Explanatory Memorandum
(Circulated by the authority of the Treasurer the Hon John Dawkins, M.P.)Leases of luxury cars
Overview
6.1 The Bill will insert a new section 26AK in the Income Tax Assessment Act 1936 to require an amount resulting from the application of a formula contained in the section to be included in the assessable income of lessors of luxury cars who use the "finance method" to return the lease income.
Summary of the amendment
6.2 To increase the income returned under the "finance method" by lessors of luxury cars to take account of the depreciation limit on such cars, thus ensuring that the depreciation limit is not avoided by lessors using the "finance method" to return income.
6.3 The amendment will apply from 8 July 1993 to leases existing at that date and leases entered into on or after that date.
Background to the legislation
6.4 Section 57AF of the Income Tax Assessment Act limits the depreciable cost of motor cars and station wagons to a certain price for taxation purposes. The depreciation cost limit, which is indexed each year, is $48,415 for the year ending 30 June 1994.
6.5 When a car is leased, the lessor, being the owner of the car, normally claims depreciation on that car, subject to the depreciation limits, as a deduction and includes in gross income the lease payments received from the lessee. This method of accounting for income for tax purposes is known as the gross rentals method.
6.6 Under the finance method, the lease is treated as if it were a loan from the lessor to the lessee, with lease payments dissected on an actuarial basis into a principal component and an interest component. Only the interest component is brought to account as income in the lessor's hands.
6.7 However, Justice Beaumont of the Federal Court decided in the case of Citibank Ltd. v. Federal Commissioner of Taxation 92 ATC 4822; (1992) 24 ATR 437, that Citibank Ltd. could use the finance method to return lease income received from finance leases of luxury cars, without adjusting its assessable income to reflect the section 57AF depreciation cost limit. Although the decision of Justice Beamont has been overturned by the Full Federal Court, 93 ATC 4691, the taxpayer is seeking special leave to appeal to the High Court.
6.8 The Treasurer announced on 8 July 1993 that the legislation would be amended to ensure that lessors who use the finance method to return lease income arising from the leasing of luxury motor vehicles would be required to make an adjustment to their income to take account of the depreciation limit.
Explanation of the amendment
6.9 The legislation is being amended to ensure that the income of lessors who use the finance method to return income from luxury car leases is increased to take account of the depreciation limit on such cars. The adjustment will put the lessor in much the same position, over the term of the lease, as if it had used the gross rentals less depreciation method of returning its lease income.
6.10 This change is not intended to indicate a Government or Taxation Office view on whether the finance method is, or may be, an appropriate way for lessors to return lease income.
6.11 The required adjustment is identical to that set out in Taxation Ruling No. IT 2105.
6.12 The lessor who uses the finance method excludes part of the cost of the car from its income. That part is the difference between the cost of the car and the residual value, which is treated as the principal being repaid by the lease instalments. [New subsection 26AK(5)]
6.13 Where the car costs more than the depreciation limit, the share of the excess proportionate to the share of the car's cost which the finance method excludes from income must be added to the lessor's income [Clause 24] . The adjustment formula includes that share of the excess in income on a straight line basis. So the amount included in income depends on the proportion of days in the lease which relate to the particular year of income [Clause 25; new section 26AK] .
6.14 The adjustment formula is
(C - RV) (C - DL)/ C
6.15 The proposed section only applies to lessors who get income from leasing motor vehicles to which the depreciation limits apply. [New paragraph 26AK(1)(a); definition of "eligible car", subsection 26AK(8)]
6.16 It applies to lessors who use the finance method to return income from a lease of such a motor vehicle [new paragraph 26AK(1)(b)], if they would otherwise have been entitled to depreciation for the vehicle, and if that depreciation would actually have been reduced by the operation of the limit [new paragraph 26AK(1)(c)]. This does not require that the lessor would have been entitled to a deduction on account of depreciation; for instance, the motor vehicle might have been (notionally) fully written off by the particular year of the lease, so the deduction on account of depreciation would be nil.
6.17 The proposed section includes an amount in the lessor's income. That amount is a part of the excess of the cost of the motor vehicle over the depreciation limit. For this purpose, the depreciation limit is the amount that would have been the cost of the car for the purposes of section 57AF, had that section applied to the lessor [definition of 'depreciation limit', new subsection 26AK(2)]; the cost of the motor vehicle is the amount that would be the cost if section 57AF did not apply [definition of 'cost', new subsection 26AK(2)].
6.18 The amounts included in assessable income won't usually total the whole excess of cost over the depreciation limit. Lessors who use the finance method only exclude part of the cost of a motor vehicle from assessable payments. That part is the difference between the cost of the motor vehicle and its residual value - that is, the residual value it is given for the purposes of the lease [definition of 'residual value', new subsection 26AK(2)]. So it is only that proportion of the excess that must be included in assessable income.
