Edited version of your written advice

Authorisation Number: 1013105457951

Date of advice: 12 October 2016

Ruling

Subject: Income tax - capital allowances - other

Question 1

Will the rulee be subject to Division 250 of the Income Tax Assessment Act 1997 (ITAA 1997) in relation to the leasing of the building?

Answer

Yes.

Question 2

To the extent that the rulee is considered to lack a predominant economic interest in the building, will the Commissioner make a determination under subsection 250-45 of the ITAA 1997 that it is unreasonable that Division 250 of the ITAA 1997 should apply to the rulee in these circumstances?

Answer

Yes.

Question 3

Will the rulee be subject to Division 250 of the ITAA 1997 in relation to the leasing of the depreciating assets?

Answer

Yes.

Question 4

To the extent that the rulee is considered to lack a predominant economic interest in the depreciating assets, will the Commissioner make a determination under subsection 250-45 of the ITAA 1997 that it is unreasonable that Division 250 of the ITAA 1997 should apply to the rulee in these circumstances?

Answer

Yes.

This ruling applies for the following periods:

1 July 20XX to 30 June 20XX.

The scheme commences on:

August 20XX.

Relevant facts and circumstances

The rulee

The rulee is an Australian resident unit trust. 100% of rulee's units are held by Assets Holding Trust, an Australian resident unit trust. All of the units in Asset Holding Trust are held by A Property Trust, an Australian discretionary trust.

Tax Exempt Entity

Tax Exempt Entity is exempt from Australian income tax under a Commonwealth Act.

Tax Exempt Entity has a location in XXX.

Sale of Tax Exempt Property

The rulee entered into a Contract of Sale in August 20XX to acquire land, buildings, and associated equipment in respect of a property located in XXX (the Property).

The purchase was settled on DD MM YY. The purchase price under the Contract of Sale was $XXX million. Including stamp duty of $X.XX million, the total cost of the property was financed by limited recourse debt in the form of a relevant facility of $XX.XX million and total equity contribution of $XX.XX million.

As part of the acquisition of the Property, the existing leasehold on the property with Tax Exempt Entity was transferred to the rulee.

Lease Agreement

The Lease Agreement (Lease) with Tax Exempt Entity commenced on DD MM YY. The term of the lease is XXX. The termination date is DD MM YY.

The following clauses are relevant to Tax Exempt Entity's end of term rights:

● Under clause 32 of the Lease, Tax Exempt Entity, as lessee, has the option to purchase the 'Premises' at the end of the lease for the 'Purchase Value';

● The 'Purchase Value' is determined under clause 32.3 of the Lease as the value determined by an independent valuer; and

● Tax Exempt Entity also an option to renew the lease for XXX under clause 23 and item 14 of Schedule 1 of the Lease. On the basis of discussions it had with Tax Exempt Entity in late 20XX following the acquisition of the Property, the rulee reasonably expects that the Tax Exempt Entity will not exercise these options of renewal.

The following clauses are relevant to the property subject to the Lease:

● The 'Premises' is defined in the Lease to mean the 'Land', 'Buildings', 'Plant', 'Lessor's fixtures and fittings' and any other improvements on the land from time to time (clause 1.2);

● 'Lessor's fixtures and fittings' is any property owned by the Lessor on the 'Premises' (including all 'Plant') at any time (clause 1.2);

● 'Buildings' is defined to mean all improvements on the Premises, including the 'New Buildings' and all 'Lessor's fixtures and fittings' and Plant but does not include the 'Lessee's Property' (clause 1.2);

● 'New Buildings' is defined as Building A and Building B (clause 11.1); and

● 'Lessee's Property' is defined as all fittings, fixtures and other articles on the 'Premises' at any time which are the property of the Lessee (clause 1.2).

The following clauses are relevant to the alterations and additions Tax Exempt Entity may make to the Property:

● Under clause 12 of the Lease, Tax Exempt Entity can make alterations and additions to the property;

● Under clause 12.5, Tax Exempt Entity owns all the alterations, additions and fittings installed by it; and

● Under clause 12.6(2), on termination of the lease, Tax Exempt Entity has a right to remove all or part of the alterations and additions made to the premises that it has paid for or it owns. These alterations, additions and fittings form part of the 'Lessee's Property' under clause 1.2 of the Lease.

The following clauses are relevant to the development works that Tax Exempt Entity may carry out on the Property:

● Tax Exempt Entity is entitled to carry out certain development works under clause 11 of the Lease, known as 'Lessee's Development Works' which specifically includes the construction of Building A and Building B (New Buildings);

● Tax Exempt Entity has completed the building of these two buildings. The completed new buildings form part of the 'Premises' (as defined) for the purposes of the Lease and are the property of the Lessor pursuant to clause 11.2(2) of the Lease;

● Tax Exempt Entity was paid $XX.XX million from the previous lessor for these works in accordance with clause 31 and Schedule 10 of the Lease; and

● Construction of these new buildings involved the installation of equipment and fixtures integral to the completion of the buildings. This included elevators, Heating, Ventilation and Air Conditioning (HVAC) equipment, light fittings, water heating/cooling, removable floor coverings, fire services equipment, and security and surveillance equipment.

XYZ Report

The rulee commissioned a report from a quantity surveyor, XYZ Property Consultancy Pty Ltd to assess future deductions available under Division 40 and Division 43 of the ITAA 1997 in respect of the Property. The findings of the analysis are in a report titled XYZ report.

The XYZ report produced the following findings:

● A split of the total purchase price of the property as follows:

● Building: $XXX million

● Land: $XX.X million

● Depreciating assets: $XX.X million

● Total: $XXX million.

