Edited version of private advice

Authorisation Number: 1051711576230

Date of advice: 3 July 2020

Ruling

Subject: The sale and leaseback transaction

Question 1

Will a balancing adjustment event occur to Company A under Subdivision 40-D of the Income Tax Assessment Act 1997 (ITAA 1997) in respect of any of the assets as a consequence of the Transaction?

Answer

Yes. A balancing adjustment event occurred in respect of certain depreciating assets.

Question 2

Will Company A continue to be the holder, for the purposes of Division 40 of the ITAA 1997, of any of the assets as a consequence of the Transaction?

Answer

Yes. Company A continues to be the holder in respect of certain assets for the purposes of Division 40 of the ITAA 1997.

Question 3

Will any capital gain made by Company A on the sale of the land and buildings be reduced under section 118-20 of the ITAA 1997 or any other provision of the ITAA 1997 or the ITAA 1936?

Answer

No. Any gain made on the sale is on capital and not revenue account.

Question 4

Will the transaction legally be characterised as a sale and leaseback such that:

(a)  the depreciation consequences will be as set out above at Questions 1 and 2; and

(b)  the ongoing rent payments by Company A will be deductible under section 8-1 of the ITAA 1997?

Relevant facts and circumstances

Company A is an Australian proprietary company and resident of Australia.

Company A entered into a sale and leaseback transaction with arm's length third parties to disposed of certain properties and to then lease back those properties.

The key commercial drivers for the transaction are as follows:

(a)  release of surplus capital from existing assets;

(b)  capitalise on the strong commercial property market in Australia;

(c)   retain effective asset control with long-term flexibility.

'Property' is defined to mean the land, building and the Inclusions under the Property Sale Agreement.

Exclusions' means the listed items under the Property Sale Agreement. The Exclusions are excluded from the sale and Company A is not required to remove any Exclusions from the property under the Property Sale Agreement.

Company A acquired all the relevant assets after 1 July 2001.

The relevant assets are not 'trading stock' as defined in subsection 995-1(1).

Completion of the sale of the properties was conditional on the Purchaser (as lessor) entering into a lease of that property.

The lessor (Purchaser) grants to the lessee (Company A) a lease for a period of seven years with an option to renew (the Property Lease).

'Premises', 'Building', 'Lessor's property' and 'Lessee's property' are defined terms under the Property Lease.

The Property Lease does not contain an option for Company A to purchase the premises at the end of the lease period.

Relevant legislative provisions

Reasons for decision

Question 1

Will a balancing adjustment event occur to Company A under Subdivision 40-D in respect of the relevant assets as a consequence of the sale and leaseback transaction?

Summary

A balancing adjustment event occurred in respect of certain depreciating assets but excluding any items which are Exclusions.

Detailed reasoning

Balancing adjustments: Subdivision 40-D

Subsection 40-295(1) states that a balancing adjustment event occurs for a depreciating asset if:

(a)  you stop holding the asset; or

(b)  you stop using it, or having it installed ready for use, for any purpose and you expect never to use it, or have it installed ready for use, again; or

(c)   you have not used it and:

                     i.        if you have had it installed ready for use - you stop having it so installed; and

                   ii.        you decide never to use it.

For a balancing adjustment event to occur for a depreciating asset under subsection 40-295(1), you must have first held a depreciating asset.

An amount is included in your assessable income if a balancing adjustment occurs for a depreciating asset you held and the asset's termination value for the purposes of Division 40 is more than its adjustable value just before the event occurred.

You can deduct any amount if where the termination value is less than the adjustable value.

Depreciating asset: Subsection 40-30

Subsection 40-30(1) provides that a depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used, except:

(a)  land; or

(b)  an item of trading stock; or

(c)   an intangible asset, unless it is mentioned in subsection (2).

The meaning of 'an asset' is not defined and it takes its ordinary meaning. In Taxation Ruling TR 2012/7 Income tax: capital allowances: treatment of open pit mine site improvements (TR 2012/7), the Commissioner states that in the context of Division 40, an asset is taken to have the broad meaning of something that is capable of being put to use in the business of the holder (paragraph 16 of TR 2012/7).