6.19 The proposed section includes an amount in assessable income for a particular year of income on the basis of the proportion of the lease that relates to that year of income. This is worked out according to the ratio of eligible lease days to total lease days. Total lease days include all the days covered by the lease, ignoring both early termination and any possible extension or renewal [definition of 'total lease days', new subsection 26AK(2); new subsection 26AK(7)].
6.20 Eligible lease days for a particular year of income include the days during the year on which the lease was in effect. Eligible lease days for a particular year also include a number of days to cover payments made on early termination to substitute for the remaining lease payments. A lease could be terminated early during a particular year of income. If payments are made on an early termination to substitute for the remaining lease payments, the lessor has the benefit of payments equal to a proportion of those lease payments. In that case, the additional income of the lessor includes an additional amount, to cover the proportion of the remaining days in the lease for which an equivalent additional payment is made [definition of 'eligible lease days', new subsection 26AK(2)].
6.21 These additional days are calculated as a proportion of the number of days from the termination of the lease to the end of what would otherwise be its period [definition of 'post-termination days', new subsection 26AK(3)]. That proportion is based on the ratio between the payments made to substitute for the remaining lease payments, and those remaining payments [new subsection 26AK(3)]. However, any payments to make up a guaranteed residual value or acquire the property at that value are not included in either figure. This is because such payments are neither periodic payments under the lease, nor payments in lieu of such payments.
6.22 As the number of days in a year on which the lease was in effect could include all the days in the year, there can be more days than a year's worth of eligible lease days for a particular year of income, but only if additional days are included because of early termination of the lease.
When do the changes take effect?
6.23 Because the new provisions are only to include additional income from the date of the Treasurer's announcement, several provisions operate from that date, 8 July 1993. The new provisions first apply to a lessor for the year of income which includes 8 July 1993, a wording which ensures that taxpayers with substituted accounting periods are not advantaged over other taxpayers [paragraph 26AK(1)(d)]. The eligible lease days do not include days before 8 July 1993, or days arising through an early termination of the lease before 8 July 1993 [definition of 'eligible lease days', subsection 26AK(2)].
6.24 Some other provisions help to clarify the operation of the provisions. Because the depreciation limit is worked out on the basis that would have applied had the lessor declared gross rentals for income tax purposes, that method, the gross rental method, is specified [new subsection 26AK(6)]. It applies to the method under which income includes all the periodic payments of the lessee.
6.25 To avoid possible dispute over the ordinary meaning of 'lease', new subsection 26AK(8) includes a definition extending to any arrangements described as finance leases by accounting principles, and giving corresponding meanings to 'lessor' and 'lessee'. Any such arrangements, whether properly leases or not, would be likely to be accounted for using the finance method.
6.26 Assume that a lessor purchases a car for $90,000. The car is leased out under a lease with a residual value of $30,000. To make the calculation simpler, it is assumed that the depreciation limit for that particular year is $50,000.
6.27 In effect the amount of the cost of the car which is to be paid to the lessor, the "principal" on the loan, is the difference between the cost of the car and the residual value. So the "principal" is cost minus residual value (C - RV).
6.28
C - RV = $90,000 - $30,000 = $60,000
The excess of the cost of the car over the depreciation limit is C - DL.
C - DL = $90,000 - $50,000 = $40,000
The income of the lessor will be increased by
(C - RV) (C - DL) / C
= $60,000 x $40,000 / $90,000 = 2/3 x $40,000 = $26,666
6.29 This amount is to be included in the assessable income of the lessor over the period of the lease.
I lease a luxury car. Will I be affected by this change?
6.30 No. Only the lessor will be affected by the change.
What happens if the lease is terminated early?
6.31 If the lessee needs to pay an additional amount to the lessor in the event of an early termination, the income adjustment which the lessor needs to make will be altered. The number of "lease days in year" will be increased. As the additional amount which the lessee may need to pay may be less than the lease payments which it replaces, it would be inequitable for the lease days to be increased by the unexpired days of the lease. The proposed amendment provides a formula to adjust the additional number of days appropriately.
Could this lead to the number of "lease days in year" exceeding 365?
6.32 Yes.
What if the lease is renewed or extended?
6.33 Perhaps a simple extension of the term of a lease, with no change to the rate of periodic payments or to the residual value, is not a further lease. In that case the new section 26AK would include in income the correct proportion of the excess of cost over the depreciation limit, spread over the original term. The extension would not lead to the inclusion of any more additional income.
6.34 If a supposed renewal or extension of a lease specified a new residual value, this would amount to a fresh lease. The new section 26AK would apply to that new lease, with a cost of the property equal to the residual value under the previous lease and a new residual value. It would not apply on the basis of the original cost of the motor vehicle under the former lease.