Edited version of private ruling

Authorisation Number: 1011650868428

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Ruling

Subject: Application of Division 250

Question 1

The Commissioner is requested to confirm that Division 250 of the Income Tax Assessment Act 1997 (ITAA 1997) does not apply to the Trust in respect of the lease.

Answer

The Commissioner confirms that Division 250 of the ITAA 1997 applies to the Trust and the assets in respect of the lease.

The scheme commences on:

The scheme commenced on 7 July 2009.

Relevant facts and circumstances

Prior to 30 June 2009, Trust owned a parcel of land.

Builder entered into an agreement for lease (Agreement for Lease) with the Exempt End User under which Builder would demolish the existing structure on the Land and construct new premises. The new premises would be leased to the Exempt End User for a period of 20 years on the terms described below.

The income of the Exempt End User is exempt from tax by virtue of its status as a charitable institution. The obligations of the Exempt End User in respect of this transaction are guaranteed by a Commonwealth government body.

The relevant terms of the Agreement for Lease are:

§ Builder is to design and construct the Works;

§ Builder assumes responsibility for ensuring that the Land was suitable for the Works and that the Works are fit for the use to which Exempt End User would put the Works;

§ If construction of the Works was not substantially commenced within 8 months of the relevant conditions precedent being satisfied, Exempt End User could terminate the Agreement for Lease;

§ Exempt End User is to prepare a Fit Out Brief from which Builder would design and construct the Fit Out Works at the cost of Exempt End User;

§ The Works and the Fit Out Works are required to reach Practical Completion by 31 January 2011. Builder would be liable for liquidated damages in the event of a delay beyond 31 January 2011 and Exempt End User would be entitled to terminate the Agreement for Lease in the event of a delay beyond 31 January 2013.

It is anticipated that the Building will in fact be completed by the end of 2010.

The nature of the Work includes the demolition of the existing building and construction of a special purpose building.

The Building represents a purpose built facility for the specialised functions of the Exempt End User. Although the Building is a purpose built facility, it is capable of being occupied by other similar businesses or, after refurbishment, general businesses.

The significant terms of the Lease are:

§ An initial term of 20 years;

§ Annual rent increases of the greater of 3.5% and the movement in the CPI;

§ Exempt End User must pay a contribution to Outgoings, which include insurance, repairs, rates and taxes and must pay for the use of the Services (other than in respect of air conditioning);

§ Exempt End User must keep the Building in good and tenantable repair and condition, other than where Capital Repairs are required;

§ Exempt End User may assign or sub-let the Land to the Commonwealth or a Commonwealth-related body without the consent of the Trust, or to any other party with the consent of the Trust;

§ Exempt End User is not obliged to make good the Building at the end of the Lease;

§ The Trust warrants that the Building is, and will remain, fit for the Permitted Use and will comply with the specified standards and makes certain additional warranties regarding the presence of hazardous materials;

§ The Trust must undertake any necessary Capital Repairs, repair any defects in the Building or the Services and repaint the Building once every 15 years

§ Exempt End User's obligations to pay rent and to repair are suspended in the event that the Building is unfit for use.

The Lease is a net lease, such that only a limited portion of the Property outgoings are borne by the Trust.

Exempt End User has an option to extend the Lease for a two terms of five years. Rent and other charges payable in respect of the further term is as agreed between the parties or otherwise on the same terms as the Lease.

The Commonwealth does not have a right to acquire Land at the end of the Lease.

The Lease will be classified as an operating lease in the accounts of the Trust, which will be prepared in accordance with Australian accounting standards. The Lease will also be classified as an operating lease in the accounts of the Exempt End User.

The arrangement is an effectively non-cancellable, long term arrangement test and section 250-125 of the ITAA 1997 is satisfied for assets with an effective life of 26.67 years or less.

The sum of the present value of the expected financial benefits as a proportion of the market value of assets for the purposes of paragraph 250-135(2)(b) of the ITAA 1997 are as follows.

