Edited version of your written advice

Authorisation Number: 1013044601260

Date of advice: 21 July 2016

Ruling

Subject: Division 250 of the Income Tax Assessment Act 1997

Question 1

Will the Commissioner make a determination under section 250-45 that Division 250 of the Income Tax Assessment Act 1997 (ITAA 1997) does not apply to the taxpayer's asset which is being put to tax preferred use?

Answer

Yes

This ruling applies for the following period:

Income year ending 1 July 20XX to 30 June 20YY

The scheme commences on:

01 July 20XX

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

The taxpayer entered into an arrangement in July 20XX involving the acquisition of a building (the Asset) that is leased to a government department.

The costs of acquisition were funded by X% debt and the remainder by equity.

The taxpayer would ordinarily be entitled to a deduction in respect of assets subject to Division 40

of the ITAA 1997 (Division 40 assets) and Division 43 of the ITAA (Division 43 assets).

The taxpayer's aggregated turnover is greater than $2 million per annum.

At the time of entering the contract of sale, the asset was leased to a tax preferred entity as defined by section 995-1 of the ITAA 1997.

The lease commenced on 1 July 20ZZ and had an expiry date of 30 June 20XX (Lease agreement). It was extended presumably at the time of sale to 30 June 20YY, and the remaining term became greater than 5 years.

On settlement of the Asset, the Lease agreement between the vendor and the lessee was assigned to the taxpayer (lessor).

The Lease agreement does not allow the option for the lessee to purchase the Asset at the end of the lease period.

The nominal values of the lease payments over the life of the Lease agreement relating to the whole asset, being real property, are greater than $50 million.

The lessee is unable to cancel the lease without the consent or approval of the taxpayer.

Division 40 assets will be replaced by the taxpayer as required, and the likelihood that assets will be replaced increases in the period that assets continue to be used after the end of their period of effective life. Capital allowance deductions will only be claimed in the period of an asset's remaining effective life and will not be claimed in respect of assets that continue to be used after the end of their effective life.

Under the leasing arrangement there is no guaranteed residual (at the end of the arrangement period) and the tax preferred use of the Asset is not classified as a debt interest under Subdivision 974-B of the ITAA 1997.

The taxpayer is in a net taxable position in relation to the Asset.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 40

Income Tax Assessment Act 1997 Division 43

Income Tax Assessment Act 1997 section 250-5

Income Tax Assessment Act 1997 section 250-10

Income Tax Assessment Act 1997 section 250-15

Income Tax Assessment Act 1997 section 250-20

Income Tax Assessment Act 1997 section 250-25

Income Tax Assessment Act 1997 section 250-30

Income Tax Assessment Act 1997 section 250-40

Income Tax Assessment Act 1997 section 250-45

Income Tax Assessment Act 1997 section 250-55

Income Tax Assessment Act 1997 section 250-60

Income Tax Assessment Act 1997 section 250-95

Income Tax Assessment Act 1997 section 250-115

Income Tax Assessment Act 1997 section 250-120

Income Tax Assessment Act 1997 section 250-125

Income Tax Assessment Act 1997 section 250-135

Income Tax Assessment Act 1997 section 974-20

Income Tax Assessment Act 1997 section 974-160

Income Tax Assessment Act 1997 section 995-1

Income Tax Assessment Act 1997 subsection 995-1(1)

Reasons for decision

Division 250 operates to deny or reduce capital allowance deductions that would otherwise be available in respect of an asset that is put to a tax preferred use and when a taxpayer has insufficient economic interest in the asset (section 250-5 of the ITAA 1997).

Section 250-10 of the ITAA 1997 states that Division 250 applies to an asset at a particular time if the general test in section 250-15 is satisfied and none of the exclusions in sections 250-20, 250-25, 250-30, 250-40 and 250-45 of the ITAA 1997 apply.

Section 250-15 General Test

This Division applies to you and an asset at a particular time if:

(a) the asset is being *put to a tax preferred use; and

(b) the *arrangement period for the *tax preferred use of the asset is greater than 12 months; and

(c) *financial benefits in relation to the tax preferred use of the asset have been, will be or can reasonably be expected to be,

*provided to you (or a *connected entity) by:

(i) a *tax preferred end user (or a connected entity); or

(ii) any *tax preferred entity (or a connected entity); or

(iii) any entity that is a foreign resident; and

(d) disregarding this Division, you would be entitled to a *capital allowance in relation to:

(i) a decline in the value of the asset; or

(ii) expenditure in relation to the asset; and

(e) you lack a *predominant economic interest in the asset at that time.

