Leasing and Tax
Tax & Accounting13/05/2021 12:00:00 AM

Leasing and tax consolidation back to the future part ii

Contributed by Enzo Coia, Partner, and Anna Chen, Manager, Deloitte M&A Tax

Whilst the prospect of hoverboards and self-lacing sneakers were exciting glimpses into a possible future as presented in the movie Back to the Future Part II, less exciting were warnings about the impact that making changes in one place can have on another.

Exposure draft legislation released on 5 May 2021 provides welcome relief from the uncertainty and potential inappropriate outcomes caused by a change in accounting standards relating to leases in a tax consolidation context.

The Australian income tax system usually operates independently from accounting concepts and standards. As this article illustrates, that is often an approach that means the tax system needs less ongoing maintenance.

The concepts of assessable income and allowable deductions share similarity with their accounting counterparts of revenue and expenses. And there are many cases referring to the usefulness (but not conclusiveness) of accounting outcomes in analysing the tax legislation. For example:

  • FC of T v James Flood Pty Ltd (1953) 10 ATD 240; [1953] HCA 65; (1953) 88 CLR 492, where the High Court stated “… [c]ommercial and accountancy practice may assist in ascertaining the true nature and incidence of the item as a step towards determining whether it answers the test laid down by sec 51(1) but it cannot be substituted for the test”1
  • RACV Insurance Pty Ltd v Federal Commissioner of Taxation 74 ATC 4169, in which the Supreme Court of Victoria held that the provisions for unreported insurance claims recognised in the accounts of an insurer are presently existing liabilities and therefore an allowable deduction so long as they are a reasonable actuarial estimate.

As such, changes in accounting standards are usually not determinative on tax outcomes.

In some cases, however, the income tax legislation specifically incorporates accounting aspects. For example:

  •  The thin capitalisation rules in Div 820 of ITAA 1997. In particular, where they rely upon accounting standards in determining an entity’s assets and liabilities per s 820-680.
  • The ability for an entity to rely on its financial reports to determine the tax treatment of its gains or losses under a financial arrangement, per Subdiv 230-F of ITAA 1997.
  • The inclusion of an entity’s accounting liabilities for working out the tax cost setting amount of the assets of an entity upon joining (at Step 2) and exiting (at Step 4) an income tax consolidated group in accordance with s 705-70 and 711-45 of ITAA 1997 respectively.

Tax consolidation and finance leases

When the tax consolidation regime was first introduced in 2002, there were no specific rules relating to entities that had leasing arrangements (finance leases or otherwise).

The lack of specific rules for finance leases created problems for taxpayers. In relation to the lessor, there was uncertainty as to whether it had two assets (being the actual plant and the right to receive lease payments). Correspondingly, in relation to the lessee, it was uncertain whether the lessee should have an amount included in Step 2 of the allocable cost amount (ACA) calculation in respect of the lease liability, as recognised under accounting standards, and whether it also had an asset recognised under the finance lease to which the ACA needs to be allocated.

To address this uncertainty, s 705-56 of ITAA 1997 was introduced in March 2005 to clarify the treatment of finance leases on entry into a tax consolidated group. Section 705-56 operates such that only the entity which ‘holds’ the underlying asset for ITAA 1997 Div 40 purposes is able to assign a tax cost setting amount to it, as set out in the table below.

Amendments were also made to s 711-30 and 711-45 of ITAA 1997 to provide certainty regarding the treatment of finance leases on exit. For lessors, s 711-30(3) provides that, where its right to receive lease payments was recognised as an asset on entry into the tax consolidated group, its tax cost base of that asset on exit is its market value. For lessees, s 711-45(2A) stipulates that, where the underlying asset and lease liabilities were not taken into account on, entry the lease liability will also be excluded from the entity’s Step 2 amount on exit.

These amendments provided a sensible outcome, even if the exit outcomes were dictated by the entry treatment (ie to apply, the exit outcomes required the rules to have previously applied on entry).

Introduction of AASB 16

Australian Accounting Standards Board (AASB) 16 is a comprehensive leasing standard which applies for annual reporting periods commencing from 1 January 2019.

Lessors are still required to classify leases as operating or finance leases in accordance with para 61 of AASB 16. However, the terminology used in AASB 16 for lessees does away with the distinction between operating and finance leases.

Further, AASB 16 contained significant changes to the way in which lessees account for their leases. Almost all leases with a term of 12 months are now brought onto the balance sheet and a lessee is required to recognise a lease liability (reflecting the obligation to make future lease payments) and a right of use asset (representing the right to use the underlying leased asset) on its balance sheet. From a profit and loss statement perspective, the interest on the lease liability and depreciation on the right-of-use asset are reported as expenses, rather than the operating lease payments (ie rent) that were previously recognised as an expense.

In a case of Back to the Future Part II for lessees, following the introduction of AASB 16, they have had to tackle the same types of questions to work through the tax consolidation aspects as they did before the amendments made to introduce s 705-56 in 2005.

