Edited version of private ruling

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Ruling

Subject: GST and Hire Purchase Apportionment Methodology

Question

Is the use of a revenue based formula based on the proportion of consideration receivable from the principal and interest components under a disclosed hire purchase agreement a fair and reasonable method to calculate the input tax credit entitlement for acquisitions that relate to the making of supplies under these agreements?

Answer

No, the use of a revenue based formula based on the proportion of consideration receivable from the principal and interest components under a disclosed hire purchase agreement is not a fair and reasonable method to calculate the input tax credit entitlement for acquisitions that relate to the making of supplies under these agreements because it allocates a disproportionate amount of expenditure to the taxable activity which is contrary to the fundamental nature of the typical enterprise offering this type of credit arrangement.

Relevant facts and circumstances

You are entity A.

You are involved in the three categories of inventory finance, corporate financial services and equipment finance. Commercial hire purchase agreement is one of the products offered in the corporate financial services and equipment finance categories

You advised that the acquisitions relating to making supplies under disclosed hire purchase agreements include the following:

· Initial application - customers make applications directly to you. The decision as to which product to offer will be made once you better understand the customer's business and finance needs.

· Underwriting process - it is to assist in determining if you will make a supply to a customer, i.e. is the customer's risk profile sufficiently low that you will risk supplying that customer with an asset? The risk that you face is the risk that you will lose the asset and not the risk that you will forego the interest component of the supply. It is concerned with determining if you will supply the customer with the requested asset.

· Approval and settlement - this involves application of proceeds to settlement and distribution of funds. In the case of a hire purchase agreement, raising a tax invoice in favour of the customer for the 'sale' of the asset to the customer. It involves the acquisition of the asset and the supply of the asset to the customer.

· Collections - customers may remit their rentals either by direct debit or cheque. The payment comprises a principal and interest component so all collection activity relates to both the taxable supply of the asset and the derivation of interest income which is input taxed.

· Defaults - recovery action will be initiated when a customer has not made payment which will be followed by repossession and then sale after the expiry of the statutory period. The purpose of prompt action is the 'flight risk' in relation to the asset. Where the asset has not been repossessed and the contract is overdue more than 'N' days you cease to recognise interest income. When the contract is terminated in the system, the future interest receivables are rebated and interest owing is written off.

You advised that it is the derivation of the interest income that is incidental to the supply of the asset itself.

The consideration receivable under a disclosed hire purchase agreement is the rent that comprises the principal and interest components.

Over the life of an asset, the principal represents approximately X% of the total consideration.

You essentially are a wholesale business providing various forms of finance to industry which is generally fully creditable.

Taxpayer's contentions

In support of your contention that the recovery rate for input tax credits under hire purchase agreements should be higher than 15% and that a higher percentage X% is appropriate, you state:

· A hire purchase agreement is a rental arrangement with an option to purchase.

· The rental is taxable except for the interest component, therefore under a revenue method, only the interest element of the supply is input taxed.

· The balance, being the principal, is taxable.

· Nearly all effort (inputs) is directed towards managing risk in the asset and the bulk of the consideration has gone for the taxable supply, it is logical to conclude that the bulk of costs incurred in the administration of hire purchase agreements are directed towards the principal, that is, taxable component of the supply.

· The processes involved in the initiation, maintenance and conclusion of leases and hire purchase agreements are largely similar. For each contract type the financier supplies the physical possession of an asset to a lessee for consideration. For the periodic consideration, charged as rentals, is determined by reference to the value of the asset, the interest rate to be charged, the term of the lease and the estimated value of the asset on termination of the agreement.

· In each case the financier follows the same process in assessing whether to enter into a contract with the applicant, the set up of the contract and the operation aspects of the contract. The only difference occurs on termination of lease and hire purchase agreements. Under an operating lease, the asset must be returned. Under a financier lease, the asset is returned but the lessee guarantees the residual value. Under a hire purchase agreement, the purchaser has an obligation to purchase the asset so it is not returned unless there is a default.

· Lessee's obligations under a finance lease and hire purchase agreement are substantially the same.

· Under each contract type the financier is the legal owner of the asset until title passes to either the customer or a third party.