The following applies to each element of the general test in section 250-15:

(a) The asset is being put to a tax preferred use for the purpose of paragraph 250-15(a). The asset is leased to a tax preferred end user.

(b) The arrangement period between the taxpayer and the tax preferred entity is the period that the taxpayer is party to the lease. The arrangement period for the taxpayer is therefore from the time of purchase rather than the time the lease was originally entered into. As the period of the arrangement is greater than 12 months, paragraph 250-15(b) is satisfied.

(c) Financial benefit is defined in section 974-160 of the ITAA 1997 to include anything of economic value. Financial benefits are provided (in the form of regular rental payments) by the tax preferred end user for the tax preferred use of the Asset; as such paragraph 250-15(c) is satisfied.

(d) In the absence of Division 250 applying, it is expected that the taxpayer would be entitled to capital allowances in relation to a decline in the value of the Asset (under Division 40 of the ITAA 1997) and expenditure in relation to the Asset (under Division 43 of the ITAA 1997). Paragraph 250-15(d) is therefore satisfied.

(e) Whether or not the taxpayer lacks a predominant economic interest in the Asset is considered below.

Lack of predominant economic interest:

In order to determine whether there is a lack of predominant economic interest for the purpose of paragraph 250-15(e), four tests will need to be considered:

1. Limited recourse debt test - section 250-115;

2. Right to acquire asset test - section 250-120;

3. Effectively non-cancellable, long term arrangement test - section 250-125; and

4. Level of expected financial benefits test - section 250-135

If any one of the tests is satisfied then the legal owner will lack a predominant economic interest in the asset for the purpose of Division 250.

1. Section 250-115 - limited recourse debt test

The test states that you will lack a predominant economic interest in an asset if more than the allowable percentage of the cost of acquiring the asset is financed by limited recourse debt (subsection 250-115(1)). Limited recourse debt occurs when the rights of the creditor against the debtor are limited in the event of debtor default (section 243-20). In the present situation, the test will be satisfied where the Asset is financed by more than 80% limited recourse debt as the Asset is put to tax preferred use because the end user is a tax preferred entity (paragraph 250-115(3)(a)). The indirect debt ratio used to acquire the Asset is X% and is not limited recourse debt. Accordingly, the limited recourse debt test is not satisfied as less than 80% of the cost of acquiring the Asset was funded by limited recourse debt.

2. Section 250-120 - Right to acquire asset test:

An entity will lack a predominant economic interest in an asset when there is a right, obligation, or contingent obligation to acquire the asset at the end of the arrangement period and the consideration for that acquisition is not fixed as the market value of the asset at the time of the transfer (section 250-120). The lease agreement does not include a right to acquire the Asset, therefore the right to acquire asset test will not determine that the taxpayer lacks a predominant economic interest in the Asset.

Section 250-125 & section 250-135:

The applicant advised that two tests of a predominant economic interest are satisfied; the effectively non-cancellable, long term arrangement test in subparagraph 250-125(b)(ii) and the level of expected financial benefits test in section 250-135.

The applicant advised that for the purposes of paragraph 250-15(e) a predominant economic interest is lacking in the depreciable Division 40 assets and for the Division 43 improvements (albeit marginally) in the context of section 250-125 and section 250-135.

The ruling will now address each of the above two tests in detail.

3. Section 250-125 - Effectively non-cancellable, long term arrangement test

The legislation is set out as follows:

Section 250-125: Effectively non-cancellable, long term arrangement test

250-125(1) You lack a predominant economic interest in an asset at a particular time if:

(a) any *arrangement that relates to:

(i) the *tax preferred use of the asset; or

(ii) the *financial benefits to be *provided by the *members of the tax preferred sector in relation to the tax preferred use of the asset;

is *effectively non-cancellable (see section 250-130); and

(b) the *arrangement period for the tax preferred use of the asset is:

(i) greater than 30 years; or

(ii) if the arrangement period is less than or equal to 30 years - 75% or more of that part of the asset's *effective life that remains when the tax preferred use of the asset starts.

250-125(2) Disregard section 40-102 in working out the asset's *effective life for the purposes of subparagraph (1)(b)(ii).

