Asset Financing Plant and machinery, cars, trucks, computer hardware and software that are acquired for use in a business can be very expensive and generally require a substantial financial commitment by the business. Most businesses will strive to achieve the optimum way to finance this expenditure. Businesses are generally reluctant to pay for this capital expenditure in cash, even if there is surplus cash to be able to do so. Most businesses wish to spread the cost of capital assets over the period during which the assets will generate income. The usual or most commonly used sources of finance for capital expenditure are: loan; lease; hire purchase; and chattel mortgage Under both leasing and hire purchase arrangements, the financier purchases the asset for the business entity. The financier enters into an agreement with the business entity, under which the business entity is permitted to use the assets for a fixed term in return for periodic payments. 44 November 2013
Leases Leasing is a commonly used method of financing the acquisition of business assets. The lease can be: an operating lease; or a finance lease. Whether a lease is an operating lease or a finance lease depends on the substance of the transaction rather than the form of the contract 3. The differences between operating leases and finance leases are set out in the table below. Operating lease Does not transfer substantially all the risks and rewards incidental to ownership. The lessor takes the asset back at the end of the operating lease term. There is no contractual obligation or option under the lease agreement for the transfer of the ownership of the asset to the lessee. The lease is cancellable. The lease will usually be structured in a way that ensures that the lessor s residual position is equal to the expected realistic fair market value of the asset at the end of the lease term. The lessee is not obliged to pay any residual amount. Finance lease Transfers substantially all the risks and rewards incidental to ownership. The lessee usually acquires ownership of the asset by the end of the lease term. The lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised. The lease term is for the major part of the economic life of the asset even if title to the asset is not transferred. If the lessee can cancel the lease, the lessee must bear any losses associated with the cancellation. The residual price for the asset may not have any bearing on the fair market value of the asset at the end of the lease. The lessee may also continue to rent the asset for rental that is substantially lower than market value rental. Operating leases An operating lease is an agreement between the financier and the customer for the rental of plant or equipment. Business plant and equipment, office or factory premises and computer hardware are examples of capital assets that can be acquired under an operating lease. Operating leases are typically used for assets that are unlikely to be retained by the lessee for the whole of the asset s effective life. Motor vehicles are often acquired under an operating lease because the business may require its vehicles to be upgraded regularly and it may prefer not to own them. 3 AASB 117 at para. 10. November 2013 45
Advantages of operating leases The advantages of operating leases for lessees include the following: rental payments are deductible provided that the asset is used in the course of carrying on a business to derive or produce assessable income; the amount of each rental payment is usually fixed for the term of the lease and is therefore unaffected by changes in interest rates; operating leases reduce working capital requirements; operating leases provide flexibility in up-grading equipment which may become obsolete; the equipment is returned to the lessor at the end of the lease term this alleviates the lessee s responsibility to scrap or off-load obsolete equipment; the off-balance sheet nature of operating leases as a form of finance improves performance ratios such as return on assets; and the lessee is usually entitled to claim input tax credits for the GST on the rental payments. Fully maintained or non-maintained operating leases Operating leases can be fully maintained or non-maintained leases. Fully maintained lease Under a fully maintained lease the lessor is responsible for the ongoing servicing and maintenance of the leased item. For example, a business that requires a fleet of cars that are used predominantly for business purposes is likely to consider acquiring the cars under a fully maintained lease. The lessee is required to pay a monthly rental fee that covers all the costs associated with the use of the car including servicing and maintaining the cars. The lessor is responsible for the cars as well as for all associated maintenance and administration of the fleet. Non-maintained lease Entities that prefer to look after the servicing and maintenance of the leased items themselves will choose non-maintained leases. The choice between fully maintained and non-maintained leases will depend on: the needs of the business; the resources which it has available to attend to administration associated with the leased assets; and the relative costs of the two options. Finance leases A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred. 4 Taxation treatment of payments under finance lease For taxation purposes, there is no distinction between an operating and a finance lease since neither lease would give the lessee the right or obligation to acquire the leased asset. 4 AASB 117 definitions at para. 4. 46 November 2013