● Capital works in relation to the property were incurred in numerous stages with the first stage being completed on DD MM YY. After YY, the remaining capital works and structural improvements were completed on or after DD MM YY.

● The buildings and capital improvements to such buildings have an effective life of forty years based on the 2.5% rate of deduction for building works which commenced construction after DD MM YY and structural improvements which commenced construction after DD MM YY.

● For depreciating assets forming part of the property, the 'effective life' used by XYZ as a basis for calculating rates of depreciation under Division 40 correspond to the Commissioner's published effective life for assets. The rulee has chosen to adopt these effective life periods for depreciating assets as an estimate of their remaining effective lives as at DD MM YY (when the rulee purchased the property).

Relevant legislative provisions

Income Tax Assessment Act 1997 section 40-10,

Income Tax Assessment Act 1997 section 43-10,

Income Tax Assessment Act 1997 section 250-5,

Income Tax Assessment Act 1997 section 250-10,

Income Tax Assessment Act 1997 section 250-15,

Income Tax Assessment Act 1997 section 250-20,

Income Tax Assessment Act 1997 section 250-25,

Income Tax Assessment Act 1997 section 250-30,

Income Tax Assessment Act 1997 section 250-40,

Income Tax Assessment Act 1997 section 250-45,

Income Tax Assessment Act 1997 section 250-65,

Income Tax Assessment Act 1997 section 250-115,

Income Tax Assessment Act 1997 section 250-120,

Income Tax Assessment Act 1997 section 250-125,

Income Tax Assessment Act 1997 section 250-130,

Income Tax Assessment Act 1997 section 250-135,

Income Tax Assessment Act 1997 section 974-160, and

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

Question 1

Division 250 operates to deny or reduce capital allowance deductions that would otherwise be available in respect of an asset that is put to a tax preferred use and when a taxpayer has insufficient economic interest in the asset (section 250-5).

Section 250-10 states that Division 250 applies to an asset at a particular time if the general test in section 250-15 is satisfied and none of the exclusions in sections 250-20, 250-25, 250-30, 250-40 and 250-45 apply.

Section 250-15 General Test

This Division applies to you and an asset at a particular time if:

(a) the asset is being *put to a tax preferred use; and

(b) the *arrangement period for the *tax preferred use of the asset is greater than 12 months; and

(c) *financial benefits in relation to the tax preferred use of the asset have been, will be or can reasonably be expected to be, *provided to you (or a *connected entity) by:

(i) a *tax preferred end user (or a connected entity); or

(ii) any *tax preferred entity (or a connected entity); or

(iii) any entity that is a foreign resident; and

(d) disregarding this Division, you would be entitled to a *capital allowance in relation to:

(i) a decline in the value of the asset; or

(ii) expenditure in relation to the asset; and

(e) you lack a *predominant economic interest in the asset at that time.

An important thing to note is that Division 250 applies to each asset, noting to the words 'This Division applies to you and an asset' in both sections 250-10 and 250-15.

The Commissioner agrees that Division 250 needs to be considered separately in relation to the leasing of the building and depreciating assets. This is consistent with the idea that Division 250 applies to each asset and section 250-75 which states that Division 250 applies to an improvement to land or a fixture on land as if it were an asset separate from the land.

Therefore, the Commissioner will consider the application of Division 250 in relation to the building under Questions 1 and 2, and then consider the application of Division 250 in relation to the depreciating assets under Questions 3 and 4.

Asset being put to a tax preferred use - paragraph 250-15(a)

An asset is put to a 'tax preferred use' when the end user of the asset holds rights as a lessee under a lease of the asset and the asset is used by a tax preferred end user (section 250-60).

The asset is the Property located in XXX currently occupied by Tax Exempt Entity (the Asset). For the purposes of Questions 1 and 2, the Asset only includes the buildings and improvements made to the buildings and excludes the depreciating assets that may otherwise form part of the building.

The lessee and end user of the Asset is Tax Exempt Entity, which is an 'exempt entity' and a 'tax preferred entity' under section 995-1 of the ITAA 1997.

Therefore, the Asset is being put to a tax preferred use and paragraph 250-15(a) is satisfied.

Arrangement period is greater than 12 months - paragraph 250-15(b)

Start of the arrangement period

The arrangement period for a particular tax preferred use of an asset starts when that tax preferred use of the asset starts (subsection 250-65(1)). Each separate tax preferred use means that there is a separate and distinct arrangement period.

The arrangement period commenced when the rulee took over as lessor of the lease with Tax Exempt Entity on DD MM YY, the date on which the Asset was first put to tax preferred use, rather than the time the lease was originally entered into (DD MM YY).

End of the arrangement period

The arrangement period for a particular tax preferred use of an asset ends on the earliest of the day that the tax preferred use may reasonably be expected to, or is likely to, end and the day that Division 250 no longer applies to the taxpayer and the asset (subsection 250-65(2) and (3)).

Under clause 23 of the Lease, Tax Exempt Entity has the option to renew the Lease for XXX According to the rulee, based on its discussion with Tax Exempt Entity in late 20XX the rulee expects Tax Exempt Entity will not exercise its option to renew the lease. More importantly, unless it is clear that the Tax Exempt Entity will exercise the option to renew the lease it cannot be assumed for the purposes of this ruling that the option will be exercised. Therefore, the Lease is reasonably expected to end on its termination date on DD MM YY.

Under paragraph 250-65(4)(b), it must be assumed that any right Tax Exempt Entity has to renew the lease will not be exercised unless it is reasonable to assume that the right to renew will be exercised because of the commercial consequences for the Tax Exempt Entity of not exercising that right. Since there are no commercial consequences (e.g. financial penalties) for Tax Exempt Entity for not extending the lease, the rulee is entitled to assume, in the absence of evidence to the contrary, that Tax Exempt Entity will not exercise its right to extend the lease.

