Lease or Hire… Which do you desire?
Tax Telegraph, March 2013
Does your business carry on leasing activities?
It is quite common for the tax treatment of leases to be applied incorrectly. The tax deductions which can be claimed for lease expenses depend on whether your leases are classified as a normal commercial lease or a hire purchase agreement.
A normal commercial lease agreement, often referred to as an operating lease, is similar to a typical rental agreement on a real property where the lessee has the right to use the asset in return for lease payments over the term of the lease. The legal ownership of the leased asset however, stays with the lessor. As the lessor is the owner of the leased asset, the lessor is entitled to claim tax depreciation deductions in respect of the asset and show the lease payments on income. The lessee can claim a tax deduction for the actual lease payments.
For income tax purposes, if an arrangement is considered a hire purchase agreement, it is effectively treated as a sale of property combined with a loan to finance the purchase price. The lessee has notional ownership of the asset and is able to claim tax depreciation and interest deductions (rather than a deduction for the actual lease payments).
To determine whether an agreement is a normal commercial lease or a hire purchase, it is first necessary to consider the meaning of the terms 'lease' and 'hire purchase agreement'.
There is no statutory definition of the term 'lease' in Australian tax law. Generally, it has been taken to mean an agreement conveying the right from the lessor to lessee to use property for a stated period of time in return for a series of rental payments.
The term 'hire purchase agreement' is defined in the Income Tax Assessment Act 1997 (ITAA 1997) as:
- A contract for the hire of goods where:
- The hirer has the right, obligation or contingent obligation to buy the goods; and
- the charge that is or may be made for the hire, together with any other amount payable under the contract, exceeds the price of the goods. ``Any amount payable'' includes an amount to buy the goods or to exercise an option to do so; and
- title in the goods does not pass to the hirer until the option referred to in sub-para (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.
If your lease falls into the category of a normal commercial lease, it is the actual lease payments which are deductible to you (subject to certain exclusions such as luxury cars). However, if it would be considered a hire purchase agreement, you can claim tax depreciation and interest deductions (rather than the lease payments).
Limited Recourse Debt
Where limited recourse debt is used to finance or refinance the acquisition of income producing depreciable assets and the capital expenditure is deductible (such as with hire purchase agreements), termination of the limited recourse debt without payment in full may result in an amount being included in your assessable income.
Limited recourse debt refers to a debt where a creditor’s ability to recoup any money owed to them, in the case of the borrower defaulting, is limited. For example, in the event of the debtor defaulting, the creditor’s right to recovery is limited to the rights against the asset secured by the loan.
An amount is included in the assessable income of the debtor if the total capital allowance deductions up to the time of termination of the debt arrangement have been excessive, taking into consideration the amount of debt unpaid at that time.
The excessive capital allowance deductions that are included in assessable income is worked out as follows:
- The total net capital allowance deductions
- the net capital allowance deductions that would be allowable assuming that the expenditure did not include the amount of debt unpaid.
Sally purchases an asset under hire purchase for $10,000 on 1 July 2009. A limited recourse loan of $10,000 finances the purchase. This arrangement is terminated three years later on 30 June 2012 when the asset is surrendered to the financier. At that time $7,000 remains unpaid and the market value of the asset is $5,000.
The decline in value of the asset is calculated over five years using the prime cost method. After three years of Sally owning the asset, the total decline in value of the asset is $6,000 and its written down value is $4,000. As the market value of the asset when the arrangement terminates is $5,000, there is an assessable balancing adjustment of $1,000 (i.e. $5,000 less $4,000).
The total net capital allowance deductions is calculated as follows:
capital allowance deductions of $6,000 less assessable balancing adjustment of $1,000 equals $5,000.
The amount of the total net capital allowance deductions that would otherwise be allowable (the deduction limit) is $3,000. This is calculated on the basis that the original expenditure of $10,000 was reduced by the unpaid loan amount of $7,000 and that deductions continued for the effective life of the asset.
The amount that is included in Sally’s assessable income is:
the actual deductions of $5,000 less the deduction limit of $3,000 equals $2,000.
The Government recently announced in Budget Paper No.2 2012-13 that it will clarify the definition of limited recourse debt to include arrangements where the creditor’s right to recover the debt is effectively limited to the financed asset or security provided. This announcement was followed by the introduction of Tax Laws Amendment (2012 Measures No. 6) Bill 2012 and Explanatory Memorandum in November 2012.
The purpose of this measure is to ensure that tax deductions are not available for capital expenditure on assets that have been financed by limited recourse debt to the extent that the taxpayer is not effectively at risk for the expenditure and does not make an economic loss.
These changes are being introduced following the High Court’s judgement in Commissioner of Taxation of the Commonwealth of Australia v BHP Billiton Limited & others (2011). In this case, the High Court considered that the creditor’s rights to recourse against the borrower in the event of default are only limited where, at the inception of the loan, the borrower has the capacity to bring about the limitation. This would not be satisfied if there is just a possibility for the borrower to bring about the limitation at some point in the future.
The Treasury discussion paper, ‘Clarifying the definition of limited recourse debt’ explains that currently, if such a limitation occurs and the arrangement is terminated upon the borrower’s default, where the debt has not been fully repaid, capital allowance deductions that exceed the repaid amounts will not be included in assessable income.
This is contrary to the policy objectives of Division 243 in the ITAA 1997 which were aimed at ensuring that total deductions for allowable capital expenditure do not exceed the total amount actually expended by a taxpayer where the expenditure has been financed under hire purchase or limited recourse debt arrangements.
As a result of the proposed amendments, the ATO recently updated its administrative treatment in light of proposed amendment to the limited recourse debt definition. The ATO will accept tax returns as lodged during the period up until the proposed law is enacted. After the new law is enacted, taxpayers will need to review their positions back to the 2011-12 income year.
Contact your local Deloitte Private advisor if you are unsure how these rules apply to you.
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