· The supply made under a lease or a hire purchase agreement is treated under GST as a taxable supply. The interest component of a hire purchase agreement is treated as an input taxed supply under item 8 of subregulation 40-5.09(3) of the A New Tax System (Goods and Services Tax) Regulations 1999 (GST Regulations) where it is separately disclosed to the customer.

You also provided further information as follows:

Entity A undertakes three main branches of business activities, namely,

· distribution finance which comprises three main bailment products including approved distributor/manufacturer programs, direct customer programs and import finance;

· corporate financial services which offer financial products including revolving credit facilities, fixed-term loans, operating leases, sale and leaseback, financial leases and commercial hire purchase arrangement; and

· equipment finance which offers the same financial products as item 2 above to mainly equipment distributor or manufacturer.

The actual contractual terms of hire purchase agreements shows that entity A continues to have title in the asset until the hirer exercises its option or obligation to pay the residual owing on the asset. This means that there is no actual 'sale' until entity A has received the full price. Accordingly, entity A should be entitled to recover GST on costs it incurs managing the principal component of a hire purchase agreement.

Examples of how entity A calculates its input tax credit entitlements on a cost centre by cost centre basis and how input tax credits are determined by rent. They show that Y% is the current general recovery rate for entity A in respect of equipment finance stream which comprises such financial products as hire purchase, loans and leases.

A hypothetical example of how entity A arrived at a recovery rate of X% as the actual rate would be in the order of Z%. For practical reasons, entity A uses X% as the taxable proportion of a hire purchase agreement.

Relevant legislative provisions

A New Tax System (Goods and Services Tax) Act 1999 section 11-5

A New Tax System (Goods and Services Tax) Act 1999 section 11-15

A New Tax System (Goods and Services Tax) Act 1999 section 11-20

A New Tax System (Goods and Services Tax) Act 1999 section 11-25

A New Tax System (Goods and Services Tax) Act 1999 section 11-30.

Detailed reasoning

Is the use of a revenue based formula based on the proportion of consideration receivable from the principal and interest components under a disclosed hire purchase agreement a fair and reasonable method to calculate the input tax credit entitlement for acquisitions that relate to the making of supplies under these agreements?

Under section 11-20 of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act), an entity is entitled to the input tax credit for any creditable acquisition that it makes.

An entity makes a creditable acquisition, under section 11-5 of the GST Act, when that entity:

(a) acquires anything solely or partly for a creditable purpose

(b) the supply of the thing to the entity is a taxable supply

(c) the entity provides, or is liable to provide, consideration for the supply, and

(d) the entity is registered or required to be registered.

The entity made creditable acquisitions which were only partly for a creditable purpose, as defined in subsections 11-15(1) and 11-15(2) of the GST Act. These subsections provide that:

(1) You acquire a thing for a creditable purpose to the extent that you acquire it in carrying on your enterprise.

(2) However, you do not acquire the thing for a creditable purpose to the extent that:

(a) the acquisition relates to making supplies that would be input taxed; or

(b) the acquisition is of a private or domestic nature.

Accordingly, to the extent that acquisitions made by entity A relate to making supplies that would be input taxed, they are not acquired for a creditable purpose. Therefore, such acquisitions are not, to that extent, creditable acquisitions and entity A is not entitled to input tax credits. It is our understanding that the exceptions to this, as provided for in section 11-15(3), 11-15(4) or 11-15(5) of the GST Act do not apply to entity A's circumstances.

Section 11-25 of the GST Act provides that the amount of input tax credit is that equal to the GST payable on the supply of the thing acquired (unless the acquisition is made partly creditable).

Given the facts provided, entity A makes a range of supplies which can be taxable (or GST-free) and input taxed financial supplies. Entity A makes a direct allocation of the acquisitions that are used only for a creditable purpose or only for a non-creditable purpose. However, some of entity A's acquisitions are made for both a creditable purpose (for making taxable or GST-free supplies) and a non-creditable purpose (for making input taxed financial supplies).

In particular, the input tax credits for acquisitions related to making supplies under a disclosed hire purchase agreement where the credit for the goods supplied under the arrangement is provided as a separate charge that is disclosed to the recipient of the goods. Therefore, such acquisitions relate to the taxable supply of goods and the input taxed supply of credit.

