House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

General outline and financial impact

Amendment of the Sales Tax (Exemptions and Classifications) Act 1992

Amends Item 192 of the Sales Tax (Exemptions and Classifications) Act 1992 (ST(EC)A 1992) to ensure that sales tax exemption for goods incorporated into properties owned by, or leased to, always exempt persons (AEPs) or the government of a foreign country is only available for the purchase of goods principally for their own use or for use by organisations conducting the business of AEPs or the government of a foreign country.

The following types of property will also be ineligible for sales tax exemption:

•

shops and shopping centres;

•

hotels;

•

casinos;

•

apartment blocks.

Date of effect: The amendment applies to dealings after 2 April 1998, unless the goods concerned were acquired on or before 2 April 1998.

Proposal announced: The amendment was originally contained in Taxation Laws Amendment Bill (No. 4) 1998 which was introduced into the House of Representatives on 2 April 1998. That Bill lapsed when Parliament was prorogued.

Financial impact: Estimated gain in revenue of $10 million in 1997-98 and $50 million in 1998-99 and subsequent years.

Compliance cost impact: The Compliance Cost Impact Statement is incorporated into the Regulation Impact Statement which appears at the end of Chapter 2 of the Explanatory Memorandum.

SUMMARY OF REGULATION IMPACT STATEMENT

Impact: Low

Main points:

•

There is a deficiency in the sales tax law which allows a private entity who has a contract with an AEP or a government of a foreign country (foreign government) to obtain the benefit of a sales tax exemption for certain goods incorporated into properties owned by, or leased to, that AEP or foreign government. That deficiency can only be overcome by making an amendment to the ST(EC)A 1992.

•

The amendment will have the effect that private entities who have contracts with AEPs or foreign governments will no longer be entitled to the sales tax exemption for goods attached to land owned by, or leased to, AEPs or foreign governments, where the land is not used by the AEP or foreign government but used by a private entity as, eg. a casino, shopping centre or other commercial development.

•

The amendment facilitates competitive neutrality:

-

between entities operating on properties owned by or leased to an AEP or foreign government and entities who conduct a similar business on other properties without access to sales tax free goods; and

-

between functions performed directly by AEPs or foreign governments and functions carried out by a private entity on behalf of an AEP or foreign government.

•

This measure will result in an estimated gain to revenue of $10 million in 1997-98 and $50 million in 1998-99. The compliance costs for this measure cannot be reliably quantified because it is uncertain how many people have structured their arrangements to gain the unintended access to the sales tax exemption. The administrative costs to the Australian Taxation Office (ATO) of this change relate mainly to advising clients on the application of the proposed amendments to various construction projects. The compliance costs to taxpayers (including contractors and subcontractors involved in the construction or repair of properties belonging to or leased by an AEP or a foreign government) due to this change involve:

-

learning about the change to the law; and

-

incurring costs in obtaining professional advice as to their tax status.

•

The benefit of removing the unintended access to the exemption outweighs the costs of this measure. The ATO will monitor this measure as part of the whole taxation system on an ongoing basis, as well as obtaining feedback through consultation with professional, small business and other taxpayer consultation forums.

Arrangements treated as a sale and loan and limited recourse debt

Amends the income tax law to:

•

include an amount in the assessable income of a taxpayer where amounts are unpaid on the termination of a hire purchase or limited recourse debt arrangement. The adjustment will apply where capital expenditure has been financed by the hire purchase or limited recourse debt but, because amounts remain unpaid, deductions have been allowed that exceed deductions that would be allowable if based on actual outlays.

•

treat taxpayers who acquire capital assets by hire purchase or installment sale as the owners of those assets for the purpose of determining eligibility for capital allowance deductions and relevant anti-avoidance provisions.

•

treat a hire purchase or installment sale as though it were a loan transaction. If the asset is used for income producing purposes, the hire purchaser is able to deduct the finance charge component of the hire purchase payments, and the financier is taxed on that component of the payments, but not the payments themselves.

Date of effect: Adjustments to taxable income relating to unpaid amounts under hire purchase and limited recourse debt arrangements apply to such arrangements which terminate after 27 February 1998. The rules which treat hire purchasers as the owners of assets under hire purchase, and a hire purchase arrangement as a sale, loan and debt transaction, apply to relevant transactions entered into after 27 February 1998.

Proposal announced: 1997-98 Budget, 13 May 1997 and by Press Release No. 60 of 1997 and No. 21 of 1998.

Financial impact: The gain to revenue from this measure will be approximately $40 million in 1998-1999, $50 million in 1999-2000, $50 million in 2000-2001, $50 million in 2001-2002, $50 million in 2002-2003 and $50 million in 2003-2004.

Cost of compliance impact: The initial and recurrent compliance costs are estimated to be less than $1 million per annum.

SUMMARY OF REGULATION IMPACT STATEMENT

Policy objective:

To ensure that total deductions for allowable capital expenditure do not exceed the total amount actually expended by a taxpayer where the expenditure has been financed under hire purchase or limited recourse debt arrangements.

Implementation options:

Option 1: Insert a capital expenditure adjustment rule to apply on termination of the financial arrangement. The adjustment amount is the difference between the total net capital allowance deductions obtained and deductions that would be allowable on the basis of the capital amount actually expended by the taxpayer under the financing arrangement. The adjustment amount would be included in the borrowers assessable income.

Option 2: Incorporate a capital expenditure adjustment rule into existing adjustment calculations which apply on the disposal of property. This option would amend existing rules that apply to various capital allowance provisions. The amendment would ensure that any unpaid principal under the financial arrangement was included in the calculation of any adjustment rule on disposal of the relevant property.

Regulation Impact on Business

Impact: Low

•

This measure affects taxpayers claiming capital allowances on property financed by hire purchase or limited recourse debt and who do not discharge their payment obligations.

•

The number of private ruling requests will increase in the short term. This workload is expected to be dealt with within existing resources.

•

To the extent that proposed rules which treat a hire purchaser as the owner of the property for capital allowances will formalise the existing administrative practice, no significant additional compliance costs to taxpayers are expected.

•

Compliance costs are likely to be less under Option 1 because the adjustment rule would be common to all capital allowances.

•

The initial and recurrent compliance costs of this proposal are estimated to be less than $1 million per annum on the expectation that only a small percentage of taxpayers will terminate their hire purchase or limited recourse debt transactions while amounts are unpaid.

Conclusion:

Option 1 is preferred. It requires less complex legislative drafting and its application on the termination of the relevant financial transaction eliminates any additional adjustments that may be necessary if the capital expenditure adjustment were to apply on disposal of the underlying asset.

Chapter 1 - Amendment of the Sales Tax (Exemptions and Classifications) Act 1992

Sales tax measures

1.1 This Chapter deals with an amendment of the Sales Tax (Exemption and Classifications) Act 1992 (ST(EC)A 1992). The measure deals with property owned or leased by always exempt bodies.

Overview

1.2 Item 1 of Schedule 1 to the Bill will remove the unintended access to sales tax exemption for certain goods used in the construction or repair of property owned by, or leased to, an always exempt person (AEP) or the government of a foreign country (foreign government) unless:

•

the property is principally occupied by the AEP or the foreign government; or

•

the occupant has a contract to provide services to the AEP or the foreign government and the property is used principally for the provision of those services.

1.3 Item 1 also provides details of properties which will be ineligible for the exemption regardless of the occupier or owner.

Summary of the amendments

Purpose of the amendments

1.4 The amendment proposes to overcome a deficiency in the sales tax law which allows a private entity who has a contract with an AEP or foreign government to obtain the benefit of sales tax exemption for certain goods incorporated into properties owned by, or leased to, that AEP or foreign government.

Date of effect

1.5 The amendment will apply to any dealing after 2 April 1998, unless the goods concerned were acquired on or before 2 April 1998. This ensures that goods acquired on or before 2 April 1998 will continue to be exempt from sales tax. [Item 2]

Background to the legislation

1.6 Item 192 of Schedule 1 to the ST(EC)A 1992 provides a sales tax exemption for certain goods incorporated into any property owned or leased by an AEP or foreign government.

1.7 It is a condition of the exemption that a contract must exist between the AEP or foreign government and the person who incorporates the goods into the property. Alternatively, where the property is privately owned and leased by the AEP or foreign government, the contract would be between the lessor and the person carrying out the work. In the latter case the exemption only covers work that is required to be done under the lease with the AEP or foreign government.

1.8 This exemption is available regardless of whether the AEP or foreign government is ever to occupy the property, and regardless of whether the activity to be conducted from the property is related to the purposes of the AEP or foreign government.

1.9 The broad scope of Item 192 of the ST(EC)A 1992 is being used for commercial development on land owned by, or leased to, an AEP or foreign government. This is not consistent with the original intention of the exemption. In particular it is being used to ensure that at least part of the exemption is going to private sector commercial developments at the expense of the Commonwealth revenue. This provides unfair competitive advantages to these developments.

