Revised Explanatory Memorandum(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)
Chapter 2 - Deducting prepayments
2.1 This Chapter explains the amendments to the ITAA 1936 made by Parts 1 to 3 of Schedule 2 to this Bill. The amendments implement the Government's decision to prevent prepayments under tax shelter arrangements being immediately deductible. These prepayments must be deducted on a proportional basis over the period during which the benefits attributable to the prepayment are provided.
What is the current treatment of prepayments?
2.2 Section 82KZM of the ITAA 1936 disallows an immediate deduction for prepayments that are deductible under the general deductions provision, section 8-1 of the ITAA 1997, unless they are incurred for something that is to be done wholly within 13 months.
2.3 Amendments made by the Integrity and Other Measures Actto Subdivision H of Division 3 of Part III of the ITAA 1936 changed the law in relation to deducting prepayments. The change provided that, for prepayments incurred after 11.45 am, by legal time in the Australian Capital Territory, on 21 September 1999, immediate deductibility is no longer available to businesses other than small businesses, subject to a 4 year transitional period. These taxpayers are now always required to spread deductions for prepayments incurred in carrying on a business over the period the prepayment covers or 10 years if that is less. These amendments are referred to as 'stage 1' amendments.
2.4 Prepayments by small business and non-business taxpayers for things to be done within 13 months are unaffected by the stage 1 amendments.
Why is the current law being changed?
2.5 Under the current law, including stage 1 amendments, the key feature of many tax minimisation arrangements (or so-called 'tax shelters'), particularly end-of-year schemes, is the reliance on the existing 13 month prepayment rules to obtain a tax benefit. This is particularly the case where the benefit is derived from the mismatch between the time when the assets or services are provided and the earlier time when the deduction may be claimed.
2.6 The measure contained in this Bill ('stage 2 amendments') will provide a structural solution to limit the tax advantages that are derived from participation in tax shelter arrangements by limiting immediate deductibility for certain prepayments. This is achieved by requiring deductions for those prepayments to be matched to the time over which the benefits are provided.
2.7 The stage 2 amendments will not allow immediate deductibility for prepayments of expenditure under 'tax shelter' type arrangements. The prepaid expenditure to which the rules apply is that which is deductible under section 8-1 of the ITAA 1997. The rules do not affect the entitlement to the deduction nor the amount which may be deducted, rather they alter the timing of deductibility of prepayments made under those arrangements.
2.8 The deduction for the expenditure will have to be apportioned over the period that the prepaid benefits are provided. An apportionment rule will determine how much of the prepaid expenditure a taxpayer may deduct for each income year.
2.9 Prepayments by businesses other than small businesses, which are not in respect of tax shelter arrangements, will still be covered by the stage 1 transitional rules.
2.10 A number of specific prepayments are excluded from the scope of the measure. The excluded prepayments are:
- interest for the acquisition of, and building, contents and rent protection insurance in respect of, real property;
- interest for the acquisition of listed shares and widely held units;
- interest on a loan used to acquire infrastructure borrowings under the former tax exempt infrastructure borrowing scheme;
- prepaid 'excluded expenditure';
- those made under a pre-existing contractual obligation that existed before 1 pm, by legal time in the Australian Capital Territory, on 11 November 1999; or
- those made under arrangements which, prior to the announcement of the measure, had obtained, or had applied for and later obtained, a favourable ATO product ruling in respect of the arrangement.
2.11 The stage 2 amendments apply to prepaid expenditure incurred under tax shelter arrangements after 1 pm, by legal time in the Australian Capital Territory, on 11 November 1999.
|New law||Current law|
2.12 The stage 2 amendments will prevent immediate deductibility for prepaid expenditure for things that relate to a tax shelter type arrangement. Instead, the deduction for the expenditure will be apportioned over the period that the benefits are provided.
2.13 The central conditions under which this measure will apply describe the type of payment and the type of arrangement to which the payment relates. Where these conditions are satisfied, the deduction for the prepaid expenditure will be apportioned over the period that the benefits are provided. [Schedule 2, item 7, sections 82KZME and 82KZMF]
Treatment of the prepaid expenditure
Apportionment of the deduction
2.14 The operative provision is stated as a proportional deduction and applies to expenditure incurred by a taxpayer in a year of income. The fraction of the amount subject to the new treatment is worked out by dividing the number of days (including part days) the prepaid expenditure covers in the current income year by the total number of days it covers. The formula in paragraph 82KZMF(1)(b) implements this. [Schedule 2, item 7, subsection 82KZMF(1)(b)]
Example 2.1 Claire makes a prepayment of $10,000 for services in relation to a managed vineyard on 14 June 2000. The services are to be provided between 14 June 2000 and 30 December 2000.Claire may claim a deduction for $850 in the 2000 income year (i.e. 17 200 $10,000) and $9,137 in the 2001 income year (i.e. 183 200 $10,000).