Applying the test in section 250-125, the taxpayer lacks a predominant economic interest in the Asset if the arrangement, being the lease of the Asset, is effectively non-cancellable. The arrangement is effectively non-cancellable if it can only be cancelled with the taxpayer's permission (section 250-130). The taxpayer has stated that the lease is effectively non-cancellable as the arrangement requires the permission of the taxpayer to cancel the lease agreement.

The arrangement must also be for a period of greater than 30 years, or if less than 30 years the arrangement must have 75% or more of the effective life of the Asset remaining (paragraph 250-125(1)(b)). The arrangement period (section 250-60) is less than 30 years; therefore the 75% test must be applied.

Subparagraph 250-125(1)(b)(ii) requires an analysis of the effective life of the Asset. The taxpayer did not perform an analysis of the Asset to determine its effective life due to cost and the Commissioner has not provided a determination of effective life for buildings and structural works under Division 40. Instead, the method applied by the taxpayer was to adopt the effective life applied in respect of Division 43 for buildings and structural works. Applying that methodology, the taxpayer concluded that the effective life for the Asset would range from 3 to 20 years, and adopted an average effective life of 15 years. In applying the statutory rates as a guide for determining the effective life of the asset, the Division 43 assets can range from 25 to 40 years. The taxpayer has stated that the building in question attracts the 2.5% deduction rate and the effective life of 40 years should be used as the effective life of the Asset.

In applying section 250-125, the Division 40 assets of the taxpayer exceed the 75% threshold; therefore the taxpayer lacks a predominant economic interest in those assets. For the Division 43 assets, as the 75% threshold has not been exceeded, the taxpayer has a predominant economic interest in those assets.

Division 250 applies to each asset in the arrangement with the consequence that it might apply to some assets but not others. This is true between asset type (Division 40 and Division 43 assets) and to assets within a type. As such, long effective life assets might not be satisfied whereas shorter effective life assets might be satisfied.

It is advised, that the remaining effective life of Division 40 assets when being tested as a group is 10 years, but that some individual assets have an effective life of 24 years or more and as such may not lack a predominant economic interest with respect to those individual assets.

As a group however the arrangement period as a percentage of the remaining effective life for Division 40 assets is 100% or more. If the arrangement involved goods and therefore only involved the use / lease of Division 40 assets then the likelihood that the effective life of the assets would be expended during the period of the lease would be a significant factor indicative that economic ownership belonged with the entity with physical use of the asset.

The arrangement for the use of the assets however also involves an arrangement for the use of other assets (Division 43) of a much longer effective life, and the arrangement might entail a replacement of Division 40 assets should their effective life actually terminate during the period of the lease, or an absence of capital allowance deductions if the exhausted assets are not replaced.

Assets with a shorter effective life, including those that are older or second hand will more easily satisfy the test under section 250-125. If the arrangement period exceeds the period of an asset's remaining effective life then it would indicate that deductions for capital allowances will not be claimed during a portion of the arrangement because of the limited remaining effective life.

Division 250 denies deductions for capital allowances to a holder of an asset where under an arrangement the holder does not retain a predominant economic interest in the asset; Division 250 presupposes that capital allowances are being claimed during the arrangement that is being examined. It is the inappropriate access to these deductions given the nature of the taxpayer's interest that Division 250 seeks to deny.

Some assets having an effective life of 24 years or more will give rise to capital allowance deductions, but the majority of assets it would appear would not be in this category and Division 250 could only apply during this shorter effective life even though such assets if not replaced will be used throughout the arrangement period.

If an asset is replaced at the end of a typical effective life of 5 years, the remainder of the arrangement period might not be sufficient to recoup cost of the replacement asset. It would be a risk borne by the taxpayer who would either need to deploy such assets through the term of their effective lives, or sell the assets and or the property to which the assets are attached or affixed in order for a recovery of asset cost and a derivation of gain.

The actual replacement of assets is hypothetical and any replacement asset would need to be tested separately under Division 250, but the risk arising in replacing existing assets would seem to increase in the period beyond the effective life.

An arrangement period that extended beyond the effective life of an asset would seemingly involve an economic risk to the owner; the greater the arrangement period extended beyond the effective life of an asset, the greater the risk that the asset will fail and needs to be replaced during the arrangement. The reduced risk in the period that the arrangement period equates to the effective life of such assets is balanced by an increased risk in the period that the arrangement period extends beyond the effective life of the asset.

