The Tax Office could consider issuing TDs dealing with Divisions 243 and 250 and leave TR 96/22 for section 51AD.
The chair again noted that it would be quicker to develop TDs, each dealing with one issue, than a ruling on multiple issues.
PCA commented that examples in TR 96/22 of effective 'undertakings to pay' would be helpful in any TD.
Issue 2.03 This issue was discussed earlier as issue 3 in agenda item 2.1
Issue 2.04 End Value
The Tax Office was asked to clarify whether the remaining undeducted Division 43 expenditure could be used as a reasonable estimate of market value. A member suggested that this was more an issue for Treasury but noted that an asset may go up in value and on a principal and interest loan all rental payments would be assessed as interest. Example 2 brought out this point exactly. The market value might therefore need to be undeducted expenditure.
Issue 2.05 Commissioner’s discretion
A member suggested that the application of Division 250 to Controlled Foreign Companies (CFCs), foreign hybrids and so on, was a suitable subject for an exercise of the Commissioner's discretion as there appeared to be no policy reason for the application of Division 250 to CFCs.
Ms Fitton commented that it would not seem to be an appropriate use of the Commissioner's discretion as Government had not included Division 250 in the exclusions to the CFC provisions. She understood that the issue had been raised in the development of the measures.
The Tax Office stated it was an issue that should be referred to Treasury.
Issue 2.06 Addition and improvement during the lease
A member suggested that a Taxation Determination could be developed to approve a shortcut for additional expenditure incurred during the arrangement that enabled expenditure to be capitalised into the existing loan. The examples discussed were of carpet replaced or additional lease area added during the course of an arrangement. He observed that whether payments would increase as a consequence of the expenditure might vary between arrangements.
A member commented that what might be appropriate for a commercial shopping centre might not be appropriate for a public private partnership infrastructure arrangement. The additional expenditure should be a timing difference, but such an adjustment could make a permanent difference.
Issue 2.07 Apportionment Rule
This issue was discussed earlier as issue 4 in agenda item 2.1
Issue 2.08 Exclusion for low value assets
Confirmation is sought that the exclusion for low value assets in paragraph 250-30(1)(c) does not include the land even though the provision refers to real property.
Issue 2.09 Start of arrangement period
When an arrangement is taken to start should be clarified – for example, is it when the lease is signed or when the agreement to lease is entered into? As Division 250 is about turning off capital allowances, such allowances cannot be turned off until the lease is in existence and the asset is being used. This can arise for pre-leasing arrangements entered prior to or during construction and is relevant for many aspects of the application of Division 250 including the short term arrangement exclusion.
Ms Fitton said that if it is an issue then the Tax Office would need more data on when it is a problem.
Issue 2.10 Effective control and use
Issue 2.11 Right to control
Issue 2.12 In substance leases
It was agreed that the above three issues are low priority. The Tax Office will give consideration to clarification.
The action items arising from this agenda item are as follows:
D250-021208-2.2-1
| |
Responsibility |
Tax Office |
Due date |
On the call for agenda items for the next meeting |
D250-021208-2.2-2
| |
Responsibility |
External members |
Due date |
On the call for agenda items for the next meeting |
2.3 Debt test exclusion from safe harbour test, and debt test element of Predominant Economic Interest test
It was noted that many of the issues raised by the Law Council of Australia (LCA) in Attachment D are similar to those raised in the submission received by the Australian Equipment Lessors Association (AELA).
The LCA member spoke on this item which is detailed in and circulated with the agenda as issue 1 in Attachment D.
Ms Fitton commented that the Tax Office would need to look at the issue more closely. An example is to be provided.
D250-021208-2.3 | |
Responsibility |
LCA |
Due date |
On the call for agenda items for the next meeting |
2.4 Payments through intermediate entities
The LCA member spoke on this item which is detailed in and circulated with the agenda as issue 2 in Attachment D.
An ICAA member said that the provision for payments through intermediaries could be understood where a head lessor and a sub-lessee were parties to one arrangement, but subjecting the head lessor to Division 250 did not appear appropriate where the head lessor was unaware of a sub-lease or the identity of the sub-lessee and the head lease was not part of the arrangement for the tax preferred use under a sub-lease. An example was given of an office building where a floor becomes vacant and is sub-leased to an exempt entity.
Ms Fitton commented that this issue was difficult as section 250-90 is an integrity measure to prevent circumventing legislation by interposing intermediaries. There may be instances where tracing of the payments would be appropriate even if parties are unrelated.
The chair suggested that the Tax Office would be better to able consider something generic and invited the member to put forward something of that nature.
The following action item was agreed.
D250-021208-2.4 | |
Responsibility |
ICAA |
Due date |
To be considered for next meeting |
2.5 Limited recourse debt
The LCA member spoke on this item which is detailed in and circulated with the agenda as issue 3 in Attachment D.
Limited recourse debt in section 243-20 uses the words ‘wholly or predominantly’, and the use of these words in identifying limited recourse debt may involve an additional test to the 80% test in paragraph 250-115 (3)(a). Reference was made to TR 96/22 paragraphs 59-61 which recognise this issue and provide the Tax Office view that the tests do not operate in this way.
Ms Fitton commented that the Tax Office had not seen this as an issue and the Tax Office might consider clarification, but she noted from the meeting that a legislative fix appeared to be the preferred approach. The Tax Office undertook to discuss the issue with Treasury.
