Edited version of private advice

Authorisation Number: 1051573620646

Date of advice: 29 August 2019

Ruling

Subject: Base rate entity passive income

Question 1

Is assessable income the Company derives from leasing equipment base rate entity passive income pursuant to section 23AB of the Income Tax Rates Act 1986?

Answer

Yes

Question 2

Is assessable income the Company derives from the disposal of assets that were previously leased to third parties base rate entity passive income pursuant to section 23AB of the Income Tax Rates Act 1986?

Answer

No

This ruling applies for the following period:

1 July 20XX to 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The Company carries on a business of equipment leasing. The Company is not carrying on business in partnership.

The assessable income of the Company primarily consists of income arising from leasing equipment and the sale of previously leased equipment.

The Company does not hold a credit or financial services licence.

The assets leased by the Company are used by lessees in carrying on a business of an industrial or commercial nature. The assets leased are not property or premises.

The leased asset is always owned by the Company.

The terms of each lease agreement are individually negotiated between the lessor and lessee, with agreements modified as necessary to reflect the terms agreed upon by the Company and lessee.

The intentions of the Company and lessee with respect to the asset at the expiration of the lease are not determined at the commencement of the lease.

The residual value of an asset, as specified upon commencement of a lease, reflects its market value at the expiration of a lease.

No lease agreement entered into the Company as lessor contains a clause that gives the lessee an obligation or right to acquire the asset subject to the lease.

Upon expiration of a lease, the Company disposes of the asset, by way of either:

(a)          sale to the lessee; or

(b)          sale to a third party as soon as practicable.

The Company does not keep or store previously leased assets.

The Company uses a number of lease agreement templates. Each template reflects a different type of lease, with terms unique to that type of lease and arrangement negotiated with the lessee.

Relevant legislative provisions

Subsection 6(1) of the Income Tax Assessment Act 1936

Section 102M of the Income Tax Assessment Act 1936

Section 159GP of the Income Tax Assessment Act 1936

Section 6-5 of the Income Tax Assessment Act 1997

Section 104-10 of the Income Tax Assessment Act 1997

Section 108-5 of the Income Tax Assessment Act 1997

Section 118-20 of the Income Tax Assessment Act 1997

Section 960-120 of the Income Tax Assessment Act 1997

Section 974-120 of the Income Tax Assessment Act 1997

Section 974-115 of the Income Tax Assessment Act 1997

Section 23AB of the Income Tax Rates Act 1986

Reasons for decision

Question 1

Rates of tax payable

Section 23 of the Income Tax Rates Act 1986 ('ITRA') provides the rates of tax payable by a company, other than a company in the capacity of a trustee.

Paragraph 23(2)(a) of the ITRA provides that if a company is a base rate entity for a year of income, the applicable tax rate in respect of its taxable income is 27.5%.

Base rate entity

Section 23AA of the ITRA defines the term base rate entity. It provides that an entity is a base rate entity for a year of income if:

(a)          no more than 80% of its assessable income for the year of income is base rate entity passive income; and

(b)          its aggregated turnover for the year of income, worked out as at the end of that year, is less than $25 million for the 2018 income year.

For the 2019 income year, and subsequent years, the threshold is $XXX.

Base rate entity passive income

Section 23AB defines the term base rate entity passive income ('BREPI'). It provides that BREPI is assessable income that is:

(a)          a distribution by a corporate tax entity, other than a non-portfolio dividend;

(b)          an amount of franking credit on such a distribution;

(c)          a non-share dividend by a company;

(d)          interest (or a payment in the nature of interest), royalties and rent;

(e)          a gain on a qualifying security;

(f)           a net capital gain; or

(g)          an amount included in the assessable income of a partner in a partnership or of a beneficiary of a trust, to the extent that the amount is referable directly or indirectly to another amount that is BREPI.

Is income derived from the leasing of assets BREPI?

For lease income derived to be BREPI, it must be one of the seven types of assessable income listed in the definition of BREPI contained in section 23AB of the ITRA, as set out above.