Improvements to land and fixtures on land are treated as if they were assets separate from the land. This is regardless of whether the improvement or fixture is removable or not: subsection 40-30(3). Therefore, in determining whether the improvement or fixture satisfies the definition of 'depreciating asset' in section 40-30(1), that is, whether it is an asset with a limited effective life that can reasonably be expected to decline in value and which is not trading stock, the improvement or fixture is to be treated as separate from the land. If the improvement or fixture satisfies the definition, a deduction may be available for its decline in value under Division 40.

In the present case, the Inclusions, Exclusions under the Property Sale Agreement, Lessor's Property and Lessee's Property under the Property Lease are assets because they were something used by Company A to conduct its business and therefore recognised as having commercial and economic value to Company A.

Further, an improvement to land or a fixture on land, are treated as if it were an asset separate from the land, whether the improvement or fixture is removable or not (subsection 40-30(3)).

Given that Company A acquired the relevant assets on or after 1 July 2001, and the relevant assets were not trading stock as defined in subsection 995-1(1); the relevant assets will not be prevented from being depreciating assets for Division 40.

Meaning of hold a depreciating asset: Section 40-40

Section 40-40 identifies the holder of a depreciating asset in any particular circumstance. The general or 'default' rule is that you hold an asset when you are the owner of the asset: item 10. Other items provide that you hold an asset in various other circumstances even though you are not the asset's owner. For example, tenants are taken to hold fixtures over which they have certain rights (items 2 and 3 of the table in section 40-40).

The table below lists items 2 and 10 which are relevant to the present case.

Item 2 of the table in section 40-40 provides that if a depreciating asset is fixed to land over which there is a quasi-ownership right and the owner of the right has a right to remove the asset, then the asset is held by the owner of the quasi-ownership right for as long as the right to remove the asset exists.

For the purposes of Division 40, this item effectively overcomes the common law presumption that ownership of assets affixed to land rests with the owner of the land.

Paragraph 1.43 of the Explanatory Memorandum to the New Business Tax System (Capital Allowances) Bill 2001 ('the EM') explains the policy intent of item 2 of the table in section 40-40:

Where...a depreciating asset is fixed to land where the owner of the quasi-ownership right has a right to remove the asset, the uniform capital allowance system recognises them as the holder while the right of removal exists. Right of removal is consistent with the established legal concept, connoting a right to remove the asset for the benefit of the holder of the right, with the removed item being for their rather than the landowner's benefit. Often the right of removal will extend beyond the term of the quasi-ownership right, allowing the quasi-owner reasonable time to remove the asset; they will remain a holder of the asset until that right ends, as until then they might exercise the right and remove the asset, and so continue to hold the asset.

Assets that are Inclusions under a Property Sale Agreement

As a consequence of Company A entering into a Property Sale Agreement, it is no longer the owner of depreciating assets that are Inclusions in respect of the property that was subject to the sale agreement. Therefore, Company A stops being the holder of such assets under item 10 of the table in section 40-40.

Further, Company A does not become the holder of the assets under any other item in that table, including after the Property Lease in respect of that property is entered into.

Therefore, a balancing adjustment event occurred for Company A in respect of such assets.

Accordingly, Company A will include an amount in, and/or deduct an amount from, its assessable income depending on whether the termination value for a particular asset is more, or less, than its adjustable value just before the event occurs: section 40-285.

Assets that are Exclusions under a Property Sale Agreement

The Exclusions are excluded from the sale of each property and Company A is not required to remove any Exclusions from the property according to the Property Sale Agreement.

For depreciating assets that are Exclusions and also chattels: Company A continues to be the owner of such assets and thus continues to hold them under item 10 of the table in section 40-40. Therefore, a balancing adjustment event does not occur in respect of such assets.

