CONSOLIDATION: TREATMENT OF FINANCE LEASES UNDER THE COST SETTING RULES PURPOSE BACKGROUND

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1 CONSOLIDATION: TREATMENT OF FINANCE LEASES UNDER THE COST SETTING RULES PURPOSE 1. The interaction of the treatment of finance leases under the accounting standards and its treatment under the income tax law raises a number of issues for the operation of the cost setting rules in Division 705 of the Income Tax Assessment Act 1997 (ITAA 1997). These issues arise because the tax law, depending on the circumstances, may provide that either the lessor or the lessee of an asset that is subject to a finance lease is entitled to deductions for the decline in value of the asset. Under the accounting standards, the lessee under a finance lease recognises the leased asset and not the lessor. 2. The following issues arise: In relation to the lessor, does the lessor have two assets (being the physical asset and the right to receive lease payments) or one to which allocable cost amount (ACA) needs to be allocated? In relation to the lessee: should the lessee have an amount included in step 2 of the ACA calculation in respect of the lease liability that would be recognised under the accounting standards; or does the lessee have an asset recognised under the finance lease to which ACA needs to be allocated (for example, right to use the leased asset)? BACKGROUND 3. This paper does not provide comments or instructions on how assets subject to an operating lease should be treated under the cost setting rules. It is limited to assets subject to a finance lease recognised in accordance with the accounting standards. 4. An asset, for the purposes of the cost setting rules, represents anything of economic value, which is brought into a consolidated group when an entity becomes a subsidiary The principles outlined in this paper are supported by Government. However, they are not yet law. As a consequence, this paper is merely a guide as to how the principles might operate.

2 2 member. 1 In working out the ACA to allocate to the assets of joining entity, step 2 adds amounts that can or must be recognised as liabilities in accordance with the accounting standards. 5. Under Accounting Standard AASB 1008 (Leases) and AAS 17 (Accounting for Leases), a lessor of an item of plant which is leased under a finance lease is effectively treated as having sold the plant to the lessee and provided finance for the acquisition. The lessor does not therefore recognise the plant as an asset but rather recognises an asset consisting of the lease receivables equal to the aggregate of the present value of the minimum lease payments and the present value of any unguaranteed residual value. 6. AASB 1008 requires a lease to be classified as either an operating lease or a finance lease at the inception of the lease (paragraph 5.1). AASB 1008 is also compatible with AAS 17 entitled Accounting for Leases. 7. The classification of a lease depends upon its economic substance. Where substantially all of the risks and benefits incidental to ownership of the leased asset effectively remain with the lessor, the lease is an operating lease. Where substantially all of the risks and benefits effectively pass to the lessee, the lease is a finance lease (paragraph 5.3.1). Type of lease Lessee Lessor Operating lease No asset or liability is recognised (other than where lease payments are made in arrears or prepaid). The minimum lease payments must be recognised as an expense. Finance lease Recognise both a lease asset 2 and a lease liability equal to the present value of the minimum lease payments at the beginning of the lease term. The asset recognised under the finance lease must be depreciated by the lessee in accordance with the relevant accounting standard. The minimum lease payments must be allocated by the lessee between interest expense and reduction of the lease liability. Asset being leased is recognised (no other assets and liabilities are recognised other than lease payments made in arrears or prepaid). Recognise an asset consisting of the lease receivables equal to the aggregate of the present value of the minimum lease payments and the present value of any unguaranteed residual value; and The asset being leased is not recognised. 8. For income tax purposes, deductions for decline in value are only available to the person who holds the depreciating asset for the purposes of Division 40 of the ITAA The general rule for depreciating assets that are subject to a lease is that the owner is the holder of the asset. However, specific rules provide, in certain circumstances, for another 1 See paragraph 5.19 of the Explanatory Memorandum to the New Business Tax System (Consolidation) Bill (No. 1) In accordance with paragraph of Accounting Standard AASB 1008 Leases (October 1998), a lessee in a finance lease recognises the right to use the leased asset as an asset, and the obligation for minimum lease payments as a liability.

