Bills Digest No. 150  1998-99 Taxation Laws Amendment Bill (No. 5) 1999


Numerical Index | Alphabetical Index

WARNING:
This Digest was prepared for debate. It reflects the legislation as introduced and does not canvass subsequent amendments. This Digest does not have any official legal status. Other sources should be consulted to determine the subsequent official status of the Bill.

CONTENTS

Passage History
Purpose
Background
Main Provisions
Concluding Comments
Endnotes
Contact Officer and Copyright Details

Passage History

Taxation Laws Amendment Bill (No. 5) 1999

Date Introduced: 11 March 1999

House: House of Representatives

Portfolio: Treasury

Commencement: Upon Royal Assent, however, the measures contained in the Bill have different application dates, which will be considered in the Main Provisions section of the Digest.

 

Purpose

The amendments contained in the Bill are:

  • Measures to ensure the sales tax exemption for goods placed in properties owned or leased by always exempt persons or foreign governments is only available for the purchase of goods acquired for their own use (Schedule 1).
  • Measures to treat certain hire purchase agreements as sale and loan agreements for income tax purposes to ensure that excessive tax benefits are not obtained (Schedule 2).

Background

As this Bill contains no central theme the background to the two main measures is included in the discussion of the main provisions.

Main Provisions

Amendment of the Sales Tax (Exemptions and Classifications) Act 1992

Sales tax generally applies to goods which are manufactured in Australia or goods imported into Australia, for use in Australia. Sales tax is a wholesale tax. The Sales Tax Assessment Act 1992 provides that dealings with assessable goods are subject to sales tax unless an exemption applies. The exemptions from sales tax are contained in the Sales Tax (Exemptions and Classifications) Act 1992 (ST(EC) Act). Schedule 1 of the ST(EC) Act contains a list of goods that are exempt from sales tax.

For the purposes of the sales tax law the term an 'always exempt person' is defined in section 5 of the Sales Tax Assessment Act 1992. The definition states that an always exempt person means a person whose use of goods is always covered by an exemption, irrespective of the way in which the goods are used by that person. Examples of always exempt persons are: government agencies; local councils; schools; public hospitals; and benevolent funds. As a result of the proposed amendment to the ST(EC) Act an always exempt person will not be exempt from sales tax in all situations.

Under property law, goods used by a person in the repair or construction of a building become part of the building. Item 192 of Schedule 1 of the ST(EC) Act provides a sales tax exemption to certain persons for goods that become integrated with real property (buildings and structures). This exemption is provided to two categories of persons: always exempt persons and foreign governments. The provision applies to property that is either owned or leased by the always exempt person or a foreign government.

According to the Explanatory Memorandum, the exemption is available regardless of whether the always exempt person or foreign government ever occupies a building in respect of which sales tax exemptions have been obtained for goods used in construction of the building.(1) The Explanatory Memorandum asserts that this exemption is being used for commercial developments on property owned by always exempt persons or foreign governments.(2) It also asserts that this use of the exemption is a misuse and results in competitive advantages to certain property developments. If a developer is able to obtain a sales tax exemption for goods used in a property development, that developer has a significant cost advantage over developers who have correctly paid sales tax on goods used in a development. The Explanatory Memorandum describes examples of misuse of the exemption. It is stated that the following developments on land owned by State and local governments benefited from the exemption:

  • the building of residential apartments by private developers, and
  • the refurbishment of shopping centres.

The measures contained in Schedule 1 of the Bill counter a shortcoming in the sales tax law which allows a person who has a contract with an always eligible person or foreign government to obtain an exemption from sales tax on goods used in a property. The measures contained in Schedule 1 of the Bill were first introduced into Parliament on 2 April 1998 in Taxation Laws Amendment Bill (No 4) 1998. This Bill lapsed when Parliament was prorogued for the 1998 General Election.

Item 1 of Schedule 1 of the Bill amends Item 192 Schedule 1 of the ST(EC) Act. Proposed Item 192(4) restricts the exemption to the following situations:

  • residential property which is provided by an always exempt person, at a rate of rent that is below the market rate
  • a property that is principally occupied by an always exempt person or foreign government
  • in the case of service providers to always exempt persons or foreign governments, the property must be used principally for the provision of those services.

Proposed Item 192(4)(b) directs that the relevant property cannot be an 'ineligible property'. A list of ineligible properties is contained in proposed Item 192(5). The list includes the following properties: shops and shopping centres; hotels; casinos; apartment blocks. Properties that are similar to one of the above listed properties are also expressly excluded under proposed Item 192(5)(e). Under proposed Item 192(5)(f) properties prescribed for the purposes of the definition are also excluded from the exemption.

