Journal of Law and Financial Management
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Accounting standards characterise leases as either finance or operating, with the difference between the two based on concepts of economic ownership, but Australian taxation law does not recognise any such difference, except in three limited cases.[1]
The lack of separate recognition of finance leases in tax law produces advantageous tax outcomes including in substance:
Deductible repayment of a loan,
Deductible of the cost of the leased asset, and
Transfer of capital allowance deductions to the non-economic owner.
The Ralph Review proposed that finance leases be treated for tax in the same way that they are for accounting purposes and, that was to be implemented in the current review of the taxation of financial arrangements (The TOFA rules).[2]
The taxation of finance leases was expected to change to that used in accounting standards as a result of the TOFA rules.[3]
However, the Government announced in the 2007 Federal Budget that finance leases are excluded from the operation of the TOFA rules, which means that they will continue to be taxed as they always have been.[4]
But is that the correct result given these apparent advantages tax outcomes?
This paper reviews the economic nature of finance leases and, also, the way that they are taxed under current law producing beneficial tax results. It then considers the application of the TOFA rules to finance leases, prior to the Government’s announcement. Finally, it considers whether finance leasing should be a separately recognised form of leasing in Australian taxation law.
It argues that full deductibility of rentals to the lessee under a finance lease, even if it is regarded as payment for the cost of the asset or repayment of a loan, is neutral to the Government, as the rentals will be fully assessable to the lessor. As deductibility of rentals is symmetrical with assessability of rentals there is no cost to the revenue.
The Government’s real concern with finance leases is the ability to transfer the capital allowance deductions of an asset (depreciation) to the non-economic owner (the lessor) as that can bring forward the use of those deductions.
However, the equity owners of the asset can advance the use of the capital allowance deductions simply by choosing the appropriate legal vehicle to hold the asset.
Finance leasing simply facilitates the debt funders of the asset achieving that same effect. In that regard finance leases should be seen as unobjectionable.
Lease financing is to be preferred over other types of financing because of: conservation of capital, convenience, cash flow and earnings generation, amortisation of cost of acquisition, known fixed costs, budget limitations, loan covenants and joint venture and project finance. [5]
In a finance lease the lessor is the owner and is therefore able to claim capital allowance deductions for tax purposes, which deductions can enable it to reduce the rental costs of the lessee. [6]
A second and less compelling reason is that in a finance lease the lessee is not required to make a down payment as is usually standard in a conditional sale, which is a comparable method of financing.[7]
In a finance lease the period of the lease tends to reflect the effective life of the asset. In addition, the rentals plus the residual value are typically equivalent to the cost of the asset plus a return for the lessor.[8]
Thus, in a finance lease the residual value will be a balancing figure which, when added to the rental instalments, will produce an amount equal to a return of
the lessor's capital plus interest over the period for the outlay of its capital. It does not necessarily have to bear any relation to the market value of the asset at termination. The lessor may calculate it at a lower figure than market value to ensure that if the lessee chose not to buy it at the end of the term it could then be sold without detriment to the lessor, thus protecting the lessor’s asset.
Taxation rules impact on the residual value calculation, as they require that the residual value be a reasonable estimate of the market value of the asset at termination, otherwise the arrangement will be taxed as a sale of the asset for tax. [9]
The lessee will have exclusive use of the asset during the period of the lease and may eventually be the owner of it, even though this is not provided for expressly in the lease. [10]
The economics of a finance lease are that the lessee will provide some security to the lessor that it will recoup its expenditure for acquiring the asset and, also, its required return on funds invested.