1.10 Examples of the types of private sector projects benefiting from the Item 192 exemption by taking advantage of being located on land leased from or owned by State and local governments (AEPs) include:

•

the building of residential apartments by private consortia;

•

the refurbishment of shopping centres;

•

the building and refurbishment of private sports facilities; and

•

the fitout of major hotels and casinos.

1.11 The amendment was originally contained in Taxation Laws Amendment Bill (No. 4) 1998 which was introduced into the House of Representatives on 2 April 1998. That Bill lapsed when Parliament was prorogued.

Explanation of the amendments

1.12 Item 1 provides that where exemption is currently available under the existing Item 192 of the ST(EC)A 1992, it will only continue to be available where:

•

the property constitutes housing which is provided by an AEP at a rate below market rate; or

(a)

the property is

•

occupied principally by an AEP or foreign government; or

•

used by a service provider to an AEP or foreign government where the property is used principally for providing those services; and

(b)

not ineligible Item 192 property.

1.13 Concern was raised with the use of the term occupied (in Item1) when this measure was before the Senate Economics Legislation Committee on 5 August 1998, as Schedule 1 to the Taxation Laws Amendment Bill (No. 4) 1998. Whether a property is occupied principally by an AEP or foreign government will generally be a question of fact. As such it will be necessary to look at factors such as ownership, possession and control of the property.

1.14 In relation to various infrastructure projects the amendment is not intended to impede the private sector provision of public sector infrastructure projects such as: toll roads, prisons, hospitals and water and sewerage treatment plants. In normal circumstances, where the private sector is involved in the provision of these types of projects it would be expected that they would fall within the scope of providing services to the AEP or foreign government and continue to qualify for exemption by virtue of the proposed new subparagraph 4(a)(ii) in Item 1 .

1.15 The following properties are ineligible Item 192 properties:

•

shops and shopping centres;

•

hotels;

•

casinos;

•

apartment blocks;

•

any properties mainly consisting of a kind which are similar to the above type of properties; and

•

any properties of a type prescribed by regulation as ineligible Item 192 properties. [Item 1]

1.16 The application of Item 192 is illustrated by the following chart:

Regulation Impact Statement

1. Specification of policy objective

1.17 The policy objective of this measure is to remove unintended access to the sales tax exemption, under Item 192 of the ST(EC)A 1992, for goods used in the construction or repair of property owned by, or leased to AEP or foreign government.

2. Identification of implementation options

1.18 The objective can only be achieved by an amendment to the ST(EC)A 1992.

3. Assessment of impacts (costs and benefits) of each option:

Impact group identification

1.19 The following groups will be impacted by the proposed amendment:

•

some AEPs eg. Public Benevolent Institutions, Commonwealth, State and local Governments, public and private non-profit hospitals, public and private non-profit schools and universities where these bodies own or construct properties that are unlikely to satisfy the new requirements of Item 192, exemption will no longer be available for goods used to construct or repair those properties;

•

some contractors and subcontractors who purchase goods, after 2 April 1998, for use in the building or refurbishment of properties for AEPs or foreign governments;

•

some private businesses currently receiving sales tax exemption for goods used in the construction or repair of properties on land belonging to, or leased by an AEP or foreign government, will lose that entitlement as a result of the proposed amendment;

•

the Australian Taxation Office (ATO); and

•

some private sector tax professionals.

Assessment of costs

Compliance costs

1.20 The compliance costs for this measure are difficult to quantify as the prevalence of arrangements structured to gain the unintended access to the sales tax exemption is uncertain. Additional compliance costs may be incurred as people need to ensure that they satisfy the new tests before claiming the exemption.

1.21 The compliance costs to taxpayers due to this change involve:

•

learning about the change to the law; and

•

incurring costs in obtaining professional advice as to their tax status.

Other costs

1.22 The administrative costs to the ATO of this change relate mainly to advising clients on the application of the proposed amendments to various construction projects.

Assessment of benefits

Financial impact

1.23 This measure will result in an estimated gain to revenue of $10million in 1997-98 and $50 million in 1998-99.

Other benefits

1.24 The exemption was wide enough to provide a sales tax exemption for goods incorporated into properties owned by, or leased to, AEPs and foreign governments but used by people other than AEPs or foreign governments. However, some private sector firms have captured the benefit of this exemption for projects in a manner not envisaged by the Parliament eg. casinos, shopping centres etc. The amendment will have the effect that private entities who have contracts with AEPs or foreign governments will no longer be entitled to the sales tax exemption for goods attached to land owned by, or leased to, AEPs or foreign governments but which are not used by the AEP or foreign government. The amendment will not apply where the private entity carries out the kind of function ordinarily performed by the AEP or foreign government on their behalf.

1.25 This amendment incorporates competitive neutrality between functions performed directly by AEPs or foreign governments and functions carried out by a private entity on behalf of an AEP or foreign government.

1.26 Entities operating on properties owned by or leased to an AEP or foreign government will no longer enjoy the competitive advantage of obtaining sales tax free goods compared to other parties who conduct similar business on other properties and do not enjoy access to sales tax free goods.

Consultation

1.27 This measure is designed to remove unintended access to the sales tax exemption, under Item 192 of the ST(EC)A 1992, and as such it was not possible to engage in public consultation prior to the measure being introduced into the Parliament.

4. Conclusion

1.28 The benefit of removing unintended access to the exemption outweighs the costs of this measure. The ATO will monitor this measure, as part of the whole taxation system, on an ongoing basis. In addition, the ATO has consultative arrangements in place to obtain feedback from professional and small business associations and through other taxpayer consultation forums.

Chapter 2 - Arrangements treated as a sale and loan and limited recourse debt

Overview

2.1 Schedule 2 to the Bill will insert new Divisions 240 and 243 into the Income Tax Assessment Act 1997 (ITAA 1997). New Division 240 will treat hire purchase arrangements as equivalent to sale, loan and debt transactions. New Division 243 will ensure that deductions for capital allowances do not exceed the total amount expended by a taxpayer where expenditure relating to the capital allowances has been financed by limited recourse debt or hire purchase.

2.2 Parts 2 and 3 of Schedule 2 contain technical amendments to the ITAA 1997 and the Income Tax Assessment Act 1936 (ITAA 1936) that are consequential upon the enactment of new Divisions 240 and 243 .

2.3 Part 4 of Schedule 2 inserts a rule into the ITAA 1936 and ITAA 1997 to ensure persons who own property will retain ownership for taxation purposes where legal title is transferred by way of security only.

2.4 Part 5 of Schedule 2 contains the relevant application dates of the amendments.

Summary of the amendments

Purpose of the amendments

2.5 The amendments have the following broad features:

•

hire purchase and installment sales are treated as the equivalent of sale, loan and debt transactions;

•

persons who acquire goods under hire purchase or installment sales arrangements are treated as the owners of the goods for the purpose of applying the various taxation capital allowances and relevant anti-avoidance provisions;

•

owners of goods who transfer title to goods by way of security under a chattel mortgage or other charge over the goods are not taken to lose their ownership interest in the goods;

•

deductions for allowable capital expenditure, eg. plant depreciation and income producing building allowances, will not exceed total amounts actually expended by a taxpayer where the expenditure has been financed by hire purchase or limited recourse debt;

•

total amounts actually expended are the principal amounts paid under the hire purchase or limited recourse debt, and other capital payments in respect of the expenditure; and

•

where deductions allowed exceed deductions that would have been allowed if all of the capital payments under the hire purchase or limited recourse debt had been made, the excess is included in assessable income of the year in which the hire purchase or limited recourse debt arrangement is terminated.

Background to the legislation

2.6 These measures have become necessary as taxpayers may currently obtain deductions greater than the total amounts they outlay in relation to capital expenditure under hire purchase or limited recourse debt. This occurs typically where the balance of an outstanding debt that has financed the expenditure is not paid and the financier can only recover a specific asset on the termination of the finance arrangement.

2.7 Under present law, capital allowances are based on the initial cost of an asset or specified capital expenditure but do not take into account any non-payment under related financing transactions.

2.8 Some capital allowance provisions require a balancing adjustment calculation to be made when the property is disposed of. The difference between its written-down tax value and its disposal price is brought to tax as a balancing adjustment, either as taxable income where there is a gain (balancing charge), or as a deduction where there is a loss. The balancing adjustment is to ensure that deductions for capital allowances do not exceed the net cost of the asset. However, deductions for capital allowances and balancing adjustments are calculated on the basis that the cost is actually incurred and is ultimately paid or payable. Where assets are financed under hire purchase or by limited recourse debt arrangements, the total cost may not be expended if principal amounts remain unpaid at the termination of these arrangements.

2.9 The proposed amendment, whereby taxpayers acquiring assets by hire purchase or installment sales are treated as owners of the assets, will ensure that the same person who is eligible to obtain relevant capital allowances is liable to adjustments which reflect non-payment of amounts, eg. under the hire purchase agreement.

Explanation of the amendments

Part 1 - Financial transactions

New Division 240 - Arrangements treated as a sale and loan

2.10 New sections 240-1 to 240-7 explain the broad taxation effects of the new Division 240 in relation to transactions that they apply to and the parties to such transactions.