That the period of the arrangement for the tax preferred use of Division 40 assets will be equal to or exceed the remaining effective life might cause the test to be satisfied in a more than marginal way, but the percentage to which an arrangement period might extend beyond the effective life of an asset might not accurately indicate the presence of reduced risk. It might in fact indicate increased risk, because the risk in the subject assets cannot be assessed in isolation but would need to take account of the commercial factors governing their use including the period of use and the economic risk retained in other assets.

Further, the absence of capital allowance deductions being concomitant with the more than marginal nature of the breach of section 250-125 indicates that capital allowances are not being inappropriately accessed by the owner given either the ongoing exploitation of the asset under the arrangement after capital allowances have expired, or the replacement of the asset at the cost of the owner.

4. Level of expected financial benefits test - section 250-135

The section is set out below:

Section 250-135 Level of expected financial benefits test  

Effective guarantee or indemnity for value of asset

250-135(1) You lack a predominant economic interest in an asset at a particular time if the asset has a *guaranteed residual value at that time.

Likely financial benefits exceeding 70% limit

250-135(2) You also lack a predominant economic interest in an asset at a particular time if, at that time:

(a) the *arrangement under which the asset is *put to the tax preferred use (either alone or together with any other arrangement in relation to the *tax preferred use of the asset or the *provision of *financial benefits in relation to the tax preferred use of the asset) is a *debt interest; or

(b) the sum of the present values of the *expected financial benefits that *members of the tax preferred sector have provided, or are reasonably likely to provide, to you (or a *connected entity) in relation to the tax preferred use of the asset exceeds 70% of:

(i) the *market value of the asset if subparagraph 250-15(d)(i) applies; or

(ii) so much of the market value of the asset as is attributable to the expenditure referred to subparagraph 250-15(d)(ii) if that subparagraph applies

'Guaranteed residual value' is defined in subsection 250-85(3) of the ITAA 1997. It describes the situation where the entity holding the asset disposes of that asset, and in the event the disposal proceeds are less than the guaranteed amount, it receives the difference in payment from the tax preferred end user. The Asset is not part of a guaranteed residual value arrangement and therefore the taxpayer does not lack a predominant economic interest under subsection 250-130(1).

Paragraph 250-135(2)(a) considers whether the arrangement for the tax preferred use of the Asset is a debt interest. The test for a debt interest is contained in section 974-20 of the ITAA 1997. Broadly, a scheme will be a debt interest where it is a financing arrangement under which the entity receives financial benefits that are effectively non-contingent, and the value of those financial benefits provided is substantially more likely than not to equal the value received. Certain leases of real property, such as the lease of the Asset, are excluded from being a financing arrangement (subsection 974-130(4) of the ITAA 1997). This means that the lease is not a debt interest and that the taxpayer will not lack a predominant economic interest under paragraph 250-135(2)(a).

Paragraph 250-135(2)(b) compares the expected financial benefits that the taxpayer expects to receive in rent under the lease with both the market value of the Asset and the market value of the Asset relating to capital allowance expenditure. That figure needs to be less than 70% or the taxpayer will be deemed to lack a predominant economic interest in the asset. For the purpose of Division 250, section 250-95 of the ITAA 1997 defines expected financial benefits as financial benefits that have, will, or can reasonably be expected to be provided in relation to the tax preferred use of the Asset under normal operating conditions. That is, it is expected that the tax preferred end user will continue to pay rent for the duration of the lease.

The sum of present values for the Division 43 assets is marginally greater than the 70% threshold as required by paragraph 250-136(2)(b). Division 43 assets exceed 70% of the market value of the assets by 0.39 of a percent, and on a strict reading of the provision, the taxpayer would be considered to lack a predominant economic interest in those assets. A breach of this level is close to the benchmark, such that the breach can be considered marginal.

The present value of the financial benefits provided in relation to Division 40 assets have breached the level of expected financial benefits test by nearly 12%. As a result, the taxpayer would lack a predominant economic interest in relation to the Division 40 assets.

the taxpayer recovers most but not all of the cost of the asset through derivation of recurrent arrangement payments, and the extent to which cost is not recovered is sufficiently large to indicate that sufficient economic risk in Division 43 assets is retained by the taxpayer rather than having been passed through to the tax preferred end user. As noted above, the arrangement is not simply for the use of Division 40 assets but is part of a larger arrangement involving use of and economic risk in other assets. The arrangement being the provision of a maintained building would entail an obligation to replace Division 40 assets as required, and the cost of replacing such assets would be a risk borne and retained by the taxpayer where the cost might not be recouped from the tax preferred end user under the arrangement being tested.