The “security” offered to the lessor is in the form of the agreement by the lessee that the lessor will receive at least the residual value of the asset on termination plus the rentals payments during the term of the lease. On that analysis the lessors’ role is that of a lender where the asset risks are “subsumed in the credit risk”.[11]
To avoid the arrangement being taxed as a hire purchase arrangement (discussed below), the lessee must not have a right or option to acquire the asset, even though this is what may invariably happen.[12]
Another way of describing a finance lease is to use the terminology of “risk”. This is the language used in the accounting standards, which, broadly, looks at which of the two parties, the lessor or the lessee, has the risks associated with ownership of the asset. [13]
According to that analysis, a finance lease is one that transfers the risks and rewards of ownership of the asset to the lessee. This is determined from the terms of the arrangement where, for example, the lessee guarantees that the lessor will receive at least the residual value of the asset on termination, the lessee undertakes to maintain the asset in good order and insure it against loss. Also, from such things as the lessee taking all the operational risk, such as down time and inoperability, of the asset, which are considered to be indicia of the risks of ownership being transferred to the lessee.[14]
Where the lessor has such underpinning financial support from the rentals and residual value obligations securing the return or, on the alternative risk analysis view, the transfer of the risks and rewards of ownership from the lessor to the lessee, a finance lease can look very much like a loan of the cost of the asset to the lessee by the lessor.
When that economic effect is coupled with the way that finance leases are presently taxed (see below), it results in advantageous taxation outcomes such as fully deductible repayment of a loan for the lessee and capital allowance deductions for the lessor.
Except in some very limited circumstances that are discussed below, a finance lease is taxed in exactly the same way as other forms of leasing.[15] Under a finance lease rental payments are deductible to the lessee and assessable to the lessor in accordance with the general deduction and assessing provisions, and the lessor is entitled to the capital allowance deductions in respect of the asset in accordance with the capital allowance provisions.[16]
Within that simplistic view there are, however, tax rulings that have been issued by the ATO to ensure that the terms of the lease create a lease and are not a de facto sale of the asset by the lessor to the lessee.[17]
The matters that are considered in the ruling in determining whether the lease is, indeed, a true lease are:
The residual value of the asset compared with its cost at commencement. The residual value, must be based on a reasonable estimate of its market value at termination, and
Whether the lessee has any right to acquire the asset at the termination of the lease.[18]
The agreed residual at termination of the lease may be very low as the term of the lease can match the effective life of the asset. However, even if inflation is ignored, some assets can still have a value at expiration of their effective life that can result in the lessee making a gain if it acquires the asset at the agreed residual value and sells it into the market.
This outcome had been considered by the courts in the context of whether such an outcome was consistent with a lease. It was decided that it was acceptable and would not cause the lease to be taxed differently. [19]
Any financing charges, such as interest, incurred by the lessor, where it has borrowed funds to acquire the asset (a leveraged lease), will be deductible under the general deduction rules subject to the lease complying with the tax ruling referred to above and that discussed below.[20]
If the lease is a leveraged lease there must not be a right to acquire the asset at termination and the residual value must be a reasonable estimate of the market value at termination as per the ruling discussed above, for it to be accepted by the ATO. In addition the ATO requires that:
The lessors must contribute at least twenty percent of the cost of the asset,
Any lessor partners must share partnership profits and losses in proportion to capital contributed and the common or majority partner accounting period must be used,
The cost of the asset cannot include capitalised interest, and
The pattern of rental payments should not be large at commencement and smaller closer to termination.[21]
If there is an option to acquire the asset the arrangement is then characterised as a hire purchase arrangement for tax, which means that the cash flows will be taxed as if they were a sale and loan transaction under specific provisions dealing with hire purchase arrangements. [22]
Under Australian tax law the entitlement to capital allowance (depreciation) deductions belongs to the "holder" of the asset, who is usually the legal owner but more generally the person who will suffer economic loss from the decline in value of the asset.[23] In the case of a finance lease this will be the lessor.[24]
The ATO challenged the taxation of a finance lease, in the context of a sale and leaseback arrangement, which is where the owner sells an existing asset to a financier and immediately leases it back. The decision in the case, Metal Manufacturers, gives some indication of the ATO’s difficulties with finance leases.[25]
In that case the taxpayer had sold an interest in plant and fixtures which it had owned for some time, which was integral to the business that it conducted, which had effectively no market other than the taxpayer and which, in all practicality, could not have been removed from the taxpayer’s premises.
