Edited version of private advice

Authorisation Number: 1052121789744

Date of advice: 26 May 2023

Ruling

Subject: Division 250 of the ITAA 1997

Question

Will Division 250 of the ITAA 1997 apply to Entity A and the Property that has been leased to Entity B?

Answer

No.

This ruling applies for the following period:

1 July 20xx to 30 June 20xx

The scheme commenced on:

1 July 20xx

Relevant facts and circumstances

Group structure and background

1.    Entity C is a property investment trust.

2.    Entity A is a wholly owned subsidiary of Entity C. Entity A is not a small business entity for Australian income tax purposes.

The arrangement:

Acquisition of the Property

3.    Entity A entered into a contract of sale to acquire the Property on 1 July 20xx for $x plus acquisition costs.

4.    The Property means the assets that comprise the Land, the Building (Division 43 assets) and the Plant and Equipment (Division 40 assets).

5.    The settlement of the Property took place in 20xx at which time Entity A took possession of the Property.

6.    The acquisition of the Property was indirectly debt financed by Entity C. The lenders received the benefit of security over Entity C's entire property portfolio.

Lease arrangement for the Property

7.    At the time of entering into the contract of sale, the Property has been leased (the Lease) and the major existing tenant of the Property is Entity B (the Lessee), a tax-preferred entity as defined in section 995-1 of the ITAA 1997.

8.    The Lease with Entity B commenced on 1 July 20xx and had a term of y years. The Lease was assigned to Entity A on 1 July 20xx when Entity A acquired and settled the Property.

9.    The end date of the Lease is 30 June 20xx. Entity B has the option to renew the Lease for a further z years.

10.  The Lease does not provide the option for the Lessee to purchase the Property at the end of the lease period or does not confer on the Lessee a right to purchase the Property at any time. It also does not provide for any guaranteed residual value (at the end of the arrangement period).

11.  The annual gross amount paid by Entity B for the year ended 30 June 20xx was $x, which comprises $y as annual rental income and $z as annual recovery of expenses.

12.  On each rent review date, the rent will be increased by x%. The rent will be reviewed on the commencement of any further term.

Termination of the Lease

13.  The Lease states that if the Property is damaged resulting in the Property being unfit for the occupation or use by the Tenant, the Tenant may request that the Landlord repair the damage to the Property. If the Landlord does not:

•         substantially commence works to repair the damage to the Property within a reasonable time; or

•         complete the works required to repair the damage to the Property within a reasonable period after the date the Tenant's request

then the Tenant may terminate this lease by giving written notice to the Landlord.

14.  The Tenant may also terminate the Lease pursuant if the Landlord fails to undertake the work required in relation to the damage repair within the period specified in these clauses.

15.  In addition, the Tenant may terminate the Lease if the occupation and use of the Property by the Tenant has been rendered hazardous as a result of the presence of Asbestos or any other Hazardous Substance in the Property.

16.  The Landlord may also terminate the Lease in relation to the Tenant's Event of Default.

Assumptions

17.  The values determined by the quantity surveyor's report for the value of Land, the Building and the Plant and Equipment are the fair market value.

18.  Entity A, Entity B or any member of the tax preferred sector will not do something, or omit to do something, that increases the value of the expected financial benefits in relation to the tax preferred use of the asset during the remaining term of the Lease that would require the retest of predominant economic interest under section 250-135.

Relevant legislative provisions

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 250-50

Income Tax Assessment Act 1997 section 250-55

Income Tax Assessment Act 1997 section 250-60

Income Tax Assessment Act 1997 section 250-65

Income Tax Assessment Act 1997 section 250-75

Income Tax Assessment Act 1997 subsection 250-105(2)

Income Tax Assessment Act 1997 section 250-110

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 250-130

Income Tax Assessment Act 1997 section 250-135

Reasons for decision

Question

Will Division 250 of the ITAA 1997 apply to Entity A and the Property that has been leased to Entity B?

Summary

Division 250 of the ITAA 1997 will not apply to Entity A and the Property that has been leased to Entity B.

Detailed reasoning

All the legislative references are to theITAA 1997 unless otherwise stated.

Division 250 - the general test

Section 250-5 sets out the main objects of Division 250 which, where applicable, denies or reduces capital allowance deductions that would otherwise be available in respect of an asset that is put to a tax preferred use when a taxpayer claiming those capital allowance deductions has an insufficient economic interest in the asset.