Draft Law Companion Ruling LCR 2018/D7 Base rate entities and base rate entity passive income provides advice on the meaning of the types of assessable income that are BREPI.

A distribution by a corporate tax entity and franking credits on such a distribution

A distribution by a corporate tax entity includes:[1]

(a)          if from a company, a dividend, or something that is taken to be a dividend;

(b)          if from a corporate limited partnership, a distribution made by a partnership to a partner in the partnership, other than a distribution, or part thereof, that is attributable to profits or gains in an income year the partnership was not a corporate limited partnership;

(c)          if from a public trading trust, a unit trust dividend, as defined in section 102M of the Income Tax Assessment Act 1936.

The income the Company derives from leases does not meet the definition of a distribution by a corporate tax entity, and consequently, it is not such a distribution nor is it franking credits on such a distribution.

A non-share dividend by a company

A non-share dividend means all non-share distributions, except for where the amount is debited against the company's non-share capital account or the company's share capital account.[2]

A non-share distribution is where:[3]

(a)          you hold a non-share equity interest in a company;

(b)          the company:

              i.                distributes money to you;

             ii.                distributes other property to you;

            iii.                credits an amount to you;

as a holder of that interest.

The lease income derived by the Company is not paid because of a non-share equity interest they hold in in a company, and consequently, the income is not a non-share dividend by a company.

Interest, or payments in the nature of interest

The Full Federal Court in FCT v. Century Yuasa Batteries[4] said that interest 'is the return, consideration, or compensation for the use or retention by one person of a sum of money belonging to, or owed to, another, and that interest must be referable to a principal'.

At paragraph 11, LCR 2018/D7 refers to FCT v. Century Yuasa Batteries in providing advice on what constitutes payments in the nature of interest. Such payments must have the character of return or profit to the lender for the use of money belonging to, or owed to another, and whether a payment has this character turns on its substance.

Taxation Ruling TR 98/21 Income tax: withholding tax implications of cross border leasing arrangements explores the relationship between section 128AC and subsection 128B(5A) of the Income Tax Assessment Act 1936 ('ITAA 1936').

Section 128AC operates to deem certain amounts payable to non-residents in respect of hire-purchase and similar agreements to be interest.

Paragraph 7 of TR 98/21 provides:

Where it is clear from the outset that the purchase or repurchase of the equipment is paramount, payments made under a cross border equipment leasing transaction are not subject to equipment royalty withholding tax under subsection 128B(5A) of the Act. The paramount purpose of a transaction is to be decided by having regard to all the surrounding circumstances and commercial consequences of the transaction (such as the passing of the incidents of ownership and economic risks to the lessee and other matters). Where an instalment payment under a hire-purchase agreement in respect of the type of arrangements covered by this Ruling contains an implicit interest component, that interest component is subject to interest withholding tax in accordance with section 128AC.

Paragraph 8 discusses the converse, that is, where the main object of the lease is hire, even where the hirer has an option to purchase the equipment, the payments arising from such a lease would be subject to royalty withholding tax (and not interest withholding tax).

Paragraph 25 of TR 98/21 quotes paragraph 9 of the Commentary on Article 12 of the 1977 Model Double Taxation Convention on Income and on Capital:

A clear distinction must be made between royalties paid for the use of equipment, which fall under Article 12, and payments constituting consideration for the sale of equipment, which may, depending on the case, fall under Articles 7, 13, 14 or 21. Some contracts combine the hire element and the sale element, so that it sometimes proves difficult to determine their true legal import. In the case of credit sale agreements and hire purchase agreements, it seems clear that the sale element is the paramount use, because the parties have from the outset agreed that the ownership of the property in question shall be transferred from one to the other, although they have made this dependent upon payment of the last instalment. Consequently, the instalments paid by the purchaser/hirer do not, in principle, constitute royalties. In the case, however, of lend-lease, and of leasing in particular, the sole, or at least the principal, purpose of the contract is normally that of hire, even if the hirer has the right thereunder to opt during its term to purchase the equipment in question outright. Article 12 therefore applies in the normal case to the rentals paid by the hirer, including all rentals paid by him up to the date he exercises any right to purchase.