A payment under a lease is a payment for the use of an asset. Payments under a bona fide lease are of a revenue nature and therefore deductible because they are not outlaid to acquire an enduring benefit and the payments are recurring. When a lease will not be accepted as a lease for income tax purposes IT 28 was issued on 6 July 1960. This old Ruling refers to the publicity associated with, and the promotion of, leasing as an arrangement under which lessees had the opportunity of acquiring the goods at a low written-down value. The Ruling considers whether under a lease arrangement for plant and machinery the payments are: lease rentals and therefore deductible; and consideration for the sale of goods purported to be leased and therefore on capital account and not deductible. Features which point to a purchase The lessee has an option to purchase the goods at any point of time under the arrangement. The lessee is permitted, whether under the main lease agreement or pursuant to some other collateral agreement, to retain the goods at the end of the lease term. The lessee is required to pay an amount to the lessor, by way of an adjustment, if the value of the goods falls short of the agreed residual value. The lease payments would not be payable if the asset is defective or damaged. The term of the arrangement is relatively short (i.e. up to five years) and the residual value is only nominal. Features which indicate a lease The goods must be sold at public auction. There is no express or implied arrangement in the lease or in any other collateral agreement that grants to the lessee a right to acquire the asset at the end of the lease term. No payment is required by the lessee on the termination of the lease. The lease payments must continue to be made even if the asset is damaged or cannot be used. The residual price is more or less equivalent to the expected termination value of the asset at the end of the lease term. The residual value complies with the indicative rates set out in IT 28 (see table below). Typically, a finance lease arrangement will be used to acquire assets which the lessee expects to hold for the whole of the asset s effective life. Arrangements which include an option or an obligation for the lessee to reacquire the asset at the end of the lease term would likely be considered to be hire purchase arrangements rather than genuine leases. November 2013 47
Minimum residual values The table below indicates the minimum residual values for plant and machinery at the end of a lease 5, as a percentage of cost, which the ATO considers are acceptable for different categories of assets based on the prime cost rates applicable to them. The Ruling states that a lease agreement will not be called into question in relation to the residual value if the residual value on the leased item equals or exceeds the relevant percentage in the following table: Term of lease Plant and machinery classified according to the prime cost rates 20% 15% 10% 7.5% 5% Year 1 60% 63.75% 67.5% 68.5% 70% Year 2 45% 52.5% 60.0% 62.5% 65% Year 3 30% 41.25% 52.5% 55.0% 60% Year 4 15% 30.0% 45.0% 50.0% 55% Year 5 Nil 18.75% 37.5% 45.0% 50% Following the increase in the effective life for cars on 1 July 2002 from 6 years to 8 years, the Commissioner reissued the minimum residual values for leased cars based on an effective life of eight years in ATO ID 2002/1004. Term of lease Minimum residual values (using an effective life of 8 years) Year 1 65.63% Year 2 56.25% Year 3 46.88% Year 4 37.5% Year 5 28.13% The Commissioner has been suspicious of leasing arrangements because: the lessee effectively obtains a deduction over the term of the lease for the capital cost of the asset; and the lessor or financier of the asset as the holder of the asset entity for the purposes of s. 40-40 is entitled to deduction for the decline in value (depreciation) of the asset. The Commissioner s concerns are even stronger in relation to sale and leaseback arrangements. 5 The table shows the minimum residual values based on the applicable prime cost depreciation rates for leases ranging from one to five years. Under Div 40, the depreciation rate is determined by reference to the effective life of the asset as set out in either Table A or B of the Commissioner s Determinations of Effective life of Depreciating Assets. 48 November 2013