An acquisition which relates to both taxable and input taxed activities can be illustrated by collections when customers may remit their rentals either by direct debit or cheque. The payment comprises a principal and interest component so all collection activity relates to both the taxable supply of the asset and the derivation of interest income which is input taxed.

Accordingly, the acquisitions are partly creditable and the amount of input tax credits to which entity A is entitled will depend upon the extent of creditable purpose as provided for under section 11-30 of the GST Act.

The 'extent of creditable purpose' is defined in subsection 11-30(3) of the GST Act to mean 'the extent to which the creditable acquisition is for a creditable purpose, expressed as a percentage of the total purpose of the acquisition.

Consequently, an apportionment of these acquisitions between creditable and non-creditable acquisitions is necessary to determine the extent of creditable purpose for entity A's acquisitions.

GSTR 2006/3

Goods and Services Tax Ruling GSTR 2006/3 Goods and services tax: determining the extent of creditable purpose for providers of financial supplies outlines the Commissioner's views on apportionment and the methods of calculating the extent of creditable purpose of your acquisitions.

Paragraph 73 of GSTR 2006/3 sets out the following principles for an appropriate method used to apportion acquisitions:

73. Following those principles set out by the High Court, the method you choose to allocate or apportion acquisitions between creditable and non-creditable purposes needs to:

· be fair and reasonable

· reflect the intended use of that acquisition (or in the case of an adjustment, the actual use), and

· be appropriately documented in your individual circumstances.

Paragraph 74 of GSTR 2006/3 confirms that, of itself, using an apportionment method that meets the above principles will not be regarded as an arrangement to which Division 165 of the GST Act applies if the method gives the most advantageous result. Paragraph 74 states:

74. If you allocate or apportion acquisitions or importations using a method which meets all these principles, the Commissioner will not consider the fact that you choose the method that gives the most advantageous result to be, of itself, an arrangement to which Division 165 applies.

GSTR 2006/3 explains the different methods which can be used to apportion the extent of the planned use of an acquisition for a creditable purpose:

Methods of calculating the extent of creditable purpose

80. To calculate the amount of your input tax credits, you need to adopt a method of estimating the extent of creditable purpose of your acquisitions and importations. The requirement that your estimation is fair and reasonable in your circumstances is a prerequisite for any decision you make.

81. The Commissioner considers that the use of direct methods, including direct estimation (see paragraph 92 to 101 of the Ruling) best accords with the basic principles explained above (see paragraph 73). If it is not possible or practicable to use a direct method, you may use some other fair and reasonable basis, including an indirect estimation method.

The Commissioner expressed the view that the direct estimation methods are preferred to indirect estimation methods at paragraphs 93 and 94 of GSTR 2006/3:

93. Direct estimation methods are preferable to indirect estimation methods (see paragraphs 102 to 130 of this Ruling), particularly if the direct estimation method used involves a detailed measure of the intended (or actual) use of the acquisition or importation. Measures based on inherent characteristics of, or factors directly connected with, the acquisition usually give a fair reflection of the use of the thing. These factors are sometimes referred to in management accounting and costing systems as 'drivers'.

94. The use of such characteristics or factors provides an estimation of a direct link between the acquisition or importation and its (or its intended) application. Some examples of these factors and characteristics are:

· distance (for example, for fuel acquired for use partly in connection with bank branches, the kilometres travelled by a motor vehicle as evidenced by a logbook);

· time (for example, computer processing time spent on various input taxed and other activities, as evidenced by a time sheet);

· volume (for example, numbers of financial transactions of particular types);

· space (for example, floor area if the space is used for different activities); and

· staff numbers (for example, measuring the actual use of acquisitions by identified staff).

The method chosen as fair and reasonable would express the relevant use of the acquisition or importation as a percentage of total application (or intended application).

For GST purposes, the acquisition must be acquired in carrying on an enterprise as it requires a connection or link between the thing acquired and the enterprise under Division 11 of the GST Act. Acquisitions that do not directly relate to any specific type of supplies have an indirect relationship to all the supplies that an entity makes in carrying on its enterprise.