Paragraph 26 of TR 98/21 provides that the case referred to in the last sentence of paragraph 9 of the Commentary would cover a situation where there was a lease and an option to purchase the equipment under which the purchase price was not related to an implicit financing of the equipment. The purchase at the market price of equipment at the expiration of the lease without application of part of the previous rental payments towards the purchase price suggests that the payment of the purchase price does not have a financing element.

Paragraph 28 of TR 98/21 states that the ATO adopts the distinction drawn in paragraph 9 of the Commentary as applicable to the interpretation of the definition of royalty in subsection 6(1) of the ITAA 1936 as it relates to equipment leasing.

In this case, the Company, as lessor, does not make any agreement or determination with the lessee at the outset of a lease as to whether the equipment shall be acquired by the lessee upon expiration of the lease. The lease agreements entered into by the Company with lessees give no obligation or right to the lessee to acquire the equipment that is leased.

The circumstances of the leases offered by the Company indicate the transaction is not one of financing, and that the regular instalments payable under the lease agreements are for the use of the relevant equipment.

Consequently, the lease income derived by the Company is not interest, nor payments in the nature of interest.

Royalties

Royalties include any amount paid or credited as consideration for, amongst others, the use of, or the right to use, any industrial, commercial or scientific equipment.[5]

The Commissioner has set out his views on the definition of royalties in Taxation Ruling IT 2660 Income tax: definition of royalties.

Paragraph 18 of IT 2660 provides that in the context of royalties, 'equipment' does not have a narrow meaning and includes such things as machinery and apparatus.

As well as having application in considering whether payments are interest or in the nature of interest, TR 98/21 also has application in considering whether payments for equipment leases constitute royalties.

Paragraph 37 of TR 98/21 refers to The Macquarie Dictionary (third edition) which defines the terms industrial, commercial and scientific as follows:

industrial ... of or relating to, of the nature of, or resulting from industry or productive labour ... engaged in an industry or industries ... designed for use in industry';

commercial ... of, or of the nature of, commerce ... engaged in commerce ... preoccupied with profits or immediate gains ... (of a vehicle) used primarily for carrying goods for trade, or paying passengers';

scientific ... of or relating to science or the sciences ... occupied or concerned with science'.

As mentioned earlier, where the main object of the lease is hire, even where the hirer has an option to purchase the equipment, the payments arising from such a lease would be subject to royalty withholding tax. As concluded in the discussion on Interest, or payments in the nature of interest, the instalments payable under the lease agreements are for the use of the relevant asset.

The assets offered for lease by the Company are industrial, commercial or scientific equipment.

The instalments paid by the lessees to the Company constitute royalties. That is because the instalments are consideration for the right to use industrial, commercial or scientific equipment.

Rent

Rent is the consideration payable by a tenant to a landlord for the exclusive possession and use of land or premises.[6]

The lease income derived by the Company is not rent. That is because it does not arise from the right to exclusive possession and use of land or premises.

A gain on a qualifying security

A qualifying security is broadly a security issued after 16 December 1984 for a period that is reasonably likely to exceed 12 months, under terms whereby it is reasonably likely that the security will produce receipts (other than of periodic interest) which are in excess of the issue price of the security.[7]

The lease income derived by the Company is not a gain on a qualifying security. That is because the lease income does not originate from a security.

A net capital gain

A net capital gain is calculated using the following formula:

total capital gains for the year,

less total capital losses,

less any CGT discount or concession applicable.

A capital gain occurs if capital amounts received because of a CGT event exceed the total costs associated with that event. The types of CGT events are listed in Division 104 of the ITAA 1997.

The lease income derived by the Company is not a net capital gain. That is because if a CGT event happens as a consequence of a transaction pursuant to a lease arrangement, any resulting capital gain will not be subject to tax by virtue of section 118-20 of the ITAA 1997.