2.11 The arrangements eg. hire purchase transactions, are recast as a sale of property by a financier (called the notional seller ) to a buyer (called the notional buyer ), financed by loan by the notional seller to the notional buyer. The selling price (called the notional sale price ) is either the agreed cost or value, or the property arms length value.

2.12 If the property is not trading stock, the notional seller will be required to treat as assessable income any profit on the sale, as well as any profit on a later sale of the property after they have been re-acquired. The notional seller is also taxable on the finance charge component of payments that are made under the arrangement. Those taxation consequences occur instead of those that would result otherwise. For example, because the transaction is treated as a sale, the notional seller ceases to be the owner and is not entitled to deduct relevant capital allowances such as depreciation.

2.13 For the notional buyer, the cost of the property is the same as the selling price. The consequences of the transaction are that the notional buyer is treated as the owner of the property and is entitled to relevant taxation benefits such as depreciation deductions or, if the property is trading stock, deductions for the cost.

2.14 Whereas the notional seller is taxable on the finance charge component of the payments, the notional buyer may deduct a corresponding amount if the property is used wholly for income producing purposes. The actual payments under the arrangement, eg. hire purchase payments under a hire purchase agreement, are not deductible.

New Subdivision 240-A: Application and scope of Division

Application of this Division

2.15 New section 240-10 lists the arrangements which new Division 240 will treat as a notional sale and notional loan, the kind of property to which the arrangement may relate, any special conditions that need to be satisfied and any special rules that apply to particular arrangements. In this Bill, the table in new section 240-10 lists only hire purchase agreements in relation to any kind of goods. Special conditions applicable to hire purchase are contained in new Subdivision 240-I . It should be noted that the definition of hire purchase agreement in section 995-1 of the ITAA 1997 includes an agreement for the purchase of goods by installments where title in the goods does not pass until the final installment is paid, ie. installment sales.

Scope of this Division

2.16 The rules contained in new Division 240 relating to arrangements to be treated as sale and loan transactions apply for all purposes of the ITAA 1936 and the ITAA 1997, but do not affect the application of capital gains rules nor provisions relating to liability for withholding tax on dividends, interest and royalties paid to non-residents. [New section 240-15]

New Subdivision 240-B: The notional sale and notional loan

Who is the notional seller and the notional buyer

2.17 New section 240-17 introduces the concepts of the notional seller and the notional buyer. They are the persons under an arrangement to which new Division 240 applies hire purchase etc. who are, respectively, the person who is the owner and the person who has the right to use the goods. For example, the hire purchase company will be the notional seller and the hire purchaser will be the notional buyer. If the notional buyer were to enter into another arrangement to which the Division applied (eg. a sub-hire purchase), the notional buyer would become the notional seller under that other arrangement.

Notional sale of property by notional seller and notional acquisition of property by notional buyer

2.18 Once there is a notional seller and notional buyer, new section 240-20 operates so that the notional seller is treated as selling the property to the notional buyer, and the notional buyer as acquiring it, at the beginning of the arrangement. The notional buyer is thereafter treated as the owner of the property for the duration of the arrangement or until the notional buyer becomes the notional seller under a further arrangement, as explained in the previous paragraph. This is subject to special rules, see new Subdivision 240-H.

Notional loan by notional seller to notional buyer

2.19 Under new section 240-25 , the hire purchase arrangement is to be treated as if it were a loan made by the notional seller to the notional buyer for a period equal to the term of the arrangement and subject to the payment of a finance charge.

2.20 The amount of the notional loan principal will be equal to the consideration for the sale of the property from the notional seller to the notional buyer reduced by any amount paid by the notional buyer, or credited as having been paid to the notional seller at, or prior to, the commencement of the arrangement.

2.21 Where the notional seller and notional buyer are dealing at arms length and the cost or value of the property is stated in the agreement between them, that amount will be taken to be both the notional sellers consideration for the sale and the notional buyers cost of the property. In other cases, the consideration will be equal to the amount that the notional buyer could have been expected to pay to purchase the property under an arms length transaction.

2.22 Payments made under the arrangement will be treated as payments of principal and finance charge under the loan.

New Subdivision 240-C: Amounts to be included in notional sellers assessable income

2.23 The notional interest is assessable income of the notional seller on an accruals accounting basis during the term of the arrangement. Any profit on the notional sale of the property to the notional buyer or on sale of the property after re-acquiring the property from the notional buyer is also assessable income of the notional seller. [New subsection 240-30]

Amounts to be included in notional sellers assessable income

2.24 The amount which the notional seller is required to include in assessable income in the income year is the sum of the notional interest amounts for each of the arrangement payment periods, and parts of such periods, in the income year. [New subsection 240-35(1)] The arrangement payment period is described in new section 240-70 .

2.25 If the property is not trading stock, the assessable income of the notional seller also includes the difference between the acquisition cost of the property to the notional seller and the consideration for the property under the notional sale to the notional buyer. [New subsection 240-35(2)]

2.26 Where the property is returned to the notional seller, ie. a notional re-acquisition under new subsection 240-90(2), by the notional buyer and subsequently sold, the assessable income of the notional seller will also include any excess of the selling price over the cost of re-acquisition (ie. market value - new subsection 240-90(3). [New subsection 240-35(3)]

Arrangement payments not to be included in notional sellers assessable income

2.27 Arrangement payments (as defined in new section 240-65 ) received or receivable by the notional seller will not be assessable income to the notional seller but are taken into account in calculating the notional interest. Further, the arrangement payments are not taken to be exempt income, and losses or outgoings incurred in deriving the arrangement payments are not taken to be in relation to gaining or producing exempt income. [New section 240-40]

New Subdivision 240-D: Deductions allowable to notional buyer

Extent to which deductions are allowable to the notional buyer

2.28 New section 240-50 authorises a deduction to the notional buyer for the notional interest for an income year, calculated in the same way as the notional sellers assessable amount under new section 240-35 . The deduction is allowable only to the extent that the notional buyer would have been entitled to a deduction for the arrangement payments if they were not capital in nature. In practice, the extent of the deduction will equal the extent to which the notional buyer uses the property to which the arrangement applies for the purpose of deriving assessable income.

Arrangement payments not to be allowable deductions

2.29 Arrangement payments made by the notional buyer will not be allowable deductions to the notional buyer except to the extent they are taken into account in calculating the notional interest under new section 240-50 . [New section 240-55]

New Subdivision 240-E: Notional interest and arrangement payments

Notional interest

2.30 New section 240-60 sets out how to calculate the notional interest for an arrangement payment period. Notional interest is equal to the outstanding loan principal at the start of the arrangement payment period multiplied by the implicit interest rate. New section 240-70 see the explanation in paragraphs 2.36 and 2.37 defines arrangement payment periods.

2.31 The notional loan principal outstanding at the start of the arrangement payment period is:

the notional loan principal

plus

the aggregate of all notional interest amounts from previous arrangement periods

reduced by

the aggregate of all payments that the notional buyer paid or was required to pay under the arrangement before the start of the arrangement payment period.

2.32 The implicit interest rate that is to be applied to the outstanding notional loan principal at the start of an arrangement payment period is that rate of compound interest for the arrangement payment period which causes the present value of:

•

the arrangement payments payable by the notional buyer under the arrangement; and

•

any termination amounts as defined in new section 240-78;

to be equal to the notional loan principal.

2.33 Where an arrangement payment period falls into more than one income year, the notional interest is apportioned in accordance with generally accepted accounting principles.

2.34 Where, at the start of an arrangement to which new Division 240 applies, the payments or the termination amounts etc. payable under the arrangement are not known, a reasonable estimate may be made for the purpose of working out the implicit interest rate, and used for each year of income. Where a reasonable estimate of the variables cannot be made,an estimate of the amount or amounts is to be made at the end of each income year based on amounts payable to date and whatever reasonable assumptions are necessary in respect of future amounts payable that are not certain at that time.

Arrangement payments

2.35 New section 240-65 defines an arrangement payment as an amount the notional buyer is required to pay under the agreement. The definition does not include penalty payments or termination amounts. Monthly hire purchase payments would be arrangement payments.

Arrangement payment periods

2.36 An arrangement payment period is the period under the arrangement in respect of which a payment is allocated or expressed to be payable, provided the period does not exceed six months. [New subsection 240-70(1)]

2.37 Where an arrangement payment period under the arrangement exceeds 6 months, it is divided into arrangement payment periods of 6 months duration. Where the arrangement payment period is not an exact multiple of 6 months, the last part of the period is the residual part. For example, a 15 month payment period specified in an agreement will not be an arrangement payment period but will be divided up into 3 arrangement payment periods for the purpose of new Division 240 of 6 months, 6months and 3 months. [New subsection 240-70(2)]

New Subdivision 240-F: The end of the arrangement

When is the end of an arrangement

2.38 New section 240-75 specifies when an arrangement to which new Division 240 applies comes to an end. The basic rule is that it ends at the time it is stated (in the relevant agreement) that it is to cease. That rule means an arrangement ends at the stated time notwithstanding that it is extended or renewed beyond that time. The extension or renewal will be a new arrangement. An arrangement will end, however, if it ceases (for whatever reason) before the stated time, eg. when the property is lost or destroyed.