For depreciating assets that are Exclusions and also fixtures: Although Company A remained the equitable owner, those assets were no longer legally owned by Company A such that Company A ceased to hold such assets under item 10 of the table in section 40-40. However, given that the completion of the sale is conditional on the Purchaser (as lessor) entering into a Property Lease of that property, Company A remains the holder of as a consequence of entering into the transaction under item 2 of the table in section 40-40. Accordingly, a balancing adjustment event does not occur to Company A in respect of such assets.

Conclusion

A balancing adjustment event occurred in respect of certain depreciating assets under the Property Sale Agreement but excluding any items which are Exclusions.

Question 2

Will Company A continue to be the holder, for the purposes of Division 40 of the ITAA 1997, of any of the assets as a consequence of the sale and leaseback transaction?

Summary

Company A continues to be the holder in respect of assets that come within the definition of Exclusions under the Property Sale Agreement for the purposes of Division 40 of the ITAA 1997.

Detailed reasoning

Section 40-40 specifies who 'holds' the depreciating asset (referring to Question 1 above).

Assets that are Inclusions under a Property Sale Agreement

As discussed at Question 1, Company A does not continue to be the holder, for the purposes of Division 40 of the 1997 Act, of assets that are Inclusions under a Property Sale Agreement as a consequence of the Transaction.

Assets that are Exclusions under a Property Sale Agreement

As discussed at Question 1:

For depreciating assets that are Exclusions and also chattels: Company A continues to be the owner of such assets and thus continue to hold them under item 10 of the table in section

40-40.

For depreciating assets that are Exclusions and also fixtures: Company A is no longer the legal owner and ceases to hold such assets under item 10 of the table in section 40-40 as a consequence of the Property Sale Agreements. However, Company A is the holder those depreciating assets under item 2 of the table in section 40-40 when the Property Lease is entered into. Therefore, Company A continue to hold assets that come within the definition of Exclusions under the Property Sale Agreement as a consequence of the transaction.

Question 3

Will any capital gain made by Company A on the sale of the Land and Buildings be reduced under section 118-20 of the ITAA 1997 or any other provision of the ITAA 1997 or the ITAA 1936?

Summary

No, because any gain made on the sale is on capital and not revenue account.

Detailed reasoning

Section 118-20: Reducing capital gains if amount otherwise assessable

Section 118-20 contains certain anti-overlap provisions that apply to ensure that amounts which are assessable income outside of the CGT provisions are not also taxed as capital gains. In the absence of such a provision, it is conceivable that a receipt properly characterised as ordinary income and which has also been derived as a result of a CGT event could result in the receipt being taxed twice.

Relevantly, under section 118-20, a capital gain you make from a CGT event is reduced if, because of the event, a provision outside of the CGT provisions includes an amount (for any income year) in your assessable income. If the amount so included is:

(a)  more than the capital gain, the gain is reduced to zero: subsection 118-20(2); or

(b)  less than the capital gain, the gain is reduced by that amount: subsection 118-20(3).

CGT event A1

CGT event A1 happens if you dispose of a CGT asset (section 104-10(1)). You dispose of a CGT asset if a change of ownership occurs from you to another entity, whether because of some act or event or by operation of law (section 104-10(2)).

A CGT asset is any kind of property or a legal or equitable right that is not property (section 108-5). The Land and Buildings are CGT assets (Note 1 of section 108-5).

In the present case, Company A disposed of the Land and Buildings as part of the Transaction by selling them to the Purchaser under the Property Sale Agreements. Company A is no longer the beneficial owner of the Land and Buildings. Therefore, a change of ownership of the Land and Buildings occurred from Company A to the Purchaser and thus Company A disposed of the Land and Buildings for the purposes of CGT event A1.

Capital vs Revenue

There are three ways the profit from the sale of Land and Buildings can be treated for taxation purposes:

(a)  As ordinary income under section 6-5, on revenue account, as a result of carrying on a business of property sale, involving the sale of land as trading stock; or

(b)  As ordinary income under section 6-5, on revenue account, as a result of a profit-making undertaking or scheme; or

(c)   As statutory income under the CGT provisions.