3 3 party to hold the asset. There are also a number of special anti-avoidance provisions dealing with particular types of leasing arrangements (e.g. section 51AD and Division 16D of the Income Tax Assessment Act 1936 (ITAA 1936)). 9. The following example illustrates the issues created by finance leases in the application of the cost setting rules. Following the diagram, a summary is provided of the outcome under the cost setting rules and also the proposed adjustments (which are discussed later in this paper). Example 1: Issues created by the treatment of finance leases under the cost setting rules. ABC Head Company Lease Payments $100 XYZ Head Company $100 $100 Contributed Contributed Capital capital Lessor Co Lessee Co Assets/Liabilities Assets/liabilities 1. Plant 1. Lease Asset 2. Right to receive lease 2. Cash (contributed payments capital) Right to use asset 3. Lease liability Note: A liability (not recognised for accounting) also exists to provide a physical asset

4 4 Cost setting process without adjustments ACA for Lessor ACA for Lessee Step 1 $100 Step 1 $100 Step 2 $100 3 Total ACA $100 Total ACA $200 Tax cost setting amounts: 4 Tax cost setting amounts: Plant $55 Cash $100 Right to receive lease payments $45 Lease asset $100 Cost setting process with adjustments - where the lessor is holder of the leased asset for the purposes of Division 40 ACA for Lessor no recognition of right to receive lease payments as an asset. ACA for Lessee No recognition of lease liability for the purposes of step 2 of the ACA calculation. Step 1 $100 Step 1 $100 Tax cost setting amounts: Step 2 Tax cost setting amounts: Nil Plant $100 Cash $100 Cost setting process with adjustments - where the lessee is holder of the leased asset for the purposes of Division 40 ACA for Lessor No recognition of the underlying asset. Recognition of right to receive lease payments. ACA for Lessee Recognition of lease liability for the purposes of step 2 of the ACA calculations on entry. No recognition of the lease asset as an asset. However, there is recognition of the underlying asset. Step 1 $100 Step 1 $100 Step 2 $100 Total ACA $100 Total ACA $200 Tax cost setting amounts: Right to receive lease payments Tax cost setting amounts: $100 Plant $100 Cash $100 3 The $100 represents what the Lessee will have forgo to gain the benefit of the asset (being the lease liability recognised under the accounting standards). 4 The allocation of the ACA among the two assets will need to recognise that the right to receive lease payments may be a retained cost base asset and may get ACA allocated to it before allocating remaining ACA to reset cost base assets.

5 5 Treatment of finance leases under the income tax law 10. There is no explicit reference to finance leases under the income tax law, nor is there a singular treatment of the various types of arrangements which fall within the AASB 1008 definition of a finance lease. General treatment under Division 40 of the ITAA Deductions for decline in value are only available to the person who holds the depreciating asset for Division 40 purposes. Section of the ITAA 1997 sets out who holds a depreciating asset. 12. The general rule for depreciating assets that are subject to a lease is that the owner is the holder of the asset (item 10 of the table in section 40-40). Generally, this would be the lessor unless a specific holder rule applies. 13. Items 1, 4, 6 and 10 of the table in section of the ITAA 1997 could generally be applicable to finance leases. Item 1 of the table provides that the lessee of a luxury car is the holder of the car (while the lessee has the right to use the car). Item 4 treats the lessor as the holder of a leased asset where that asset is fixed to land and the lessor has the right to recover the asset. Item 6 treats a person (referred to as the economic owner) as the holder of the asset if: that person possesses the asset or has a right against another person (the former owner) to possess the asset immediately, and the economic owner has a right against the former owner, the exercise of which would make the economic owner the holder of the asset under any other item of the table in section 40-40, and it is reasonable to expect that the economic owner will become the holder of the asset by exercising the right, or the asset will be disposed of at the direction and for the benefit of the economic owner. Under item 10 the holder of a depreciating asset is the owner (or the legal owner if there is both a legal and equitable owner). However, other items may specifically preclude the owner from being the holder. Summary of the general treatment under Division 40 for the lessor and lessee 14. The lessor can be the holder of the asset under items 4 and 10 of the table in section of the ITAA The lessee can be the holder of the asset under items 1 and 6 of the table in section of the ITAA 1997.