The action item agreed from this agenda item is:
D250-021208-2.5 | |
Responsibility |
Tax Office |
Due date |
To be considered for next meeting. |
2.6 Definition of ’member of the tax exempt sector’
The LCA member spoke on this item which is detailed in and circulated with the agenda as issue 4 in Attachment D.
Inclusion of non-residents as members of tax preferred end user means a non-resident insurer, foreign bank lender, resale support by a non-resident manufacturer would invite the application of Division 250 to an arrangement and an asset even though the non-resident is not the end user of the asset.
It was noted that the issue was whether this was an intended or unintended consequence of the legislation. If the latter, then some exercise of the discretion might be warranted; but if the consequence was intended, then it would be inappropriate to exercise the discretion to defeat legislative intention.
The Tax Office undertook to confirm with Treasury that the consequence for non-residents in the above circumstances was intended.
The agreed action item:
D250-021208-2.6 | |
Responsibility |
Tax Office |
Due date |
On the call for agenda items for the next meeting |
2.7 Section 51AD switch off
The LCA member spoke on this issue which is detailed in and circulated with the agenda as issue 5 in Attachment D.
The Tax Office confirmed that neither section 51AD nor Division 16D applied to arrangements where the use started and contracts for the use were entered into after 1 July 2007.
The Tax Office undertook to consider the manner by which the issue could be clarified.
The agreed action item:
D250-021208-2.7 | |
Responsibility |
Tax Office |
Due date |
On the call for agenda items for the next meeting |
2.8 Lease of multiple assets under a Single Master Lease Agreement
The LCA member spoke on this issue which is detailed in and circulated with the agenda as issue 6 in Attachment D.
Ms Fitton said that an exemption should be available for short term leases, but low value assets would need to be aggregated in accordance with the legislation.
A member said that there was a further problem with the treatment under transitional provisions of a master lease that straddles June 2007.
Ms Fitton said it would be hard to provide a determination on transitional cases, as the Tax Office would need to look at each case and the contract terms.
The agreed action item:
D250-21208-2.8 | |
Responsibility |
Working group members |
Due date |
On the call for agenda items for the next meeting |
2.9 Items submitted by AELA
The member from AELA spoke on this item.
He confirmed that the issues raised in AELA's submission had already been discussed in the submission from the Law Council of Australia.
In identifying priorities for the issues raised by the Law Council of Australia he advised that AELA considered issues 1, 4 and 5 as being top priority, and issues 2, 3 and 6 being medium priority.
3. Other business, action items
Summary of action items
Practical application of Division 250 to investments in real estate –
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Practical application of Division 250 to investments in real estate –
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Register of issues requiring clarification by the Tax Office and/or Treasury:
Issues 2.06, 2.10, 2.11 and 2.12 to be considered further by the Tax Office. | ||||
Register of issues requiring clarification by the Tax Office and/or Treasury:
| ||||
Debt test exclusion from safe harbour test; and debt test element of PEI test – Examples of debt test exclusion from safe harbour test; and debt test element of PEI test to be provided. |
||||
Payments through intermediate entities – ICAA to provide more information that covers a generic situation of payments through intermediate entities. |
||||
Limited Recourse Debt – The Tax Office to discuss with Treasury the issue of Limited Recourse Debt words ‘wholly or predominantly’ in addition to the 80% test in paragraph 250-115(3)(a). |
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Definition of ‘member of the tax exempt sector’ – The Tax Office to discuss with Treasury the issue of the definition of ‘member of the tax exempt sector’ and whether its consequences for non-residents are intended. |
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Income Tax Assessment Act 1936 (ITAA 1936) section 51AD switch off – The Tax Office to consider the issue of ITAA 1936 section 51AD switch off with regard to issue of a public response. |
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Lease of multiple assets under a Single Master Lease Agreement – working group members to further consider issue. |
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Next meeting
The chair suggested that the next meeting should be held around the end of February and a firm date will be proposed to members by the secretariat after Treasury has confirmed the availability of its representative.
Meeting concluded.
Attachments
Attachment A
Example 1
Issues 1.01, 2.01 and 2.03 – Applying the level of expected financial benefits test
This example aims to illustrate the following issues in relation to the application of the level of expected financial benefits test:
In a multi-tenanted building, what is the relevant Division 43 asset put to a tax preferred use?
Is there a requirement to test each depreciating asset separately?
How is the market value of the relevant asset determined?
How are the expected financial benefits in relation to the relevant assets determined?
How is the discount rate determined?
The majority of these issues arise because Division 250 appears to assume an arrangement with a single tax preferred end user, with a term equal to the effective life of the assets. These assumptions are not valid in relation to real property where there are likely to be multiple tenants, only some of which may be tax preferred end users, and none of whom would have leases over the property for the remainder of its effective life.
Background
RealTrust is the owner of a five storey commercial office building and land which it uses to derive rental income. RealTrust acquired the land and building as well as the building fit-out for $100 million from a developer upon completion of construction on 1 July 2008. The acquisition was 70% funded by limited recourse debt (that is, section 250-115 does not apply).
The building is pre-tenanted, with leases of all five floors commencing on 1 July 2008. Each floor is identical. One floor is leased to a tax preferred entity as defined in section 995-1 with the remaining four floors of the building being leased to non-tax preferred entities. Rent is paid annually in arrears.
Other relevant circumstances are as set out in Figure 1.