2.39 In some circumstances, an arrangement may be of indefinite duration, ie. there is no specified termination and the end of the arrangement cannot be determined from its terms. In that case, the arrangement ends when it ceases to have effect. If the indefinite arrangement is renewed, it is taken to have ceased and a new arrangement commenced.

Termination amounts

2.40 Under new section 240-78 , a termination amount is an amount payable at the end of an arrangement, not being an arrangement payment under new section 240-65 . It includes the acquisition cost payable to the notional seller where the notional buyer acquires the property, eg. an amount payable by the notional buyer at the end of an arrangement to exercise an option to purchase the property.

2.41 Where the property is lost or destroyed, the termination amount will include any amount paid to the notional seller by an entity other than the notional buyer as a result of the loss or destruction. It will also include any amount received by the notional buyer as a result of the loss or destruction and paid over to the notional seller.

2.42 In a case where the arrangement terminates early, the termination amount is the value of the property at the end of the arrangement. New paragraph 240-78(c) covers situations where the property is returned to the notional seller as a form of payment towards the outstanding debt.

What happens if the arrangement is extended or renewed

2.43 If the notional buyer continues to retain the right to use the property because the arrangement is extended or renewed:

•

the notional seller is to be treated as providing a new notional loan for the new arrangement payment period. The notional loan in relation to the previous arrangement is treated as having ended [new subsection 240-80(2)] ; and

•

the notional buyers continuing ownership for capital allowance purposes is not disturbed. [New subsection 240-80(3)]

2.44 Where the notional seller and notional buyer are dealing at arms length and the new arrangement states the cost or value of the property, the new notional loan principal will be taken to be equal to the specified amount. In other cases, the amount of the new notional loan principal will be equal to the amount that the notional buyer could have been expected to pay to purchase the property under an arms length transaction with the notional seller. [New subsection 240-80(4)]

2.45 An adjustment on termination of the previous arrangement may be necessary under Subdivision 240-G, treating the new notional loan as a termination amount under the original arrangement. [New subsection 240-80(5)]

What happens if an amount is paid by or on behalf of the notional buyer to acquire the property

2.46 If the notional seller is paid an amount by the notional buyer or on behalf of the notional buyer at or after the end of the arrangement to acquire the property:

•

the amount is neither an allowable deduction to the notional buyer nor assessable income of the notional seller;

•

the notional buyers ownership of the property is not disturbed; and

•

transfer of legal title to the property from the notional seller to the notional buyer is not to be treated as a disposal of the property. [New section 240-85]

What happens if the notional buyer ceases to have the right to use the property

2.47 If at the end of the arrangement the notional buyer ceases to have the right to use the property because the arrangement is not extended or renewed and no amount is paid by the notional buyer to the notional seller to acquire the property, the property is to be treated as being sold by the notional buyer to the notional seller at that time. This section does not apply where the property is lost or destroyed. [New subsections 240-90(1) and (2)]

2.48 The consideration for the disposal of the property by the notional buyer and the cost of acquisition by the notional seller is equal to the market value at the end of the arrangement. [New subsection 240-90(3)]

Note : In calculating a future capital loss, the cost base of the asset to the notional seller would be reduced by the principal components of the arrangement payments that have not been included in assessable income under new Division 240 . See subsection 110-55(6) of the ITAA 1997.

2.49 New subsections 240-90(4) and (5) provide a special rule which applies where the property is a luxury car (a car subject to the depreciation limits in section 57AF of the ITAA 1936 and section 42-80 of the ITAA 1997) at the beginning of the arrangement and is later acquired by an associate of the notional buyer. The special rule will apply where the associate either acquires ownership of the car or, as notional buyer under a separate arrangement, is taken by new section 240-20 to have acquired the luxury car. The rule is that the cost of the luxury car for calculating the associates entitlement to depreciation deductions is taken to be the lesser of:

•

the written down value applicable to the associate notional buyer as if it had remained the notional buyer of the car, adjusted for any balancing charge that applies because the car is taken to have been disposed of by the associate notional buyer; and

•

the acquisition cost of the car to the associate.

New Subdivision 240-G: Adjustments if total amount assessed to notional seller differs from amount of finance charge

Adjustments for notional seller

2.50 The calculation of the finance charge amounts included in the notional sellers assessable income as notional interest may in some cases be based on estimated amounts or amounts that have been varied by the time the notional loan is taken to have ended. As a result, new section 240-105 provides for cases where there may be a need to make an adjustment to income assessed.

2.51 Such variation may be due, for example, to an early termination of a hire purchase agreement without full payment being made.

2.52 The adjustment is to be made by adding or subtracting an amount to or from the notional sellers taxable income in the income year in which the end of the arrangement occurs.

2.53 The adjustment to the notional sellers taxable income is calculated as the sum of all amounts paid or payable to the notional seller under the arrangement (including the termination amount as defined in new section 240-78 ) adjusted by the following formula:

Notional loan principal + Assessed notional interest


where :

notional loan principal is the notional loan principal for the notional loan that is taken to have been granted by the notional seller to the notional buyer; and

assessed notional interest is the aggregate of the notional interest amounts included in the notional sellers assessable income.

2.54 Where the sum of all amounts paid or payable to the notional seller under the arrangement (including the termination amount) exceeds the amount calculated using the formula, the amount of the excess is to be included in the assessable income of the notional seller in the income year in which the arrangement is terminated. [New subsection 240-105(2)] If that sum is less than the amount calculated using the formula, the difference is allowable as a deduction to the notional seller in the income year in which the arrangement ends. [New subsection 240-105(3)]

Adjustments for notional buyer

2.55 Where an adjustment amount is included in the notional sellers assessable income under new subsection 240-105(2) or would have been included if the notional seller had been subject to tax on assessable income, an amount calculated in a similar manner is allowable as a deduction to the notional buyer in the notional buyers income year. [New subsection 240-110(1)]

2.56 Correspondingly, if an adjustment amount is allowed as a deduction to the notional seller under new subsection 240-105(3) , an amount calculated in a similar manner is included in the notional buyers assessable income in the notional buyers income year. [New subsection 240-110(2)]

2.57 The notional buyers deduction or assessable amount, as the case requires, is deductible or assessable only to the extent to which the notional buyer would have been entitled to deduct the arrangement payments if they were not capital in nature, ie. to the extent to which the notional buyer has used the property to which the arrangement applies for the purpose of deriving assessable income. [New subsection 240-110(3)]

New Subdivision 240-H: Provisions applying to hire purchase arrangements

Division 16E applies to certain arrangements

2.58 New section 240-112 applies the accrual basis of taxation under Division 16E of the ITAA 1936 to an assignment by a notional seller to another person of the rights to future payments under a notional loan to which new Division 240 applies. This application rule is necessary to prevent double taxation where a notional seller wishes to transfer rights to the payments without terminating the notional loan itself.

2.59 The effect is that the assignment arrangement is treated as a separate Division 16E security (a qualifying security), the issue price of which is the consideration for the transfer of the rights to the payments. The payments are treated as payments under the qualifying security to ensure that net gains or losses under that security are taxed on the basis of the Division 16E accrual amounts applicable to each income year.

Another person, or no person, taken to own property in certain cases

2.60 Under specified circumstances, new section 240-115 modifies the rules of ownership as they would otherwise apply to a notional buyer under a hire purchase agreement to which new Division 240 applies.

2.61 The general rule that a notional buyer is taken to be the owner of the goods under the hire purchase agreement does not apply unless the notional buyer would have been the owner (or quasi-owner under Subdivision 42-I of the ITAA 1997) if the agreement were a sale of the goods, and the notional buyer is reasonably likely to exercise its right under the agreement to acquire the goods, or it is reasonably likely that any obligation on the notional buyer to acquire the goods will be enforced. Having regard to the basic rule in new section 240-17 that the notional buyer is the entity which has the right to use (including the right to possess) the goods under a hire purchase agreement, a notional buyer is unlikely to seek to acquire the goods if it has granted use and possession back to the notional seller (or an associate), eg. under a lease, or to someone who previously owned the goods. Those sorts of arrangements would suggest that the hire purchase agreement was merely a means of refinancing pre-existing ownership. A notional buyer who is entitled to determine the agreement without obligation to make further arrangement payments also may not seek to acquire the goods.

2.62 If those conditions are not satisfied, the person who otherwise would own the goods other than the notional seller will be the owner for purposes of applying the capital allowance rules. If only the notional seller would own the goods in those circumstances, no person will be entitled to capital allowance deductions as owner of the goods.

2.63 Those same modifications will apply if the notional buyer disposes of its interest in the property or, if the property is a luxury car, leases the car to another person so that Schedule 2E of the ITAA 1936 would apply to the lease. (Broadly, Schedule 2E treats a luxury car lease as a sale and loan transaction in much the same manner as new Division240 arrangements).

New Division 240 - Example

This is an example of how new Division 240 would apply to a traditional hire purchase transaction. It is for the purposes of illustration only and may not precisely reflect industry practice.