6 6 Treatment under specific provisions Anti-avoidance provisions 16. The anti-avoidance provisions in section 51AD and Division 16D of the ITAA 1936 may also deny an otherwise available deduction for depreciating assets under Division 40 (see section ) 5. Division 42A of Schedule 2E to the ITAA A lease (as defined in section 42A-115) of a luxury car (as defined in section 42A- 120) is deemed to be a sale of the car by the lessor to the lessee at the start of the lease term and a loan made by the lessor to the lessee. Division 240 of the ITAA Division 240 re-characterises certain hire purchase transactions as loans. It applies to leases that fall within the definition of hire purchase in circumstances where it is reasonably likely that the purchase option will be exercised. ISSUES UNDER THE CONSOLIDATION COST SETTING RULES FOR ASSETS SUBJECT TO A FINANCE LEASE Where the lessor holds the asset Division The following issues arise where the tax law provides that the lessor of an asset that is subject to a finance lease is entitled to deductions for the decline in value of the asset. Issues for the lessor 20. For the purposes of determining the tax cost setting amount for each of the joining entity s (the lessor) assets, does the lessor have two assets (being actual plant and the right to receive lease payments) or one? 21. If the lessor is taken to have two separate assets then the allocation of ACA will produce the following results. The tax cost setting amount allocated to the leased asset may be significantly less, given that its market value will be lower (due to the exclusion of the value of the right to receive the rental income over the remaining period of the lease), with the result that the ACA amount is skewed towards the right to receive future lease payments. The right to receive future lease payments may also be a retained cost base asset and therefore receive priority in the allocation of the ACA amount. This will thereby impact on future calculations for the decline in value in respect of the underlying asset. 5 Section applies where a taxpayer holds a depreciating asset for which a deduction would be available under Division 40, but it is not the owner of the asset for the purposes of applying the anti-avoidance provisions in section 51AD and Division 16D. The section deems the taxpayer to be the owner of the asset for the purposes of applying the anti-avoidance provisions to the deduction available under Division 40.

7 7 A tax cost setting amount will be allocated to the right to receive future lease payments. This is unlikely to be a depreciable asset and therefore would not be entitled to deductions for decline in value. Issues for lessee 22. The lessee under a finance lease is required under AASB 1008 (or where applicable under AAS 17) to recognise a liability in respect of the outstanding lease payments and accordingly there will be an amount included at step 2 in working out the ACA calculation for the lessee. 23. It is not clear, however, whether the lessee has an asset to which ACA must be allocated given that it does not have any legal title to the underlying lease asset. It might be argued that the lessee has an asset consisting of the right to use the leased asset. However, if this right were recognised as an asset, then in the case of operating leases an asset would be recognised but there would be no corresponding liability for accounting purposes. 24. If these rights were recognised as an asset (and given a tax cost setting amount), then this would have implications when the lease expires as to whether a capital or revenue loss arises at that time. 25. There is also an issue that the lessee s rights to use the leased asset are contingent on their continued obligation to make future lease payments and as such the right may have little economic value. Where the lessee holds the asset - Division The following issues arise where the tax law provides that the lessee of an asset that is subject to a finance lease is entitled to deductions for the decline in value of the asset. Issues for the lessor 27. For the purposes of determining the tax cost setting amount for each of the joining entity s (the lessor) assets, does the lessor have two assets (being actual plant and the right to receive lease payments) or one? 28. If the lessor is taken to have two separate assets then the allocation of ACA will produce the following results. The lessor would have two assets being the underlying asset and the rights to receive lease payments. There is no deduction available to the lessor for the decline in value of the right to lease payments because such a right is an intangible asset and not within the meaning of depreciating asset. 6 This means the lessor will not get the deduction for the decline in value of the underlying asset under Division Section of the ITAA 1997.