Figure 1.1 Tax preferred entity 4th Floor
Non-tax preferred entities 2nd Floor 1st Floor Ground Floor Building value1: $50 million Land value: $50 million Undeducted Division 43 expenditure: $40 million Total Division 40 adjustable values: $5 million Rental yield 7% p.a. Floor rental: $1.4 million p.a. (i.e. $100M/5 x 7%) Lease term: 10 years Inclusive of Division 43 expenditure and Division 40 assets Adjustable value after the acquisition |
The tax preferred entity is a tax preferred end user for the purposes section 250-50 and section 250-55 as a holder of rights as lessee under a lease of the fourth floor of the building. As the tax preferred entity is a tax preferred end user, the fourth floor of the building is put to a tax preferred use under sub-section 250-60(1), with the tax preferred use being the lease.
Issue 1 – In a multi-tenanted building, what is the relevant Division 43 asset put to a tax preferred use?
From sub-section 250-75(1) it is clear that the building is an asset separate from the land for the purposes of Division 250, however, it is unclear whether the floor of the building put to a tax preferred use should be treated as a separate asset for the purpose of sub-section 250-135(2)(b), or whether there is a requirement to test the building as a whole.
Recommendation 1 That the Tax Office provide guidance in a public ruling or administrative practice statement setting out that sub-section 250-75(2) will be considered to treat the relevant asset for the purposes of section 250-135 as the part of the building subject to the lease to the tax preferred entity, rather than the entire building. This construction best achieves the purposes of Division 250 in denying, or reducing, capital allowances deductions that would otherwise be available in relation to an asset which is put to a tax preferred use. As the only part of the building being put to a tax preferred use is the fourth floor it is not consistent with the intended operation of Division 250 to test whether RealCo may lack a predominant economic interest in the building as a whole. |
This example continues assuming that Recommendation 1 is adopted.
Issue 2 – Is there a requirement to test each depreciating asset separately?
It is also not clear whether each depreciating asset on the fourth floor which is put to a tax preferred use should be treated as a separate asset for the purposes of sub-section 250-75, or whether it may be appropriate to aggregate certain depreciating assets for these purposes.
Recommendation 2 That the Tax Office provide guidance in a public ruling or administrative practice statement setting out that aggregation of depreciating assets will be accepted provided the adjustable value of each relevant depreciating asset does not exceed a de-minimus threshold of [$50,000] per asset, and that in these circumstances sub-section 250-75(2) will treat this notional asset as the relevant asset for the purposes of section 250-135. Requiring taxpayers to test each depreciating asset separately under section 250-135 imposes an overly onerous compliance burden, for example: A requirement to allocate a proportion of expected financial benefits to each and every depreciating asset in the fixed asset register A requirement to determine whether the taxpayer may lack a predominant economic interest in relation to each of the assets (requiring present value calculations for each asset) Where the taxpayers lacks predominant economic interest in some but not all of the depreciating assets put to a tax preferred use, a requirement to separately determine the impact of deemed loan treatment in relation to each of the relevant depreciating assets and track the principal and interest components of the proportion of financial benefits relating to the asset over the term of the arrangement. It is considered that the risk to the revenue of allowing a level of aggregation in relation to low value depreciating assets should be insignificant, whereas the savings in compliance costs for taxpayers would be considerable. |
This example continues assuming that Recommendation 2 is adopted.
To determine whether RealTrust lacks a predominant economic interest in the fourth floor of the building the following analysis is required.
Compare the sum of the present values of the expected financial benefits that the tax preferred end-user is reasonably likely to provide in relation to … |
to ... |
1. the assets referred to in subparagraph 250-15(d)(i) (i.e. Division 40 depreciating assets) |
the market value of the assets, or |
2. the expenditure referred to in subparagraph 250-15(d)(iI) (i.e. the Division 43 expenditure) |
so much of the market value of the asset as is attributable to the Division 43 expenditure referred to in subparagraph 250-15(d)(ii). |
There are a therefore a number of values that need to be determined:
- market value of relevant assets
- expected financial benefits that the tax preferred end-user is reasonably likely to provide in relation to the relevant assets
- the present value discount rate to apply to the relevant expected financial benefits.
Issue 3 – How is the market value of the relevant asset determined?
There is currently no guidance as to an acceptable way to determine the market value of the relevant assets.
Recommendation 3 That the Tax Office provide guidance in a public ruling or administrative practice statement setting out market valuation short cuts for the purposes of Division 250. A suggested shortcut in relation to Division 43 assets is a reasonably allocation of the market value of the entire building based on:
Without Tax Office guidance taxpayers would require independent or audited valuations to ensure compliance with Division 250. As commercial and retail property investors do not discriminate between tenants that are members of the tax preferred sector and taxpaying tenants, there is generally no commercial or accounting need to value particular floors or sections of a building. Requiring valuations to be performed in these circumstances imposes a significant compliance burden, particularly where there are a number of discrete tax preferred end users (as may be the case in a large office building, mixed use property or shopping centre). |
This example continues assuming that Recommendation 3 is adopted.
Applying a market valuation shortcut based on lettable floor space, the market value of the Division 40 depreciating assets subject to the lease with the tax preferred entity is $1,000,000 (that is, $5M/5) and the market value of the fourth floor of the building so far as it relates to Division 43 expenditure is $8,888,888 (that is, $50M/5 x (($40M/($40M+$5M))).