Therefore the arrangement period is from DD MM YY to DD MM YY, a period of approximately X years. As this period is greater than 12 months, paragraph 250-15(b) is satisfied.

Financial benefits must be provided in relation to the tax preferred use of the asset - paragraph 250-15(c)

Financial benefit is defined in section 974-160 of the ITAA 1997 to include anything of economic value. In the current arrangement, financial benefits are provided in the form of regular rental payments to the rulee by Tax Exempt Entity for the use of the building, such that paragraph 250-15(c) is satisfied.

Entitlement to a capital allowance in relation to expenditure in relation to the asset - paragraph 250-15(d)

Disregarding Division 250, the rulee must be entitled to capital allowance deductions in respect of the building under Division 43 in order for paragraph 250-15(d) to be satisfied.

Under Division 43, certain construction expenditure incurred in constructing capital works (such as buildings and structural improvements) can be deducted at a rate of 2.5% per year.

Broadly, deductions for capital works can be claimed in accordance with section 43-10 if:

(a) the capital works have a construction expenditure area;

(b) there is a pool of construction expenditure for that area; and

(c) the relevant taxpayer uses the construction area that it owns in the income year in the way set out in the table in section 43-140 (i.e. the capital works must be used in a deductible way)

Having regard to the Property, the relevant construction expenditure areas will be the buildings and improvements made to the buildings located on the Property.

Based on the Asset being leased to Tax Exempt Entity in return for rent which is assessable income for the rulee, the Asset is considered to be used by the rulee in a deductible way under section 43-140.

Having regard to the requirements in section 43-10, it is expected that the rulee will be entitled to capital works deductions in relation to those assets; therefore paragraph 250-15(d) is satisfied.

Summary: 250-15(a)-(d) satisfied

Since the rulee satisfies the requirements in paragraphs (a) to (d) of section 250-15, Division 250 will apply to the rulee if it satisfies the remaining requirement under paragraph (e) which requires that the rulee lacks a predominant economic interest in the Asset.

Lacking a predominant economic interest - paragraph 250-15(e)

In order to determine whether there is a lack of predominant economic interest for the purpose of paragraph 250-15(e), four tests, also known as the 'safe harbour tests' will need to be considered:

1. Limited recourse debt test - section 250-115;

2. Right to acquire asset test - section 250-120;

3. Effectively non-cancellable, long term arrangement test - section 250-125; and

4. Level of expected financial benefits test - section 250-135

If any one of the safe harbour tests is satisfied then the rulee will lack a predominant economic interest in the asset and Division 250 will apply.

1. Section 250-115 - limited recourse debt test

The effect of the 'limited recourse debt test' is that for the duration of the arrangement, the taxpayer must hold some equity or investment effectively at risk in an asset to be treated as having the predominant economic interest in the asset.

The test states that you will lack a predominant economic interest in an asset if more than the allowable percentage of the cost of acquiring the asset is financed by limited recourse debt (subsection 250-115(1)). Limited recourse debt occurs when the rights of the creditor against the debtor are limited in the event of debtor default (section 243-20). In the present situation, the test will be satisfied where the Asset is financed by more than 80% limited recourse debt as the Asset is put to tax preferred use because the end user is a tax preferred entity (paragraph 250-115(3)(a)).

The total cost of acquiring the Property was $XXX.X million. The rulee financed the purchase of the Property with relevant Facility of $XX.XX million obtained from XXX Bank and total equity contribution of $XX.XX million. On the basis that the relevant Facility is limited recourse debt, it does not exceed 80% of the cost of acquiring the property and therefore the limited recourse debt is not satisfied.

2. Section 250-120 - Right to acquire asset test

The 'right to acquire asset test' is relevant in determining whether the taxpayer has the predominant economic interest in an asset because the right or obligation of the tax preferred end user to acquire the asset during or at the end of the arrangement indicates that the arrangement is a financing arrangement as the tax preferred entity effectively has the risks and benefits of ownership of the asset.

Under section 250-120, an entity will lack a predominant economic interest in an asset when there is a right, obligation, or contingent obligation to acquire the asset at the end of the arrangement period and the consideration for that acquisition is not fixed as the market value of the asset at the time of the transfer.

Under clause 32 of the Lease, Tax Exempt Entity has a right to purchase the Asset at the end of the term of the lease for the Purchase Value which is determined by an independent valuer. Given that the consideration to be paid for the purchase is set at the market value of the asset at the end of the arrangement, the right to acquire asset test is not satisfied.

3. Section 250-125 - Effectively non-cancellable, long term arrangement test

The 'effectively non-cancellable long term arrangement test' is relevant in determining whether the taxpayer has the predominant economic interest in an asset because it discourages the tax preferred entity from cancelling the arrangement. This generally means that the tax preferred entity has to make payments that are likely to cover all or a substantial proportion of the un-recouped cost of the asset. Consequently, all or a substantial proportion of the risks and benefits of ownership of the asset are borne by the tax preferred end user rather than the taxpayer.

Under subsection 250-125(1) an entity will lack a predominant economic interest in an asset at any particular time if:

(a) any *arrangement that relates to:

(i) the *tax preferred use of the asset; or

(ii) the *financial benefits to be *provided by the *members of the tax preferred sector in relation to the tax preferred use of the asset;

is *effectively non-cancellable (see section 250-130); and

(b) the *arrangement period for the tax preferred use of the asset is:

(i) greater than 30 years; or

(ii) if the arrangement period is less than or equal to 30 years - 75% or more of that part of the asset's *effective life that remains when the tax preferred use of the asset starts.