8 8 Issues for the lessee 29. The lessee under a finance lease is required under AASB 1008 (or where applicable under AAS 17) to recognise a liability in respect of the outstanding lease payments and accordingly there will be an amount included at step 2 in working out the ACA for the lessee. 30. While Division 40 treats the lessee to be the holder of the depreciating asset (for example, plant) for tax purposes, it may not be an asset of the lessee for cost setting purposes. The asset recognised for cost setting purposes for the lessee may be the right to use the leased plant. Therefore, there may be no tax cost setting amount attributed to a depreciating asset under paragraph (2)(a) of the ITAA Where the lessee holds the asset - Division 240 of the ITAA The following issues arise where the tax law provides that the lessee is the holder of an asset that is subject to a finance lease under Division 240. Issue for the lessor 32. Under a hire purchase finance lease, the asset is disposed to the lessee. Effectively 100 per cent of the future economic benefits stored in the underlying plant is to be disposed to the lessee. The plant is not recognised as an asset of the lessor. However, the rights attached to the asset of the lessor are treated as a retained cost base asset in allocating ACA. Issue for the lessee 33. The above issues that arise in circumstances where the lessee is the holder of the asset under Division 40 similarly arise for the lessee where Division 240 applies. REQUIRED CHANGES Amendments where Division 40 applies 34. Amendments are required where the income tax law provides that either the lessor or lessee of an asset that is subject to a finance lease (recognised in accordance with the accounting standards) is entitled to deductions for the decline in value of the asset. The proposed amendments will not apply to operating leases. The following amendments are proposed for the purposes of applying Division 705 of the ITAA Rules for where the lessor holds the asset Rule 1: Rule for the lessor Where a lessor holds a depreciating asset that is subject to a finance lease (recognised in accordance with AASB 1008 or AAS 17), the lessor is required to allocate ACA only to the physical leased asset and not to the right to receive future lease payments and residual payments. 35. In order to achieve this outcome, the right to receive future lease payments under a finance lease will be excluded from being an asset to which the ACA is allocated. This rule

9 9 will apply where the lessor holds the depreciating asset. The term hold is used because this is the relevant term under Division The lessor also has a liability to provide the asset under the lease (although this is not a liability recognised by the accounting standards) and therefore no rules are considered necessary. Rule 2: Rule for the lessee Where a lessee does not hold a depreciating asset, that is subject to a finance lease for tax law purposes, however, does hold an asset for accounting purposes (recognised by the lessee in accordance with AASB 1008 or AAS 17), any lease liability will not be included for the purposes of determining the step 2 amount in working out the ACA. 37. In order to achieve this outcome, the step 2 amount in the ACA calculation should exclude a liability that is recognised in accordance with the accounting standards for a lease liability under a finance lease. 38. This rule will apply where the lessee does not hold the depreciating asset. Rule 3: Rule for the lessee Where a lessee does not hold a depreciating asset, that is subject to a finance lease for tax law purposes, however does hold an asset for accounting purposes (recognised by the lessee in accordance with AASB 1008 or AAS 17) the lessee s rights to use the leased asset will not be an asset for the purposes of allocating ACA. 39. In order to achieve this outcome, it is proposed that the right to use the leased asset would be excluded from being an asset to which ACA is allocated. Rules for where the lessee holds the asset Rule 4: Rule for the lessee Where a lessee holds a depreciating asset that is subject to a finance lease (recognised by the lessee in accordance with AASB 1008 or AAS 17), the lessee will be required to allocate ACA only to the physical asset and not to the leased asset (recognised for accounting purposes). 40. In order to enable the lessee to depreciate the underlying asset, there will be no recognition of the leased asset. Instead, the underlying physical asset will be recognised. This rule will apply where the lessee holds the depreciating asset. Rule 5: Rule for the lessor Where a lessor does not hold a depreciating asset that is subject to a finance lease for tax law purposes, however does hold an asset for accounting purposes (recognised by the lessee in accordance with AASB 1008 or AAS 17), the lessor is required to allocate ACA to the right to receive lease payments and not to the physical leased asset. 41. This rule will apply where the lessor does not hold the depreciating asset.

10 10 Amendments where Division 240 applies 42. The above amendments for Division 40 will also cover Division 240 in circumstances where the hire purchase agreement is also a finance lease. APPLICATION 43. The date of effect of any amendment would be 1 July 2002, consistent with the commencement date of the consolidation regime. This would provide maximum certainty and minimise the risk of arbitrary outcomes from a later commencement date.