For the purposes of paragraph 250-135(2)(b) therefore RealTrust will not lack a predominant economic interest in either the Division 40 depreciating assets or the assets to which the Division 43 expenditure relates provided that the present value of the financial benefits to be provided in relation thereto does not exceed $700,000 (i.e. 70% of $1,000,000) or $6,222,222 (i.e. 70% of $8,888,888) respectively.
Issue 4 – How are the expected financial benefits in relation to the relevant assets determined?
Sub-section 250-135 requires a comparison of the expected financial benefits that the tax preferred end-user is reasonably likely to provide in relation to the asset with the market value of the asset. There is no guidance as to the way to determine the proportion of a financial benefit (that is, rent) to particular assets.
Recommendation 4 That the Tax Office provide guidance in a public ruling or administrative practice statement setting out administrative apportionment short cuts in relation expected financial benefits that the tax preferred end-user is reasonably likely to provide in relation to an asset for the purposes of Division 250. A suggested shortcut is a pro-rata allocation of the financial benefit to particular assets based on the proportion of market value of the asset compared with the market value of all assets, or another method provided the method is reasonable and consistently applied. |
This example continues assuming that Recommendation 4 is adopted.
In the circumstances described, an appropriate apportionment of annual rental would be:
Rental component |
Working | |
Building |
||
Division 40 depreciating assets |
$77,777 |
$1.4M x ($50M/$100M) x ($5M/($40M + $5M)) |
Division 43 expenditure |
$622,222 |
$1.4M x ($50M/$100M) x ($40M/($40M + $5M)) |
Land |
$700,000 |
$1.4M x ($50M/$100M) |
Total rental |
$1,400,000 |
Issue 5 – How is the discount rate determined?
There is a requirement under section 250-135 to discount the expected financial benefits that are reasonably likely to be provided in relation to the relevant assets based on a discount rate determined under sub-section 250-105(2), being the constant period rate of return worked out on a compounding basis (IRR) on the investment in the relevant asset that is implicit in the arrangement under which the asset is put to a tax preferred use.
For an arrangement (that is, the 10 year lease in the example) with a term shorter than the life of the asset (that is, 40 years), the IRR on the investment in the assets put to a tax preferred use (that is, the fourth floor of the building and relevant depreciating assets) would often not equate to the discounted value of financial benefits in relation to the particular arrangement. In the current example the nominal value of total rent payments in relation to the Division 40 and Division 43 assets would be $7 million (that is, $700,000 x 10 years) which is less than the value of the relevant assets, being $11 million (that is, $50m/5 floors plus $5M/5 floors). As such there is no discount rate reflecting the IRR on the arrangement.
Recommendation 5 That the government amend section 250-105 such that taxpayers can apply either the rate prescribed in sub-section 250-105(1) or the IRR inherent in the investment, determined based on appropriate commercial assumptions, including the entering into of new arrangements on expiry of current arrangements in relation to the use of the assets. A 'global approach' to the IRR on the investment would provide a more accurate reflection of the appropriate discount rate to apply to expected financial benefits that are likely to be provided in relation to the relevant assets for the purposes of Division 250. In addition, taxpayers are likely to have IRR calculations in investment approval documents which would rreduce the cost of compliance. |
This example continues assuming that Recommendation 5 is adopted.
Based on an assumption that RealTrust will enter into leases on the same terms as the current lease with the tax preferred end user following the end of the current arrangement and throughout the effective life of the relevant assets, the IRR for the investment is 6.42%, calculated, being the discount rate that provides RealTrust with a nil NPV over the life of the investment, as shown in Appendix A.
Based on a 6.42% discount rate the present value of rental income in relation to the Division 40 depreciating assets is $561,247 and in relation to the Division 43 expenditure is $4,490,023, as shown in Appendix B.
As the present value of rental in relation to Division 40 depreciating assets and assets relating Division 43 expenditure do not exceed 70% of the relevant market values, RealTrust should not lack a predominant economic interest in the asset being the fourth floor of the commercial office building.
Year |
Rental |
NPV |
11 |
7.000 |
3.531 |
12 |
7.000 |
3.318 |
13 |
7.000 |
3.118 |
14 |
7.000 |
2.930 |
15 |
7.000 |
2.753 |
16 |
7.000 |
2.587 |
17 |
7.000 |
2.431 |
18 |
7.000 |
2.284 |
19 |
7.000 |
2.146 |
20 |
7.000 |
2.017 |
Year |
Rental |
NPV |
21 |
7.000 |
1.895 |
22 |
7.000 |
1.781 |
23 |
7.000 |
1.674 |
24 |
7.000 |
1.573 |
25 |
7.000 |
1.478 |
26 |
7.000 |
1.389 |
27 |
7.000 |
1.305 |
28 |
7.000 |
1.226 |
29 |
7.000 |
1.152 |
30 |
7.000 |
1.083 |
Year |
Rental |
NPV |
31 |
7.000 |
1.017 |
32 |
7.000 |
0.956 |
33 |
7.000 |
0.898 |
34 |
7.000 |
0.844 |
35 |
7.000 |
0.793 |
36 |
7.000 |
0.745 |
37 |
7.000 |
0.700 |
38 |
7.000 |
0.658 |
39 |
7.000 |
0.618 |
40 |
7.000 |
0.581 |
Discount rate |
6.419% |
Sum NPV |
–0.02 |
Assets re Division 43 expenditure | ||
Year |
Proportion of rent |
NPV (at 6.419%) |
0 |
||
1 |
622,222 |
584,690 |
2 |
622,222 |
549,422 |
3 |
622,222 |
516,281 |
4 |
622,222 |
485,139 |
5 |
622,222 |
455,876 |
6 |
622,222 |
428,378 |
7 |
622,222 |
402,538 |
8 |
622,222 |
378,257 |
9 |
622,222 |
355,441 |
10 |
622,222 |
334,001 |
Sum NPV |
4,490,023 | |
Attachment B
Division 250 Issues Register
The following issues list has been split between issues which are seen to require legislative change and issues which it is considered can be dealt with administratively by the Tax Office. Each section is ordered in terms of high to LOW priority.