The Explanatory Memorandum states that the measures in proposed Item 1 of Schedule 1 will not apply to the private sector involvement in infrastructure projects such as toll roads.(3) Under proposed Item 192(4)(a)(ii) a person who is involved in providing services for an infrastructure project would be treated as a service provider to an always eligible entity. Following the amendments, the goods used in such a project would be eligible for the sales tax exemption under Item 192.

The measures contained in Schedule 1 of the Bill are expected to result in an estimated gain to the revenue of $10 million in 1997-98 and $50 million in 1998-99.(4) The implication from the large estimated gain to the revenue is that tax avoidance arrangements were being used to exploit the exemption.

Application

Item 2 of Schedule 1 of the Bill sets the application date as dealings after 2 April 1998. The measures do not apply to goods acquired on or before 2 April 1998. The first Bill was introduced into the House of Representatives on 2 April 1998.

Arrangements treated as a sale and loan and limited recourse debt

Under the existing income tax law, taxpayers are entitled to a deduction for capital allowances such as depreciation. The capital allowance is based on the cost of the asset and certain capital expenditure. Any related finance transactions are not taken into account for capital allowance purposes.

Generally a capital allowance requires a balancing adjustment to be made when the depreciated property is sold for a price which is different from its value for capital allowance purposes. If a person sells an asset for an amount that exceeds the depreciated value of the asset for income tax purposes, the seller will be subject to income tax on the difference between the depreciated value and the sale value of the asset. This process captures the tax benefit, in the form of depreciation deductions, that the seller has obtained by depreciating an asset to a value below its market value.

In the case of assets that are financed under hire purchase agreements or by limited recourse debt arrangements, the total cost of an asset may not be paid by the purchaser if an amount remains unpaid at the termination of a lease. For example, if the cost of an asset is $100,000 and the asset is acquired under a finance agreement, the taxpayer will be able to claim capital allowance deductions on the asset from a starting value of $100,000. Should the seller not require payment of the full loan and interest, the buyer might obtain an excessive depreciation deduction because of the reduced cost of the asset. The existing income tax law does not require an adjustment to be made for such a reduction in the cost of an asset. This provides tax avoidance opportunities for certain taxpayers.

The measures in Schedule 2 counter arrangements that allow taxpayers to acquire assets under finance arrangements that result in excessive capital allowance deductions being obtained because the full consideration for an asset is not paid. The proposed measures will require such persons to make adjustments for capital allowance purposes to reflect the actual cost of an asset where the expenditure has been financed by a hire purchase arrangement or limited recourse debt.

The measures were first announced by the Treasurer in the 1997 Budget.(5) The Budget announcement contained the following example of the operation of the existing law and proposed amendments:

Existing Law

Plant purchased for $10,000 under a hire purchase agreement may be re-possessed for non-payment after two years. If at that time the plant has been depreciated for tax purposes by $7,000 but the taxpayer has paid only $4,000 of the hire purchase cost, the taxpayer would have obtained a tax gain which exceeds costs by $3,000. A further deduction would be available to the taxpayer equal to the difference between the depreciated value of $3,000 and the taxpayer's disposal price - in this case nil because the plant was repossessed. For a total outlay of $4,000, the taxpayer's deductions would be $10,000.

Amended Law

The $6,000 of the unpaid cost under the hire purchase arrangement - adjusted if necessary for any further amount the taxpayer was required to pay - would be treated as consideration on disposal, thereby creating a balancing charge of $3,000 ($6,000 less the depreciated value) to offset the $7,000 depreciation already deducted. The taxpayer's net tax deductions then would be $4,000 - equal to net outlays.(6)

The Treasurer announced, by Press Release No. 21 of 27 February 1998, changes in the way the measures would be implemented and some technical amendments. The measures contained in Schedule 2 were first introduced into Parliament on 2 April 1998 in Taxation Laws Amendment Bill (No. 4) 1998. This Bill lapsed when Parliament was prorogued for the 1998 General Election.

Under the limited recourse debt measures (debt that is not to be fully repaid), a taxpayer will be denied the opportunity to claim capital allowances that exceed the cost of an asset. Hire purchase arrangements will be treated as limited recourse debt to bring these arrangements within the scope of the limited recourse debt measures. In addition, hire purchase arrangements will be recharacterised through the use of a legal fiction as a sale of property and concurrent loan.

Arrangements treated as a sale and loan

Proposed Division 240 contains the rules that apply to treat hire purchase arrangements as a sale and loan agreement. Proposed Division 240 provides the rules for determining the income and deductions applicable to the parties to a hire purchase agreement. Hire purchase agreements are treated as limited recourse debt for the purposes of proposed Division 243 to ensure that taxpayers may not obtain deductions for capital allowances that exceed the actual cost of an asset to a taxpayer (discussed below).