Implicit interest rate per arrangement payment period .75%

This example does not include a termination amount.

It is assumed that the goods are wholly used for income producing purposes. The end of year amounts will be rounded off to whole dollars in the taxpayers returns.

Profit on sale of goods by notional seller

As the hire purchase arrangement is treated as a sale of the goods by the notional seller to the notional buyer, any profit on the sale will need to be included in the notional sellers assessable income in the year the arrangement begins.

Profit = Selling price (ie. cost price to notional buyer)less Purchase price to notional seller

$5,000 = $120,000 - $115,000


Accordingly, $5,000 will be brought into account as assessable income of the notional seller in the 1998-99 income year because the date of sale is the date the arrangement is entered into 15/12/98.

Capital Allowances

As owner of the goods, the notional buyer would be entitled to claim capital allowance deductions based on the cost of $120,000.

Notional Interest

The first arrangement payment period:

•

commences with the date of commencement of the arrangement when the first payment is due and payable; and

•

ends with the day immediately preceding the day on which the next succeeding payment is payable.

An adjustment needs to be made to the arrangement payment period at the end/beginning of each income year as it straddles two income years. The notional interest for inclusion in the relevant income year has to be calculated in a manner consistent with the generally accepted accounting principles. For instance, in the income year 1998-99 the following calculation is required.

The notional interest for the June/July arrangement payment period of $782.11 may be apportioned as follows for the income year of 1998-99:

$782.11 * 16/30# = $417.12


# There are 16 days in the month of June 1999 that relate to the notional interest of $782.11 accruing on 15 July 1999.

$417.12 would form part of the notional buyer's allowable deductions and the notional seller's assessable income in the 1998-99 income year. Therefore, the total notional interest that will be allowable to the notional buyer and assessable to the notional seller, in the 1998-99 income year, would be $5,446.69.

Limited recourse debt

What this Division is about

2.64 The rules contained in new Division 243 of the ITAA 1997 include an amount in assessable income to compensate for any excess of deductions for capital allowances (to which Part 2-10 applies) over and above what a taxpayer has actually outlaid where the expenditure relating to the capital allowance has been financed by limited recourse debt. For this purpose, financing by way of hire purchase or installment sales is included with other forms of limited recourse debt. New Division 243 will apply where there is an unpaid amount of debt when the limited recourse financing arrangement is terminated. [New section 243-10]

2.65 Deductions for investment allowances and drought investment allowances are not counted as capital allowances in the operation of new Division 243 .

New Subdivision 243-A: Circumstances in which Division operates

When does this Division apply?

2.66 New section 243-15 sets out the basic conditions under which an amount will be included in assessable income on the termination of a limited recourse debt. The tests are that:

•

the limited recourse debt has been used wholly or partly to finance or refinance capital expenditure which is deductible under the capital allowance rules or has funded property whose cost is deductible as a capital allowance, eg. as depreciation;

•

the limited recourse debt has not been paid in full by the debtor; and

•

because the debt has not been paid in full, the capital allowance deductions exceed what would have been allowable if the capital expenditure were reduced by the amount unpaid.

2.67 In determining whether or not new Division 243 will apply, it is necessary to understand that reductions in amounts owing under a limited recourse debt that occur as a result of property that was financed by the debt being transferred to the creditor, do not count as payments of the debt by the debtor. Likewise, a payment to reduce the debt will not be counted if it in turn is funded on a non-arms length basis by limited recourse debt or from disposing of the financed property.

2.68 Interest payments and similar payments on a debt are not to be counted as payments off the debt. At the time a debt terminates, accrued interest or similar accrued amounts are not counted and, in working out if a debt has been paid, payments must be attributed first to interest accrued. [New subsections 243-15(3) and (4)]

2.69 Where a transaction such as a hire purchase agreement is treated under new Division 240 as a notional loan, in applying new Division 243 that notional loan must be treated as wholly or partly financing or refinancing the cost of the asset being acquired under the agreement. [New subsection 243-15(5)] As explained later in these notes, a notional loan under a hire purchase agreement falls within the definition of limited recourse debt under new Division 243 . See new subsection 243-20(4) .

2.70 In working out whether new section 243-15 applies, it is necessary to be familiar with the meaning of limited recourse debt (as defined in new section 243-20 ) and financed property (defined in new section 243-30 ). It is also necessary to understand the concepts inherent in working out under new section 243-35 whether, on termination of a limited recourse debt which has not been paid in full, the total capital allowance deductions relating to the capital expenditure exceed what should have been allowed if the unpaid amount was not counted.

What is limited recourse debt?

2.71 New section 243-20 defines the kind of limited recourse debt to which new Division 243 applies where the debt has been used to wholly or partly finance expenditure that gives rise to capital allowance deductions.

2.72 The notion of limited recourse specified in new subsection 243-20(1) is that the creditors rights as against the debtor, if there is default in the payment of debt or interest, are limited wholly or predominantly to property that has been financed by the debt (the financed property) or is security for the debt, or rights in relation to such property. (See the definition of financed property and debt property in new section 243-30 ) Such rights would include the use of the property, goods or services produced by means of the property and rights on the loss or disposal of the property. Other limitations are security over the property (or other property) and rights under financial obligations to the debtor of a person who uses the financed property.

2.73 Under new subsection 243-20(2) , a debt is also limited recourse if, notwithstanding that there may be no specific conditions to that effect, it is reasonable to conclude that the creditors rights against the debtor are able to be limited, directly or indirectly, to those property rights specified in new subsection 243-20(1) in relation to the financed property. In reaching such a conclusion, regard is had to:

•

the debtors assets;

•

arrangements the debtor is a party to;

•

whether all of the debtors assets would be available to discharge the debt; and

•

whether the debtor and creditor are acting at arms length.

2.74 New subsection 243-20(3) applies in a case where there is no debt property in relation to the debt, ie. property financed by the debt or provided as security for the debt. (See the definition of debt property in new subsection 243-30(3) ) The debt in such a case may be limited recourse if the creditors rights are capable of being limited having regard to the same matters listed in new subsection 243-20(2) . The final category of limited recourse debt is a notional loan under a hire purchase agreement to which new Division 240 applies. (See earlier notes on new Division 240 )

2.75 New subsection 243-20(5) operates to override the application of new subsection 243-20(1) to a debt if the creditors recourse is not in a practical sense limited because there is adequate security over other assets of the debtor. [New subsection 243-20(5)] Nor will new Division 243 apply to a debt which is technically limited recourse under new subsections 243-20(1), (2) and (3) if, in all circumstances, it would be unreasonable for it to be treated as limited recourse debt. It might be unreasonable to apply new Division 243 , for example, if all but a very minor component of a debtors relevant deductible capital expenditure has been funded by limited recourse debt and, in a practical sense, the debtor is fully at risk of loss for the expenditure. The debt would not, in a practical sense, be limited recourse if it is fully secured by assets other than the financed property. [New subsection 243-20(6)]

2.76 New subsection 243-20(7) stipulates that a limited recourse debt is not at arms length if the debtor and creditor do not deal with each other as such in relation to the debt. Arms length is defined in section 995-1 of the ITAA 1997 and requires that any connection between parties and any other relevant circumstances be taken into account in determining whether parties deal at arms length. In Chapter 2 of Taxation Ruling TR 97/20, the Commissioner of Taxation discusses the general principles which he considers should be applied when determining whether a transaction is an arms length one. ( New subsection 243-20(7) is relevant to the application of new section 243-35 which calculates any excessive deduction of the termination of a limited recourse debt: any reduction in a limited recourse debt that is funded by a non-arms length limited recourse debt is not treated as being a payment off the debt)

When is a debt arrangement terminated?

2.77 Because new Division 243 applies on the termination of a limited recourse debt, new section 243-25 specifies the various circumstances in which a debt is taken to terminate. They are when:

•

the debt is actually terminated;

•

the debtors obligations under the debt are varied in a way that reduces, transfers or extinguishes them, or an agreement having that effect is entered into. Where a debt is terminated as a result of it being reduced due to waiver, novation or other variation, or an agreement to that effect being entered into, the remaining debt is taken to be a separate debt for the purposes of new Division 243. [New subsection 243-25(3)] Ordinary ongoing repayments of a debt under a continuing arrangement do not terminate the debt;

•

the creditor can no longer legally recover the debt. A debt will not be terminated, however, if the creditors rights under the debt are merely assigned to another person under an arms length transaction;

•

the debtors rights, eg. as owner, lessor etc., in the debt property are extinguished because the property or relevant interest has been transferred to the creditor on default by the debtor; or

•

the debt is bad.

2.78 New subsection 243-25(2) makes it clear however, that a notional loan, eg. a hire purchase transaction to which new Division 240 applies, is not terminated if it is simply renewed or extended. (See earlier notes on new Division 240 )

What is the financed property and the debt property?

2.79 As implied in paragraph 72 relating to limited recourse debt, the term financed property in new Division 243 means property that has been acquired or created etc., through the capital expenditure mentioned in new section 243-15 or is the property to which new Division 240 applies.