Two examples are also provided to illustrate particular issues, as indicated in the table.
1. Submissions to Treasury
Number |
Issue |
Description |
Priority |
Submission |
1.01 |
Applying the level of expected financial benefits test |
This test requires the taxpayer to calculate the sum of the present value of the expected financial benefits that members of the tax preferred sector have provided or are reasonably likely to provide. Pursuant to subsection 250-105(2), the discount rate to be used in working out the present value is the internal rate of return for the arrangement. This raises a number of issues as discussed in Example 1. |
High |
That section 250-105 be amended such that taxpayers can apply either the rate prescribed in sub-section 250-105(1) or the IRR inherent in the investment (rather than the particular arrangement). |
1.02 |
Present value of expected financial benefits |
Using the IRR may not always be appropriate in determining the PV of the expected financial benefits under certain types of leases: e.g. those considered to be a genuine 'operating' lease for tax purposes such as shopping centre leases, where there is no rate of return that is implicit in the lease rentals or the lease arrangement. |
High |
For the purpose of section 250-235, allow the use of the discount rates listed in section 250-105. This would ensure that genuine operating leases are not likely to be subject to Division 250. |
1.03 |
Working out the end value of Division 43 assets that appreciate in value |
The end value of an asset is worked out under section 250-180. It is unclear how that provision applies to Division 43 assets which appreciate in value, e.g. buildings. Refer to Example 2. |
High |
Modify the definition of end value so that it is equal to the undeducted construction expenditure at the end of the arrangement. |
1.04 |
Application to non-Australian property |
A tax preferred end user is defined in section 250-55 to include a non-resident. Under the CFC rules, the attributable income of a CFC is calculated on the basis that the CFC is a resident of Australia. Accordingly, Division 250 may apply inappropriately to a CFC where, for example, a CFC leases offshore property to a non-resident. Other situations where Division 250 may inappropriately apply include:
|
High |
Remove arrangements in relation to non-Australian real property from scope of Division 250. |
1.05 |
Exception to LRD test and short term or low value arrangements where financing from tax preferred sector |
One of the exceptions to the exclusions for the LRD test (refer s.250-115(4) – (6)) and certain short term or low value arrangements is the provision of financing or support for financing, e.g. by way of loan, guarantee, indemnity, security, etc., by a member of the tax preferred sector (subsection 250-35(4)). The exception to the exclusion applies even if the member of the tax preferred sector is unrelated to the tax preferred end user under the particular arrangement. For example, a taxpayer may borrow from an offshore financial institution to construct an asset that is leased to a tax exempt entity in Australia. Even though the financial institution may be unrelated to the tax exempt end user, the exclusion would not be available. This is particularly relevant in the context of non-Australian property. In addition, where provision of financing or support for financing is provided on an arm’s length basis this should not result in an exception from the exclusions to the LRD test. |
High |
Modify the exclusion to only include the financing or support for financing provided by an entity associated with the tax preferred end user on other than arm’s length terms. |
1.06 |
Expenditure in relation to an asset |
One of the conditions in the general test in section 250-15 is that the taxpayer must, apart from the operation of Division 250, be entitled to a capital allowance in relation to a decline in the value of an asset or expenditure in relation to an asset. Capital allowances include deductions over 5 years for blackhole expenditure under section 40-880. |
Low |
Clarify that this type of capital allowance would not be in relation to the decline in value of the asset or expenditures in relation to an asset, and therefore not subject to Division 250. |
1.07 |
Exception to short term or low value arrangements where irregular financial benefits |
One of the exceptions to the exclusion for certain short term or low value arrangements is where the financial benefits that are provided are not provided on a regular periodic basis (and at least annually) (subsection 250-35(6)). However, with some arrangements, e.g. property leases, it is not uncommon for financial benefits to be provided that are irregular or once-off. Examples are rent free periods or lease incentives. Does the receipt of such benefits by the taxpayer automatically exclude the application of the exclusion for short term or low value arrangements? |
Low |
Amend ss250-35(6) to remove the requirement that financial benefits must be 'provided on a regular periodic basis (and at least annually)'. |
2. Submissions to the ATO
Number |
Issue |
Description |
Priority |
Submission |
2 |
Other issues | |||
2.01 |
Identifying the relevant asset |
What is the relevant asset for the purposes of Division 250? An 'asset' may comprise separate items that may be recognised as assets in their own right. The EM gives the example of a floating restaurant, which comprises many separate components, e.g. the ship, stove, fridge, etc. Another example is a shopping centre where the relevant asset could be the whole centre, each shop within the centre, or the plant and equipment within each shop. See Example 1. |
High |
Given the potential compliance burden of identifying each and every asset under an arrangement, the ATO should provide an administrative shortcut or ruling permitting a certain level of aggregation, e.g. aggregation of assets into two pools – one for Division 40 assets and another for Division 43 assets, or the aggregation of Division 40 assets with a de minimus adjustable value. Refer to Example 1. For Division 43 assets it should be made clear that only the part of the capital works that are put to a tax preferred use should be relevant for the purposes of Division 250. Refer to Example 1. |
2.02 |
Definition of 'limited recourse debt' |
The definition of 'limited recourse debt' is set out in section 243-20. It is unclear if the ATO's guidance in TR 96/22 on the non-recourse debt requirement in section 51AD continues to be applicable. Furthermore, in what circumstances would it be unreasonable for an obligation to be treated as limited recourse debt under subsection 243-20(6). In addition, the practical implications of applying the LRDT are unclear where a single debt facility has been used to fund multiple property acquisitions. |