Proposed section 240-10 is the application provision. It prescribes that an arrangement will be treated as a notional sale and notional loan if it is a hire purchase agreement in relation to any goods. It applies to all hire purchase agreements.

Under this measure, a notional seller is treated as having sold the property to a notional buyer to finance the purchase price (proposed sections 240-17 and 240-20). The notional seller is the financier and the notional buyer is the person receiving the finance to acquire property. A notional loan is treated as having been provided by the notional seller to the notional buyer. The notional loan is the consideration for the sale of the property.

Proposed section 240-35 lists the amounts that are to be included in the notional seller's income. The notional seller's income includes the notional interest in respect of the notional loan (proposed subsection 240-35(1)). If the property is not the notional seller's trading stock, the profit is to include the seller's profit on the transaction (proposed subsection 240-35(2)). Under proposed subsection 240-50(1) the notional buyer is entitled to a deduction for notional interest. The rules for calculating the notional interest are contained in proposed section 240-60.

Proposed Subdivision 240-D provides that a notional buyer (the borrower) may be entitled to deductions for the notional interest for the notional loan that the notional seller is treated as having made. Under proposed subsection 240-50(2) a notional buyer is generally entitled to a deduction for notional interest.

Proposed Subdivision 240-G contains income reconciliation rules for a notional seller. If the sum of the amounts included in the notional seller's assessable income differs from the finance charge, determined at the end of the arrangement for the notional loan, an adjustment to the seller's assessable income will be made. This adjustment mechanism takes into account all the finance charges over the life of the loan.

The formula for determining if an adjustment is necessary is contained in proposed subsection 240-105(4). If the sum of the amount paid to the notional seller and any termination payments is less than the amount calculated under proposed subsection 240-105(4), the difference is to be included in the notional seller's assessable income. Proposed subsection 240-105(4) directs that the formula is the sum of the 'notional loan principal' and the 'assessed notional interest'. The assessed 'notional interest' is defined in proposed subsection 240-105(4) as the notional income that has been included in the notional seller's assessable income. The term 'notional loan principal' is defined in proposed section 240-25 as generally being the consideration for the sale of the property.

If the notional loan principal and the assessed notional interest calculated under proposed subsection 240-150(3) exceeds the amount calculated under subsection 240-105(4), the notional seller is entitled to a deduction for the difference. In this situation the taxpayer has been assessed on amounts that it has not received and the deduction corrects the situation.

Limited Recourse Debt

Proposed Division 243 applies where a taxpayer's deductions for capital allowances obtained for expenditure, which has been financed by debt, are excessive because part of the debt was waived by the lender. This is a tax avoidance technique to inflate a taxpayer's cost base for capital allowance purposes by writing off part of the debt used by the taxpayer to acquire an asset. Proposed Division 243 ensures that a taxpayer's deductions for capital allowances do not exceed the actual cost of the asset to the taxpayer. If a taxpayer's deductions for capital allowances exceed the actual cost of an asset, proposed Division 243 requires the taxpayer to treat the difference as income in the income year the loan is terminated.

The criteria for the application of proposed Division 243 are (proposed section 243-15):

  1. a limited recourse debt has been used to finance expenditure

  2. at the termination of the debt arrangement, the debt has not been fully discharged by the debtor, and

  3. the debtor has been able to obtain deductions for capital allowances.

Under proposed subsection 243-15(2) an amount will only be included in the debtor's assessable income if the net capital allowances have been excessive, having regard to the amount of unpaid debt. The Digest considers in detail the meaning of limited recourse debt, termination of a debt arrangement, and whether the debtor has been able to obtain excessive deductions for capital allowances.

What is limited recourse debt?

The first step is to determine if there is limited recourse debt. The term 'limited recourse debt' is defined in proposed section 243-20 as a loan to a borrower for the acquisition of property under which the loan rights of the lender are limited. There are four categories of limited recourse debt.

The first category is in proposed subsection 243-20(1) which lists the limitations that may be imposed on a creditor in the case of default. In general the lender has rights that are limited to the property acquired with the debt, however, the value of the property may be significantly less than the outstanding principal and interest. Due to the recovery limitations in the loans, the lender does not have the right to seek recovery of any outstanding amounts.

The second category is in proposed subsection 243-20(2) which treats a loan as a limited recourse loan even if there is no express limitation in the loan but it would be expected that the creditor's rights would be limited to the property rights referred to in proposed subsection 243-20(1). The criteria by which this conclusion is to be determined are (proposed subsection 243-20(2)):

  • the assets of the debtor
  • any arrangements involving the debtor
  • whether all the debtor's assets would be available for the discharge of the debt, and
  • whether the debtor and creditor are dealing with each other at arm's length.