Whether an acquisition is acquired in making taxable (or GST-free) or input taxed supplies is a question of fact and degree. Entity A may choose its own apportionment method, but the method chosen needs to be fair and reasonable in the circumstances of entity A's enterprise and must appropriately reflect the intended or actual use of those acquisitions.

Hire purchase agreement apportionment methodology - current view

In relation to input tax credits for acquisitions related to making supplies under a disclosed hire purchase agreement. Practice Statement Law Administration (General Administration) PS LA 2008/1(GA): GST and input tax credits for acquisitions related to making supplies under a disclosed hire purchase agreement explains a method for the calculation of input tax credits for acquisitions related to supplies made under a disclosed hire purchase agreement that will be accepted by the Commissioner as complying with the relevant provisions of the GST Act.

The ATO view in respect of the approach to calculating the input tax credits entitlement for acquisition that relates to the making of supplies under disclosed hire purchase agreements refers to GSTR 2006/3 and requires that the method chosen to determine 'use' of an acquisition must be justifiable.

A justifiable apportionment methodology in this context is one that takes into account the level of enterprise activities or business effort devoted to the taxable and input taxed elements of a disclosed hire purchase agreement. The main activity of the enterprise predominantly involves the provision of credit and hence the majority of the expenditure would be related to the making of input taxed supplies.

In this regard, the methodology should reflect that acquisitions are predominantly used by the taxpayer in carrying out its financial intermediary role and to a much lesser extent in the making of taxable supplies notwithstanding the fact that the making of a taxable supply by the taxpayer to the customer is an integral part of the arrangement of which the taxpayer typically employs little in the way of business effort in making such a supply.

Accordingly, the use of a revenue based method is not a fair and reasonable method because it allocates a disproportionate amount of expenditure to the taxable activity which is contrary to the fundamental nature of an enterprise whose business activities are predominantly the provision of credit.

For a tax period up to and including a tax period ending on 31 March 2008, we agree with the application of a revenue based method of apportionment (incorporating consistent values to values for both financial supplies and non-financial supplies) to determine the extent of creditable purpose for partly creditable acquisitions given the particular circumstances surrounding the implementation of GST to disclosed hire purchase agreement transactions.

However, for a tax period ending on or after 1 April 2008, we agree with an apportionment method (including a set-rate method) that achieves an extent of creditable purpose for partly creditable acquisitions of less than or equal to 15% under a disclosed hire purchase agreement.

Entity A's contentions

Entity A contends that a hire purchase agreement is a rental arrangement with an option to purchase. The rental is taxable except for the interest component, therefore under a revenue method, only the interest element of the supply is input taxed. The balance, being the principal, is taxable.

Nearly all effort (inputs) is directed towards managing risk in the asset and the bulk of the consideration has gone for the taxable supply, it is logical to conclude that the bulk of costs incurred in the administration of hire purchase agreements are directed towards the principal, that is, taxable component of the supply.

The processes involved in the initiation, maintenance and conclusion of leases and hire purchase agreements are largely similar. For each contract type the financier supplies the physical possession of an asset to a lessee for consideration. For the periodic consideration, charges as rentals, is determined by reference to the value of the asset, the interest rate to be charged, the term of the lease and the estimated value of the asset on termination of the agreement.

In each case the financier follows the same process in assessing whether to enter into a contract with the applicant, the set up of the contract and the operation aspects of the contract. The only difference occurs on termination of lease and hire purchase agreements. Under an operating lease, the asset must be returned. Under a financier lease, the asset is returned but the lessee guarantees the residual value. Under a hire purchase agreement, the purchaser has an obligation to purchase the asset so it is not returned unless there is a default. Lessee's obligations under a finance lease and hire purchase agreement are substantially the same.

Under each contract type the financier is the legal owner of the asset until title passes to either the customer or a third party.

The supply made under a lease or a hire purchase agreement is treated under GST as a taxable supply. The interest component of a hire purchase agreement is treated as an input taxed supply under item 8 of subregulation 40-5.09(3) of the GST Regulations where it is separately disclosed to the customer.