The asset was leased back to the taxpayer and it used the proceeds from the sale to retire debt that it owed to other creditors.
The Commissioner challenged the taxation of the leasing financing on two aspects. First by, in effect, disaggregating the rental payments into financing charges and repayment of capital on a loan. He argued that part of the rental payments had a collateral advantage to the taxpayer, in addition to paying the lessor for the use of the leased asset, of being a repayment of a loan in effect to the lessor.
Interestingly the court acknowledged that the taxpayer would acquire the leased plant at the expiration of the lease for its previously agreed residual value-in effect having compensated the lessor for its purchase cost of the asset in the first place.
Notwithstanding that the court found that the entire rental payments were considered to be deductible.
Secondly, the Commissioner challenged the arrangement on the basis that the general anti-avoidance provision in the Act applied. [26] On this aspect the Commissioner argued that the taxpayer had entered into the leasing arrangement for the sole or dominant purpose of obtaining deductibility of the full rental payments. The court rejected this argument as it was satisfied that the dominant purpose of the transaction was not tax related, as it was to retire debt and make the balance sheet appear less leveraged.
After the decision in Metal Manufacturers Ltd the Commissioner issued a taxation ruling replacing a previous rulings issued on sale and leasebacks. In that most recent ruling, the ATO accepts sale and leaseback arrangements will be taxed as any other form of leasing, where the precedents of the Full Federal Court in Metals Manufacturers Ltd have been followed.[27] Any variation from that approach will likely be treated as a loan arrangement and apportionment of rentals will be made between principal and interest. [28]
In addition to the general taxing rules for finance leases discussed above there are three sets of provisions in the tax law that tax implicit finance leases differently to other forms of leasing. These provisions relate to leases of assets used by tax exempt end users, which includes Governments in particular. Secondly, there are provisions dealing with luxury car leasing and, finally, there are provisions that define debt and equity arrangements for taxation purposes.[29]
The first of those set of provisions, which deals with leasing to tax exempt entities such as Government, has just been re written.[30] Their intent is to prevent tax exempt end users from leasing assets from taxpaying entities, which entities then claim the capital allowance deductions and share the benefit with the tax exempt end user. The tax exempt end user would not have been entitled to those capital allowance deductions at all, so in one sense, these arrangements are an attempt to get around that problem.
One of the criteria for application of these rules is that the tax exempt end user does not have a “predominant economic” interest in the asset. Broadly, this is to identify transactions that are financing transactions, rather than operating lease. Within that criteria are several circumstances that are virtually identical to the accounting standard measures for recognising finance leases.
The second set of provisions is specific to cars costing more than a certain amount and, similar to that mentioned above, are intended to prevent parties who would not be entitled to the capital allowance deductions from “structuring” with a finance lease.[31]
The third set of provisions defines “debt” for the purposes of the tax law. [32] In this case, these rules have the effect of characterising a finance lease as debt for tax. However, they are not operational taxing rules, just definitional rules, so have no material effect in this case.
Overall then, finance leases are presently taxed in exactly the same way as all other forms of leasing, excluding luxury cars leases and certain finance type leases to a defined class of taxpayers. The debt/equity rules apply to characterise finance leases as debt by reason of the nature of the lessee’s undertakings to the lessor, however that has no practical effect on the way that the arrangement is taxed.
Applying the general tax rules for leases to finance leases means that rental payments are fully deductible to the lessor and assessable to the lessee and the lessor will be entitled to any capital allowance deductions. Thus producing positive tax outcomes for both the lessor and the lessee.
The TOFA rules are a new set of tax rules the broad intent of which is to address tax non-neutralities and market distortions caused by the ad hoc treatment of the taxation of financial arrangements over the years and, also, from rapidly evolving structured financial product markets.[33] The TOFA rules reconcile the existing tax law whereby income and deductions from some financial arrangements are assessed on an accruals basis and others on a realisation basis. Having two different bases for taxing financial arrangements is undesirable when the components of a financial arrangement could be disaggregated and reassembled into a different form. That different form could have the same economic effect as its predecessor but a more beneficial tax outcome, leading to deferral of tax.