2.15 If the stage 2 amendments apply to prepayments that would otherwise fall within the transitional rules in the stage 1 amendments, those transition rules do not operate [Schedule 2, item 7, subsection 82KZMF(3)] . The rules apply immediately from 1 pm, by legal time in the Australian Capital Territory, on 11 November 1999, as discussed in paragraph 2.40.
2.16 The new rules have effect despite section 8-1 of the ITAA 1997. Whilst the prepaid expenditure must first be deductible under section 8-1, the new rule will override section 8-1 to apportion the amount deductible over the period that the services for which the prepayment is made are performed. [Schedule 2, item 7, paragraph 82KZMF(2)(a)]
To what prepaid expenditure do the new rules apply?
2.17 For the stage 2 amendments to apply, there must first be expenditure which is deductible under the general deduction provision section 8-1 ITAA 1997. [Schedule 2, item 7, paragraph 82KZME(1)(a)]
2.18 The expenditure must be incurred after 1 pm, by legal time in the Australian Capital Territory, on 11 November 1999 under an arrangement that provides for the doing of a thing that is not to be wholly done within the expenditure year, that is, the expenditure is a prepayment. [Schedule 2, item 7, subsection 82KZME(2)]
Arrangements covered by the measure
What is the scope of arrangement?
2.19 In the income tax law the concept of an agreement has a very broad meaning, including amongst other things an 'arrangement undertaking or scheme'. The stage 2 amendments apply to prepaid expenditure under agreements for the doing of things in respect of tax shelter agreements. In order that the scope of an 'agreement' is not limited the amendments provide that an 'agreement' referred to in the new rules includes all activities that relate to the agreement, including those that give rise to deductions or assessable income. [Schedule 2, item 7, subsection 82KZME(4)]
2.20 The broader 'tax shelter arrangement' includes all the particular contracts for the performance of specific things in relation to the tax shelter. Contracts which provide for borrowings and prepayments can be considered a subset of the broader tax shelter arrangement. For example, in an agricultural scheme, the broader arrangement would encompass the financing of and investment by the taxpayer in the scheme and the operation of the scheme by the promoter or manager. Under the new rules, the specific contract or contracts for planting, watering or pest control would be subsets of the broader arrangement. This may also be described in terms of the arrangement producing assessable income and deductions, whereas the individual contract(s) give rise to specific deductions. [Schedule 2, item 7, subsection 82KZME(4)]
Example 2.2 Greg decides to invest in a pine plantation scheme. The investment is essentially a passive one, so he chooses a scheme under which the scheme promoter organises financing for him, transfers the funds invested to the scheme and liaises with the plantation manager.In this situation the organising of the financing for Greg by the promoter, the provision of the funds to the scheme and the management of the scheme are the activities which subsection 82KZME(4) requires to be taken into account in describing the arrangement to which the tests in subsection 82KZME(3) would be applied.
Example 2.3 Another taxpayer, Bill, decides to invest in an ostrich farming scheme. He arranges his own financing for the investment, but the other aspects of the investment are similar to those for Greg's pine scheme.In this situation Bill's arrangement of his own financing for the investment would be an element of the arrangement, as well as the transfer of the funds to the manager and the management of the scheme on behalf of Bill and other investors. This is because the funds that Bill borrows and the interest deduction are directly related to the activities under the arrangement.
When is an arrangement a tax shelter?
2.21 The arrangements at which these rules are targeted are those that may be characterised as tax shelter arrangements. The term 'tax shelter' is not used in the legislation. Rather, the legislation describes these arrangements by focussing on 3 required characteristics. The deduction apportionment rule will apply where these characteristics exist for an arrangement and the requirements for the prepayment are also satisfied, unless one of the specific exclusions referred to in paragraph 2.26 to 2.34 applies.
2.22 The first required characteristic is that, for the year when the prepayment is incurred, the taxpayer's allowable deductions under the arrangement exceed the taxpayer's assessable income from the arrangement [Schedule 2, item 7, paragraph 82KZME(3)(a)] . The tax shelter effect arises from the fact that the taxpayer would, apart from this measure, offset the excess of the deductions over assessable income from the arrangement against their other income, thereby reducing their taxable income and tax payable. This requirement would include circumstances where no assessable income is derived in particular income years.
2.23 The second required characteristic is that the taxpayer does not have the day-to-day control of the arrangement, even though they may have organised their own finance, have occasional input in some decisions or occasionally participate in the activities [Schedule 2, item 7, paragraph 82KZME(3)(b)] . In practice, all significant aspects of the day-to-day conduct of the arrangement are managed by someone else.
2.24 The third key characteristic of the arrangements to which the new rules are to apply, is that they are promoted to a group of investors by those that arrange, manage or promote them.