Section 250-130 explains that an arrangement is effectively non-cancellable if the arrangement can be cancelled only with the permission of the taxpayer or if the arrangement can be cancelled without permission, the tax preferred entity would be required to enter into a replacement arrangement or incur a penalty of such magnitude that it would discourage cancellation. An example of a financial penalty that would discourage cancellation is provided by paragraph 1.94 of the EM to Tax Laws Amendment (2007 Measures No. 5) Bill 2007 as a payment equivalent to the un-recouped investment in the asset.

Cancellation of the Lease by Tax Exempt Entity is possible without the permission of the rulee. If Tax Exempt Entity defaults under the lease and the arrangement is cancelled, the arrangement is taken to have been cancelled without the rulee's permission. Upon cancellation, Tax Exempt Entity is liable to pay the 'Lease Termination Amount' as calculated under the Lease in Schedule 11. Clause 19.3(2) of the Lease explains that the 'Lease Termination Amount' is a genuine pre-estimate of the damages the Lessor will suffer as a result of the cancellation. The 'Lease Termination Amount' is based on a formula which appears to be calculated by reference to the maturity date of the lease which suggests that the penalty would be of a magnitude that would discourage cancellation.

Therefore, the arrangement that relates to the tax preferred use of the asset is effectively non-cancellable.

The rulee will satisfy the effectively non-cancellable, long term arrangement test if:

(a) the arrangement period for the tax preferred use of the asset is greater than 30 years or

(b) the arrangement period is less than or equal to 30 years and the arrangement period is 75% or more of that part of the asset's effective life that remains when the tax preferred use of the asset starts.

The test under paragraph 250-125(1)(b) compares the arrangement period with the remaining effective life of the asset (building) when the tax preferred use starts. Therefore, the relevant consideration is the building's remaining effective life as at DD MM YY.

Presently, the arrangement period is less than 30 years; it is X years. Therefore, the effectively non-cancellable, long term arrangement test will be satisfied if the arrangement period is 75% or more of the building's remaining effective life as at DD MM YY. Effectively, the test will be satisfied if the building's remaining effective life as at DD MM YY is less than approximately X years.

What is the effective life of the building?

'Effective life' is defined under section 995-1 as 'the effective life of a depreciating asset is worked out under section 40-95, 40-100, 40-102, 40-105 and 40-110'. Generally, a taxpayer has a choice of determining effective life by either using an effective life determined by the Commissioner for a depreciating asset under section 40-100 or self-determining the effective life under section 40-105.

Paragraph 1.5 of the EM to New Business Tax System (Capital Allowances) Bill 2001 explains the meaning of the effective life of an asset as follows:

It is the period that the asset can be used by you or anybody else for income producing purposes, assuming it will be subject to wear and tear at a reasonable rate and that it will be maintained in reasonably good order and condition…..

The rulee has commissioned XYZ to undertake an independent analysis of the capital allowances available under the ITAA 1997 in respect of the Property.

Based on the XYZ report^:

● capital works in relation to the property were incurred in numerous stages with the first stage being completed on DD MM YY;

● the remaining capital works and structural improvements were completed on and after DD MM YY; and

● the buildings and capital improvements to such buildings have an 'effective life' of 40 years.

Remaining effective life

As at DD MM YY, the remaining effective life of the building is as follows:

Therefore:

● capital works that were completed on DD MM YY have a remaining effective life that is less than X years such that the 'effectively non-cancellable, long term arrangement test' is satisfied; and

● the remaining capital works and structural improvements were completed on or after DD MM YY and have a remaining effective life that is greater than X years such that the 'effectively non-cancellable, long term arrangement test' is not satisfied.

In conclusion, the effectively non-cancellable long term arrangement test is satisfied in relation to the building due to the capital works that were completed on DD MM YY.

4. Level of expected financial benefits test - section 250-135

Section 250-135 is set out below

Effective guarantee or indemnity for value of asset

250-135(1) You lack a predominant economic interest in an asset at a particular time if the asset has a *guaranteed residual value at that time.

Likely financial benefits exceeding 70% limit

250-135(2) You also lack a predominant economic interest in an asset at a particular time if, at that time:

(a) the *arrangement under which the asset is *put to the tax preferred use (either alone or together with any other arrangement in relation to the *tax preferred use of the asset or the *provision of *financial benefits in relation to the tax preferred use of the asset) is a *debt interest; or

(b) the sum of the present values of the *expected financial benefits that *members of the tax preferred sector have provided, or are reasonably likely to provide, to you (or a *connected entity) in relation to the tax preferred use of the asset exceeds 70% of:

(i) the *market value of the asset if subparagraph 250-15(d)(i) applies; or

(ii) so much of the market value of the asset as is attributable to the expenditure referred to subparagraph 250-15(d)(ii) if that subparagraph applies

The 'level of expected financial benefits test' is relevant in determining whether the taxpayer has the predominant economic interest in an asset because it is an indicator of whether the arrangement is in the nature of financing by the taxpayer of an asset purchased for a tax preferred entity.

'Guaranteed residual value' is defined in subsection 250-85(3). It describes the situation where the entity holding the asset disposes of that asset, and in the event the disposal proceeds are less than the guaranteed amount, it receives the difference in payment from the tax preferred end user. The Asset is not part of a guaranteed residual value arrangement and therefore the rulee does not lack a predominant economic interest under subsection 250-135(1).

Paragraph 250-135(2)(a) considers whether the arrangement for the tax preferred use of the Asset is a debt interest. The test for a debt interest is contained in section 974-20. Broadly, a scheme will be a debt interest where it is a financing arrangement under which the entity receives financial benefits that are effectively non-contingent, and the value of those financial benefits provided is substantially more likely than not to equal the value received. Certain leases of real property, such as the lease of the Asset, are excluded from being a financing arrangement (subsection 974-130(4)). This means that lease is not a debt interest and that the taxpayer will not lack a predominant economic interest under paragraph 250-135(2)(a).

