Edited version of private advice

Authorisation Number: 1052152139009

Date of advice: 8 August 2023

Ruling

Subject: Depreciation

Question 1

Will the Trust be the entity solely entitled to the depreciation deductions for depreciable assets installed by the Company pursuant to item 2 of the table in section 40-40 of the ITAA 1997 and calculated by reference to the costs incurred by the Company?

Answer

Yes

This ruling applies for the following periods:

Income year ending 30 June 2024

Income year ending 30 June 2025

Income year ending 30 June 2026

Income year ending 30 June 2027

Income year ending 30 June 2028

The scheme commenced on:

1 July 2023

Relevant facts and circumstances

1.      An income tax exempt entity (the Company) is developing a Housing Project (the Project).

2.      The Project will comprise residential accommodation and commercial spaces.

3.      The Company will lease land to build the Project

4.      The Company will sublease part of the residential accommodation and the commercial spaces to the Trust.

5.      The types of depreciating assets the Company will install in the Project will include those installed as part of the initial fit-out of the Project such as within the kitchen and bathroom, as well as lighting, carpet, air cooling and heating, etc.

6.      The Company will incur the cost of installing the depreciating assets.

7.      Under the sublease the Trust will have a right to remove depreciating assets.

8.      The effective lives of the depreciating Assets, for the purposes of Division 40 of the ITA 1997, will be shorter than the term of the sublease.

9.      The sublessee (the Trust) will replace all the depreciating assets during the term of the sublease.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 40

Income Tax Assessment Act 1997 Subdivision 40-B

Income Tax Assessment Act 1997 section 40-25

Income Tax Assessment Act 1997 section 40-30

Income Tax Assessment Act 1997 section 40-40

Income Tax Assessment Act 1997 section 40-45

Income Tax Assessment Act 1997 section 40-65

Income Tax Assessment Act 1997 section 40-70

Income Tax Assessment Act 1997 section 40-75

Income Tax Assessment Act 1997 section 40-295

Income Tax Assessment Act 1997 section 995-1

Income Tax Assessment Act 1997 Division 58

Income Tax Assessment Act 1997 Subdivision 58-B

Income Tax Assessment Act 1997 section 58-5

Income Tax Assessment Act 1997 section 58-10

Income Tax Assessment Act 1997 section 58-65

Income Tax Assessment Act 1997 section 58-70

Reasons for decision

Division 40 of the Income Tax Assessment Act 1997 (ITAA 1997) contains the capital allowance provisions which allow deductions for the decline in value of depreciating assets.

Subsection 40-25(1) of the ITAA 1997 provides that 'you can deduct an amount equal to the decline in value for an income year (as worked out under this Division) of a depreciating asset that you held for any time during the year.

Subsection 40-30(1) of the ITAA 1997 provides that 'a depreciating asset is an asset that has a limited effective life and can reasonably 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)'.

Held

The meaning of 'held' is provided in subsection 995-1 (1) of the ITAA 1997 which refers to the meaning of 'hold' in that subsection, which relevantly states that 'hold a depreciating asset has the meaning given by section 40-40 of the ITAA 1997'.

Item 2 of the table in section 40-40 of the ITAA 1997 provides the following:

Item 2 of the table in section 40-40 of the ITAA 1997 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 of the ITAA 1997, 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 Revised Explanatory Memorandum to the New Business Tax System (Capital Allowances) Bill 2001 (the Revised EM) which inserted the current Division 40 of the ITAA 1997, explains the policy intent of item 2 of the table in section 40-40 of the ITAA 1997:

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.

Quasi-ownership right

'Quasi-ownership right' over land is defined in subsection 995-1(1) of the ITAA 1997 to mean:

(a)          a lease of land;

(b)          ...

The term lease is not defined in the ITAA 1997 and takes on its ordinary meaning.

ATO ID 2009/156 Income tax: Capital allowances: quasi-ownership right over land - meaning of lease, provides the following meaning of lease:

LexisNexis Butterworths, Halsbury's Laws of Australia, Volume 16 (at 24 November 2009), 245 'Leases and Tenancies', paragraph 245-1 discusses the meaning of a lease of land as follows:

A 'lease' or 'tenancy' of land is a means by which a lesser estate in the land than that originally held by the grantor (termed the 'lessor') is transferred, creating an on going relationship, to another person (termed the 'lessee'), so as to give the lessee exclusive possession of the demised premises for an ascertainable period of time, with the grantor retaining a reversionary interest in the property. The term 'lease' may refer to the grant, that which is granted and the document by which it is granted. A lease is a demise and as such confers an interest in rem in the legal estate of the subject matter of the lease. One usual incident of this interest is an obligation to pay rent. (footnotes removed)

What constitutes 'exclusive possession' is explained in LexisNexis Butterworths, Halsbury's Laws of Australia, Volume 16 (at 24 November 2009), 245 'Leases and Tenancies', at paragraph 245-15:

'Exclusive possession' is a right which permits the holder to exclude other persons from the property. A lessee having exclusive possession of the demised premises can restrict all persons, including the lessor, from the demised premises, subject to any contrary statutory provision and certain exceptions. (footnotes removed)

The Revised EM states that 'a sublessee will have a quasi-ownership right' (at paragraph 1.41).