High |
Clarification by way of ruling. Request ATO to update its existing rulings to reflect the introduction of Division 250. |
2.03 |
Expected financial benefits |
The expected financial benefits that are taken into account under section 250-135 are those in relation to the tax preferred use of an asset. Under property leases, rental may have three components – land, building (Division 43) and plant and equipment (Division 40). Only the rental received in respect of the building, and the plant and equipment, would be financial benefits taken into account under section 250-135. Guidance is sought on the basis on which rental is to be apportioned between those components. Refer Example 1. |
High |
ATO should provide an administrative shortcut or ruling setting out that taxpayer can apply certain reasonable methods to allocate financial benefits to Division 40 assets, Division 43 assets and other assets including a pro rata allocation based on relative market values or tax cost, or some other reasonable method provided that the taxpayer applies the method consistently. |
2.04 |
Working out a reasonable estimate of the end value |
Under section 250-160, the financial benefits subject to deemed loan treatment include a reasonable estimate of the end value of the asset in some circumstances including where the asset is not to be purchased, acquired by, or transferred to, a member of the tax preferred sector at the end of the arrangement. There is no guidance on how a reasonable estimate of end value is determined. It may be difficult to estimate the end value (especially where the end value will be an accounting estimate or the market value of the asset) for arrangements that will be in place for many years. |
Medium |
ATO should provide an administrative shortcut or ruling outlining what is considered to be an acceptable way to estimate future market value including the future tax written down value of an asset or the balance of undeducted expenditure, and/or setting out other acceptable ways to determination future market values. |
2.05 |
Commissioner's discretion |
There is currently no guidance on when the Commissioner would exercise his discretion in section 250-45. |
Medium |
ATO ruling on Division 250 providing examples of situations where the exercise of the discretion may be appropriate (for example for certain non-Australian property). |
2.06 |
Addition and improvement during the lease |
Where an arrangement is subject to Division 250, clarification regarding whether an acquisition of assets or improvements to Division 43 assets during the arrangement period will impact on the overall gain or loss for the purposes of sub-division 250-E. There is a provision for re-estimation of the Div 250 gain/loss where there is a material change in the value or timing of financial benefits subject to deemed loan treatment, which includes the end value of the asset. Is this intended to provide for re-estimate for material additions or improvements to assets which are put to tax preferred use following the start of the arrangement? The examples in s250-255(2) do not address this issue. Where there is no re-estimation the taxpayer should not be denied capital allowances for the relevant assets. |
Medium |
ATO ruling on Division 250 to clarify whether a re-estimation of the overall gain/loss can be made in these circumstances. |
2.07 |
Apportionment rule |
Where an asset is used by both tax preferred users and non-tax preferred users (for example, lift/escalator in a building where only some floor space is leased to tax preferred user), it is necessary to work out the disallowed capital allowance percentage in respect of the lift of escalator. This is based on the sum of the present values of financial benefits that are subject to deemed loan treatment over the market value of the asset. |
Medium |
ATO ruling on Division 250 regarding what are acceptable methods of allocating financial benefits, for example based on floor space, rental or actual use. In working out the actual use, one may have regard to a number of staff/employees of tax preferred user and or the actual need for use by the tax preferred user. For example, if the tax preferred user is located the ground floor, it would not use a lift as often as the tenants using higher floors. |
2.08 |
Exclusion for low value assets. |
Clarification that the relevant assets for the purposes of the $40 million threshold are only the Division 43 and 40 assets, and not the land. |
Low |
Seek guidance in a ruling on Division 250. |
2.09 |
Start of the arrangement period |
The start of the arrangement period is usually when the tax preferred use starts, being when an end user 'holds rights as lessee' under a lease of the asset – does this include pre-completion leases which are entered into prior to the completion of a development and prior to possession of the premises? Although Div 250 will not apply in the period of development (as there is no asset in relation to which capital allowance would be available), however once it is complete, then does the arrangement period for calculating the Div 250 gain/loss start at the date of execution of the lease or possession of the premises? When does a party hold rights as lessee? |
Low |
Seek guidance in a ruling on Division 250. |
2.10 |
Meaning of effective control and use |
What is the meaning of 'effective control' and 'use'? Is the existing ATO guidance on these concepts in TR 96/22 and IT 2602 still relevant even though that guidance was released in the context of section 51AD and Division 16D? |
Low |
Clarify ATO's interpretation of these terms. Request ATO to update its existing rulings to reflect the introduction of Division 250 so that the interpretation under the old ruling applies to Division 250. |
2.11 |
Right to control the use of an asset |
Section 250-80 states that Division 250 applies to an arrangement as if it were a lease where, amongst other things, the arrangement gives a right to control the use of the asset (other than for temporary purposes of ensuring public health or safety, protecting the environment or continuing the supply of an essential service). There is no guidance on when a taxpayer will have a right to control the use of an asset. Similar terminology is used in AASB Interpretation 4 but the explanatory memorandum states that the accounting classification of the arrangement does not necessarily determine this question. |
Low |
Clarify the ATO's interpretation of the types of arrangements caught by section 250-80. |
2.12 |
In substance leases |