For example, a debt could be structured as a “repo” arrangement, which is where the “borrower” sells an asset to the “lender”, who has a put option to sell it back to the “borrower” at higher price than that which it was sold. The difference in the price represents financing charges. That arrangement was taxed was reversed, rather than being taxed on an accruals basis, as would have been the case had it been treated as a loan.
The TOFA rules specifically excluded certain classes of leases from their application but, importantly, finance leases where not one of the classes of lease excluded. In other words, finance lease were to be included in application of the TOFA rules, which meant that they would have been characterised as a loan for taxation purposes and not a lease.[34] Also, the capital allowance deductions would have remained with the lessee/borrower and not the lessor/lender.
The Explanatory Memorandum to the exposure Draft emphasised this point, as did another document released by Treasury at the same time as the draft. That document showed clearly that finance leases were intended to be caught by the TOFA rules and taxed as a sale and loan.[35]
However, the Government announced in the 2007 Federal Budget that the TOFA rules will not apply to finance leases because of the adverse effect on small taxpayers had they been subject to TOFA. In other words, finance lease will continue to be taxed as they have been, which is exactly the same as other types of lease.
Arguably the revenue should be indifferent to a finance lease being taxed in the same way as other types of leases.
Taxing a finance lease in exactly the same as other types of leases means that the rental payments are fully deductible to the lessee and fully assessable to the lessor. The lessor will claim the capital allowance deductions in respect of the asset.
If, in the alternative, a finance lease was taxed on a loan basis the lessee would claim the interest component in the rental payments as a deduction and the equivalent amount would be assessed to the lessor, plus it would claim the capital allowances deductions.
In either case, “All other things being equal, the net deductions and inclusions for the parties should be the same under either arrangement.”[36]
In other words, so long as there is symmetry between the deductibility of the rental payments to the lessee and their assessability to the lessor, there is no disadvantage to the revenue.
It is intriguing to a non-tax people why a taxpayer would want to structure the arrangement as a finance lease such that repayment of a loan would be fully assessable to the lessor.[37]
The response to that question is that the assessable rentals are sheltered from tax by the capital allowance deductions that have been transferred to the lessor from the lessee by way of a finance lease.
That points to the underlying reason for these transactions, which is that the lessor can use the capital allowance deductions, whereas the lessee may have no immediate use for them.
In that case the real effect of the transaction, and the real concern for the revenue, is the brining forward of the use of the capital allowance deductions when they are transferred to the lessor under the finance lease.
For example, capital allowances could be transferred from an entity that is in tax loss and, as such, has no immediate use for the capital allowance deductions, to an entity that is taxpaying and which could use the capital allowances immediately.
In that case the revenue is prima facie disadvantaged by the capital allowance deductions being used earlier than they otherwise would have been. Yet that disadvantage seems to depend largely on the choice of legal vehicle that is used to hold the asset.
If a trust is used to hold the asset then the equity investors (beneficiaries) can access the capital allowance deductions. This is achieved through the indirect route of reduction of the cost base of their interest in the trust (assuming a unit trust) when distributions are made from the trust from income that has been sheltered by the capital allowance deductions. Those distributions will be non-assessable to the beneficiaries until the interest (the units) is disposed of or the total of all such distributions exceed the cost of their interest in the trust. [38]Even then, for some taxpayers only fifty percent of any gain will be assessable, meaning that the other fifty percent will be tax free.[39]
The point is that equity investors can get the benefit of the use of the capital allowance deductions immediately through this indirect route.
By way of comparison, if a company is the vehicle holding the asset, the capital allowance deductions will be carried forward until it has enough income to utilise those deductions.
So the timing of use of the capital allowance deductions simply depends on the choice of legal vehicle used to hold the asset that is generating the capital allowance deductions.