For example:

  • Should an amount be included in Step 2 of the entry ACA calculation in respect of the lease liability?
  • Is that liability a “deductible liability” at least to some extent such that it should be excluded from the entry ACA by virtue of s 705-70(1C)?
  • Could that lease liability in some cases “transfer with” the leased asset such that the liability could be excluded from the entry calculation under s 705-70(2)?
  • In allocating the ACA to the entity’s assets, is the “right of use asset” an asset which meets the definition of an asset to which tax cost can be allocated when applying s 701-67?
  • If it does meet that definition of an asset, and if it is a reset cost base asset, should it be allocated ACA instead of the lease itself or in addition to that lease agreement?

It is easy to see the complication when considering a simple example of an entity that is the lessee which has the following balance sheet and is acquired for $110.

Assets  $ Liabilities   $

Cash

Right of use asset

10

1,000

Lease liability 

 

1,000

 

 Total assets  1,010  Total liabilities  1,000

Similar uncertainty exists in respect of the exit from a tax consolidated group, in particular in relation to lessees where it is unclear as to whether it is necessary to include the lease liability at Step 4 under s 711-45, despite not having a corresponding tax asset to include at Step 1. Clearly, this uncertainty may result in unforeseen and detrimental outcomes for the lessee upon exit from a tax consolidated group.

Generally, in the authors’ experience, tax practitioners have tended to use common sense to interpret the provisions to provide a sensible outcome.

For example:

  • Lessees should exclude the lease liability at Step 4 of their exit ACA under s 711-45 in accordance with:
  • either s 711-45(2), on the basis that the liability transfers with the right of use asset, or
  • s 711-45(5), on the basis that the lease payments would ordinarily be deductible.
  • The right of use asset would not ordinarily be a tax consolidation asset separate and distinct from the lease agreement itself.

Even though the accounting standards have been in place for some time, the above approach has not been supported by any legislative certainty.

Whilst the ATO has been aware of the uncertainty surrounding the interaction of AASB 16 and the potential for peculiar tax consolidation outcomes for taxpayers under the current legislation for some years, it has not published any formal administrative guidance to date.

Legislative amendments – exposure draft

On 5 May 2021, Treasury released for consultation the exposure draft and explanatory materials of the Treasury Laws Amendment (Measures for Consultation) Bill 2021: Miscellaneous and Technical Amendments (the Exposure Draft). Consultation is open until 25 May 2021.

The Exposure Draft contains proposed amendments to allow the tax consolidation legislation to operate effectively in respect of leases.

In relation to entry into tax consolidated groups, the word ‘finance’ is proposed to be removed throughout s 705-56, meaning that the modified tax cost setting rule should now apply broadly to all leases involving a depreciating asset to which a Div 40 applies. These amendments mean that leases and leased assets brought into a consolidated group will have the treatment as set out above in the table referencing s 705-56.

In respect of exit from a tax consolidated group by a lessee, the Exposure Draft outlines a similar amendment to s 711-45(2A) which removes the word ‘finance’ to enable the modified tax cost setting rule to operate effectively where a lessee exits a tax consolidated group.

The proposed amendments provide much desired certainty for both lessees and lessors and are consistent with the approach that has been adopted by tax practitioners in dealing with leases in a tax consolidation context following the commencement of AASB 16.

However, we offer four observations aimed at improving the operation of the exposure draft legislation.

First, the start time of the proposed measures. The Exposure Draft notes that these proposed amendments should apply in relation to an entity that becomes a subsidiary member of a tax consolidated group or a multiple entry consolidated group on or after the day the Bill for this Act is introduced into the House of Representatives. This is disappointing given the length of time since AASB 16 has been operative. It would be preferable to at least give taxpayers the choice to apply the amendments from the introduction of AASB 16.

Second, in respect of entity’s that leave a consolidated group, there are no proposed amendments to remove the need for the lease to have been taken into account on entry into the consolidated group before the amendments can apply on exit.

Third, the Exposure Draft does not specifically address the tax consolidation treatment of the lessees’ right of use asset. Accordingly, it is recommended that a sensible approach is adopted to clarify that the right of use asset is not an asset for tax consolidation purposes (perhaps an amendment or note to s 701-67 to provide clarification).

Finally, as mentioned above, the amendments only apply to leases in relation to depreciating assets. As such, care will need to be taken if there are any arrangements which do not involve depreciating assets.

The Exposure Draft amendments erase much of the “bad things” that happened when the accounting changes occurred just like the ending in Back to the Future Part II. Let’s hope lightning does not strike again and sends us back to 1885.

Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily represent those of Deloitte. The article is not to be used as advice.

Footnotes

1 Dixon CJ, Webb, Fullagar, Kitto and Taylor JJ in FC of T v James Flood Pty Ltd (1953) 88 CLR 492 at pp 506-507.

2 In which it is noted that applies to an asset only if the asset is one or more of the following types of assets:

(a) a CGT asset
(b) a revenue asset
(c) a depreciating asset
(d) trading stock
(e) a thing that is or is part of a Division 230 financial arrangement.