Application of the GST law to entity A's circumstances

The Commissioner's view on what is a 'fair and reasonable method' on the basis that any expense must recognise the nature of the underlying supply to be made is explained in paragraphs 75 to 76 of GSTR 2006/3:

Fair and reasonable method

75. The extent of your planned use of an acquisition for a creditable purpose must be established on a fair and reasonable basis having regard to the nature of the acquisition and the circumstances of your enterprise. Any apportionment method should aim to achieve an accurate reflection of the input tax credits available for acquisitions or importations acquired in carrying on your enterprise. The criteria used in relation to any expense must therefore recognise the nature of the underlying supply to be made.

76. An example of this is to be found in the decision of the New Zealand High Court in Commissioner of Inland Revenue v. BNZ Investment Advisory Services Ltd (BNZ case). The Court was required to consider the New Zealand GST 'principle purpose' test, under which an initial entitlement to input tax credits arises only if the principal purpose of the acquisition is to make taxable supplies. In that case the taxpayer's employees spent approximately 90% of their time giving taxable financial advice, and the taxpayer argued that this meant the principal purpose of its acquisitions was to provide taxable supplies. However, the High Court considered that an apportionment based on time spent was not an appropriate measure as the income and expenses did not directly relate to the giving of advice.

Entity A's principal activities

The extent of entity A's planned use of an acquisition must be established on a fair and reasonable basis having regard to the nature of its acquisition and the circumstances of its enterprise.

We do not agree with entity A's contentions above. We conclude that the circumstances outlined in PS LA 2008/1 (GA) are intended to apply to the set of circumstances outlined in entity A's asset finance business.

In the case of asset financier, the Commissioner considers that the 15% set rate method is a fair and reasonable method based on the asset financier's use of acquisitions by taking into account its overall level of enterprise activities or business effort devoted to the making of taxable and input taxed supplies of disclosed hire purchase agreements.

Entity A advised that it provides a range of finance products in the three main streams of business activities, namely, distribution finance, corporate financial services and equipment finance. On the basis of information provided, entity A's principal enterprise activities are the provision of a range of finance products to customers including hire purchase finance across the whole spectrum of asset-finance and non-asset finance products offered.

We consider that the amount of business effort required in making taxable supplies, that is, the supply of bailment products is an extension of entity A's effort in arranging finance in the course of selling bailment products.

We conclude that the principal enterprise activities of entity A are geared and directed towards the making of input taxed financial supplies in its role as both an asset finance provider as well as a non-asset finance provider. Consequently, the bulk of its acquisitions relate to the making of input taxed supplies.

Underlying supply of a hire purchase agreement

In reaching our conclusion above we need to consider the true nature of a hire purchase agreement and its underlying supply in determining the appropriate apportionment of overhead expenses which are referable to all supplies.

Paragraphs 195 to 198 of Goods and Services Tax Ruling GSTR 2000/29 Goods and services tax: attributing GST payable, input tax credits and adjustments and particular attribution rules made under section 29-25 (GSTR 2000/29) explain the essential nature of a hire purchase agreement:

195. The essential nature of a hire purchase agreement was discussed by Finnemore J in Warman v Southern Counties Car Finance Corporation Ltd W J Ameris Car Sales [1949] 2 KB 576. His Honour outlined at page 582 of his judgement, the nature of a hire purchase agreement as follows:

'A hire purchase agreement is in law, an agreement in two parts. It is an agreement to rent a particular chattel for a certain length of time. If during the period or at the end of the period the hirer does not wish to buy the chattel he is not bound to do so. On the other hand, the essential part of the agreement is that the hirer has the option of purchase, and it is common knowledge - and I suppose , common sense - that when people enter into a hire purchase agreement they enter into it not so much for the purpose of hiring , but for the purpose of purchasing , by a certain method , by what is, in effect, deferred payments, and that is done by this special kind of agreement known as a hire purchase agreement, the whole object of which is to acquire the option to purchase the chattel when certain payments have been made. (our emphasis)

Now, I think it might well be right to say if at any stage the option to purchase goes, the whole value of the agreement to the hirer has gone with it. If he wanted to make an agreement merely to hire a car he would make it, but he enters into a hire purchase agreement because he wants to have the right to purchase the car; that is the whole basis of the agreement, the very foundation of it.'

196. This statement by Finnemore J recognises two basic ingredients of a hire purchase agreement, namely, the paramount purpose of purchasing and the financing element of the hire purchase (purchasing by deferred payments).

