Edited version of private ruling

Authorisation Number: 1011521650234

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Ruling

Subject: Operating Leases

Question 1

Whether, for the purposes of section 20-110 of the Income Tax Assessment Act 1997 (ITAA 1997) the lease contract will be treated as a normal commercial lease arrangement under the terms of Taxation Ruling IT 28 (IT 28)?

Answer

Yes. For the purposes of section 20-110 of the ITAA 1997 the lease contract will be treated as a normal commercial lease arrangement under the terms of IT 28.

This ruling applies for the following period

Year ending 30 June 2011 to year ending 30 June 2015

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 20-110.

Facts

The company provides operating leases on motor vehicles and fleet management services for its clients.

To capture a bigger share of the fleet market the company would like to offer its customers the ability to receive the 'net' profit on those vehicles that are sold for a profit at the termination of the lease contract.

The company intends to provide a product in the form of an operating lease with an additional provision whereby lessees would receive a return of 'net' profit, if any, based on the difference between the realised market values and the disclosed residual values. Lease premiums will not be adjusted to factor in any possible return of profit to the lessee.

The company would take all risk on losses on disposal of the vehicles. The lessee has no residual value risk. Profits and losses made on respective customer's vehicles will be placed in a settlement account from which net profits are paid periodically to the lessee as a 'commission' and net losses are taken up by the company.

The lease contracts (save for the new provision allowing for the payment of a commission) will be normal operating leases complying with all taxation and accounting requirements. Unlike finance leases, the contracts have no option for lessees to acquire the motor vehicles on the termination of the lease. All risks and responsibility for the motor vehicle stays with the company.

Explanation

The question of what constitutes a genuine lease for income tax purposes is considered in IT 28. If the arrangement allows the property in the goods to pass from the lessor to the lessee at any point, the arrangement will be treated as a contract of sale and not a lease, as per paragraph 15 of IT 28.

This treatment also extends to events occurring on termination of the arrangement. IT 28 explains that an arrangement which permits the lessee to retain use of the goods, by property in the goods passing to the lessee's nominee or agent, would not be regarded as a normal commercial lease. A provision in the agreement that goods be disposed at the termination of the arrangement otherwise than by public auction raises a presumption that there is a right of purchase. This would not satisfy the requirements of a lease arrangement.

Taxation Ruling IT 2287 further elaborates the Commissioner's view on events at termination of the lease:

…that a provision for payment in the nature of an adjustment of lease rentals, either to or by the lessee, in relation to the sale price of the leased goods at the expiration or earlier termination of the leasing period, would be regarded as transferring the risk of loss or the right to profit on disposal, which is inherent in the ownership of the leased goods, from the lessor to the lessee. Accordingly, the transaction would be regarded as inconsistent with the provisions of a normal commercial lease.

Taxation Ruling IT 2051 summarises the Tax Office view of a lease for taxation purposes:

An agreement may be accepted for income tax purposes as a lease, as distinct from a purchase agreement, only if the lessee does not, either during the term of the lease or at its end, have an obligation, right or option to purchase the plant. It would correspondingly be unacceptable if the obligation, right or option were to be given to an associate of the lessee or the lessor had a right or option to require the lessee or an associate to purchase. Any right in the lessee to nominate a third party purchaser would be examined to ensure that it did not amount to an arrangement for purchase.

It is proposed to include a provision in the current lease agreement to enable lessees to share profits, if any, derived from the sale of leased vehicles on termination of the agreement. The profit is calculated as the difference between realised market value and disclosed residual value. The company would take all risk if a loss was incurred on disposal. Sale of vehicles will be through public auction. Lease premiums will not be adjusted in relation to the sale price of vehicles.

IT 28 does not define an 'operating lease' or identify different types of commercial leases for tax purposes. IT 28 provides guidelines to distinguish normal commercial lease arrangements from contracts for sale/purchase of goods, so that the appropriate taxation legislation is applied to payments made under these agreements. It is to be noted that the guidelines contained in IT 28 are directed towards normal commercial lease arrangements, which includes operating and finance leases.

The proposed variation to the lease agreement does not involve a transfer of property or adjustment of lease premiums to reflect events at disposal on termination of the agreement. The risks inherent in the ownership of the leased vehicles would not transfer to the lessee. The lessee has no right nor any expectation to purchase the car at the end of the lease. The lessor continues to bear any economic loss on disposal.

On the basis of the facts provided, the arrangement would be treated as a normal commercial lease.

The lessee would not be required under section 20-110 of the ITAA 1997 to include in their assessable income any profit on the disposal of the motor vehicle as the lessee will not have acquired the motor vehicle under the terms of the lease.

However, the lessee would be assessable on the receipt of the 'commission' income.