Under section 250-80, certain arrangements are deemed to be leases for the purposes of Division 250. The lessee of an asset is taken to be an end user of the asset under subsection 250-50(4). However, the note to section 250-80 states that 'Even if this section applies to treat an arrangement in relation to an asset as a lease, the requirements in section 250-50 still need to be satisfied before an entity can be an end user of the asset.' It is unclear what the purpose of this note is given that a lessee is automatically treated as an end user under section 250-50 without having to satisfy the effective control or use requirements stipulated in that provision. |
Low |
Clarify the ATO's interpretation of sections 250-50 and 250-80. There should be no need to satisfy the effective control or use tests in the case of an 'in substance' lease. If there was such a requirement, that would obviate the need for section 250-80. |
Attachment D
LCA agenda items
1. Debt Test exclusion from safe harbour test; and debt test element of PEI test
The short-term/low value exclusion does not apply to arrangements that are 'debt interests', as defined (with modification) in Subdivision 974-B. The modification to the definition applies to disregard section 974-130(4), which essentially relates to lease transactions.
The problem arises in that, in the case of any commercially negotiated operating lease, it would be expected that the value of the rights provided by the lessor to the lessee (in terms of right of occupation, quiet enjoyment, use etc) would be equally reflected by the rental payments struck between the parties. In fact, it would be expected that on day one, the value of the expected rights would equal the NPV of the future lease payments. This means that, in any commercially negotiated operating lease (either for a period of 10 years of less, on an actual payment basis; or over 10 years, on a NPV basis), the debt test would theoretically apply. This is, indeed, why the exclusion in section 974-130(4) was inserted into the debt/equity rules in the first place (to avoid automatic characterisation of leases as debt interests).
The fact that section 250-35(2) requires section 974-130(4) to be disregarded, effectively means that the short term/low value test cannot be satisfied in the case of all leases. This is inconsistent with the specific exclusion in section 250-35(5) of certain types of leases; and also in section 250-35(7), which operates only in respect of lease transactions.
Whilst it is a technical issue, I think the legislation requires amendment to delete section 250-25(2). This seems to me to be the only way to address what otherwise must be an unintended consequence of that section. Also, in deleting that section, no obvious gaps arise, as the definition of debt interest (even including the otherwise deleted section 974-130(4)) does not cover certain leases (including hire purchases) and other leases with a greater 'financing' character are separately excluded in section 250-35(5).
If this is not corrected, it will result in the short-term/low value exception not being applicable to lease transactions, which does not appear to be the intention of the exception. It is also something that, because of the way the modified definition works with the new provisions, would be easily overlooked by entities seeking to rely on the short-term/low value exception and, thus, causes a potentially hazardous issue for taxpayers and advisers.
2. Payments through intermediate entities
Section 250-90 states that a person (the provider) is taken to provide a financial benefit to a person (the recipient) in relation to a tax preferred use of an asset whether the financial benefit is provided to the recipient directly, or indirectly (including indirectly through an entity that is not a connected entity of the recipient or the provider). This is fine if there is a clear and transparent flow-through of funds, but it is difficult in terms of head lease/sub lease arrangements, particularly where the head lessor does not necessarily have control or (perhaps in some cases) even knowledge of the identity of the ultimate sublessee. In any case, it is difficult to track exactly what portion of the payment from the head lessee to the head lessor (say that is a transaction between taxpaying entities) could be attributed to use by a tax exempt sublessee. There needs to be some clarification about this provision. Perhaps it should be limited to situations only where the ultimate use by a tax preferred end-user is part of an overall scheme or arrangement entered into at the time of putting in place the intermediate entity (that is the one in the middle, flowing through the funds). Alternatively, it could be clarified by legislative amendment to exclude subleasing arrangements in certain circumstances (say, where the owner of the asset is not aware of the identity of the ultimate end-user; or where the head lease payments are calculated on a full arm's length basis, at market value between taxpaying entities).
3. Limited recourse debt
Section 250-115 provides the 'lack of predominant interest' test for limited recourse debt. The section sets out specific debt thresholds (80% for Australian use; 55% for non-resident use). The section also then incorporates the definition of 'limited recourse debt' in section 243-20. The difficulty here arises in that the section 243-20 test refers to the debt being wholly or predominantly limited to the asset and income related to the asset. This is on the basis that Division 243 does not otherwise apply any threshold level. The concept of 'wholly or predominantly' has been administratively applied as a '50% or more' test. So, for Division 243 (and previously, section 51AD), this gives a sensible application so that, essentially, assets other than those specifically funded by the relevant debt need to be worth at least 50% of the value of the debt. In the context of the application of this definition to section 250-115, it gives an anomalous result, that could lead to an interpretation that 100% debt funding would always be acceptable (as the 'wholly or predominantly' reference in section 243-20 effectively operates to double the value of debt:asset ratio). This would just potentially lead to confusion and appears to have simply been overlooked in the drafting and cross-referencing. This is clearly unintended and, I think, arises only because the definition used comes from a Division that doesn't, otherwise, have internal debt thresholds (as Division 250 does). I think this could be easily rectified by either still incorporating the section 243-20 definition, but with the modification that the words 'wholly or predominantly' are disregarded; or by restating the definition in Division 250, but omitting those words.