2.80 The term debt property whenever it is used means the financed property or, if applicable, property that has been put up as security for a limited recourse debt. [New section 243-30]

New Subdivision 243-B: Working out the excessive deductions

2.81 New section 243-35 is the central operative provision of new Division 243 . It sets out how to determine whether there is an excessive deduction amount when a limited recourse debt that has financed expenditure relating to a capital allowance is terminated and remains unpaid. New subsection 243-35(1) expresses the basic proposition that there is an excess if the actual deductions exceed the deductions worked out as if the unpaid amount of debt were deducted from the expenditure.

2.82 New subsection 243-35(2) explains how to work out the actual deductions. They are the deductions allowed or allowable in the years up to the end of the debt termination year for the expenditure or the property financed by the expenditure (including deductible balancing adjustment on disposal of the financed property), minus any amount assessable on the disposal of the financed property which effectively reverses such a deduction.

2.83 Amounts which effectively reverse a deduction include assessable balancing adjustments on the disposal of property eg. under section 42-190 of the ITAA 1997. New subsection 243-35(3) also specifies that amounts that would be assessable balancing adjustments but are instead taken off the undeducted cost of other plant by the operation of section 42-285 or 42-290 are to be treated as reversing a deduction. So are amounts included as assessable income under section 26AG of the ITAA 1936 as consideration for the disposal of an interest in the copyright of an Australian film.

2.84 The debtors actual capital allowance deductions (as calculated under new subsection 243-35(2) ) relating to the expenditure are reduced by any amounts included in assessable income by a previous application of new Division 243 to the debt. Those capital allowance deductions are increased, however, by any amount deducted under new section 243-45 or 243-50 . (Those sections can apply if after the termination of a limited recourse debt, the debtor makes further payments on the debt or on a replacement limited recourse debt)

2.85 New subsection 243-35(4) explains how to work out the deductions that would be allowable on the basis, broadly, that the expenditure is reduced by the unpaid amount of the limited recourse debt that is terminated. The method is to work out what would have been the actual deductions under new subsection 243-35(2) if the following assumptions were made:

1.

The expenditure on which deductions were based is reduced by the unpaid amount of the debt. If the debt has been reduced because the financed property was given up to the creditor, or through refinancing on a non-arms length basis by further limited recourse debt, or from the proceeds of disposing of the financed property, that is not to be treated as a payment of the debt by the debtor.

2.

Capital allowance deductions relating to the expenditure for later income years were also taken into account. This assumes that the debtor will be entitled to future deductions based on the expenditure as reduced under assumption (1) as if the property has not been disposed of. (See assumptions 2 and 4 in new subsection 243-35(4) )

3.

The expenditure on which deductions were based is increased by any amount paid by the debtor for another person to take over liability for the debt. (This does not apply, however, if the payment was funded by non-arms length limited recourse debt or disposing of the financed property)

New Subdivision 243-C: Amounts included in assessable income and deductions

Amount included in debtors assessable income

2.86 New section 243-40 specifies that the amount to be included in a debtors assessable income of a year in which a limited recourse debt to which new Division 243 applies is terminated, is the excess worked out by deducting the total net capital allowance deductions that would otherwise be allowable (the new subsection 243-35(4) amount) from the total net capital allowance deductions (the new subsection 243-35(2) amount).

Deductions for later payments in respect of debt

2.87 Provision is made by new section 243-45 for the possibility that a debtor under an unpaid limited recourse debt that has terminated might later pay amounts to the creditor in respect of the debt. If that were to happen after an amount had been included in the debtors assessable income under new section 243-40 or a deduction reduced under new section 243-55 (which covers a case where there is no excessive deduction under new section 243-35 but there would be an excessive amount at a later time if deductions continue to be allowed based on the original expenditure) a deduction may be allowable.

2.88 If the debtor pays an amount in respect of the debt after the debt has terminated, it is necessary to work out whether, taking into account the subsequent payment by the debtor, there would be an under deduction on the basis of the calculations in new section 243-35 . If the amount of actual net deductions so calculated is less than the deductions based on the adjusted expenditure, the difference is allowable as a deduction in the year the payment is made.

2.89 New subsection 243-45(4) limits the deduction allowable under the section and under new section 243-50 (which relates to payments under a replacement limited recourse debt) to the total included in assessable income under new section 243-40 in relation to the original debt plus any reduction of deductions under new section 243-55 . Original debt means limited recourse debt under new subsection 243-15(1) , including, where applicable, refinanced debt.

Deduction for payments for replacement debt

2.90 New section 243-50 applies on a similar principle to new section 243-45 to provide for an allowable deduction relating to payments (other than interest) made by a debtor under a limited recourse debt which has funded a reduction in the amount of a terminated limited recourse debt.

If an amount was included in the debtors assessable income under new section 243-40 or a deduction reduced under new section 243-55 because the terminated debt was unpaid and the replacement debt was not at arms length and therefore not treated as reducing the unpaid amount (under new subsection 243-35(4) ) there may be an allowable deduction. There will be an allowable deduction if, the total net deduction, worked out under new subsection 243-35(2) as if the replacement debt is terminated immediately before the payment; is less than the total net deductions worked out under new subsection 243-35(4) that would arise if the payment relating to the replacement debt had been treated as a payment in respect of the original debt.

The amount of the deduction is the difference and is allowable in the income year in which the payment is made.

2.91 New subsection 243-50(5) imposes the same limits on deductions under new sections 243-45 and 243-50 as are imposed by new subsection 243-45(4).

Effect of the Division on later capital allowance deductions

2.92 New section 243-55 will operate to reduce a capital allowance deduction (including a balancing adjustment deduction) relating to capital expenditure in some circumstances after a limited recourse debt has terminated where the taxpayer continues to be entitled to deductions in respect of the expenditure. The section could apply, for example, where the creditor under a limited recourse debt has not enforced its right to recover the financed property, so that the debtor retains ownership and use notwithstanding the debtors default.

2.93 In that sort of circumstance, it is necessary to determine year by year whether there would be excessive deductions if new section 243-35 were applied. In applying the tests contained in new section 243-35 , it is to be assumed that the debt was terminated at the later time or period for which a capital allowance deduction would be allowed, the amount unpaid is reduced by any amounts paid under a replacement debt and that the capital allowance deduction was taken into account under Step 1 of new subsection 243-35(2) , ie. as if it had been allowed as a deduction.

2.94 If, on those assumptions, there would be an excess deduction under new section 243-35 , the deduction that would be allowed at the later time is reduced by the excess.

Example New section 243-55

Facts:

The limited recourse debt is refinanced with a non-arm's length replacement limited recourse debt. It is therefore terminated so that a new section 243-35 calculation is required:

The replacement debt of $90,000 is subsequently repaid in full. Therefore new section 243-50 applies to calculate the deduction for payments of the replacement debt:

However, the limitation in new subsection 243-50(5) would limit the deduction allowed for repayments of the replacement debt to $40,000.

Later capital allowance deductions:

Assume that in the next tax year the taxpayer would be entitled to a further capital allowance deduction to the maximum extent of $10,000.

New section 243-55 calculation:

As the new subsection 243-35(2) amount does not exceed the new subsection 243-35(4) amount, the capital allowance deduction of $10,000 is allowable.

Effect of the Division on later capital allowance adjustments included in assessable income

2.95 New section 243-57 may reduce an amount that otherwise would be included in assessable income so as to effectively reverse a capital allowance deduction eg. a depreciation balancing adjustment under section 42-190 of the ITAA 1997, where financed property is disposed of after the termination of a limited recourse debt which has caused an amount to be included in assessable income under new section 243-40 .

2.96 In order to work out whether or not there is to be a reduction, it is necessary to re-do the calculations under new subsection 243-35(2) (actual deductions) and new subsection 243-35(4) (deductions allowable taking into account unpaid debt amounts). The new calculations are on the assumptions that the debt was terminated on disposal of the financed property, and that the otherwise assessable balancing adjustment reduces the deductions allowed as required under step 2 of new subsection 243-35(2) . Further, the amount worked out under new subsection 243-35(4) is reduced by the amount, if any, by which the disposal proceeds exceed the amount of the unpaid debt.

Example - New section 243-57

This example demonstrates how new section 243-57 operates where, after the termination of the debt, the property is sold.

Facts:

The limited recourse debt is terminated so that a new section 243-35 calculation is required:

The asset is later sold for $40,000 and the proceeds applied against the unpaid debt. New section 243-57 applies when:

•

a new section 243-40 adjustment has been made previously ($20,000 as above); and

•

a balancing adjustment arises on the sale of the asset: in this case $10,000, ie. sale price ($40,000) less written down value ($30,000).

The balancing charge in (ii) above is to be reduced by the amount that the new subsection 243-35(4) amount exceeds the new subsection 243-35(2) amount, given the assumptions stated.

The balancing adjustment to be included in assessable income would be reduced by $10,000 to nil.

