Private ruling: Lease with Call Option
Published: October 2014
Date scheme commenced: Income year ending 30 June 2015

Ruling: Q1: Will the lessee be entitled to a deduction pursuant to section 240-50 of the Income Tax Assessment Act 1997 (ITAA 1997) for the 'notional interest' calculated under Subdivision 240-E of the ITAA 1997? | A1: Yes | Q2: Will the lessee be entitled to claim a deduction under section 40-25 of the ITAA 1997 for the decline in value of the commercial equipment that is subject to the lease agreement? | A2: Yes | Q3: Will the lessee have an obligation to withhold an amount from the notional interest in respect to the lease rentals paid to the lessor under section 12-245 of Schedule 1 to the Tax Administration Act 1953 (TAA)? | A3: No | Q4: Will the lessee have an obligation to withhold an amount from a royalty in respect to the lease rentals paid to the lessor under section 12-280 of Schedule 1 to the TAA? | A4: No

Relevant facts and circumstances: 1. The lessor will acquire the commercial equipment from the lessee. 2. The majority of the funding, for the acquisition of the commercial equipment by the lessor, will be obtained through a traditional loan from lenders, who are a syndicate of banks (loan). Under the loan, the lessor has an effectively non-contingent obligation to repay the debt with interest. 3. Once the lessor has acquired the commercial equipment, the equipment will be leased back to the lessee (the lease) under a lease agreement for the lease term. The lease agreement is entered into on commercially agreed terms and negotiated on an arm's length basis. 4. The lease agreement contains an option for the lessee to purchase the commercial equipment. The lessee intends to exercise the option to purchase the commercial equipment. It is the common practice of the lessee to exercise the purchase option under similar arrangements. 5. During the term of the lease, the lessee is required to make periodic rental payments in arrears to the lessor. The sum of the total rental payments and amounts payable on exercise of the option to purchase the equipment (option amount) exceed the purchase price of the commercial equipment. 6. The lessee is a resident of Australia for income tax purposes. During the term of the lease, the lessee will adapt and use the commercial equipment for the purpose of producing its assessable income. Title to the commercial equipment will be transferred to the lessee on the payment of the applicable termination value. 7. There is and will not be any direct or indirect common ownership between the lessor and lessee. The lessor, its associated companies or their directors, do not have any control of or ability to sufficiently influence the lessee, and vice versa. 8. The lessor is a company incorporated under the laws of a foreign country. The lessor is a resident of, and liable to tax in, the foreign country. 9. The lessor is a wholly owned subsidiary of a non-resident company. Its central management and control and voting power is exercised by non-residents who reside outside Australia. 10. The lessor carries on business in the foreign country. The lessor's business is limited to the lease and other activities related to the lease. The lessor merely leases the commercial equipment and there is no active use of the commercial equipment. 11. For the purposes of the applicable tax treaty between Australia and the foreign country (the convention): • The lessor is a financial institution; • The lessor beneficially owns the rental payments; • The lessor is unrelated to and dealing wholly independently with the lessee; • The rental payments paid by the lessee to the lessor are not paid as part of an arrangement involving back-to-back loans; • The lessor does not have a permanent establishment in Australia; and • The lessor is a qualified person.