As discussed above, CGT event A1 happened on the sale of the Land and Buildings. Therefore, it is necessary to consider whether any gain made on the disposal of the Land and Buildings is on revenue or capital account for the purposes of determining whether section 118-20 applies.

In FC of T v The Myer Emporium (1987) 163 CLR 199; 87 ATC 4363; (1987) 18 ATR 693 (Myer Emporium), the Full High Court expressed the view that profits made by a taxpayer who enters into an isolated transaction with a profit making purpose can be assessable income.

Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income sets out the Commissioner's view as to the application of Myer Emporium and the general principles and factors that have been considered in determining whether an isolated transaction is of a revenue nature.

Paragraph 1 of Taxation Ruling TR 92/3outlines that isolated transactions are:

(a)  those transactions outside the ordinary course of business of a taxpayer carrying on a business; and

(b)  those transactions entered into by non-business taxpayers.

TR92/3 outlines at paragraph 6 that whether a profit from an isolated transaction will be ordinary income will depend on the circumstances of the case, however a profit from an isolated transaction will be ordinary income when:

(a)  the intention or purpose of a taxpayer in entering into the transaction was to make a profit or gain; and

(b)  the transaction was entered into, and the profit was made in the course of carrying on a business operation or commercial transaction.

In the present case, the Property were acquired and/or constructed merely to form part of and create efficiencies for the supply chain network of Company A. Having regard to the strategic importance of the Property to Company A in supporting its business, it is clear that the Property was not acquired and/or constructed for the purposes of profit-making or as part of any profit-making scheme.

The Property was sold as part of a sale and leaseback arrangement, as the commercial drivers for the sale and lease back indicated, Company A was looking to dispose of the Property and lease them back. The Transaction is an extraordinary, 'one-off' transaction having regard to the nature of Company A's ordinary business operations. The fact that Company A sold the Property at a time that enabled it to capitalise on the strong commercial property market in Australia does not preclude the receipts from the sales as being on capital account.

Therefore, the principle in Myer Emporium does not apply to Company A in the context of the Transaction. Accordingly, the sale of the Land and Buildings, as part of the sale of the Property, cannot be characterised as generating a revenue or income gain for Company A.Rather, any profit derived by Company A from the sale of the Land and Buildings is capital in nature.

As a result, neither section 118-20 nor any other provision of the ITAA 1997 Act or the ITAA1936 apply to reduce any capital gain made by Company A arising from CGT event A1 happening.

Question 4

Will the transaction legally be characterised as a sale and leaseback such that:

(a)  the depreciation consequences will be as set out above at Questions 1 and 2; and

(b)  the ongoing rent payments by Company A will be deductible under section 8-1 of the ITAA 1997?

Summary

The transaction will legally be characterised as a sale and leaseback such that:

(c)   the depreciation consequences will be as set out above at Questions 1 and 2; and

(d)  the ongoing rent payments by Company A will be deductible under section 8-1 of the ITAA 1997.

Detailed reasoning

Characterisation of the Transaction and the depreciation consequences

A sale and leaseback transaction is typically a two party arrangement under which the owner of an asset disposes of the asset by way of sale of the asset and then leases the asset back to use in the business.

The leading authorities on the taxation treatment of sale and leaseback arrangements are FC of T v Metal Manufactures Ltd 2001 ATC 4152 and Eastern Nitrogen Ltd v FC of T 2001 ATC 4164.

Taxation Ruling TR 2006/13 Income tax: sale and leasebacks (TR 2006/13) explains the taxation consequences of sale and leaseback arrangements which involve depreciating assets subject to Division 40.

Although the character of a transaction will generally follow its legal form, it is necessary to consider whether the true legal characterisation is that of a sale and leaseback, by examining what the transaction effects having regard to the legal rights and obligations conferred on the parties.

In this regard, Hill J in ANZ Savings Bank Ltd v Federal Commissioner of Taxation (1993) 25 ATR 369 at 391-392 stated:

In the absence of a submission that the transaction entered into by the parties is a sham, a disguise for some other and different transaction, and in the absence of the application of the anti-avoidance principles of Part IVA of the Act, the court must look to see what the transaction entered into by the parties by its terms effects. That is to say, regard must be had to the legal rights which the transaction actually entered into confers.

