House of Representatives

Explanatory Memorandum

Circulated By the Authority of the Treasurer, the Hon Wayne Swan MP

Chapter 4 - Luxury car leases rewrite - Schedule 2E

Outline of chapter

4.1 Schedule 3 to this Bill rewrites Schedule 2E to the Income Tax Assessment Act 1936 ( ITAA 1936) into the Income Tax Assessment Act 1997 ( ITAA 1997).

Context of amendments

4.2 Schedule 2E to the ITAA 1936 ensures that a lease of a luxury car cannot be used to provide greater tax benefits than those that would be available if the lessee had bought the car. Schedule 2E does that by putting the lessee and the lessor in the same positions they would have been in had the lessee bought the car from the lessor.

Detailed explanation of new law

4.3 The rewrite repeals Schedule 2E and reproduces its effect in the ITAA 1997 . [Schedule 3, items 1 and 2, Schedule 2E to the ITAA 1936, Division 242 of the ITAA 1997]

How the rewrite is different

Guide material

4.4 The rewrite contains newly written guide material for the Division and for each of its Subdivisions . [Schedule 3, item 2, sections 242-1, 242-5, 242-30, 242-45, 242-60 and 242-75]

Structural changes

4.5 The rewrite follows the structure of Schedule 2E: it has the same Subdivisions and they appear in the same order.

4.6 The main exceptions are that Subdivisions 42A-E (what happens when a lease expires) and F (what happens when a lease is terminated) have been merged and Subdivision 42A-G (definitions) has been deleted.

4.7 A few provisions have been moved to different Subdivisions or to other places in the ITAA 1997. For example, many of the definitions in Subdivision 42A-G have been moved into the Dictionary to the ITAA 1997. These differences are discussed in more detail later.

Differences in Subdivision A - Notional sale and loan

4.8 Subdivision 42A-A of Schedule 2E provides the rules that treat a lease of a luxury car as a notional sale of the car by the lessor to the lessee and a notional loan by the lessor of the purchase price. It also details what the consideration is for the notional sale.

4.9 Subsection 42A-20(1) defines the consideration for the notional sale of the car by the lessor (and the cost of the car to the lessee) as the amount the parties stated in an arm's-length agreement, or the amount that would reasonably have been expected to have been paid had the agreement been an arm's-length agreement for the sale of the car. The rewrite simplifies those rules by making the consideration the car's market value. Because there is little or no difference between the arm's-length sale price used by the existing provision and a market value sale price, there should be little or no difference in the substantive effect of the provisions . [Schedule 3, item 2, subsection 242-20(1)]

4.10 An exception to the rule about consideration applies to subleases between associates. In that case, Schedule 2E makes the consideration the sum of the car's depreciated value and any balancing charge arising from the notional sale. The rewrite changes 'depreciated value' to 'adjustable value', the equivalent expression used in the ITAA 1997 . [Schedule 3, item 2, subsection 242-20(2)]

4.11 The references to the 'cost' of the car (in Subdivision 42A-A and elsewhere) are changed to 'the first element of the cost' to reflect a change in terminology made with the introduction of the uniform capital allowance provisions in 2001. This change ensures that lessees can deduct the decline in the value of any improvements they make to the car . [Schedule 3, item 2, paragraph 242-25(1)(b) and subsections 242-20(1) and (2) and 242-90(3) and (4)]

4.12 The rewrite also changes the reference to the balancing charge provision so that it refers to the current balancing charge provision in the ITAA 1997 [Schedule 3, item 2, paragraph 242-20(2)(d)]. The existing reference to just the ITAA 1936 provision appears to have been an oversight made when the ITAA 1936 depreciation provisions were rewritten in 1997. The reference was also not adjusted when the 1997 rewrite was itself rewritten in 2001 as part of the uniform capital allowance regime. The rewrite adds references to the ITAA 1936 provision and to the original 1997 rewrite provision. Those references are included in the Income Tax (Transitional Provisions) Act 1997 ( IT(TP)A 1997) because of their limited future relevance [Schedule 3, item 74, section 242-20 of the IT(TP)A 1997].

4.13 Some elements of the definitions of 'associate', 'lease', 'luxury car' and 'motor car' in Schedule 2E have been moved out of those definitions into operative provisions. That allows 'lease' to take its ordinary meaning without definition, simplifies the definition of 'luxury car', and allows the existing ITAA 1997 definitions of 'associate' and 'car' to apply without amendment . [Schedule 3, item 2, paragraph 242-15(2)(b) and subsections 242-10(1) and (3) and 242-20(2)]

4.14 The provisions that stop the rewrite applying to leases granted before 7:30 pm on 20 August 1996 are moved into the IT(TP)A 1997 on the basis that they have only a limited future role . [Schedule 3, item 74, subsection 242-10(2) of the IT(TP)A 1997]

Differences in Subdivision B - Lessor's assessable income

4.15 Subdivision B of Schedule 2E explains the taxation treatment for the lessor of both the actual lease payments and the notional payments arising from the notional sale and loan.