Relevant legislative provisions: Income Tax Assessment Act 1936 subsection 6(1) | Income Tax Assessment Act 1936 section 128AC | Income Tax Assessment Act 1936 subsection 128B(5A) | Income Tax Assessment Act 1997 section 40-25 | Income Tax Assessment Act 1997 section 40-30 | Income Tax Assessment Act 1997 section 40-40 | Income Tax Assessment Act 1997 section 240-7 | Income Tax Assessment Act 1997 section 240-10 | Income Tax Assessment Act 1997 section 240-17 | Income Tax Assessment Act 1997 section 240-20 | Income Tax Assessment Act 1997 section 240-50 | Income Tax Assessment Act 1997 section 240-55 | Income Tax Assessment Act 1997 section 240-65 | Income Tax Assessment Act 1997 section 240-115 | Taxation Administration Act 1953 section 12-245 of Schedule 1 | Taxation Administration Act 1953 section 12-300 of Schedule 1

Reasons for decision: Summary: Division 240 of the ITAA 1997 deals with hire purchase agreements (as defined in subsection 995-1(1) of the ITAA 1997) entered into after 27 February 1998 (section 240-10 of the ITAA 1997 as modified by section 240-115 of the ITAA1997). The broad scheme of the Division is to treat such hire purchase agreements as a sale of the relevant goods to the hirer (notional buyer) combined with a loan from the supplier (notional seller) to the notional buyer. Further, as the taxpayer, as notional buyer, would have been the owner or the quasi-owner of the commercial equipment if the arrangement had been a sale of the commercial equipment, and it is reasonably likely that the option to purchase the commercial equipment will be exercised by the taxpayer, both requirements in subsection 240-115(1) of the ITAA 1997 will be met under the arrangement. Therefore, the modifications in section 240-115 of the ITAA 1997 do not apply. Subsection 240-7(3) of the ITAA 1997 states that the notional buyer may be able to deduct notional interest payments over the period of the loan. On the facts, the lease agreement entered into between the lessee and the lessor constitutes a hire purchase agreement as defined in section 995-1 of the ITAA 1997 for the purposes of Division 240 of the ITAA 1997. Accordingly, the lease will be treated as a notional sale of commercial equipment to the lessee (notional buyer under subsection 240-17(2) of the ITAA 1997) with a notional loan from the lessor (notional seller under subsection 240-17(1) of the ITAA 1997) to the lessee. Section 240-50 of the ITAA 1997 states: 240-50(1) The *notional buyer is only entitled to deduct *notional interest for an income year to the extent that the notional buyer would, apart from this Division, have been entitled to deduct *arrangement payments for that income year if no part of those payments were capital in nature. 240-50(2) The *notional buyer is entitled to deduct *notional interest for *arrangement payment periods, and parts of arrangement payment periods, in the income year. Section 240-55 of the ITAA 1997 states that the notional buyer is not entitled to deduct arrangement payments that the notional buyer makes under the arrangement, but those payments are taken into account in calculating notional interest that may be deducted under section 240-50 of the ITAA 1997. Accordingly, it must be determined whether the arrangement payments would have been deductible for the lessee on the assumption that none of the parts of the arrangement payments were capital in nature. During the term of the lease, the lessee will be required to make quarterly payment in arrears. Arrangement payments is defined in section 240-65 of the ITAA 1997 as the amount that the notional buyer is required to pay under the arrangement but does not include an amount in the nature of a penalty payable for failure to make a payment on time or a termination amount. On the facts, apart from Division 240 of the ITAA 1997, the lessee would have been entitled to deduct arrangement payments if no part of those payments were capital in nature. Accordingly, the lessee is entitled to a deduction pursuant to section 240-50 of the ITAA 1997 for the 'notional interest' calculated under Subdivision 240-E of the ITAA 1997. Section 40-25 of the ITAA 1997 states that you can deduct an amount equal to the decline in value for an income year (as worked out under this Division) of a depreciating asset that you held for any time during the year. On the facts, the commercial equipment is a depreciating asset (as defined in subsection 40-30(1) of the ITAA 1997) and will be used for a taxable purpose. The holder of a depreciating asset is determined in accordance with the table in section 40-40 of the ITAA 1997. Item 10 of the table in section 40-40 of the ITAA 1997 (which applies as a default rule) provides that a taxpayer holds a depreciating asset if they are the owner of the asset, or the legal owner, if there is both a legal and equitable owner. However, there are other items in the table that identify a holder in various other circumstances even though they are not the asset's owner. One of these circumstances is contained in item 6 of the table in section 40-40 (item 6). Broadly, item 6 applies where: • A taxpayer has possession, or an immediate right to possession, of the asset combined with a right; the exercise of which would make it the holder (e.g. an option to acquire); and • It is 'reasonable to expect' that the taxpayer will become the holder by exercising that right or that the asset will be disposed of at their direction and for their benefit. As determined in Question 1 (above), the lease agreement between the lessor and lessee is a hire purchase agreement to which Division 240 of the ITAA 1997 applies. Paragraphs 6 and 7 of TR 2005/20 states that the notional buyer who is taken to be the owner of goods under subsection 240-20(2) of the ITAA 1997 will not be the holder of the goods for the purposes of Division 40 of the ITAA 1997, unless it is reasonable to conclude that the notional buyer will acquire the asset, or that the asset will be disposed of at the direction, and