Paragraph 250-135(2)(b) compares the present values of the expected financial benefits that the rulee expects to receive in rent under the lease with the market value of the Asset. That figure needs to be less than or equal to 70% or the taxpayer will be deemed to lack a predominant economic interest in the asset.

For the purpose of Division 250, section 250-95 defines expected financial benefits as financial benefits that have, will, or can reasonably be expected to be provided in relation to the tax preferred use of the Asset under normal operating conditions.

The expected financial benefits reasonably expected to be provided to the rulee from the lease of the building to Tax Exempt Entity are the net rental payments expected to be received from Tax Exempt Entity. Based on the lease agreement, the forecasted rent for the arrangement of X years is $XXX million. However, as the rent is payable for the lease of both the building and depreciating assets, an apportionment of the rental payments is appropriate, based on the expected market value of the building and depreciating assets as follows:

Paragraph 250-135(2)(b) compares the sum of the present values of the expected financial benefits with the market value of the asset. The rulee has used a discounted rate of 8.5%, reflecting the expected internal rate of return of the investment in the property. The estimated present value of the expected financial benefits would be as follows:

In summary, as the sum of the present value of the expected financial benefits from the lease of the building does not exceed 70% of the market value of the Property, the level of expected financial benefits test is not satisfied.

Summary of safe harbour tests

The rulee lacks a predominant economic interest in the Property because it satisfies the effectively non-cancellable, long term arrangement test. Since the remaining conditions under section 250-15 are satisfied, the rulee satisfies the general test and Division 250 will apply to the rulee and the building.

Exclusions under section 250-20, 250-30 and 250-40

Section 250-10 states that Division 250 will not apply to the rulee and the building if one of the exclusions in sections 250-20, 250-25, 250-30, 250-40 and 250-45 apply.

1. Small business entity (section 250-20);

2. Financial benefits under minimum value limit (section 250-25);

3. Certain short term or low value arrangements (section 250-30); and

4. Sum of present value of financial benefits less than amount otherwise assessable (section 250-40).

None of the exclusions apply to the rulee for the following reasons:

In the absence of the exclusions applying, Division 250 will apply to the rulee and the building unless the Commissioner exercises his discretion under section 250-45.

Question 2

Section 250-45 states as follows:

This Division does not apply to a taxpayer and an asset at a particular time if:

(a) you request the Commissioner to make a determination under this subsection; and

(b) the Commissioner determines that it is unreasonable that the Division should apply to you and the asset at that time, having regard to:

(i) the circumstances because of which this Division would apply to you and the asset; and

(ii) any other relevant circumstances.

The rulee submits that it is unreasonable that Division 250 should apply on the basis that the capital works completed on DD MM YY only accounts for 1.65% of the total capital expenditure incurred - that is $XXX out of a total of $XX,XXX of capital expenditure on capital works and structural improvements.

The rulee also submits that the Commissioner should have regard to the objects of Division 250 as set out in section 250-5 as follows:

The main objects of this Division are:

(a) to deny or reduce your capital allowance deductions in respect of an asset if the asset is put to a tax preferred use and you have insufficient economic interest in the asset; and…..

Object of Division 250

The Commissioner agrees with the rulee that the starting point to determining whether the discretion under section 250-45 should be exercised is a consideration of the object of Division 250. This is in accordance with paragraph 1.136 of the EM to Tax Laws Amendment (2007 Measures No. 5) Bill 2007 which states as follows:

1.136 In making the determination, the Commissioner should give consideration to the objects of the Division set out in section 250-5.

The purpose or object of Division is stated in section 250-5 and also explained under the 'Context of amendments' section of the EM to Tax Laws Amendment (2007 Measures No. 5) Bill 2007. Broadly, Division 250 was introduced to capture arrangements under which the risks and benefits associated with ownership of an asset was transferred to the 'real' or 'end' user of that asset which typically a tax exempt entity, while the taxpayer would retain capital allowance deductions that should only be available to the 'real' or 'end' user of the assets. The arrangements therefore circumvented the general principle of income tax law that deductions for capital expenditure is available to an owner the asset if the asset is used for the purpose of producing assessable income or in carrying on a business for that purpose.

The Commissioner is satisfied the arrangement entered into by the rulee was not for the purposes of transferring the risk and benefits of ownership of the depreciating assets to Tax Exempt Entity.

The circumstances because of which this Division would apply to the rulee and the asset

The main reason why Division 250 applies to the rulee and the asset is because of the 'effectively non-cancellable, long term arrangement test'. Absent the satisfaction of this test, the rulee would not have met any of the four tests triggering a lack of predominant economic interest in the asset. As discussed below, the Commissioner considers that breach of the 'effectively non-cancellable, long term arrangement test' was marginal such that the discretion under section 250-45 should be exercised favourably for the rulee.

Other relevant circumstances

Paragraph 1.137 of the EM to Tax Laws Amendment (2007 Measures No. 5) Bill 2007 also states the other considerations the Commissioner should consider:

1.137 It is expected that the Commissioner would consider applying the discretion, for example, to prevent an arrangement coming within the scope of Division 250 due to:

● an unintended or marginal breach of one of the safe harbour tests; or

● an unintended or marginal breach of one of the tests that need to be satisfied to qualify for the specific exclusions for certain operating and service arrangements.