Adjustment where debt only partially used for expenditure

2.97 New section 243-58 authorises an apportionment to be made on a reasonable basis in calculating assessable amounts (under new section 243-40 ), deductions (under new sections 243-45 and 243-50 ), or reduced deductions (under new section 243-55 ) in circumstances where a limited recourse debt only partially finances expenditure that gives rise to capital allowance deductions.

New Subdivision 243-D: Special Provisions

2.98 New Subdivision 243-D contains provisions that apply in particular circumstances to limited recourse debts of a partnership, of a partner and of a company that is a subsidiary in a company group. It also prevents the commercial debt forgiveness rules in Schedule 2C of the ITAA 1936 from applying on the termination of a limited recourse debt to the extent that new Division 243 has also applied.

Application of Division to partnerships

2.99 New sections 243-60 and 243-65 apply new Division 243 to the debts of a partnership and debts of a partner, and provide for an amount to be included in the assessable income of a partner where there is an arrangement under which the partners interest in the partnership ceases or is varied or transferred and the partners liability under the debt is reduced or eliminated.

2.100 Where the debt is a limited recourse debt and there would be an excessive deduction under new section 243-35 if the debt was treated as terminated and remaining unpaid, the partners assessable income of the year in which the partners liability was reduced or eliminated is to include a proportion of the excessive deduction.

2.101 To work out the assessable amount, it is necessary to work out the capital allowance deductions of the partnership relating to the expenditure financed by the limited recourse debt, and the partners share of those deductions based on the partners share of partnership profit or loss. That proportion the partners share of the capital allowance deductions is applied to the excessive deduction for the partnership worked out under new section 243-35 . The resulting amount is included in the partners assessable income.

Application of Division to companies ceasing to be 100% subsidiary

2.102 New section 243-70 is a special provision that applies if a debtor under a limited recourse debt which has financed capital expenditure that gives rise to capital allowance deductions is a 100% subsidiary of another company or companies, ie. a 100% owned subsidiary of a company group. (100% subsidiary is defined in section 975-505 of the ITAA 1997. A company is a 100% subsidiary of a holding company if all the shares are beneficially owned by the holding company, or one or more 100% subsidiaries of the holding company, or the holding company and one or more of its 100% subsidiaries.)

2.103 The section applies to a company only if it ceases to be a 100% subsidiary, the limited recourse debt has not been paid in full by the company, and the creditors rights under the debt are transferred or assigned to another entity.

2.104 If those conditions are satisfied, new Division 243 applies as if the debt was terminated and refinanced with non-arms length limited recourse debt at the time the company ceased to be a group company. The effect will be that the transferred debt is treated as unpaid and the notional refinancing debt is not counted as paying out the transferred debt see new subsection 243-35(4), Item (1)(b) . As the new debt is treated as a non-arms length limited recourse debt, the debtor may be entitled to deductions in relation to subsequent payments by the debtor to the new creditor in respect of the debt (under the later payments rules in new section 243-50) .

Application of Division where debt forgiveness rules also apply

2.105 The purpose of new section 243-75 is to ensure there is no double taxation if it happens that new Division 243 would include an amount in the assessable income of a debtor on the termination of a limited recourse debt and there would also be a gross forgiven amount of debt under the commercial debt forgiveness rules in Schedule 2C of the ITAA 1936.

2.106 If that were to occur in respect of the same debt, new subsection 243-75(2) requires that new Division 243 be applied first without any regard to Schedule 2C, and that any amounts included in assessable income under new section 243-40 to reflect an excessive deduction under new section 243-35 are to be taken into account to reduce the gross forgiven amount under Schedule 2C.

New Division 243 - Example

This example is for the purposes of illustration only. It demonstrates the basic rule introduced in new Division 243 as it relates to depreciation and capital write-off provisions contained in Part 2-10 Capital Allowances.

Facts:

Termination of the debt arrangement occurs after disposal of the property:

Note :

•

The consideration for the sale of the property is not taken into account in determining whether the debt has been paid in full [New subsection 243-15(3)]

•

If the property had been disposed of after the income year of the termination of the debt arrangement, the consideration would not be taken into account in calculating the original adjustment. However, new section 243-57 may apply to reduce any amount of balancing adjustment included in assessable income in the year the property is sold.

Part 2 - CONSEQUENTIAL AMENDMENTS: Arrangements treated as sale and loan

2.107 Part 2 of Schedule 2 to the Bill amends various provisions in the ITAA 1936 and ITAA 1997 consequential on the enactment of new Division 240 in relation to arrangements to be treated as sale and loan transactions.

Income Tax Assessment Act 1936

Hire purchase and hire purchase agreement

2.108 To ensure consistency, section 51AD and subsection 82AQ(1) of the ITAA 1936 are amended to define a hire purchase agreement as an agreement subject to new Division 240 of the ITAA 1997. Subsection 82AHA(2) is repealed because the rule in new Division 240 that a notional buyer under a hire purchase agreement is the owner of the relevant property for the purposes of the ITAA 1936 makes it redundant.

Drought Investment Allowance

2.109 Provisions in the ITAA 1936 relating to drought investment allowance (sections 672, 674 and 675) are amended to reflect the definition of hire purchase agreement in new Division 240 .

Income Tax Assessment Act 1997

Assessable Income and Deductions

2.110 The tables in section 10-5 and 12-5 list the provisions of the ITAA 1997 which respectively deal with particular kinds of assessable income and specific types of deductions. These tables are amended to include appropriate references to income and deduction amounts under notional sales and loans to which new Division 240 applies.

Car Expenses

2.111 Various provisions in section 28 are amended to reflect new Division 240 , which treats a hire purchase transaction as equivalent to a sale and loan transaction, and therefore treats the hirer of the property as the owner.

Capital Allowances

2.112 Division 42 (depreciation of plant) and Division 43 (capital works) are amended to take into account the rules contained in new Division 240 . Several amendments (see sections 42-15, 42-55, 42-160, 42-175, 42-195, 42-235, 42-250, 42-330 42-365 and 43-110) alert taxpayers to the fact that new Division 240 treats a hire purchase transaction as equivalent to a sale and loan transaction and, therefore, treats the notional buyer of the property as the owner.

2.113 Amendments to sections 42-30 (balancing adjustment), 42-55 (signposting), 42-65 (cost of plant) and 42-205 (termination value) ensure that the depreciation rules covering the acquisition and disposal of property apply to the notional buyer under new Division 240 .

Mining and Quarrying

2.114 A Note is added to subsection 330-480(1) (balancing adjustments on disposal of mining and quarrying assets) to alert taxpayers to the fact that new Division 240 treats a hire purchase transaction as equivalent to a sale and loan transaction and, therefore, treats the notional buyer of the property as the owner.

Establishment of Grapevines

2.115 Subsection 387-305(1) is amended to alert taxpayers to the fact that new Division 240 treats a hire purchase transaction as equivalent to a sale and loan transaction and, therefore, treats the notional buyer of the property as the owner.

Substantiation of Work and Car Expenses

2.116 Various provisions in Subdivisions 900-B (substantiating work expenses) and 900-C (substantiating car expenses) are amended or notated to reflect the treatment under new Division 240 of a hire purchase transaction as equivalent to a sale and loan transaction and the notional buyer (eg. a hirer under a hire purchase agreement) as the owner of hired property.

Defined Terms

2.117 Schedule 2 will add a number of new definitions to the Dictionary of defined terms in section 995-1 of the ITAA 1997.

2.118 In addition the definition of hire purchase agreement is revised to include a contract where the hirer has only a contingent obligation to buy the goods (for example, under a put option held by another entity).

Part 3 - CONSEQUENTIAL AMENDMENTS: Limited Recourse Debt

2.119 Part 3 of Schedule 2 to the Bill amends various provisions in the ITAA 1936 and ITAA 1997 consequential on the enactment of new Division 243 in relation to limited recourse debt arrangements.

Income Tax Assessment Act 1936

Capital gains

2.120 Rules providing for an adjustment to the cost base or the indexed cost base of a CGT asset to reflect deductions allowed for expenditure on the asset, contained in sections 160ZJA and 160ZJB of the ITAA 1936, are amended to ensure that an adjustment made under new Division 243 is not taken into account.

Income Tax Assessment Act 1997

Assessable income and deductions

2.121 The tables in sections 10-5 and 12-5 list the provisions of the ITAA 1997 which respectively deal with particular kinds of assessable income and specific types of deductions. These tables are amended to include appropriate references to income and deduction amounts under limited recourse debt to which new Division 243 applies.

Provisions that reverse the effect of deductions

2.122 The table in section 20-5 lists some of the provisions of the ITAA 1936 and ITAA 1997 which have the effect of reversing deductions. This table is amended to include an appropriate reference to an amount included in assessable income as a result of the operation of new Division 243 . However, in calculating the cost base or index cost base for CGT purposes, adjustments made under new Division 243 are not taken into account. [Items 71 to 76]

Capital allowances

2.123 Division 42 (depreciation of plant) and new Division 43 (capital works) are amended to take into account the rules contained in new Division 243 . Amendments to sections 42-55 and 43-50 (signposting) alert taxpayers to the fact that new Division 243 may apply.