for the benefit of, the notional buyer. Where this requirement is satisfied, the notional buyer will be the holder of the asset under section 40-40 of the ITAA 1997. On the facts and in accordance with TR 2005/20, it is reasonable to conclude that the lessee, will be the holder of the commercial equipment under either item 6 or item 10 of the table in section 40-40 of the ITAA 1997. Since the lessee is the holder of the commercial equipment, which is a depreciating asset, it will be entitled to deduct an amount equal to the decline in value of the commercial equipment under section 40-25 of the ITAA 1997. Section 12-245 of Schedule 1 to the TAA imposes an obligation to withhold an amount from interest (within the meaning of Division 11A of Part III of the Income Tax Assessment Act 1936 (ITAA 1936)) that an entity pays to a recipient who has an address outside Australia. However, section 12-300 of Schedule 1 to the TAA provides that an entity is not required to withhold an amount if no withholding tax is payable in respect of the interest. Paragraph 7 of Taxation Ruling TR 98/21 (TR 98/21) states that where it is clear from the outset that the purchase or repurchase of the equipment is paramount, payments made under a cross border equipment leasing transaction are not subject to equipment royalty withholding tax under subsection 128B(5A) of the Act. Further, where instalment payments under a hire-purchase agreement contain an implicit interest component, that interest component is subject to interest withholding tax in accordance with section 128AC. Under section 128AC of the ITAA 1936 interest withholding tax is payable on the interest component calculated according to the requirements of the section, paid by a resident to a non-resident entity pursuant to a relevant agreement. The definition of relevant agreement includes a hire-purchase agreement and certain leases. On the facts, section 128AC of the ITAA 1936 applies to the current case. Thus, the interest component of the hire-purchase agreement is prima facie subject to interest withholding tax. In determining liability to Australian tax on Australian sourced income received by a non-resident it is necessary to consider not only the income tax laws but also any applicable tax treaty contained in International Tax Agreements Act 1953 (the Agreements Act). Subsection 4(2) of the Agreements Act, states that provisions of that Act override the provisions contained in the ITAA 1936 and ITAA 1997 (other than Part IVA of the ITAA 1936) where an inconsistency exists. The lessor, a resident of foreign country, will receive periodic lease rentals from the lessee, an Australian resident. Part of the lease rentals will be deemed to be income that consists of interest pursuant to section 128AC of the ITAA 1936. The implicit interest component of the lease rental payments, which is beneficially owned by the lessor, is interest for the purpose of the interest article of the convention. Under the interest article of the convention, Australia has a taxing right in respect of interest payments arising in Australia which the non-resident beneficially owns. However, such interest payments will not be taxed in Australia if: • the non-resident is a financial institution as defined in the interest article; • the non-resident is unrelated to and dealing wholly independently with the interest payer; • the interest arising in Australia is not paid as part of an arrangement involving 'back to back' loans or other arrangement to that effect; • the interest is not effectively connected with a permanent establishment in Australia of the non-resident; and • the non-resident is a qualified person as defined; or • the non-resident is carrying on a business in the foreign country and the interest derived in Australia is derived in connection with, or is incidental to, that business. Taxation Ruling TR 2005/5 provides guidance on the interpretation of these conditions. On the facts, the lessor satisfies all of the above requirements. Therefore, the lessor will not be liable to interest withholding tax in respect of the interest component of the rental payments. Accordingly, the lessee will not be required to withhold an amount from the rental payments under section 12-245 of Schedule 1 to the TAA, pursuant to section 12-300 of Schedule 1 to the TAA. Section 12-280 of Schedule 1 to the TAA requires an entity to withhold an amount from a royalty it pays to a non-resident. However, section 12-300 of Schedule 1 to the TAA states that withholding is not required where no withholding tax is payable pursuant to Division 11A of Part III of the ITAA 1936. A royalty is defined in subsection 6(1) of the ITAA 1936 to relevantly include any amount paid or credited, however described or computed, and whether the payment or credit is periodical or not, to the extent to which it is paid or credited, as the case may be, as consideration for the use of, or the right to use, any industrial, commercial or scientific equipment. Subsections 128B(2B) and 128B(5A) of the ITAA 1936 imposes a withholding tax liability on a non-resident who derives royalty income which is paid by a person who is a resident of Australia. Taxation Ruling TR 98/21 sets out the Commissioner's view on the withholding tax issues that arise in cross border equipment leasing arrangements in respect of payments made by an Australia resident to a non-resident lessor. Paragraph 7 of TR 98/21 states: Where it is clear from the outset that the purchase or repurchase of the equipment is paramount, payments made under a cross border leasing transaction are not subject to equipment royalty withholding tax under subsection 128B(5A) of the Act. … Based on the facts, rental payments made under the lease agreement will not be subject to royalty withholding tax under subsection 128B(5A) of the ITAA 1936. Consequently, the lessee will not be required to withhold an amount from the lease rentals payable to the lessor under section 12-280 of Schedule 1 to the TAA.