The 'safe harbour tests' referred to in paragraph 1.137 of the EM are the four tests that comprise the predominant economic interest test:

● the 'limited recourse debt test';  

● the 'right to acquire asset test';

● the 'effectively non-cancellable, long term arrangement test'; and

● the 'level of expected financial benefits test'.

The Commissioner considers that there has been only a marginal breach of one of the safe harbour test; namely the main reason for the rulee lacking a predominant economic interest in the asset is the capital works completed on DD MM YY, resulting in the rulee meeting the 'effectively non-cancellable, long term arrangement test'. This is a marginal breach since these capital works represent only a minor proportion of the total capital expenditure on the building. In the absence of the 'effectively non-cancellable, long-term arrangement test', the rulee would otherwise not lack a predominant economic interest in the asset.

Therefore, having regard to the circumstances because of which Division 250 would apply to the rulee and the Asset and the considerations identified above, the Commissioner determines under section 250-45 that it is unreasonable that Division 250 should apply to the rulee and the building.

Question 3

As mentioned, Division 250 applies to each asset separately. The general test under section 250-15 that applies to the building is applicable to all the depreciating assets that are leased. For the purposes of Questions 3 and 4, reference to 'the asset' is a reference to each depreciating asset that is leased as part of the Property.

For the same reasons that apply to the building, each of the first three conditions under paragraphs 250-15(1)(a), (b) and (c) are satisfied in respect of each depreciating asset leased. That is:

(a) the depreciating assets are put to a tax preferred use when they are used by Tax Exempt Entity which is a tax preferred entity;

(b) the arrangement period for the tax preferred use of the depreciating asset is greater than 12 months. The arrangement period for the particular tax preferred use of the depreciating assets commenced when Tax Exempt Entity first used the assets under the Lease with the rulee as the new owner and lessee of the property on DD MM YY. The arrangement period is reasonably expected to end on DD MM YY. Therefore, the arrangement period is X years.

(c) financial benefits in relation to the tax preferred use of the depreciating assets have been and will be or can reasonably be expected to be provided to the taxpayer by the tax preferred entity. Tax Exempt Entity is obliged to pay the rulee rent with respect to the lease of the 'Premises' which includes 'Plant' and 'Lessor's fixtures and fittings'. Therefore, the rulee will receive financial benefit from Tax Exempt Entity in respect of any depreciating assets to the extent that these form part of the 'Premises' as defined.

Division 40 - capital allowance deduction - paragraph 250-15(1)(d)

The requirement under paragraph 250-15(1)(d) is that disregarding Division 250, the taxpayer would be entitled to a capital allowance in relation to either the decline in value of the asset or expenditure in relation to the asset.

Division 40 is relevant to capital allowances for depreciating assets. Under subsection 40-25(1), a taxpayer can deduct an amount equal to the decline in value for an income year of a depreciating asset that is 'held' for any time during the year.

Section 40-40 contains a table that is relevant to working out who holds a depreciating asset. If more than one item in the table applies, there is more than one holder of the asset (unless one of the items states that a particular taxpayer is not taken to hold the asset in which case the taxpayer cannot then be taken to hold the asset under another item) and the asset is jointly held.

Item 10 - legal owner of a depreciating asset is the holder

Pursuant to item 10 of the table in section 40-40, for any depreciating asset, the legal owner is the holder of a depreciating asset.

The rulee became the owner of the property upon settlement on DD MM YY. As a general rule, the rulee, as the owner of the 'Premises' (as defined in clause 1.2 of the Lease) which is subject to the Lease is the holder of any depreciating assets that fall within the definition of 'Premises'.

Under the Lease, 'Premises' includes all 'Plant', 'Buildings', 'Lessor's fixtures and fittings' and any improvements on the land from time to time. The rulee is entitled to a deduction for the decline in value of these depreciating assets.

● Equipment and fixtures part of the New Buildings (Lessee's Development Works)

Under the Lease, pursuant to clause 11 ('Lessee's Development Works'), Tax Exempt Entity was authorised to build two new buildings comprising Building A and Building B. Both new buildings form part of the definition of 'Premises' under the Lease and are therefore owned by the Lessor. These works were ultimately paid by the rulee's predecessor (i.e. the previous Lessor) by way of the Lessor Payments applicable under clause 31 of the Lease.

The construction of the new buildings involved the installation of equipment and fixtures integral to the completion of the building. For example the elevators, Heating, Ventilation and Air Conditioning (HVAC) equipment, light fittings, water heating/cooling, removable floor coverings, fire services equipment, security and surveillance equipment. These assets ultimately form part of the new buildings and are owned by the Lessor. The rulee contends that, to the extent that it paid for these assets and receives the enduring benefit of the improvements as the legal owner of the asset, item 10 of the table in section 40-40 should apply. The Commissioner agrees.

Item 2 - owner of quasi-ownership right over a depreciating assets fixed to land is the owner

Item 2 of the table in section 40-40 applies to a depreciating asset that is fixed to land subject to a 'quasi-ownership right' (including any extension or renewal of such right) where the owner of the right has a right to remove the asset. For this kind of depreciating asset, the owner of the quasi-ownership right is the holder of the asset while the right to remove exists. A 'quasi-ownership right' over land is defined under section 995-1 as meaning

(a) a lease of the land;

(b) an easement in connection with the land; or

(c) any other right, power or privilege over the land, or in connection with the land.

Therefore, where the lease of land affixes an asset to the leased land, the lessee is the owner of a quasi-ownership right over land. Consequently, under item 2 of the table, to the extent that Tax Exempt Entity as the lessee has the right to remove any asset that is fixed to the land that is subject to the lease (even if the right to remove is only exercisable on termination of the lease), it will be the holder of the asset.