Sale and leaseback A sale and leaseback is a form of financial arrangement. Usually a sale and leaseback occurs when a business entity acquires business assets, for example, it may construct factory premises or it may acquire plant and equipment or computers. The business entity then enters into an agreement with a bank or other financier under which: the business entity sells the assets to the financier for the agreed value of the assets; and the financier agrees to lease the assets to the business entity for the negotiated rental. The sale price and the lease payments are usually interdependent because they are negotiated as a package. TR 2006/13 defines a sale and leaseback arrangement as: typically a two-party arrangement under which the owner of an asset (referred to in the Ruling as the lessee) disposes of the asset, usually by way of sale of the asset (or by disposing of rights to or including rights to the asset), but continues to use it as lessee (or bailee) under a lease (or bailment or licence) from the acquirer (referred to in the Ruling as the lessor) 6. The Ruling expressly states that it does not consider the tax consequences of arrangements which also include an option or an obligation for the lessee to reacquire the asset at the end of the lease term. The Ruling states that these arrangements carry different tax consequences and may attract the application of Div 240 which deals with hire purchase-type arrangements: It is therefore important to ensure that the arrangement is correctly characterised as a sale and leaseback. The taxation treatment of an arrangement that is legally characterised as a sale and leaseback involving depreciable assets is as follows: Transaction Consequence Explanation Lessee sells the depreciating asset to the lessor Lessee stops holding the asset and a balancing event occurs under s. 40-295 If termination value of asset is: > asset s adjustable value the difference is included in the lessee s assessable income under s. 40-285(1); < asset s adjustable value the difference is an allowable deduction to the lessee under s. 40-285(2). 6 TR 2006/13 at para. 4. November 2013 49
Transaction Consequence Explanation Lessor becomes the legal owner of the asset Leaseback of asset lessor leases asset back to lessee (cont.) Lessor starts to hold the depreciating asset according to: item 10 7 of the table in s. 40-40; or item 4 of the table [where the asset is a fixture on someone else s land and lessor has right to recover the asset]. Lessee is required to make periodic lease payments to the lessor. Lessor receives periodic lease payments from the lessee The lessor is entitled to claim a deduction for the decline in value of the asset. The deduction will be based on the cost of the asset to the lessor. The cost to the lessor would ordinarily be the amount paid under sale agreement. Note Although the lessee holds the asset and uses it in its business, it does not have a cost base for the asset and therefore is not entitled to a deduction for the decline in value of the asset. Lease payments are an allowable deduction to the lessee if the item is being used in carrying on a business or for the purpose of deriving assessable income. The lease payments are included in the lessor s assessable income 8. The lessor is also entitled to a deduction for the decline in value of the asset (together with any other relevant deductions). The Commissioner has stated that, for the purposes of the sale and leaseback, he will accept a sale price reflecting the market value of the asset. The market value will be the price at which the asset can be bought and sold as between a willing, arm s length purchaser and vendor, both acting knowledgeably, prudently and without compulsion. 9 Where there is an identifiable recognised market for the asset the market value will ordinarily be ascertainable by reference to: factual information in that market; and the time the sale is made. Where there is no identifiable recognised market for the asset the Commissioner will accept the adjustable value 10 of the asset to the vendor lessee at the time of the sale as its market value. However, if the value is substantially higher or lower than the adjustable value, then the value should be based on an independent appraisal. 11 7 8 9 10 11 Item 10 refers to the asset being held by the owner, or the legal owner if there is both a legal and equitable owner. Refer to IT 2594 concerning the correct method for returning lease income. TR 2006/13 at para. 21. Adjustable value is usually equal to the cost of the asset less its decline in value up to the time of the balancing event. TR 2006/13 at para. 22. 50 November 2013
In para. 9 of TR 2006/13 the Commissioner states that, in substance, sale and leaseback arrangements have a similar economic effect to providing a loan to the lessee. From this point of view, there is a discount rate at which the present value of the lease payments and the residual value of the asset equals the cost of the asset to the lessor. That discount rate provides the notional interest rate implicit in the lease and often this rate is more attractive to the lessee than prevailing market debt interest rates. This may be possible in party because of the rate and timing of tax deductions allowable to the lessor and allowable to the lessee as a result of the arrangement. However in para. 81 of TR 2006/13, the Commissioner concedes that a sale and leaseback transaction cannot, without more, be characterised as a loan transaction merely because the result of the transaction is an in substance loan. A number of judicial decisions support this proposition 12. However, if an arrangement that takes the form of a sale and leaseback should be characterised as something else, then the Commissioner would seek to treat it as not being a sale and leaseback. In the Commissioner s view, the following factors might indicate that the transaction is not a genuine sale and leaseback: (a) Factors indicating a loan or a sale The intention of the parties as determined