Subsection 40-30(3) of the ITAA 1997 provides that 'this Division applies to an improvement on land, or fixture on land, whether the improvement or fixture is an improvement or not, as if it were an asset separate from the land.

However, subsection 40-45(2) of the ITAA 1997 provides that 'this Division does not apply to capital works for which you can deduct amounts under Division 43, or for which you could deduct amounts under that Division'.

Under the arrangement the Company will lease land to build the Project. As part of the Project, the Company will undertake the initial fit outs for the Project and will install kitchen, bathroom, lighting, carpet, air cooling and heating, etc.

The initial fit outs installed by the Company will be fixed to the Project constructed on the land, and are considered to be fixed to the land for the purposes of table item 2 of section 40-40 of the ITAA 1997.

The lease of the land by the Company gives the Company exclusive possession over the relevant land. The Company therefore has a quasi-ownership right over the land to which it will construct and install the Project, at its own cost.

The sublease between the Trust and the Company gives the Trust exclusive possession over the relevant land it has subleased. As such, the Trust has a quasi-ownership right over the subleased land to which the depreciating assets are fixed.

Right to remove

ATO ID 2012/9 Income tax Capital allowances: holder of a depreciating asset - right to remove provides that a taxpayer has the right to remove depreciating assets for the purposes of item 2 of the table in section 40-40 of the ITAA 1997 if the taxpayer has the right to remove the assets during the term of the quasi-ownership right even though the taxpayer does not have the right to remove the assets at the end of the term of the quasi-ownership right.

In the fact scenario considered in ATO ID 2012/9, the taxpayer had the right to remove obsolete assets, and to remove assets as the taxpayer considered necessary or desirable in the proper conduct of its business. Once the assets were removed from the land, the taxpayer became their legal owner. The taxpayer did not have the right to remove the assets at the end of the lease.

In the Reasons for Decision, the Commissioner stated:

... The right of the taxpayer to remove obsolete assets and those which it considers necessary or desirable to remove for the proper conduct of its business is a right to remove for the benefit of the taxpayer. As the taxpayer obtains the legal title to the assets that are removed, the removed assets are for the taxpayer's benefit rather than the lessor's benefit.

Therefore, as the taxpayer has the right to remove the depreciating assets during the term of its quasi-ownership right and the meaning of 'right to remove' in item 2 of the table in section 40-40 is not limited to the right to remove assets at the end of the term of the quasi-ownership right, the taxpayer has a right to remove for the purposes of item 2 of the table in section 40-40.

Under the Sublease the sublessee (the Trust) has the right to remove the depreciating assets. The Trust will therefore have the right to remove the depreciating assets from the land during the term of the sublease.

The Trust will satisfy the conditions in table item 2 of section 40-40 of the ITAA 1997. As such, the Trust will hold the depreciating assets installed by Company for the purposes of Division 40 of the ITAA 1997.

Where assets held by an exempt entity (the Company) under section 40-40 of the ITAA 1997 are subsequently held by a taxable entity (the Trust) under section 40-40 of the ITAA 1997, Division 58 of the ITAA 1997 may apply, which sets out special rules for calculating decline in value of depreciating assets.

Decline in Value

Division 58 of the ITAA 1997 sets out special rules that apply in calculating deductions for the decline in value of depreciating assets and balancing adjustments for assets previously owned by an exempt entity.

Subsection 58-5(1) of the ITAA 1997 provides that the Division applies in two situations. Relevantly, subsection 58-5(4) of the ITAA 1997 states that the second (an asset sale situation) is where:

(a)          at a particular time on or after 1 July 2001, an entity (the purchaser) whose ordinary income or statutory income is to any extent assessable acquires a depreciating asset from the Commonwealth, a State, a Territory or an exempt entity; and

(b)          the asset is acquired in connection with the acquisition of a business from the Commonwealth, the State, the Territory or the exempt entity. (emphasis added)

Subsection 58-5(5) states that in an asset sale situation:

(a)          the Commonwealth, the State, the Territory or the exempt entity is the tax exempt vendor; and

(b)          the time when the depreciating asset is acquired is the acquisition time; and

(c)           the income year in which the acquisition time occurs is the acquisition year; and

(d)          each depreciating asset the purchaser acquires from the tax exempt vendor at the acquisition time is a privatised asset. (emphasis added)

Relevantly, section 58-10 of the ITAA 1997 provides that a 'depreciating asset is taken to be acquired in connection with the acquisition of a business from the Commonwealth, the State, the Territory or the exempt entity if ... the asset was used by the Commonwealth, the State, the Territory or the exempt entity in performing functions, or engaging in activities, that did not constitute the carrying on of business by the Commonwealth, the State, the Territory or the exempt entity and the asset is used by the purchaser or another entity in performing those functions or engaging in those activities as part of carrying on a business...' (subsection 58-10(1) of the ITAA 1997 and paragraph 58-10(2)(a) of the ITAA 1997).