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

Section 250-15 provides that the Division applies to you and an asset 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 the asset; and

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

Division 250 applies on an asset-by-asset basis, and only to assets for which capital allowance deductions can be claimed. Therefore, the first step is to identify the relevant assets in the scheme that is the subject of this Private Ruling.

The asset in question - a building that is leased - is a composite asset. Composite assets may either themselves be an asset, or their separate components may be separate assets.

Subsection 250-75(2) states that whether a particular composite item is itself an asset or whether its components are separate assets is a question of fact and degree which can only be determined in the light of all the circumstances of the particular case. Example 2 under subsection 250-75(2) notes that a floating restaurant consists of many separate components that are usually treated as separate assets.

Similarly, an office building is a composite asset that has a number of clearly separate components. A building consists of a number of separate assets:

§  the land on which the building sits;

§  the building itself (which constitutes capital works under Division 43); and

§  the individual assets in the building such as carpet, fans, air conditioning equipment and lavatory fittings (Plant and Equipment, which constitute depreciating assets under Division 40).

Other than land (which does not give rise to capital allowance deductions), each of these assets is a separate asset for the purposes of Division 250.

The building (being a fixture on land) is deemed to be an asset separate from the land by subsection 250-75(1).

Paragraph 250-15(a) - The asset is being put to a tax preferred use

Pursuant to section 250-60, an asset is 'put to a tax preferred use' at a particular time if an end user holds at that time rights as lessee under a lease of the asset and the asset is used by, or on behalf of, an end user who is a 'tax preferred end user' because of paragraph 250-55(a).

Subsection 250-50(1) provides that an entity is an 'end user' of an asset if the entity uses, or effectively controls the use of, the asset. Subsection 250-50(4) provides that an entity is taken to be an end user of an asset if the entity holds rights as a lessee under a lease of the asset.

As a result, Entity B (as the Lessee of the Property) is an 'end user' of the assets constituting the Property.

Paragraph 250-55(a) provides that an 'end user' of an asset is a 'tax preferred end user' if the end user is a 'tax preferred entity'. Subsection 995-1(1) defines a 'tax preferred entity' to include an 'exempt Australian government agency'. An 'exempt Australian government agency' is defined in subsection 995-1(1) as the Commonwealth, a State or a Territory.

Entity B is an 'exempt Australian government agency'. Therefore, Entity B is a 'tax preferred entity' according to subsection 995-1(1) and, as a result, is a 'tax preferred end user' because of paragraph 250-55(a).

As a result, Entity B is a 'tax preferred end user' who leases the Property, which will include the Building, Land and the Plant and Equipment. This means that the Building, Land and Equipment will be 'put to a tax preferred use' as per subsection 250-60(1).

As such, paragraph 250-15(a) will be satisfied.

Paragraph 250-15(b) - The arrangement period for the tax preferred use of the asset is greater than 12 months

The 'arrangement period' for the tax preferred use of an asset is defined in section 250-65.

Under subsection 250-65(1), the 'arrangement period' starts when that tax preferred use of the asset starts.

For the taxpayer in this case (Entity A), the 'arrangement period' started when Entity A took possession of the Property and became entitled to rental receipts under the lease on 1July 20xx.

Under subsection 250-65(2), the 'arrangement period' is taken to end on the day that is the date on which the tax preferred use of the asset may reasonably be expected, or is likely, to end.

In determining when a particular tax preferred use of an asset is likely to end, subsection 250-65(4) directs that:

(a)  regard must be had to:

                             (i)    the terms of, and any other circumstances relating to, any arrangement dealing with that tax preferred use of the asset; and

                            (ii)    the terms of, and any other circumstances relating to, any arrangement dealing with the provision of financial benefits in relation to that tax preferred use of the asset; and

(b)  it must be assumed that any right that an entity has to renew or extend such an arrangement will not be exercised (unless it is reasonable to assume that the right will be exercised because of the commercial consequences for the entity (or a connected entity) of not exercising the right).

In this case, the terms of the lease indicate that the 'arrangement period' is likely to end at the expiry of the lease on 30 June 20xx, disregarding any right in the lease for the Lessee to renew or extend the lease.

Paragraph 250-15(b) will be satisfied as the 'arrangement period' for the tax preferred use of the assets constituting the Property (meaning, in this case, the term of the lease of the Property) will be greater than 12 months.