An amount included in the assessable income of a partner or a beneficiary from a trust or partnership, to the extent it is referable to an amount that is otherwise BREPI

The lease income derived by the Company is not an amount included in the assessable income of a partner or a beneficiary that is referable to an amount that is otherwise BREPI. That is because the Company is not carrying on business in partnership.

Is assessable income the Company derives from leasing equipment base rate entity passive income?

For assessable income to be base rate entity passive income it must be one of the types of income listed in section 23AB of the ITRA. Included in the types of income listed are royalties, which are any amounts paid or credited as consideration for, amongst others, the use of, or the right to use, any industrial, commercial or scientific equipment.[8]

The assessable income of the Company that arises from leasing is base rate entity passive income. That is because:

·     the income that arises from their business of leasing is consideration for the right to use commercial, industrial or scientific equipment;

·     the assessable amounts from carrying on that business are royalties; and

·     royalties are a type of assessable income that constitute base rate entity passive income.

Question 2

As discussed in the reasons for Question 1, section 23AB of the ITRA defines the term base rate entity passive income ('BREPI'). It provides that BREPI is assessable income that is:

(a)          a distribution by a corporate tax entity, other than a non-portfolio dividend;

(b)          an amount of franking credit on such a distribution;

(c)          a non-share dividend by a company;

(d)          interest (or a payment in the nature of interest), royalties and rent;

(e)          a gain on a qualifying security;

(f)           a net capital gain; or

(g)          an amount included in the assessable income of a partner in a partnership or of a beneficiary of a trust, to the extent that the amount is referable directly or indirectly to another amount that is BREPI.

Is the income derived from disposal of leased assets BREPI?

For the assessable income derived by the Company upon disposal of an asset previously subject to a lease to be BREPI, it must be one of the seven types of assessable income listed in the definition of BREPI contained in section 23AB of the ITRA.

Draft Law Companion Ruling LCR 2018/D7 Base rate entities and base rate entity passive income provides advice on the meaning of the types of assessable income that are BREPI.

Because the definitions of the types of BREPI were explored in detail in the reasons for

Question 1, they will not be repeated in detail in the reasons for this Question 2.

A distribution by a corporate tax entity and franking credits on such a distribution

The income from disposal of the leased equipment does not meet the definition of a distribution by a corporate tax entity, and consequently, it is not such a distribution nor is it franking credits on such a distribution.

A non-share dividend by a company

The income from disposal of leased assets derived by the Company is not derived because of a non-share equity interest they hold in in a company, and consequently, the income is not a non-share dividend by a company.

Interest, or payments in the nature of interest

The lump sum received by the Company upon disposal of a leased asset is not interest, nor is it a payment in the nature of interest. It does not have the character of return or profit to the lender for the use of money belonging to, or owed to another.

Royalties

The income received by the Company for the disposal of leased assets is not royalties. That is because such consideration is not for the use of, or the right to use, any industrial, commercial or scientific equipment.

Rent

The income derived by the Company upon disposal of a leased asset is not rent. That is because it does not arise from the right to exclusive possession and use of land or premises.

A gain on a qualifying security

The income derived by the Company upon disposal of a leased asset is not a gain on a qualifying security. That is because the income does not arise from a security.

A net capital gain

CGT event A1 occurs when an asset is disposed of. An asset is disposed of when a change of ownership occurs, whether because of some act or event or by operation of law.[9]

A CGT asset is any kind of property, or a legal or equitable right that is not property.[10]

There is a capital gain for CGT event A1 if the capital proceeds from the disposal are more than the asset's cost base.

The capital gain made from a CGT event is reduced by any amount that is assessable income because of another provision of the ITAA 1997.[11]

In this case, a leased asset would meet the definition of a CGT asset, and consequently, CGT event A1 would occur when a leased asset is disposed of.