2.25 This characteristic of the arrangement is encapsulated in the law by 2 alternative requirements. The first requirement is that there is more than one participant in the arrangement, not only the taxpayer. The alternative requirement is that the person who manages, arranges or promotes the arrangement, or an associate of such a person manages, arranges or promotes similar arrangements for other taxpayers. [Schedule 2, item 7, subparagraphs 82KZME(3)(c)(i) and (ii)]
Exclusions from the operation of the rules
2.26 Certain prepayments are specifically excluded from the operation of the new rules.
2.27 The first category of excluded prepayments are those that are in respect of certain investments that are commonly negatively geared. This category of exclusion will ensure that such investments entered into by investors are not affected by the new stage 2 amendments. [Schedule 2, item 7, subsection 82KZME(5)]
2.28 The specific types of prepaid expenditure which are excluded are:
- premiums for building, contents or rent protection insurance; or
- interest on borrowings to acquire real property or interests in real property, publicly listed shares or units in widely held unit trusts,
but only where:
- the only income derived from the investment is rent, dividends or trust income; and
- the arrangement is conducted at arm's length.
[Schedule 2, item 7, subsection 82KZME(5)]
2.29 The second category is a specific exclusion from the measure for prepayments in respect of infrastructure bonds under which the lender is entitled to a tax concession under Division 16L of Part III of the ITAA 1936. [Schedule 2, item 7, Subsection 82KZME(6)]
2.30 The third category of prepaid expenditure excluded from the operation of the apportionment rules is that which is 'excluded expenditure' under the existing rules. This applies where the prepaid expenditure under the arrangement is less than $1,000, is a payment of salary and wages or is required to be paid by law or a court order. [Schedule 2, item 6, subsection 82KZME(7)]
2.31 The fourth exclusion category provides that the new rules will not apply to prepayments under existing contractual obligations. The contractual obligations must:
- exist under an arrangement at or before 1 pm, by legal time in the Australian Capital Territory, on 11 November 1999;
- require the payment of an amount before the doing of the thing it is for; and
- not be avoided by unilateral action of the taxpayer.
[Schedule 2, item 7, subsection 82KZME(8)]
2.32 This exclusion category ensures that taxpayers who have committed themselves to making a prepayment before the commencement of the stage 2 amendments will not be affected by the new rules.
2.33 The final specific exclusion excludes the operation of the new rules to investors in an arrangement for which, at 1 pm, by legal time in the Australian Capital Territory, on 11 November 1999;
- an ATO product ruling had issued; or
- a formal application for an ATO product ruling had been lodged with, and acknowledged by, the ATO and this leads to the issue of a product ruling.
[Schedule 2, item 7, subsection 82KZME(9) and (10)]
2.34 This exclusion applies to all investors for prepaid expenditure in respect of that project and over the whole term of the project.
Application of new rules to medium and large businesses
2.35 The stage 1 amendments provided that from 11.45 am, by legal time in the Australian Capital Territory, on 21 September 1999, medium and large business taxpayers must apportion prepaid expenditure, subject to certain exclusions and transitional, rules over the period that the benefits are provided.
2.36 The special transitional rules which apply under stage 1 are, in effect, switched off where the prepaid expenditure is under a 'tax shelter arrangement'. [Schedule 2, item 7, subsection 82KZMF(3)]
2.37 Other prepaid expenditure incurred by medium and large business taxpayers will continue to be apportioned by the stage 1 rules, subject to the 4 year transitional rules from 11.45 am, by legal time in the Australian Capital Territory, on 21 September 1999.
Prepayments are still subject to the commercial debt forgiveness rules
2.38 The new rules for prepayments under tax shelter arrangements will operate subject to Division 245 of Schedule C of the ITAA 1936, which deals with the forgiveness of commercial debts. In general terms, a taxpayer who has a commercial debt that is forgiven may be required to reduce some of their deductions, including those for prepayments covered by the rules explained in this Chapter. [Schedule 2, item 7, paragraph 82KZMF(2)(b)]
2.39 Part 2 of Schedule 2 to this Bill amends the new and existing rules in Subdivision H of Division 3 of Part III of the ITAA 1936 in respect of prepayments made after 11.45 am, by legal time in the Australian Capital Territory, on 21 September 1999 to take account of the cessation of the operation and repeal of the transitional rules from the stage 1 amendments for businesses that are not small businesses. [Schedule 2, items 8 to 10]
2.40 The stage 2 amendments made by Part 1 of Schedule 2 apply to expenditure incurred by a taxpayer after 1 pm, by legal time in the Australian Capital Territory, on 11 November 1999, and the taxpayer's assessments for the year of income including that day and for later years of income. [Schedule 2, subitem11(1)]
2.41 The amendments made by Part 2 of Schedule 2 to repeal redundant references apply to expenditure incurred by a taxpayer in a year of income after the taxpayer's year of income that includes 21 September 2002. [Schedule 2, subitem 11(2)]