In the strict application of section 250-135, the taxpayer does not retain a predominant economic interest in the Division 43 assets; however being one arrangement it is not the case that the taxpayer can look to the Division 40 assets as sufficient to provide it with a return on its investment. The Division 40 assets are a component of its return, and the exposure in the Division 43 assets would collectively provide an indication of the relevance of the breach for Division 40 assets.

In this arrangement the expenditure on depreciable assets is split between Division 40 and Division 43 assets so it would appear the risk in each would appear to be balanced; neither one would alone be determinative

Exclusions

The Commissioner accepts that the taxpayer may be unable to access the following exclusions:

1. small business entity (section 250-20);

2. financial benefits under minimum value limit (section 250-25);

3. certain short term or low value arrangements (section 250-30); and

4. sum of present value of financial benefits less than amount otherwise assessable (section 250-40).

The fifth exclusion under section 250-45 allows the Commissioner to make a determination to not apply Division 250 to the asset, which has been considered further.

Section 250-45 Fifth exclusion - Commissioner determination

This Division does not apply to you and an asset at a particular time if:

(a) you request the Commissioner to make a determination under this subsection; and

(b) the Commissioner determines that it is unreasonable that the Division should apply to you and the asset at that time, having regard to:

(i) the circumstances because of which this Division would apply to you and the asset; and

(ii) any other relevant circumstances.

The private ruling application satisfies paragraph 250-45(a). The additional requirement in paragraph 250-45(b) is whether or not it is unreasonable for Division 250 to apply to the taxpayer and the asset, having regard to the relevant circumstances.

The Explanatory Memorandum to the Tax Laws Amendment (2007 Measures No. 5) Bill 2007 ('Explanatory Memorandum') explains when the Commissioner should consider applying the discretion to not apply Division 250 having regard to the circumstances under which Division 250 would apply and other relevant circumstances.

Paragraph 1.136 of the Explanatory Memorandum states that in making the determination, the Commissioner should give consideration to the objects of the Division set out in section 250-5 of the ITAA 1997.

Section 250-5 - Main objects

The main objects of this Division are:

(a) to deny or reduce your *capital allowance deductions in respect of an asset if the asset is put to a *tax preferred use and you have insufficient economic interest in the asset; and

(b) if your capital allowance deductions are denied or reduced, to treat the *arrangement for the tax preferred use of the asset as a loan that is taxed as a financial arrangement (on a compounding accruals basis).

Paragraph 1.137 of the Explanatory Memorandum further states that it is expected that the Commissioner would consider applying the discretion, for example, to prevent an arrangement from coming within the scope of Division 250 due to:

• an unintended or marginal breach of one of the safe harbour tests; or

• an unintended or marginal breach of one of the tests that need to be satisfied to qualify for the specific exclusion for certain operating and service arrangements.

Example 1.18 in the Explanatory Memorandum demonstrates that the compliance cost implication for applying Division 250 where the threshold for an exclusion is only marginally exceeded can lead to the Commissioner exercising discretion.

Division 250 applies to an asset if section 250-15 is satisfied. Passing one of the four tests for lacking a predominant economic interest is sufficient to satisfy paragraph 250-15(e).

One test of lacking a predominant economic interest is sufficient to satisfy paragraph 250-15(e) of the ITAA 1997. Section 250-115(1) provides that you lack a predominant economic interest in an asset at a particular time only if one or more of the sections listed under that provision apply to you and the asset at that time.

The fact that two tests are failed would constitute part of the circumstances, but not the only circumstance, that the Commissioner would have regard to in determining whether it was appropriate to exercise a determination that the Division not apply. That is, 2 of the 4 tests show that the taxpayer had a predominant economic interest in the Asset. In addition, of the tests that were passed, demonstrating a lack of predominant economic interest in the Asset, they were passed predominantly in respect of Division 40 assets and marginally in respect of Division 43 assets.

Given the circumstances applicable to the lack of a predominant economic interest in the Division 40 assets (and marginal breach of Division 43 assets) that cause Division 250 to apply, the Commissioner would be able to determine that it is unreasonable that Division 250 should apply to the taxpayer and the asset.