If the capital allowance deductions can be utilised by equity investors simply by choosing the correct vehicle, a finance lease can be viewed as a mechanism that can transfer the tax benefits of the capital allowance deductions to the lenders (debt providers) in the transaction to achieve the same result.
In other words, a finance lease in transferring the capital allowance deductions just facilitates the debt funding parties to the arrangement achieving the same bring forward of the capital allowance deductions that is available to the equity investors.
In either case, whether it is the equity investors or debt funders that use the capital allowance deductions, there is only one amount so the revenue should be indifferent as to which taxpayer, the equity investor or that debt funders, get the benefit of them.[40]
Leases are characterised as being either an operating or a finance lease for accounting standards but they do not, except in three specific provisions, and have a separate treatment for taxation purposes.
The economic nature of a finance lease can be described either in terms of securing the lessor’s cost of acquiring the asset or in terms of the transferring the risks associated with the ownership of the asset to the lessee.
On either analysis a finance lease can look economically equivalent to a loan from the lessor to the lessee.
As finance leases are taxed in exactly the same away as other leases, where the rentals are fully deductible to the lessee and assessable to the lessor, a finance lease is tax advantaged, including fully deductible repayment of the cost of the asset or of the loan, and transfer of the entitlement to capital allowance deductions from holding the asset to the non-economic owner (the lessor).
Tax rulings have been issued by the ATO that seek to differentiate between a sale of the asset and a lease. These rulings require, amongst other things, that the residual value in the lease at commencement be a reasonable estimate of the market value of the asset at termination and that the lessee have no right or obligation to acquire the asset at expiration.
The most recent draft of the TOFA rules proposed that finance leases be characterised as a sale and loan for taxation purposes and that the lessee be entitled to the capital allowance deductions. However, the Government announced that TOFA would not change the way that finance leases are taxed.
The result is that finance leases will continue to be taxed in exactly the same way as all other types of leases.
That is seen as the correct outcome.
The Government should not be concerned about finance leases in any case.
First, the apparent anomaly of fully deductible loan repayments or cost of the asset is not relevant as those repayments are fully assessable to the lessor, so the revenue is neutral. In other words, there is symmetry of treatment of payment and receipt of the rentals so the revenue is not disadvantaged.
Secondly, finance leases advance the use of the capital allowances deductions to the extent that they transfer those deductions to a lessor who is better able to use them.
However, the equity owners of the asset generating the capital allowance deductions can advance the use of these deductions simply by choosing the appropriate legal vehicle to hold the asset.
Finance leases transfer the capital allowance deductions to debt providers in a leasing transaction, which is the same result as for equity owners.
As there is only one amount of capital allowance deductions the revenue should be indifferent as to which of these two parties uses them.
[*] B Sc LLb (Mon) LLM (Syd) Grad Dip Securities Analysis F Fin FTIA Senior Lecturer Atax Faculty of Law UNSW
[*] BA LLb (Qld) LLM (Lon) FTIA Senior Lecturer Business Law Discipline Faculty of Economics Sydney University
[1] “Under an operating lease, the lessor retains more of an economic ownership interest in the equipment. This can include responsibility for maintaining the equipment. The obligations of the lessee are limited to the payment of rentals, use of the equipment within agreed parameters and return of the equipment at the end of the rental period.