from the documentation and surrounding circumstances. Explanation Unless the arrangement is a sham 13, the form of the arrangement will be a strong indicator of the proper legal characterisation of the arrangement. (b) The lessor has no right to obtain possession of the asset on default by the lessee. If the lessor has no right to obtain possession in the event of the lessee s default, the lessee cannot argue that the lease payments are for the right to possess and use the asset. (c) (d) (e) (f) All the risks and benefits of ownership of the asset are with the lessee after the termination of the lease (this could occur where the lessee was entitled to any excess of the sale price of the asset over the residual value). The lease is for a period that is likely to exhaust or exceed the remaining useful life of the asset The lessee has a right or option to purchase the asset at the end of the lease term or for less than the market value. The sale price of the asset to the lessor is substantially in excess of the market value of the asset. Such arrangements are consistent with a purchase rather than a hire and therefore the lease payments may instead be payments for the capital cost of the item together with an interest component. The lease payments may be taken to comprise instalments of the purchase price plus an interest component rather than payments for hire or rent. This would suggest for all practical purposes that the arrangement is for the sale of the goods. This may suggest a scheme for obtaining deductions for inflated payments rather than payments for hire or rent. 12 13 TR 2006/13 at para. 82. The arrangement would be a sham if it is simply a disguise or a façade that conceals some other real transaction. November 2013 51
Potential application of Part IVA Even in circumstances where the documentation supports a sale and leaseback and the transaction occurs in accordance with the documentation, Part IVA may apply. Although Part IVA would not generally apply to sales and leasebacks, the features which would attract the ATO s interest might include: Factors relevant for Part IVA purposes 1. The lessee or lessor omit to include a balancing adjustment or capital gain (whichever is applicable) in their assessable income. 2. At the time of the sale and leaseback, the lessor intends to assign the right to income arising under the lease. 3. The sale value is overstated and the residual is not determined in accordance with IT 28. 4. The arrangement is not designed to permit the lessor to generate a positive cash flow in the absence of the tax benefits under the arrangement including entitlements to the investment allowance. 5. The tax elements of the scheme outweigh the commercial elements. Explanation This might arise as a result of the sale to the lessor being for less than market value of the asset or the residual amount being lower than the market value of the asset at the end of the lease. Such an arrangement, particularly if the recipient of the assessable income is exempt from tax or has substantial losses, would stamp the arrangement as a tax avoidance scheme. 14 Depending on the circumstances, this would indicate that the lease payments may include some capital component. It would also be relevant to consider whether the lessee has losses against which any balancing adjustment may be offset. Such an arrangement suggests that the dominant purpose of the arrangement was to obtain the tax benefits. The application of Part IVA to a sale and leaseback arrangement will require a weighing up of all the relevant factors and will depend on the relative weight attached to each factor. Whether Part IVA applies to an arrangement can only be determined on a case by case approach. Income tax treatment of leases The lessor: pays income tax on the lease payments each year less the GST component; can claim depreciation deductions for the decline in value of the asset; and will have a balancing adjustment if the asset is disposed of to the lessee. 14 TR 2006/13 at para. 95(e). 52 November 2013
The lessee: can claim income tax deductions for the lease payments each year less the input tax credit entitlements if the asset is being used for income producing purposes; and can claim a deduction under s 25-20 for expenditure incurred in preparing, registering or stamping a lease of property or in assigning or surrendering a lease of property to the extent it is used for the purpose of producing assessable income. GST Treatment of Leases The GST treatment for lessees and lessors is as follows: Party Obligation or entitlement LESSOR Cash basis Lessor must report the leasing income on an activity statement and remit 1 / th 11 of the lease income to the ATO in the tax period in which it is received. Accruals Lessor must report the leasing income on an activity statement and remit 1 / 11 th of the lease income to the ATO in the tax period in which the lessor: receives any part of the lease payment due in that period; or if an invoice is issued, the tax period in which it is issued. LESSEE Cash basis Lessee can claim an ITC of 1 / th 11 of the lease instalment amounts paid in each tax period. Accruals Lessee is entitled to an ITC of 1 / 11 th of the lease instalments for each tax period in which the lessee either: pays any part of the lease payment due in that period, or receives an invoice from the supplier. Residual payments may be subject to GST. If ownership of the property changes hands at the end of the lease, this is a separate transaction to the lease agreements. This transaction may be subject to GST. If the buyer is registered for GST it may be entitled to claim input tax credits for any GST included in the sale price. There are special rules for entities that lease property in making input taxed supplies, including financial supplies. November 2013 53