Mining and quarrying

2.124 Subsections 330-15(1) and 330-435(1) and sections 330-80 and 330-370 are notated to alert taxpayers to the fact that new Division 243 may include an amount in assessable income if deductible mining and quarrying expenditure was financed by limited recourse debt that has terminated.

Capital allowances for primary producers and some land holders

2.125 Various provisions in Division 387 dealing with capital allowances for primary producers and some land holders (subsections 387-55(1), 387-125(2), 387-165(5), 387-305(1), 387-355(2), 387-405(2) and section 387-460) are notated to alert taxpayers to the fact that new Division 243 may include an amount in assessable income if the expenditure was financed by limited recourse debt that has terminated.

Environmental impact assessment and environmental protection

2.126 Subsection 400-15(3) is notated to alert taxpayers to the fact that new Division 243 may include an amount in assessable income if deductible expenditure was financed by limited recourse debt that has terminated.

Defined terms

2.127 Schedule 2 will add a number of new definitions to the Dictionary of defined terms in section 995-1 of the ITAA 1997.

Part 4 - PROPERTY TRANSFERRED BY WAY OF SECURITY

2.128 Part 4 of Schedule 2 to the Bill will implement legislative rules to ensure that a person who owns property will continue to be treated as owner for purposes of the capital allowances where title in the property is transferred to another person for purposes of security only.

2.129 Item 98 of Part 4 creates this effect by inserting section41-90 in Subdivision 41C of the ITAA 1997. Subdivision 41C in its present form is Common Rule 3 which treats persons who are entitled to capital allowance deductions in respect of property as the owner of the property for purposes of applying the anti-avoidance rules contained in section 51AD and Division 16D of the ITAA 1936. Section 41-90 will expand the deemed ownership rules of Common Rule 3 to property transferred as security.

2.130 Items 94 to 97, 99 and 100 of Part 4 are purely technical amendments to the ITAA 1997 consequent upon the enactment of section 41-90, whilst Items 101 to 107 duplicate that section for relevant purposes in the ITAA 1936, namely:

•

section 51AD: property used under certain leveraged arrangements;

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section 73B: expenditure on research and development;

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Subdivision B of Division 3: development allowance;

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Division 10B: industrial property;

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Subdivision A of Division 10BA: Australian films;

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Division 16D: certain arrangements relating to the use of property;

•

Division 8: drought investment allowance.

Part 5 - APPLICATION OF AMENDMENTS

2.131 The provisions of the Bill, and associated consequential changes, which treat hire purchase and installment sales as sale, loan and debt transactions, and taxpayers acquiring assets under such arrangements as the owners of those assets, apply to relevant transactions entered into after 27 February 1998. Minor consequential amendments to Tax Law Improvement Act (No. 1) 1998 take effect from the commencement of that Act, ie. the 1998-99 income year.

2.132 The inclusion in assessable income under new Division 243 of amounts to adjust for excessive capital allowance deductions and associated consequential changes, apply to hire purchase and limited recourse debt arrangements which terminate after 27 February 1998. Minor consequential amendments to Tax Law Improvement Act (No. 1) 1998 take effect from the commencement of that Act, ie. the 1998-99 income year.

2.133 Part 4 of the Bill which ensures that ownership of assets transferred for purposes of security is not disturbed, applies to relevant transactions entered into after 27 February 1998. Minor consequential amendments to Tax Law Improvement Act (No. 1) 1998 take effect from the commencement of that Act, ie. the 1998-99 income year.

REGULATION IMPACT STATEMENT

Specification of policy objective

2.134 To ensure that total capital allowance deductions for allowable capital expenditure do not exceed the total amount actually expended by a taxpayer under limited recourse debt or hire purchase.

2.135 This proposed amendment to the ITAA 1997 was announced by the Government in the 1997-98 Budget and further explained in the Treasurers Press Release No. 21 of 27 February 1998.

Identification of implementation option(s)

2.136 There are two possible options whereby this particular policy initiative could be implemented.

Option 1: Insert a separate capital expenditure adjustment rule to apply on termination of the financial arrangement.

2.137 Under this option there would be a single expenditure adjustment rule which would apply when a hire purchase or limited recourse debt financing arrangement is terminated and the total net capital allowance deductions obtained exceeded the deductions that would be allowable on the basis of the capital amount actually expended by the taxpayer under the financing arrangement. The adjustment amount would be included in the borrowers assessable income.

2.138 The calculation of this adjustment would take into account any adjustment that has applied under the capital allowance provisions on the disposal of the relevant property, eg. balancing adjustment.

Option 2: Incorporate a capital expenditure adjustment rule into existing balancing adjustment and income calculations which apply on the disposal of property.

2.139 This option would amend existing balancing adjustment and disposal rules that apply to various capital allowance provisions. The amendment would ensure that any unpaid capital cost was included in the calculation of any balancing adjustment or income rule on disposal of the relevant property ie. in working out the adjustment, the unpaid cost would be added to the disposal value of the property.

2.140 However, an additional rule would be required to deal with cases where the relevant capital allowance did not provide for an adjustment on disposal of the property. Under the additional rule, there would be an adjustment amount equal to the difference between total net capital allowance deductions obtained and deductions that would be allowable on the basis of the capital amounts actually expended by the taxpayer. The adjustment amount could be included in assessable income or treated as an adjustment to the capital allowance deductions obtained.

2.141 Under either option, rules are required which treat a taxpayer who has financed the acquisition of property by hire purchase as being in an equivalent position to one who has utilised loan finance to buy property. This is necessary to ensure there is an appropriate basis to allow capital deductions which accrue under the law only to the owner of eligible property and, in an appropriate case, to make a taxable adjustment where a capital amount remains unpaid on termination of the hire purchase arrangement.

Assessment of impacts (costs and benefits) of each option:

Impact group identification

2.142 This measure affects taxpayers claiming capital allowances on property financed by hire purchase or limited recourse debt and who do not discharge their payment obligations.

2.143 The Australian Taxation Office (ATO) expects that the number of private ruling requests will increase, at least initially, as some taxpayers may require assistance in applying the adjustment rule on termination of hire purchase and limited recourse debt arrangements and in the calculation of the adjustment amount. The increase in ruling requests is expected to be short term only. This workload is expected to be dealt with within existing resources.

Assessment of costs

2.144 To the extent that proposed rules which treat a hire purchaser as the owner of the property for capital allowances will formalise the existing administrative practice, no significant additional compliance costs to taxpayers are expected. However, taxpayers will have to come to an understanding of the tax treatment of hire purchase arrangements as equivalent to loans and the operation of the capital allowance adjustment rules that apply on termination of a hire purchase agreement or limited recourse loan.

2.145 Compliance costs are likely to be less under Option 1 because one adjustment rule will be common to all capital allowances and implemented in the same way in all cases.

2.146 The initial and recurrent compliance costs of this proposal are estimated to be less than $1 million per annum on the expectation that only a small percentage of taxpayers will terminate their hire purchase or limited recourse debt transactions.

Assessment of benefits

2.147 The benefits of Option 1 are that it:

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is capable of application to all capital allowances as a common rule, whether or not they require a balancing adjustment;

•

applies on termination of the relevant hire purchase or limited recourse debt transaction, which is when the quantum of any non payment can be ascertained;

•

does not require a special rule as Option 2 would to deal with cases where the property is disposed of but the underlying financial transaction remains on foot;

•

as a common expenditure adjustment rule, can be more easily integrated with existing commercial debt forgiveness rules for the purpose of preventing double taxation;

•

better targets the cases likely to be affected - hire purchase and limited recourse debt transactions where some amounts are unpaid on termination of the arrangement.

2.148 The benefit of Option 2 is:

Because the proposed adjustments apply to expenditure that qualifies for capital deductions, Option 2 would be easier to integrate with existing rules that relate to disposal of property under various capital allowances. This benefit is somewhat nullified because, as noted, extra legislative rules would be needed for the capital allowances that do not provide for adjustments on disposal.

Consultation

2.149 In developing the provisions relating to hire purchase, careful consideration has been given to representations made by finance industry and taxpayer representative bodies to the Joint Committee of Public Accounts in relation to similar provisions which were contained in the Tax Law Improvement Bill 1996. The measures relating to limited recourse debt take into account of submissions made to the Senate Economics Legislation Committee in the context of its deliberations on similar provisions contained in Taxation Laws Amendment Bill (No. 4) 1998. The Bill lapsed when the Parliament was prorogued prior to the 1998 Federal election.

2.150 Consultation in the form of discussions and seminars on administrative and legislative issues will be carried out with relevant industry and professional bodies and individuals in the early implementation stages of the measure.

Conclusion

2.151 Option 1 is preferred. In summary, it requires less complex legislative drafting and its application on the termination of the relevant financial transaction eliminates any additional adjustments that may be necessary if the capital expenditure adjustment were to apply on disposal of the underlying asset.

2.152 The Treasury and Australian Taxation Office (ATO) will monitor this taxation measure, as part of the whole taxation system, on an ongoing basis. In addition, the ATO has consultative arrangements in place to obtain feedback from professional and small business associations and through other taxpayer consultation forums.