Paragraph 250-15(c)

Paragraph 250-15(c) will be satisfied as financial benefits, being lease payments, in relation to the tax preferred use of the assets will be provided to Entity A by a tax preferred end user (Entity B).

Paragraph 250-15(d) - entitlement to a capital allowance

Paragraph 250-15(d) will be satisfied as, disregarding Division 250, Entity A would be entitled to a 'capital allowance' (defined in subsection 995-1(1) to include a deduction under Division 40 or Division 43).

Specifically, Entity A would be entitled to deductions for:

•         a decline in the value of the depreciating assets that form part of the Property (under Division 40);

•         expenditure in relation to the building that forms part of the Property (under Division 43).

Paragraph 250-15(d) will not be satisfied with respect to the land on which the building sits and other non-eligible capital expenditure, as land is not an asset for which deductions can be claimed under Division 40 (paragraph 40-30(1)(a)) or Division 43 (subsection 43-70(2)).

Paragraph 250-15(e) of the ITAA 1997 - predominant economic interest

A taxpayer will lack a predominant economic interest in an asset at a particular time if it satisfies one of the tests listed in section 250-110.

Limited recourse debt test - Section 250-115

Subsection 250-115(1) provides:

You lack a predominant economic interest in an asset at a particular time if more than the allowable percentage of the cost of your acquiring or constructing the asset is financed (directly or indirectly) by a limited recourse debt or debts.

Under subsection 243-20(1):

a limited recourse debt is an obligation imposed by law on an entity (the debtor) to pay an amount to another entity (the creditor) where the rights of the creditor as against the debtor in the event of default in payment of the debt or of interest are limited wholly or predominantly to any or all of the following:

(a)  rights (including the right to money payable) in relation to any or all of the following:

                             (i)    the debt property or the use of the debt property;

                            (ii)    goods produced, supplied, carried, transmitted or delivered, or services provided, by means of the debt property;

                           (iii)    the loss or disposal of the whole or a part of the debt property or of the debtor's interest in the debt property;

(b)  rights in respect of a mortgage or other security over the debt property or other property;

(c)   rights that arise out of any arrangement relating to the financial obligations of an end-user of the financed property towards the debtor, and are financial obligations in relation to the financed property.

A property is the debt property if it is the financed property, or the property is provided as security for the debt (subsection 243-30(3)).

In this case, the acquisition of the Property has been indirectly funded by Entity C borrowing under its syndicated loan facility. The lenders under the loan facilities receive the benefit of security over Entity C's entire property portfolio.

Accordingly, the cost of the acquisition of the Property is not financed (directly or indirectly) by a limited recourse debt or debts.

The limited recourse debt test in section 250-115 will not be satisfied as limited recourse debt has not been used to acquire the Property.

Right to acquire asset test - Section 250-120

The lease agreement does not provide the option for the Lessee to purchase the asset at the end of the lease period or does not confer on the Lessee a right to purchase the asset at any time.

There is nothing requiring the assets constituting the Property to be transferred to a 'member of the tax preferred sector' (defined in paragraph 250-60(4)(b) as the tax preferred end user - in this case, Entity B - and any 'tax preferred entity' and any foreign resident) after the end of the 'arrangement period'. Subsection 250-120(1) is not satisfied.

No 'member of the tax preferred end user group' (defined in paragraph 250-60(4)(a) as the tax preferred end user - in this case, Entity B - and its connected entities) has, or will have:

•         a right, obligation or contingent obligation to purchase or acquire the asset or a legal or equitable interest in the asset; or

•         a right to require the transfer of the asset or a legal or equitable interest in the asset.

Subsection 250-120(2) is not satisfied.

As a result, the right to acquire asset test in section 250-120 of the ITAA 1997 will not be satisfied as the Lessee will not have the right to acquire the Property at the end of the lease, or at any other time.

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

Section 250-125 states:

(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 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.

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

The tax preferred use of the asset is effectively non-cancellable where it satisfies section 250-130.