The third category is in proposed subsection 243-20(3). Under this provision a loan is treated as a limited recourse loan if there is no security provided for the debt and it is reasonable to conclude that the rights of the creditor are limited. The criteria by which this conclusion is to be determined are listed in proposed subsection 243-20(3). The criteria are the same as those listed in proposed subsection 243-20(2).

The final category of limited recourse loan is defined in proposed subsection 243-20(4) as being a notional loan under a hire purchase agreement. The legal fiction of loans created in respect of hire purchase agreements (proposed Division 240) is maintained for the purpose of proposed Division 243 to treat such loans as limited recourse loans.

When is a debt arrangement terminated?

The second step is to determine if a debt arrangement has been terminated. Proposed section 243-25 lists the situations in which a debt arrangement is treated as being terminated. A debt is treated as being terminated if:

  • it is actually terminated
  • the debt is waived
  • an agreement is made to waive or change the debt
  • the creditor ceases to have an entitlement to recover the debt
  • the property acquired with the debt is given to the creditor and part of the loan remains outstanding, or
  • the debt becomes a bad debt.

When does proposed Division 243 apply?

The final step is to determine if the taxpayer has obtained excessive deductions for capital allowances. Proposed section 243-35 contains a formula for determining if a taxpayer has obtained excessive deductions in respect of an asset. The provision requires a taxpayer to determine the sum of net capital allowances obtained (proposed subsections 243-35(2)). The sum must be compared to the capital deductions the taxpayer would have been entitled to if the amount of unpaid debt had been taken into account (proposed subsection 243-35(4)). The capital allowances received by a taxpayer will be treated under proposed subsection 243-35(1) as having been excessive if the amount calculated under proposed subsection 243-35(2) exceeds the amount calculated under proposed subsection 243-35(4). Proposed section 243-35 ensures that a taxpayer cannot obtain additional tax benefits because it has not fully discharged the loan.

If a taxpayer has obtained excessive capital allowance deductions for the purposes of proposed subsection 243-35(1), the taxpayer is required to include the amount of the excess in its assessable income for the income year in which the termination occurred (proposed section 243-40).

Application

The amendments relating to arrangements treated as sale and loan generally apply from 27 February 1998 (Item 108 of Schedule 2). The amendments relating to limited recourse debt generally apply from 27 February 1998 (Item 109 of Schedule 2).

Concluding Comments

Industry Concerns

The Minister for Financial Services and Regulation, the Hon Joe Hockey MP, announced, in his Second Reading Speech, that since the measures in Schedule 2 of the Bill were first introduced (Taxation Laws Amendment Bill (No. 4) 1998), the Government had consulted with industry and professional bodies. The Minister stated that '[t]wo major technical changes to the original Bill are concerned with limited recourse debt. . . . This will allow investors to refinance assets without adverse tax consequences.' This statement refers to proposed sections 243-15 and 243-50. Under proposed section 243-15, if a limited recourse debt is fully refinanced by another limited recourse debt between parties that are dealing with each other at arm's length, the refinancing will not result in an adjustment being made under this measure. Although the Minister stated in his Second Reading Speech that refinancing between arm's length parties will not be caught by the measures, industry commentators have argued it is uncertain whether the proposed provisions have resolved this issue.(7)

Endnotes

  1. The Explanatory Memorandum for Taxation Laws Amendment Bill (No. 5) 1998, p. 8.

  2. Ibid.

  3. Ibid, p. 9.

  4. Ibid, p. 12.

  5. A full extract of the description of this measure is contained in Treasurer's Press Release, no. 60, 13 May 1997.

  6. Ibid.

  7. The Australian Financial Review, 19 March 1999, 'New Depreciation tax laws get a mixed response', p. 25.

Contact Officer and Copyright Details

Michael Kobetsky, Consultant
12 April 1999
Bills Digest Service
Information and Research Services

This paper has been prepared for general distribution to Senators and Members of the Australian Parliament. While great care is taken to ensure that the paper is accurate and balanced, the paper is written using information publicly available at the time of production. The views expressed are those of the author and should not be attributed to the Information and Research Services (IRS). Advice on legislation or legal policy issues contained in this paper is provided for use in parliamentary debate and for related parliamentary purposes. This paper is not professional legal opinion. Readers are reminded that the paper is not an official parliamentary or Australian government document.

IRS staff are available to discuss the paper's contents with Senators and Members
and their staff but not with members of the public.

ISSN 1328-8091
© Commonwealth of Australia 1999

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Published by the Department of the Parliamentary Library, 1999.

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