However, the proceeds from the disposal of a leased asset would constitute assessable income pursuant to section 6-5 of the ITAA 1997 if the receipt arose:

(a)          in the ordinary course of business activity;

(b)          as an ordinary incident of business activity (even though it was unusual or extraordinary compared to the usual transactions of the business), and the lessor entered into the transaction with the intention or purpose of making a profit; or

(c)          as a profit or gain from an isolated business operation or commercial transaction entered into by the lessor (otherwise than in the ordinary course of carrying on a business), with the intention or purpose of making the relevant profit or gain.

The High Court in FC of T v The Myer Emporium[12] stated:

"Because a business is carried on with a view to profit, a gain made in the ordinary course of carrying on the business is invested with the profit-making purpose, thereby stamping the profit with the character of income. But a gain made otherwise than in the ordinary course of carrying on the business which nevertheless arises from a transaction entered into by the taxpayer with the intention or purpose of making a profit or gain may well constitute income. Whether it does depends very much on the circumstances of the case. Generally speaking, however, it may be said that if the circumstances are such as to give rise to the inference that the taxpayer's intention or purpose in entering into the transaction was to make a profit or gain, the profit or gain will be income, notwithstanding that the transaction was extraordinary judged by reference to the ordinary course of the taxpayer's business. Nor does the fact that a profit or gain is made as a result of an isolated or a 'one-off' transaction preclude it from being properly characterized as income (FC of T v Whitfords Beach Pty Ltd 82 ATC 4031 at pp 4036-4037, 4042...). The authorities establish that a profit or gain so made will constitute income if the property generating the profit or gain was acquired in a business operation or commercial transaction for the purpose of profit-making by the means giving rise to the profit. "

The Company carries on a business of equipment leasing. Upon expiration of the lease, the Company disposes of the leased equipment.

The Company does not store or keep leased equipment after the relevant lease agreement has expired.

The factors indicate disposal of the leased equipment by the Company is part of the ordinary course of the Company's business activity.

Consequently, the proceeds from disposal of leased equipment by the Company do not constitute a net capital gain. That is because the disposal of leased equipment is part of the ordinary course of the Company's business activities and the disposal proceeds are assessable income pursuant to section 6-5 of the ITAA 1997.

An amount included in the assessable income of a partner or a beneficiary from a trust or partnership, to the extent it is referable to an amount that is otherwise BREPI

The proceeds from disposal of leased equipment by the Company is not an amount included in the assessable income of a partner or a beneficiary that is referable to an amount that is otherwise BREPI. That is because the Company is not carrying on business in partnership, and in any event the proceeds are not BREPI.

Is assessable income the Company derives from the disposal of assets that were previously leased base rate entity passive income?

Assessable income is only base rate entity passive income if it is one of the types of income listed in section 23AB of the ITRA.

The proceeds from the disposal of assets that were previously leased are not one of the types of income listed in section 23AB. Consequently, such proceeds are not base rate entity passive income.

[1] Section 960-120 of the Income Tax Assessment Act 1997 ('ITAA 1997').

[2] Section 974-120 of the ITAA 1997.

[3] Section 974-115 of the ITAA 1997.

[4] FCT v. Century Yuasa Batteries 98 ATC 4380; (1998) 38 ATR 442.

[5] Subsection 6(1) of the Income Tax Assessment Act 1936.

[6] Taxation Determination TD 2006/78 Income tax: capital gains: are there any circumstances in which the premises used in a business of providing accommodation for reward may satisfy the active asset test in section 152-35 of the Income Tax Assessment Act 1997 notwithstanding the exclusion in paragraph 152-40(4)(e) of the Income Tax Assessment Act 1997 for assets whose main use is to derive rent?

[7] Section 159GP of the ITAA 1936.

[8] Subsection 6(1) of the ITAA 1936.

[9] Section 104-10 of the ITAA 1997.

[10] Section 108-5 of the ITAA 1997.

[11] Section 118-20 of the ITAA 1997.

[12] FC of T v The Myer Emporium Ltd 87 ATC 4363.