4. Definition of 'member of the tax exempt sector'
Issues are arising due to the definition of 'member of the tax exempt sector'. This definition includes a 'non-resident' and is then relevant for a number of purposes, including exclusions from the de minimus safe harbour exclusion; and also in relation to the 'limited recourse debt test' in the predominant economic interest test. The issue arises, as the term currently extends to all non-residents, regardless of other attributes. Specifically, it is not appropriate for the term to refer (at least in those cases identified in this point) to non-residents acting at or through a permanent establishment in Australia, or non-residents that are CFCs. This gives an anomalous operation of the rules where branches of foreign entities (in particular foreign banks) are used to provide financing; and in the case of CFCs. In both those cases, there does not seem to be any policy reason for treating them (especially the branches) differently to Australian residents.
5. 51AD switch off
The 'switch off' of section 51AD and Division 16D provisions are imprecise and leave some room for possible future application (even to arrangements entered into on or after 1 July 2007). This is because not all of the scope of the former provisions is covered by the term 'tax preferred use'. This potential gap is attempted to be dealt with in the EM, but it would be highly preferable if it could be dealt with by clarifying the legislation to specifically state that neither section 51AD nor Division 16D have application in respect of assets 'used' under an agreement entered into on or after 1 July 2007. Some things that could potentially still be caught by section 51AD (because of the imprecise 'switching off' language inserted in that section) are use of an asset outside of Australia by an Australian resident operating at or through a permanent establishment outside Australia; and use of any asset to which capital allowance deductions do not otherwise attach. The continued possible (although, from consultation processes and the comment in the EM, unintended) application of section 51AD (and, to a lesser extent, Division 16D) to arrangements post 1 July 2007 is unacceptable and needs to be rectified in legislative amendment.
There is considerable concern in the market place about the wording used in the legislation. The argument is that the words are clear in the new section 51AD(1A), being that a 'tax preferred use' is required, so that the references in the EM are not accessible in any case. Also, if a court were interpreting the section, it may have difficulty reconciling the fact that the language used in section 51AD(1D) (to 'switch off the section in respect of taxpayer-to-taxpayer sale and leasebacks) was able to be drafted in a very clear way – to simply say the section does not apply to property acquired on or after 1 July 2007. It might be subsequently argued by the Tax Office that, if the intention had been to shut off all operations of section 51AD from 1 July 2007 (other than relating to prior transactions), similar language could have been used in section 51AD(1A) as in section 51AD(1D) and the fact that such clear language was not used gives a necessary intention that the section is not intended to be completely 'switched off' from the relevant date. Also, in referring to the protection of the EM, the same comments made in relation to the ongoing operation of section 51AD (that 'tax preferred use' is intended to cover all application of section 51AD, in EM para 1.294) are also made in respect of the transitional rules (EM para 1.286), which are clearly not intended to apply to all applications of section 51AD (as the sale and leaseback element of section 51AD was never intended to be part of those transitional rules). Again, reliance on the EM (to the extent it is even available when the legislation is clear) is not ideal and, in this case, is also not strong enough to support a general conclusion that section 51AD cannot apply to new arrangements (from 1 July 2007). Arguments by Treasury that it is simply a drafting policy do not seem to stack up (compare section 51AD(1A) with section 51AD(1D)); and also arguments that everyone knows what is intended tend to fall by the wayside when a challenge actually arises. I think all of that supports a further request of Treasury that the amendments be made to section 51AD(1A) to make it clear that the section does not apply to any use on or after 1 July 2007 (not just tax preferred use).
6. Lease of multiple assets under a single Master Lease Agreement over time
There is ambiguity about how the rules operate where there is a single Master Lease Agreement that can cover multiple assets, over multiple periods, particularly in terms of the short-term-low-value exemption. For example, an agreement with a council to provide garbage trucks over a period, where there is a single master lease agreement, with actual assets identified in separate schedules as and when they are required, or acquired. Similarly, fleet leasing deals, which have a single master lease agreement, with multiple arrangements effected by listing assets per period in a schedule. The issue is how to determine the value for the purposes of the exemption. The Division operates on an asset by asset basis – that is one argument; another is that the master lease agreement covers the whole arrangement. Neither of those interpretations seems to be appropriate in all cases. As the preparation of a schedule of asset(s) creates each separate arrangement, albeit under the terms of the same master lease agreement, it would seem that should be the approach – ie: for the purposes of the short-term/low-value exemption in these cases, it is the value of each aggregated asset schedule per relevant period that is relevant (obviously taking account of anti-avoidance provisions ensuring that transactions are not artifically entered into across periods to attract the exemption protection). In any case, clarity should be provided in these cases, which are very prevalent for many Australian tax exempt entities.
Last Modified: Friday, 3 July 2009
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