197. Looked at as a whole, the hire purchase agreement is a method by which the 'hirer' purchases the goods. It is in commercial substance a method by which the 'hirer' purchases goods on deferred payment terms.

198. Unlike a lease or hire arrangement, the capital cost of the goods under a hire purchase agreement is paid off over the term of the agreement and full ownership of the goods will pass to the recipient at the time of the final payment.

For GST purposes, a hire purchase agreement consists of a taxable supply of the sale of an asset and an input taxed components, however the underlying nature of a hire purchase agreement is an input taxed financial supply being the provision of an interest in credit which is a separate charge disclosed to the recipient of the goods.

Although a hire purchase agreement has two basic features, namely, an agreement to hire and an option to purchase. The primary purpose for customers to enter into hire purchase arrangements is to purchase the goods by deferred payments. Therefore, the principal purpose of entity A's acquisition is to make the underlying input taxed financial supply of credit.

As such, the appropriate hire purchase apportionment methodology should reflect the planned or actual usage of the acquisitions in respect of the underlying supply of disclosed hire purchase agreements and the enterprise activities of entity A. It is in this context that the Commissioner considers that entity A is predominantly a financier and not a seller of bailment products as its main activity is the provision of credit relative to the activities of selling other bailment products.

Therefore, we do not agree with entity A's contention that nearly all effort (inputs) is directed towards managing risk in the asset and the bulk of the consideration has gone for the taxable supply of the asset.

Entity A's business effort in selling finance products

Overall, we conclude the main activity of entity A's enterprise predominantly involves the provision of credit and the majority of expenditure would be related to the making of input taxed supplies. Whilst we agree that the making of taxable supplies by entity A to the customer is an integral part of the arrangement, entity A employs little in the way of business effort in making such supplies.

In this regard, entity A has not provided any quantitative analysis of the business inputs required to support its contention that it exerts significant business efforts in the making of taxable supplies of assets apart from the provision of credit facility to the customers. In this instance, you have listed the acquisitions relating to the making of supplies under disclosed hire purchase agreements. Entity A has argued in general terms that most of the acquisitions relate to a certain extent, to the preservation of the underlying asset. However, there is as yet no evidence to support that all these acquisitions are consumed by entity A to make the actual taxable supplies of underlying assets other than making input tax supplies of credit to the customers through which they acquire those assets.

On this basis, we maintain the view that the use of a revenue based formula approach is not a fair and reasonable method of determining the creditable purpose of partly creditable acquisitions because it allocates a disproportionate amount of expenditure to the taxable activity which is contrary to the fundamental nature of the typical enterprise offering this type of credit arrangement.

It follows that we cannot accept your contention that the consideration receivable under a disclosed hire purchase agreement is the rent that comprises a principal and interest component. Over the life of an asset, the principal represents approximately X% of the total consideration. On that basis, a fair and reasonable apportionment percentage to apply to costs relating to making supplies under disclosed hire purchase agreements using this revenue based formula would be X%.

15% set-rate method

The ATO view in respect of the approach to calculating the input tax credits entitlement for acquisitions that relate to the making of supplies under disclosed hire purchase agreements refers to GSTR 2006/3 which concludes that the method chosen to determine 'use' of an acquisition must be justifiable.

PSLA 2008/1 (GA) outlines the Commissioner's approach to calculating the input tax credit entitlement for acquisitions that relate to the making of supplies under disclosed hire purchase agreements. Its aim is to reduce compliance costs for taxpayers.

We conclude that the set rate of 15% is an appropriate measure of the use of acquisition in respect of disclosed hire purchase agreements on the factual basis that an asset financier is predominantly in the business of providing finance.

The Commissioner's approach to accept the use of a set-rate method of 15% recognises the fact that some of the indirect overhead costs are acquired for a creditable purpose in relation to the taxable supply of underlying assets. The Commissioner determined that the set-rate method is a fair and reasonable proxy which reflects the intended or actual use of acquisitions to some degree but not viewed as being excessive.

We do not agree with the revenue method currently used by entity A to apportion its overheads. We conclude that the use of a hire purchase apportionment method based on revenue was not an appropriate method as it does not accurately reflect that acquisitions used in carrying out its principal activities, that is, the provision of credit to its customers.