Hire purchase agreement means 15 : (a) a contract for the hire of goods where: Hire purchase the hirer has the right, obligation or contingent obligation to buy the goods; and (Note: An example of a contingent obligation is a put option.) the charge that is or may be made for the hire, together with any other amount payable under the contract (including an amount to buy the goods or to exercise an option to do so), exceeds the price of the goods; and title in the goods does not pass to the hirer until the option referred to in subparagraph (a)(i) is exercised; or an agreement for the purchase of goods by instalments where title in the goods does not pass until the final instalment is paid. For income tax purposes, an HP arrangement is re-characterised as a sale of property, combined with a loan, by a notional seller to a notional buyer, to finance the purchase price. 16 Payments under the arrangement are treated as payments of principal and finance charge 17. The notional buyer is only deemed to own the goods under s. 240-20 if: the notional buyer would have been the owner or the quasi-owner of the goods if the arrangement had been a sale of the goods; and it is reasonably likely that the right, obligation or contingent obligation to acquire the goods will be exercised by, or in respect of, the notional buyer. The owner of the goods is the entity that would be entitled to capital allowances in relation to the property (provided that all other conditions are satisfied). 18 Paragraph 195 of GSTR 2000/29 includes the extract below from the judgment of Finnemore J in Warman v Southern Counties Car Finance Corporation Ltd W J Ameris Car Sales 19 as an explanation of the essential nature of a hire purchase arrangement: A hire purchase agreement is in law, an agreement in two parts. It is an agreement to rent a particular chattel for a certain length of time. If during the period or at the end of the period the hirer does not wish to buy the chattel he is not bound to do so. On the other hand, the essential part of the agreement is that the hirer has the option of purchase, and it is common knowledge and I suppose, common sense that when people enter into a hire purchase agreement they enter into it not so much for the purpose of hiring, but for the purpose of purchasing, by a certain method, by what is, in effect, deferred payments, and that is done by this special kind of agreement known as a hire purchase agreement, the whole object of which is to acquire the option to purchase the chattel when certain payments have been made. (emphasis added) The total amount charged to a recipient under a hire purchase agreement is typically made up of a principal component (i.e. the price of the goods financed) and a credit component (i.e. the interest and associated fees and charges). 15 16 17 18 19 Section 995-1. Section 240-1. Section 240-25(6). TR 2005/20, para. 19. At para. 21, the Commissioner states that, in his view, the notional buyer can be taken to be the holder of the goods under either item 6 or item 10 of s. 40-40. [1949] 2 KB 576 at 582. 54 November 2013
Essentially, hire purchase agreements represent financing arrangements which facilitate the sale and purchase of goods. For income tax and GST purposes, hire purchase agreements are treated as a sale of goods and a separate supply of finance. Income tax treatment of hire purchase The notional seller (the hire purchase company) pays income tax on: the annual interest component of the hire purchase payments (calculated in accordance with the method statement in s 240-60); any profit on notional sale of the asset to the notional buyer; any profit on the actual sale of the asset after notional reacquisition from the notional buyer. The notional buyer (hire purchaser) is entitled to: deduct notional interest which is calculated in the same way as for the notional seller, i.e. under the method statement set out in s. 240-60; and can claim depreciation deductions for the decline in value of the asset. to the extent that the property under the hire purchase arrangement is used for the purpose of producing assessable income. GST treatment of hire purchase Prior to 1 July 2012, GST was only payable on the amount of the principal component of a hire purchase agreement if the supply of the goods was a taxable supply. The credit component (i.e. the interest charge) was not subject to GST if it was provided separately and disclosed to the recipient of the goods under item 8 of subregulation 40-5.09(3) of the GST Regulations. From 1 July 2012 GST is payable on both the principle component and the interest component of hire purchase agreements. Timing of GST If the notional seller (hire purchase company) accounts for GST on a non-cash basis, GST is payable upon issuing the tax invoice or receiving payment for the goods, whichever is