The above statement is also cited at paragraph 79 of TR 2006/13. Further, in looking at the legal characterisation of a transaction in the context of a sale and leaseback of depreciating assets, the Commissioner at paragraph 80 of TR 2006/13 notes some factors which would indicate that the circumstances was not that of sale and leaseback:

(a)       the intention of the parties as determined from the documentation and surrounding circumstances

In the present case, both Company A and the Purchaser clearly intended the transaction to be a sale and leaseback, and not another form of transaction.

(b)       the lessor has no right to obtain possession of the asset on default by the lessee

In the present case, the lessor (Purchaser) has the right to obtain possession of the premises on default by the lessee (Company A) according to the Property Lease.

(c)       all the risks and benefits of ownership of the asset are with the lessee after the termination of the term of the lease (this could occur where the lessee was entitled to any excess of the sale price of the asset over the residual value)

During the term of the Property Leases, Company A is responsible for repair and maintenance, insuring the premises, compliance with all laws and requirements of all authorities in respect of the Property. However, all the risks and benefits of ownership of the asset will be with the Purchaser after the termination of each Property Lease.

(d)       the lease is for a period that is likely to exhaust or exceed the remaining useful life of the asset

Having regard to the nature of the assets that are subject to the Property Leases, none of the Property Leases are likely to be for a period that is likely to exhaust or exceed the remaining useful life of the Premises.

(e)       the lessee has a right or option to purchase the asset upon expiration of the term of the lease for less than the market value of the asset

The Property Leases do not contain an option or right for Company A to purchase the premises at the end of the Term. This is consistent with the commercial drivers for entering into the transaction as outlined at paragraph 11 under the heading of 'background'.

(f)        the sale price of the asset to the lessor is substantially in excess of the market value of the asset

The sale price of the Premises has been negotiated at arms-length between the parties. Therefore, the sale price of the Premises represents the market value of the Premises.

Further, there is nothing in the Property Sale Agreement, the Property Lease, any other document or from the surrounding circumstances that would support the characterisation of the transaction as a loan transaction.

Therefore, the Transaction involves a sale and leaseback of the Premises, and the depreciation consequences will be as set out above at Questions 1 and 2.

Lease payments

Section 8-1 states:

SECTION 8-1 General deductions

8-1(1)

You can deduct from your assessable income any loss or outgoing to the extent that:

(a)  it is incurred in gaining or producing your assessable income; or

(b)  it is necessarily incurred in carrying on a * business for the purpose of gaining or producing your assessable income.

8-1(2)

However, you cannot deduct a loss or outgoing under this section to the extent that:

(a)  it is a loss or outgoing of capital, or of a capital nature; or

(b)  it is a loss or outgoing of a private or domestic nature; or

(c)  it is incurred in relation to gaining or producing your * exempt income or your * non-assessable non-exempt income; or

(d)  a provision of this Act prevents you from deducting it.

Further, the Commissioner outlines at paragraph 14 of TR 2006/13:

The lease back of the asset ordinarily requires specified periodic payments by the lessee to the lessor. The lessee will incur and deduct them, and the lessor will derive them as income, on the same basis as for any lease of a similar asset on similar terms where there is no related sale of the asset to the lessor.

In the present case, Company A incurs rent under the Property Leases for use of the Premises. Company A must not use the Premises otherwise than for the permitted use. Accordingly, the rent will be a loss or outgoing that will satisfy either of the positive limbs.

Further, Company A makes periodic monthly rental payments for use of the Premises. The rent has the character of a regular outlay, or of a working expense, by which Company A obtains regular returns from its business: Sun Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337.

Accordingly, the rental payments will not be a loss or outgoing of capital, or of a capital nature. Nor will rental payments satisfy any of the other negative limbs.

Given the transaction is a genuine sale and leaseback transaction, ongoing rent payments made by Company A under the Property Lease(s) is incurred on revenue account and will be deductible to Company A under section 8-1.

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