Subsection 58-10(3) of the ITA 1997 states that 'paragraphs 2(a), (b) and (c) do not apply if the asset is used by the purchaser solely to derive assessable income from the provision of office or residential accommodation.

ATO ID 2007/84 Income Tax: Capital Allowances: starting to hold a depreciating asset previously held by an exempt entity (ATO ID 2007/84) considers whether an entity acquires a depreciating asset from the Commonwealth, a State, a Territory or an exempt entity for the purposes of Division 58 of the ITAA 1997 where the entity starts to hold the assets under section 40-40 of the ITAA 1997 which immediately before was held by an exempt entity, and states the following on the meaning of 'acquired':

... one would be led to expect that 'acquiring a depreciating asset' under Division 58 would have effect for the purposes of covering the intended range of scenarios under the holding rules in section 40-40. It follows then that Division 58 applies to depreciating assets which start to be held under any item in the table in section 40-40 which brings the asset into the tax system... The Commissioner considers that the requirement in subsection 58-5(4) for the purchaser to acquire the depreciating asset from the Commonwealth, a State, a Territory or an exempt entity should be interpreted as satisfied where a depreciating asset of an exempt entity starts to be held by a taxable entity... this view is supported by Paragraph 4.40 of the Explanatory Memorandum to the Taxation Laws Amendment Bill (No.4) 2002 which introduced consequential amendments to the Division and which (to the extent it is relevant) states:

Division 58 sets out special rules that apply in calculating deductions for the decline in value of depreciating assets and balancing adjustments for assets which were held by an exempt entity and are subsequently held by a taxable entity.

Section 58-65 of the ITAA 1997 provides two methods for working out the first element of the cost of each privatised asset:

(a)  the notional written down value of the asset; or

(b)  the undeducted pre-existing audited book value (if any) of the asset.

Subsection 58-70(1) of the ITAA 1997 states that the 'purchaser work[s] out the decline in value of, and the effect of a balancing adjustment event occurring for, each privatised asset using Division 40 (capital allowances) as if the asset had been acquired under a contract entered into on or after 1 July 2001'.

Balancing adjustment event is defined under section 995-1 of the ITAA 1997 to be the meaning given by section 40-295 of the ITAA 1997.

Subsection 40-295(1) of the ITAA 1997 states that:

(1) 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

...

Subsection 58-70(5) of the ITAA 1997 states that in an asset sale situation:

(5) The first element of the cost of a privatised asset to the purchaser at the acquisition time is the sum of:

(a)          the notional written down value of the asset or the undeducted pre-existing audited book value of the asset (depending on the choice made for the asset; and

(b)          the amount of any incidental costs to the purchaser in acquiring the asset.

For the purposes of subsection 58-5(4) of the ITAA 1997, the Trust (a taxable entity) will be treated as having acquired the depreciating assets from the Company (an exempt entity).

The depreciating assets will be acquired in connection with the acquisition of a business as the Trust subleased part of the residential accommodation and the commercial spaces to carry on a business of leasing residential and commercial premises, and prior to the Trust acquiring the depreciating assets, the Company (an exempt entity) held those depreciating assets for its activities, which do not constitute carrying on a business (the Company is not carried on for the purpose of profit).

As such, Division 58 of the ITAA 1997 will apply to the depreciating assets installed by the Company. Subdivision 58-B of the ITAA 1997 sets out rules that affect the way in which the purchaser (the Trust) works out the decline in value of, and balancing adjustments for, the depreciating assets under Division 40 of the ITAA 1997 after the time of acquisition.

Subdivision 40-B of the ITAA 1997 provides two methods for calculating the decline in value of a depreciating asset in an income year (section 40-65 of the ITAA 1997); the Diminishing value method (section 40-70 of the ITAA 1997) and the Prime cost method (section 40-75 of the ITAA 1997).

When calculating the decline in value of the depreciating assets for the Trust under subdivision 40-B of the ITAA 1997, the first element of cost will be the amount determined under subdivision 58-B of the ITAA 1997.

This has the effect that the Trust will be the only entity which may claim a deduction for the decline in value of the depreciating assets installed by the Company.

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