earlier. If a tax invoice is issued in the tax period in which a hire purchase agreement is entered into, all the GST payable on the taxable part of the agreement is attributable to the tax period in which the agreement is entered into. Availability of input tax credits If the notional buyer (hire purchaser) is registered for GST and the goods are a creditable acquisition, they may be able to claim an input tax credit for any GST paid on the purchase of the goods. Timing of input tax credits Where the recipient accounts for GST on a non-cash basis and the item purchased is a creditable acquisition, the recipient is entitled to the entire input tax credit on the principal, in the tax period in which the invoice is received or in which any payment is made, whichever is earlier. From 1 July 2012 this treatment also applies where the recipient accounts for GST on a cash basis. Previously taxpayers who accounted for GST on a cash basis could only claim their ITC as payments were made. November 2013 55
GST and luxury cars The GSTA mirrors the Income Tax Act in treating the cost of cars in excess of the prescribed cost limit as being essentially private in nature. The ITAA 1997 restricts the deductions for decline in value to the cost limit of the car. The GSTA restricts entitlement to ITCs to the same cost limit 20. A purchaser of a luxury car i.e. a car whose GST-inclusive market value exceeds $57,466 for the 2012/13 income year is entitled to a maximum ITC equal to 1 / 11 th of the car limit. The maximum credit for the 2012/13 income year is therefore $5,224.18. The limit on entitlement to ITCs does not apply to: emergency vehicles; vehicles specifically fitted out for transporting people with a disability seated in wheelchairs (unless the supply of the car was GST-free); non-passenger commercial vehicles; motor homes or campervans; acquisition of a car by lease or hire. 20 The car limit is indexed each year. 56 November 2013
Luxury car leases A luxury car is one whose market value exceeds the car limit set for a car s capital allowance deductions by s. 40-230. 21 The car limit for the 2012/13 income year is $57,466. 22 Market value is the GST-inclusive amount. Division 242 governs the taxation of luxury car leases. It applies to a car that: is leased; and was a luxury car when the lessor first leased it. Subdivision 242-A treats a leased luxury car for income tax purposes as if the lessor: sold the car for its market value to the lessee the notional sale; and lent the money to the lessee to buy the car the notional loan. The lease payments are treated as payments of the principal and interest on that notional loan. The lessee is treated as having acquired the car at the start of the term of the lease. 23 Income tax treatment of luxury car leases For the lessor: Lease payments are treated as non-assessable non-exempt income ; and The interest is included in assessable income For the lessee: The lessee is entitled to: a deduction for interest of an amount equivalent to the amount which is assessable to the lessor, calculated on a corresponding basis. a deduction for the decline in value of the car, which is calculated based on the applicable cost limit for the year of acquisition. GST treatment of luxury car leases Section 69-10(4)(b) of the GSTA states that s. 69-10, which limits the ITC on cars over the car limit, does not apply to cars acquired by way of lease. Where a business acquires a car by lease, the amount of input tax credits that the business can claim is not limited to 1 / 11 th of the car limit. The business may be entitled to claim ITCs for the amount for GST included in each lease payment if it uses the vehicle wholly for a creditable purpose. 24 21 22 23 24 Section 242-1. See TD 2010/17. The fuel-efficient car limit for the purposes of the luxury car tax for the 2011 income year is $75,375. Section 242-15. ATO Motor Vehicle Industry Partnership Issues register, Item 7.5.b. November 2013 57
Chattel mortgages A chattel mortgage is a form of personal property security. Prior to the recent reforms relating to personal property securities, personal property securities were regulated by more than 70 Commonwealth, State and Territory Acts. The law and practice varied depending on: the State or Territory in which the personal property was located; the legal form of the entity that granted the security (i.e. whether the grantor was a company, individual or other entity); the legal form of the personal property security i.e. whether the form was a fixed and floating charge, a chattel mortgage, a finance lease, commercial consignments including retention of title arrangements, and pawns; and the nature of the personal property e.g. the personal property could be motor vehicles, investment instruments or livestock. In 2007, the Council of Australian Governments agreed, in-principle, to establish a national system for the registration of personal property securities. The national system has been implemented by Commonwealth legislation supported by a referral of legislative power by the States to the Commonwealth. The Personal Property Securities Act 2009 was enacted on 14 December 2009. The Commonwealth Government s personal property security reform involves a single Commonwealth Act which provides rules for the creation, extinguishment and enforcement