● Alterations, additions and fittings made by Tax Exempt Entity

Under clause 12.5, Tax Exempt Entity owns all alterations, additions and fittings installed by it. Examples of such items would be XXX equipment or other depreciable assets that are affixed by Tax Exempt Entity to the land. Under clause 12.6(2) of the Lease, on termination of the lease, Tax Exempt Entity may remove all or part of the alterations and additions made to the property which it owns.

Therefore, any alterations, additions or fittings to the building made by Tax Exempt Entity that are affixed to the land but are removable by Tax Exempt Entity under clause 12.6(2) of the Lease are depreciating assets held by Tax Exempt Entity under item 2 of the table in section 40-40.

To the extent that clause 12.5 states that Tax Exempt Entity is the owner of the alterations and additions, this overrides the general rule that fixtures are owned by the owner of the property to which the fixture is affixed. Therefore, with respect to fixtures that are owned by Tax Exempt Entity and can be removed by it, Tax Exempt Entity is the only owner and holder of the asset and item 10 will not apply to the rulee.

To the extent any alternations, additions and fitting are not affixed to the land, but are chattels, Tax Exempt Entity is the legal owner of the asset pursuant to clause 12.5 of the Lease and is therefore the holder under item 10 of the table in section 40-40. Such assets are classed as 'Lessee's Property' under clause 1.2 and are precluded from being owned by the rulee. The rulee is therefore not the legal owner or holder of these chattels under item 10 of the table.

Item 3 - non-removable improvements to leased land

Item 3 of the table in section 40-40 applies to an improvement to land (whether a fixture or not) subject to a quasi-ownership right made, or itself improved, by an owner of the right for the owner's own use where the owner of the right has no right to remove the asset. For this kind of depreciating asset, the owner of the quasi-ownership right holds the asset while the right exists.

Therefore, item 3 deals with improvements made on leased land by the lessee for its own use where the lessee has no right to remove the asset. In this case, the lessee (as the quasi-owner of the right) is the holder of the improvement while the quasi-ownership right exists - i.e. while the lease exists.

To the extent that Tax Exempt Entity makes any improvements to the property which it has no right to remove, Tax Exempt Entity will be regarded as the holder of the asset while the lease exists. This would include plant, fixtures and fitting which were installed by Tax Exempt Entity at its own expense but which Tax Exempt Entity does not have the right to remove. Tax Exempt Entity is therefore entitled to claim a depreciation deduction for such improvements under item 3 of the table.

In summary, the following assets are potentially subject to Division 250 because the rulee is entitled to a capital allowance under Division 40:

● Lessee's Development works which consists of depreciating assets which are regarded as held by the rulee because it is the legal owner of the asset under item 10 of the table in section 40-40. Examples of such items may include the following items installed in the new buildings: elevators, Heating, Ventilation and Air Conditioning (HVAC) equipment, light fittings, water heating/cooling, removable floor coverings, fire services equipment, and security and surveillance equipment.

The following assets are not subject to Division 250 because the rulee is not the holder of the asset and is not entitled to a capital allowance under Division 40:

● Any alterations, fittings and fixtures which form part of the Lessee's Property and are owned by Tax Exempt Entity under clause 12.5 of the Lease. This includes fixtures which can be removed by Tax Exempt Entity under clause 12.6(2) at the end of the Lease.

● Improvements made by a relevant agency which it has done at its own expense and which Tax Exempt Entity does not have the right to remove.

Predominant economic interest

The 'predominant economic interest test' must be applied to each depreciating asset that may be subject to Division 250.

In order to determine whether there is a lack of predominant economic interest for the purpose of paragraph 250-15(e), four safe harbour tests will need to be considered:

1. Limited recourse debt test - section 250-115;

2. Right to acquire asset test - section 250-120;

3. Effectively non-cancellable, long term arrangement test - section 250-125; and

4. Level of expected financial benefits test - section 250-135

1. Limited recourse debt test - section 250-115

The rulee lacks a predominant economic interest in an asset if more than 80% of the cost of acquiring or constructing the asset is financed by a limited recourse debt. In relation to the depreciating assets that are owned by the rulee these were acquired by the rulee when it acquired the Property on DD MM YY. As discussed in Question 1, the purchase of the Property was financed by limited recourse debt in the form of a relevant Facility but this did not exceed 80% of the total cost of acquiring the property. Accordingly, the limited recourse debt test is not satisfied.

2. Right to acquire asset test - section 250-120

As discussed, Tax Exempt Entity has the option to purchase the property at the termination date, which would include the depreciating assets associated with the property. The right to acquire test will be satisfied if consideration for the purchase is not fixed as the market value of the depreciating asset at the time of the purchase.

Given the purchase price for the Property at termination date is to be determined by a valuer pursuant to clause 32.3, it is reasonable to conclude that the purchase price should reflect the market value of the depreciating assets at termination date. As such the right to acquire test will not be satisfied.

3. Level of expected financial benefits test - section 250-135

Guaranteed residual value - 250-135(1)

The depreciating assets are not part of a guaranteed residual value arrangement and therefore the rulee does not lack a predominant economic interest under subsection 250-135(1).

Debt interest - 250-135(2)(a)

Ordinary operating leases will generally not be classified as 'financing arrangements' under section 974-130. This means that the lease is not a 'debt interest' and that the taxpayer will not lack a predominant economic interest under paragraph 250-135(2)(a).

Expected financial benefit as a percentage of market value - 250-135(2)(b)

Subparagraph 250-135(2)(b)(i) compares the expected financial benefits that the rulee expects to receive in rent under the lease for the use of the asset with the market value of the asset. That figure needs to be less than or equal to 70% or the taxpayer will be deemed to lack a predominant economic interest in the asset.