Under section 250-130(1):

An arrangement that relates to financial benefits to be provided by a member of the tax preferred sector in relation to the tax preferred use of an asset is effectively non-cancellable if:

(a)  the arrangement can be cancelled only with:

                             (i)    your permission; or

                            (ii)    the permission of a *connected entity of yours; or

                           (iii)    an agent or entity acting on your behalf (or on behalf of a connected entity of yours); or

(b)  the arrangement can be cancelled without the permission of an entity referred to in paragraph (a) but, if the arrangement were cancelled, the member of the tax preferred sector or another member of the tax preferred sector:

                             (i)    would be required to enter into a new arrangement for the *provision of financial benefits in relation to the tax preferred use of the asset; or

                            (ii)    would incur a penalty and the magnitude of the penalty would be such as to discourage cancellation.

Section 250-130(2):

For these purposes, if a *member of the tax preferred sector defaults under an *arrangement and the arrangement is cancelled, the arrangement is to be taken to have been cancelled without the permission of an entity referred to in paragraph (1)(a).

This is illustrated in example 1.14 in the Revised Explanatory Memorandum to Tax Laws Amendment (2007 Measures No.5) Bill 2007 (Revised Explanatory Memorandum) which says that the arrangement is effectively cancellable where service standards are not achieved, and the tenant cancels the arrangement.

Under the terms of the lease agreement between Entity A and Entity B, the lease can be cancelled by Entity B where service standards are not achieved, and Entity B elects to cancel the arrangement.

Therefore subparagraph 250-125(1)(a) is not satisfied. As a result, section 250-125 is not satisfied.

Level of expected financial benefit test - Section 250-135

Section 250-135 states:

(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.

(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.

Section 250-135 is a point in time test, and the test is applied at the start of the tax preferred use, being the start of the lease. Section 250-140 provides the limited circumstances that a retest of the level of expected financial benefits may be required.

The lease agreement does not provide for a guaranteed residual value (at the end of the arrangement period). The Property, therefore, does not have a 'guaranteed residual value' (as defined in subsection 250-85(3)). Subsection 250-135(1) is not satisfied.

The arrangement under which the assets constituting the Property are put to the tax preferred use is not a 'debt interest' as defined in Subdivision 974-B because, at the very least, it is not a 'financing arrangement' (as defined in section 974-130) for Entity A or Entity B. The lease was not entered into or undertaken to raise finance for anyone (paragraph 974-130(1)(a)). Paragraph 250-135(2)(a) is not satisfied.

In applying paragraph 250-135(2)(b), the discount rate to be used in working out the present value of the expected financial benefits that members of the tax preferred sector (in this case Entity B as the Lessee) have provided, or are reasonably likely to provide, to Entity A in relation to the tax preferred use of the assets constituting the Property is determined under subsection 250-105(2), which states:

For the purposes of section 250-135 and Subdivisions 250-C and 250-D, the discount rate to be used in working out the present value of a future amount is a rate that reflects a constant period rate of return (worked out on a compounding basis) on the investment in:

(a)  the asset referred to in subparagraph 250-15(d)(i) if that subparagraph applies; or

(b)  the expenditure referred to in paragraph 250-15(d)(ii) if that subparagraph applies;

that is implicit in the arrangements under which the asset is put to a tax preferred use and financial benefits are provided in relation to that tax preferred use.

The discount rate used to discount the cashflows to net present value is x% for Division 40 assets component and y% for Division 43 assets components calculated based on the expected financial benefits from 1 July 20xx to 30 June 20xx (the arrangement period when the asset is put to a tax preferred use) as per subsection 250-105(2).

Paragraph 1.99 of the Revised Explanatory Memorandum states:

For these purposes, for a newly acquired asset, the market value of the relevant asset or capital expenditure will generally reflect the cost of acquiring the asset that is recognised for capital allowance purposes.

Therefore, the total acquisition expenditure paid by Entity A and allocated to each category of assets - Division 40 assets and Division 43 assets, will be the market value of that category of assets.

The present value of the expected financial benefits from each category of assets - Division 40 assets and Division 43 assets to be provided by Entity B to Entity A during the lease arrangement period, using the discount rate calculated as required by subsection 250-105(2), is less than 70% of the market value of each category of assets.

Paragraph 250-135(2)(b) is not satisfied.

As a result, the level of expected financial benefits test in section 250-135 will not be satisfied.

As none of the four tests in section 250-110 are satisfied, paragraph 250-15(e) will not be satisfied as Entity A will not lack a predominant economic interest in the assets constituting the Property.

In conclusion, Division 250 will not apply to Entity A and the Property.