of security interests in personal property and for determining priority among competing security interests. The Act is supported by a single national electronic register of personal property security interests. Under a chattel mortgage, the legal owner of the assets, who wants to borrow money, grants a lien to the lender over the asset as security for the loan. The borrower grants rights to the lender over the property but does not relinquish ownership of the assets. A chattel mortgage may be a legal or an equitable chattel mortgage, as follows: Type Legal chattel mortgage Equitable chattel mortgage Features The mortgagee (the lender) is the legal owner of the asset. The borrower commences to hold the asset under the chattel mortgage agreement. The borrower acquires and retains ownership of the asset but provides a charge over the asset to the lender. The purchaser acquires the chattel from the supplier, takes out a loan from the financier (in exchange for the charge over the asset and the promise to repay the loan), and uses the funds to pay the supplier. The costs of a chattel mortgage may be higher than the costs of a lease or hire purchase. This is because, in the event of default on the part of the borrower, the lender has recourse only to the chattel. 58 November 2013
Case study asset financing Lucio Capelli runs a commercial warehousing business through his family company Ditherer Pty Ltd (Ditherer). Ditherer is registered for GST. Ditherer needs to acquire two new forklifts for use in its business, as some of its existing forklifts were purchased a number of years ago and are constantly developing mechanical problems. Lucio approaches Acme Finance Ltd (Acme Finance) for assistance in funding the $44,000 (inclusive of GST) the business will need to purchase the two new forklifts. Acme Finance tells Lucio that it can offer him four alternatives by which it can assist Ditherer: Lend Ditherer $44,000 under an unsecured loan for Ditherer to purchase the forklifts. Lend Ditherer $44,000 under a loan secured by chattel mortgage for Ditherer to purchase the forklifts. Purchase the forklifts itself and sell them to Ditherer under a hire purchase agreement under which Ditherer will acquire title to the forklifts on payment of the final payment. Have its subsidiary Acme Leasing Ltd (Acme Leasing) purchase the forklifts and lease them to Ditherer. The lease will disclose a residual value for the forklifts as at the end of the lease but Ditherer will be under no obligation to purchase the forklifts at the end of the lease. Each of the arrangements will be over five years and will involve monthly payments. Acme Finance s representative explains to Lucio that the overall amounts payable will differ under each alternative, as the financing costs will vary according to: the risks to Acme Finance (or Acme Leasing); the amount of GST Ditherer will have to pass on; and the size of the monthly repayments Ditherer makes. The tax consequences will also vary and while Acme Finance can outline some of the general principles, as it is not a registered tax agent, Lucio should consult his own tax agent to confirm the exact tax consequences of these transactions. Lucio therefore visits his accountant, Sophia Douglas, to advise him of the income tax, GST and cash flow consequences of the above alternatives. Based on figures supplied by Acme Finance, Sophia prepares the following comparative table for Lucio. November 2013 59
Purchase Price Unsecured Loan Chattel Mortgage Hire Purchase 1 44,000 44,000 44,000 Depreciation 3 40,000 x 10% = 4,000 pa 40,000 x 10% = 4,000 pa 40,000 x 10% = 4,000 pa GST ITC on purchase 4,000 4,000 4,000 Prin Int Tot Prin Int Tot Prin Int Tot Monthly 733 667 payments 1,400 733 467 4 1,200 733 467 4 1,200 (rounded) Income tax deduction GST input tax credit 5-year total payments (rounded) 5-year total tax deductions 5-year total input tax credits Lease residual (if paid) Income tax deduction GST input tax credit Notes: 2 Lease 667 467 467 800 N/A N/A 67 (733/11) 5 80 (880/11) Prin Int Tot Prin Int Tot Prin Int Tot 44,000 40,000 84,000 44,000 28,000 72,000 44,000 28,000 72,000 N/A 880 52,800 40,000 28,000 28,000 48,000 N/A N/A 4,000 4,800 N/A 8,800 N/A 8,000 x 20% = 1,600 pa depreciation 6 N/A 800 1. Deemed treatment as a sale of goods accompanied by loan per Div 240. 1. If lease had given right or obligation to purchase at residual value would have been treated the same as a hire purchase agreement. 2. With unsecured loan, chattel mortgage and hire purchase the purchaser qualifies as the holder of the asset for depreciation purposes (per s 40-40 ITAA 1997). With a genuine lease the lessor qualifies as the holder. 3. Interest rates would be higher with unsecured loan due to extra risk for finance company. Both chattel mortgage and hire purchase offer security to finance company as holds or can get title. Lease payments would generally be lower as lessor receives the benefit of depreciation where a true lease (but this would be balanced against fact that more is financed for longer as residual is not part of repayments until end of contract, if at all). 4. From 1 July 2012 GST applies to total payments including interest component. 5. Having acquired asset, former lessee will now be entitled to depreciation over remaining effective life. 60 November 2013