Discounting from mid point of year:

Reasons for decision

These reasons for decision accompany the Notice of private ruling

Summary

The Trust lacks a predominant economic interest in assets with an effective life of 26.67 years or less under the effectively non-cancellable, long term arrangement test in paragraph 250-125(1)(b) of the ITAA 1997.

The Trust lacks a predominant economic interest in assets under the level of expected financial benefits test in paragraph 250-135(2)(b) of the ITAA 1997.

The Commissioner having regard to the circumstances because of which Division 250 of the ITAA 1997 applies to the Trust and to the assets has not made a determination under subsection 250-45 of the ITAA 1997 that it is unreasonable that Division 250 should apply to the Trust and the assets.

The extent by which the sum of the present values of the expected financial benefits in relation to the tax preferred use of the asset exceeds 70% of the market value of the asset if subparagraph 250-15(d)(i) of the ITAA 1997 applies, or so much of the market value of the asset as is attributable to the expenditure referred to subparagraph 250-15(d)(ii) of the ITAA 1997 if that subparagraph applies, indicates that the breach of the test is not marginal.

Detailed reasoning

Section 250-135 of the ITAA 1997 provides that you lack a predominant economic interest in an asset if the sum of the present values of expected financial benefits that members of the tax preferred sector provide to you in relation to the tax preferred use of the asset exceeds 70% of the market value of the asset if subparagraph 250-15(d)(i) of the ITAA 1997 applies, or so much of the market value of the asset as is attributable to the expenditure referred to subparagraph 250-15(d)(ii) of the ITAA 1997 if that subparagraph applies.

You have argued that the appropriate discount rate for subsection 250-105(2) of the ITAA 1997 to determine the present value of expected financial benefits for the purposes of subsection 250-135(2) of the ITAA 1997 is that derived from the property.

The test for subsection 250-105(2) of the ITAA 1997 is in relation to the asset; Division 250 of the ITAA 1997 of course applies only to assets for which a capital allowance entitlement arises, and the test is only in relation to such assets.  Division 250 does not apply to land and the value of the land at the end of the arrangement would not be relevant in determining the discount in subsection 250-105(2). 

The single discount rate or internal rate of return for the property may well be used to assess the risk/reward features relevant to the transaction as a whole, but the test in Division 250 of the ITAA 1997 is only in relation to assets for which you are entitled to a capital allowance deduction.  The discount rate in relation to assets under subsection 250-105(2) of the ITAA 1997 would not be used to assess the risk/reward features in relation to the transaction as a whole.

You have advised that the value of the assets for the purposes of subsection 250-105(2) of the ITAA 1997 is based on the assumption that the property will continue to be used as commercial/industrial property after year 20 and that it is reasonable to assume that both the land and the building will increase in value at the same rate (3.5% per annum in the calculations). 

An independent valuation of the assets for which you would be entitled to a capital allowance in relation to a decline in the value of the asset (the Division 40 assets) and of the building at the end of the arrangement has not been obtained.

As the sum of the present values of the expected financial benefits is 81.95% of the market value of the building and at least 100% of the market value of the Division 40 assets, it is considered that the expected financial benefits test in section 250-135 of the ITAA 1997 is failed by a substantial margin. It is noted that if the value of the building and of the Division 40 assets at the end of the arrangement equated to the un-deducted construction expenditure and to the written down value respectively, then the sum of the present values of the expected financial benefits would be 95.16% of the market value for the Building and 102.73% for the Division 40 assets.

Whilst you have identified risks and benefits to the Trust from the ownership of the property, it is considered that the risks and benefits to the Trust in relation to the assets are not sufficient to enable the Commissioner to determine that it is unreasonable that Division 250 of the ITAA 1997 should apply to the Trust and the assets. Although the Trust retains risk and benefits in relation to the land, the present value of the expected financial benefits referable to the tax preferred use of the assets recoups a substantial portion of the cost of the building and all of the cost of the Division 40 assets.