The distinguishing characteristic of [a finance lease] is that although the lessor owns the equipment, its responsibilities are limited. The lessor’s role is largely that of a lender with equipment risk subsumed in credit risk. The lessee is usually responsible for all maintenance and repairs, paying regular lase rentals, usually monthly. The lessee also indemnifies the lessor far any loss on sale”, Robert Bruce, Bruce Mckern, Ian Pollard, Michael Skully, Handbook of Australian Corporate Finance 5th edition 1997 Butterworths P 274
Indeed, a finance lease has also been described as just a “structured sale on credit that takes the form of a lease”. P9 TOFA: the unfinished agenda, Professor Richard Krever (2006) 35 AT Rev 1
[2] P 383 A Tax System Redesigned. Recommendation 10.8 “That where accelerated depreciation is removed leases and rights over depreciable assets that are not “routine” be taxed as sale and loan arrangements’
[3] Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2007 Exposure Draft Explanatory Memorandum and Taxation of Financial Arrangements Interactions and Consequential Amendments Consultation Paper
[4] Budget Paper No 2 Part 1 Revenue Measures, 2007 Federal Budget
[5] Robert Bruce, Bruce Mckern, Ian Pollard, Michael Skully, Handbook of Australian Corporate Finance 5th edition 1997 Butterworths P 276
[6] Goode op. cit. at 722 -- 723 In Australia Division 40 of ITAA 1997 provides that the owner (lessor) in the circumstances is the holder and thus entitled to the depreciation.
[7] ibid
[8] Accounting Standard AASB 117.
[9] IT 28
[10] “Normal commercial practice in Australia is for the lessee to be allowed to purchase the item for its residual value at the expiry of the lease” Robert Bruce, Bruce Mckern, Ian Pollard, Michael Skully, Handbook of Australian Corporate Finance 5th edition 1997 Butterworths p274-275 This aspect was recognised by the courts: Per Lee J in Granby Pty Ltd v FCT (1985) 30 ATR 400 at 404.
[11] ibid
[12] As hire purchase agreements have their own unique tax rules (Div 240 ITAA 1997), they are only considered in this paper in the context of the effect of an option or right to acquire the asset.
[13] AASB 117
[14] ibid
[15] Ss8-1, 6-5 and Div 40 ITAA1997
[16] TR 2594, Metal Manufacturers Ltd, ss 6-5 and 8-1 ITAA1997and Div 40 ITAA1997
[17] “It was necessary to decide whether the payments were lease rentals or whether they were, in substance, consideration for the sale of the goods.” Para 7 IT 28
[18] IT 28
[19]Typically the residual value in a finance lease can be in fact below the market value of the asset at the end of the lease, yet the courts have not been overly concerned with that. In Granby Pty Ltd v FCT (1985) 30 ATR 400 and 404 Lee J said that residual values were below estimated market values at the end of the lease so that lessor corporations could safeguard the capital they, as lenders, invested in their chattel purchase and lease transactions. The setting of residual values at below market at the end of the lease was, therefore, an inducement to the lessee to care for the property and as such otherwise unobjectionable.
[20] IT 28 and Para 23 IT 2051
[21] IT 28, IT 2051 and IT 2602
[22] Div 240 ITAA1997
[23] See items 1–10 40-40 ITAA1997
[24] Although see TR 13/2006 discussion on holder of a fixture
[25] Metal Manufacturers Ltd V FCT [2001] FCA 365; (2001) 46 ATR 497. Also see the parallel case of Eastern Nitrogen v FCT [2001] FCA 366; (2001) 46 ATR 474
[27] See footnote 25
[28] TR 2006/13
[29] Div 250 (released on 18 August 2007), Div 42A and Div 274 ITAA1997
[30] S 250-15 ITAA1997
[31] S 40-230 ITAA 1997
[32] Div 974 ITAA 1997
[33] Para 1.6 Explanatory Material, Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2007
[34] ibid at S 230 -315
[35] Taxation of Financial Arrangements (TOFA) Interactions and Consequential Amendments Consultations Paper
[36] Professor Richard Krever P 10 TOFA: the unfinished agenda (2006) AT Rev 1
[37] A loan is how non-tax people would view a finance lease. See footnote 1
[38] CGT Event E4 S104-70 (4) ITAA1997
[39] Sub div 115 ITAA1997
[40] Of course that argument does not hold true where the owner of the asset is not otherwise entitled to the capital allowance deductions as, in that case, using a finance lease can generate tax deductions that did not previously exist, and that is precisely what the proposed Division 250 is intended to prevent. Tax Laws Amendment (2007 Measures No5) Act 2007
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