Edited version of private ruling

Authorisation Number: 1011725425328

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Ruling

Subject: Depreciation

Question 1

Were you the holder of the equipment and facilities in the commercial property under section 40-40 Of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer: No.

Question 2

Are you entitled to a balancing adjustment on the equipment and facilities when the equipment and facilities passed to the tenant?

Answer: No.

This ruling applies for the following period:

Year ended 30 June 2011

The scheme commences on:

1 July 2010

Relevant facts and circumstances

You purchased a commercial property. The purchase came with an existing rental contract.

The shop was leased to a tenant who used the premises to operate their business.

The monthly rent charged included usage of all the facilities.

On expiry of the lease, the ownership of the shop renovation, equipment and facilities passed to the tenant as per the lease conditions.

The lease agreement states:

The Tenant acknowledges that the plant and equipment furniture and fittings in the inventory referred to in item 11 is leased by the landlord to the tenant and included in the rental hereof. Provided that the tenant complies with the covenants and conditions of this Lease and there are no breaches outstanding at the expiry of the first term then upon entering into the option in item 12A, the property in the equipment shall pass to the tenant. Until property passes to the tenant, the tenant shall insure the plant and equipment with an insurer approved by the landlord noting the interest of the landlord in the policy for the replacement value. Further, until property passes in the equipment to the tenant, the tenant shall be responsible for the repairs, upkeep and maintenance of any faulty equipment whether in whole or in part and shall not make any demand or make any claim to the Lessor to repair any of the equipment.

Relevant legislative provisions

Income Tax Assessment Act 1997, Subsection 995-1(1)

Income Tax Assessment Act 1997, Subsection 40-25(1)

Income Tax Assessment Act 1997, Subsection 40-295(1)

Income Tax Assessment Act 1997, Section 40-40

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Reasons for decision

Under subsection 40-25(1) of the ITAA 1997, depreciation (and any associated balancing adjustment) can only be claimed by the holder of the asset.

Section 40-40 of the ITAA 1997 provides a table to work out who holds a depreciating asset. Item 2 applies to your situation and states that the holder of the asset is the owner of the quasi-ownership right as follows:

Quasi-ownership

Subsection 995-1(1) of the ITAA 1997 defines 'quasi-ownership right over land' to mean:

(a) a lease of the land; or

(b) an easement in connection with the land: or

(c) any other right, power or privilege over the land, or in connection with the land.

'Lease' is not defined in the ITAA 1997 and so takes its ordinary meaning according to the common law.

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.

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 right to exclusive possession of land is the decisive characteristic that distinguishes a lease from a licence that only confers a right to occupy. This principle was confirmed by the High Court in Radaich v. Smith (1959) 101 CLR 209; [1959] ALR 1253.

In determining whether a lease has been granted, the Courts will look to the substance of the transaction and the conduct of the parties to characterise the rights that have been created. If the substance of the agreement points to an intention to confer a right to exclusive possession, then there will be a lease, regardless of the type of tenancy that is created. The tenancy may be for a fixed term, or may be a periodic lease or a tenancy at will.

In your case, the lease states:

The Tenant acknowledges that the plant and equipment furniture and fittings in the inventory referred to in item 11 is leased by the landlord to the tenant and included in the rental hereof. Provided that the tenant complies with the covenants and conditions of this Lease and there are no breaches outstanding at the expiry of the first term then upon entering into the option in item 12A, the property in the equipment shall pass to the tenant. Until property passes to the tenant, the tenant shall insure the plant and equipment with an insurer approved by the landlord noting the interest of the landlord in the policy for the replacement value. Further, until property passes in the equipment to the tenant, the tenant shall be responsible for the repairs, upkeep and maintenance of any faulty equipment whether in whole or in part and shall not make any demand or make any claim to the Lessor to repair any of the equipment.

Conclusion

The tenant had a quasi-ownership right over the land which had depreciating assets fixed to it. As the tenant had the right to remove the depreciating assets at the end of the lease, it is the tenant who is considered the holder under Item 2 of section 40-40 of the ITAA 1997.

As the tenant was the holder of the assets at the time that title passed to them in that the tenant removed all the assets from the property, the tenant was also the economic owner. The tenant is entitled to claim depreciation expenses on the assets.

Therefore, you are not entitled to a balancing adjustment under subsection 40-295(1) of the ITAA 1997, on the equipment and facilities as at 30 August 2010 as you were not the holder of the assets at the time that title passed to the tenant.