The expected financial benefits reasonably expected to be provided to the rulee from the lease of the building to Tax Exempt Entity are the net rental payments expected to be received from Tax Exempt Entity. Based on the lease agreement, the forecasted rent for the arrangement of X years is $XXX million. However, as the rent is payable for the lease of both the building and depreciating assets, an apportionment of the rental payments is appropriate, based on the expected market value of the building and depreciating assets as follows:

Paragraph 250-135(2)(b) compares the sum of the present values of the expected financial benefits with the market value of the asset. The rulee has used a discounted rate of 8.5%, reflecting the expected internal rate of return of the investment in the property. The estimated present value of the expected financial benefits would be as follows:

In summary, as the sum of the present value of the expected financial benefits from the lease of the depreciating assets does not exceed 70% of the market value of the depreciating assets, the level of expected financial benefits test is not satisfied.

4. Effectively non-cancellable, long term arrangement test - section 250-125

For the same reasons outlined in Question 1 in relation to the leasing of the building, the arrangement in respect of the leasing of the depreciating assets is effectively non-cancellable as it meets the requirements under section 250-130. As discussed, Tax Exempt Entity can cancel the lease without the permission of the rulee and would incur a financial penalty of a magnitude that would discourage cancellation.

Therefore, the rulee will lack a predominant economic interest if paragraph 250-125(1)(b) is satisfied.

Given the arrangement is not greater than 30 years, the rulee will lack a predominant economic interest if the arrangement period for the tax preferred use of the asset is 75% or more of that part of the asset's effective life that remains when the tax preferred use of the asset starts. The arrangement period is X years and commences on DD MM YY. Therefore, the rulee will lack a predominant economic interest for individual depreciating assets that have an effective life remaining of less than approximately X years as at DD MM YY.

The rulee has chosen to adopt the effective life for depreciating assets based on the XYZ Report which in turn is based on the effective life determined by the Commissioner in published determinations. Based on the XYZ report, the total depreciable value and cost of depreciating assets leased to Tax Exempt Entity as part of the lease of the Property as at DD MM YY is $XXX. The total costs of these depreciating assets with a remaining effective life of less than X years is estimated at $XXX.

In summary, the rulee will lack a predominant economic interest in respect of depreciating assets that have been leased to Tax Exempt Entity which have an effective life remaining of less than X years as at DD MM YY.

As discussed above in Question 1, the rulee accepts that the four exclusions below do not apply:

1. Small business entity (section 250-20);

2. Financial benefits under minimum value limit (section 250-25);

3. Certain short term or low value arrangements (section 250-30); and

4. Sum of present value of financial benefits less than amount otherwise assessable (section 250-40).

Therefore, in the absence of the Commissioner exercising his discretion under section 250-45, Division 250 will apply to the rulee and the depreciating assets identified above.

Question 4

As discussed in Question 2, the starting point to determining whether the discretion under section 250-45 should be exercised is a consideration of the object of Division 250.

The Commissioner is satisfied the arrangement entered into by the rulee was not for the purposes of transferring the risk and benefits of ownership of the depreciating assets to the Tax Exempt Entity, but rather represents an ordinary commercial long term property leasing arrangement.

The rulee submits that it is unreasonable that Division 250 should apply on the following basis:

● The lease to Tax Exempt Entity predominantly relates to the use of the building (rather than the depreciating assets in the building);

● The relevant depreciating assets are clearly an integral part of the buildings;

● The use of the depreciating asset is merely incidental to the use of the building;

● The cost of the depreciable assets potentially subject to Division 250 is not material, being approximately $X.XX million (i.e. approximately 6.7% of the total depreciable value of the building and depreciating assets).

As discussed, in exercising the discretion the Commissioner should have regard to the circumstances because of which Division 250 would apply to the rulee and the depreciating assets, and any other relevant circumstances.

Circumstances because of which Division 250 would apply to the rulee and the depreciating assets

In the present circumstances, Division 250 applies to the rulee and certain depreciating assets because it met the 'effectively non-cancellable, long term arrangement test', resulting in its lack of a predominant interest in the assets. The rulee met the test due to certain depreciating assets having a remaining effective life of less than X years at the time of acquisition.

The Commissioner also acknowledges the following aspects of the arrangement:

● the depreciating assets are being leased to a tax exempt entity under a single arrangement that involves the lease of buildings;

● the depreciating assets are integral to the buildings and are incidental to the leasing of the buildings;

● the depreciating assets represent a small proportion of the total value of the assets being put to a tax preferred use - approximately $X.Xmillion out of a total of $XXX million or 2.1%; and

● the building had already been leased to the Tax Exempt Entity before the rulee acquired the property; the rulee did not structure the arrangement but simply continued on the lease that existed upon acquisition.

Other relevant circumstances

As discussed, it is expected that the Commissioner would consider applying the discretion, for example, to prevent an arrangement coming within the scope of Division 250 due to an unintended or marginal breach of one of the safe harbour tests.

The Commissioner agrees that there has been a marginal breach of one of the safe harbour test; namely the main reason for the rulee meeting the 'effectively non-cancellable, long term arrangement test' for such assets is that their remaining effective life is less than X years at the start of the arrangement. Such assets however only represent a small proportion (approximately 6.7%) of the total depreciating assets under the arrangement, and an even smaller proportion of the total assets (approximately 2.1%) under the arrangement.

In the absence of the effectively non-cancellable, long-term arrangement test, the rulee would otherwise not lack a predominant economic interest in the assets.

Therefore, having regard to the circumstances because of which Division 250 would apply to the rulee and the depreciating assets, and the considerations identified above, the Commissioner determines under section 250-45 that it is unreasonable that Division 250 should apply to the rulee and the depreciating assets.

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