4.16 To avoid having to define the expressions, 'accrual amount', 'implicit interest rate' and 'outstanding notional loan principal', the rewrite incorporates those concepts directly into the operative provision that works out how much is included in the lessor's assessable income. There are some slight differences in wording, which are discussed later . [Schedule 3, item 2, subsection 242-35(2)]

4.17 Subsections 42A-35(2) and (3) provide balancing charges for the notional sale of the car to the lessee and for any actual sale the lessor makes after reacquiring it from the lessee when the lease ends. Since a car is a depreciating asset (see section 40-30 of the ITAA 1997), the same work is done by the balancing adjustment rules in Subdivision 40-D (which apply when a taxpayer stops holding a depreciating asset). This is the case even when there is only a notional sale from the lessor to the lessee because subsection 42A-15(1) treats the lessor as having sold the car for all income tax purposes, not just for the purposes of Schedule 2E.

4.18 Accordingly, since 1999 (when the depreciation provisions were amended to assess profits made on the disposal of assets for which no depreciation had been deducted), subsections 42A-35(2) and (3) have been redundant. For that reason, subsections 42A-35(2) and (3) are not rewritten.

4.19 That change could make a difference in the case where the lessor has some private use of the car either before the notional sale to the lessee or before any later real sale. Subsections 42A-35(2) and (3) make no allowance for any private use; they assess the full profit. The balancing adjustment rules in Subdivision 40-D of the ITAA 1997 only assess the non-private portion of the profit. In the unusual case where a luxury car is leased out by someone who has used it privately, this change produces a small benefit for the taxpayer.

4.20 Subsection 42A-40(2) explains that, although the actual lease payments are neither assessable income nor exempt income of the lessor, they are taken into account in working out the notional payments that are included in the lessor's assessable income. Since the calculation of the notional payments is done by a different provision, the subsection is inoperative. Reflecting that, the rewrite converts it into an inoperative note . [Schedule 3, item 2, subsection 242-40(1) (note)]

4.21 As Schedule 2E stops the actual lease payments from being assessable income (because it assesses the interest on the notional loan instead), the lease payments become exempt income. Subsection 42A-40(3) is necessary to ensure that the amounts the lessor incurs to earn those lease payments are still deductible (because deductions are not usually available for earning exempt income). Since subsection 42A-40(3) was enacted, the income tax law has recognised a new category of exempt income, called 'non-assessable, non-exempt income', which covers the lease payments. The rewrite updates the subsection so that it also ensures that deductions are not denied because the lessor incurred the amounts in earning non-assessable, non-exempt income . [Schedule 3, item 2, subsection 242-40(2)]

Differences in Subdivision C - Lessee's deductions

4.22 Subdivision 42A-C of Schedule 2E explains what deductions are available to the lessee of a luxury car.

4.23 Section 42A-55 provides that the lessee cannot deduct the lease payments but points out that they are taken into account in working out the amounts that are deductible in relation to the notional loan. That second part of the section is non-operative (because section 42A-140 calculates the deductible amount), so the rewrite converts it into a note . [Schedule 3, item 2, section 242-55 (note)]

Differences in Subdivision D - Adjustments if the lessor's income differs from the amount of interest

4.24 Subdivision 42A-D of Schedule 2E provides for balancing adjustments for the lessor and lessee if the amount of the notional payments differs from the actual payments made under the lease.

4.25 Paragraph 42A-65(1)(a) applies the balancing adjustment rules to the lessor when a lease term expires and paragraph 42A-65(1)(b) applies them when a lease is terminated beforehand. The rewrite merges those two cases into a single paragraph that applies the balancing adjustment rules whenever the lease ends . [Schedule 3, item 2, paragraph 242-65(1)(a)]

4.26 The adjustments for the lessor are worked out by comparing the total of the amounts payable to the lessor under the lease with the notional payments under the notional loan. If the former exceeds the latter, the difference is the lessor's assessable income; if the reverse is the case, the lessor can deduct the difference. The current provisions make that hard to follow by expressing the two cases in different terms. The rewrite expresses them in the same terms, so the comparison and the results are easier to follow . [Schedule 3, item 2, subsections 242-65(2) and (3)]

Differences in Subdivisions E and F - What happens when the lease ends

4.27 Subdivisions 42A-E and 42A-F of Schedule 2E respectively explain what happens if a luxury car lease expires and if it is terminated before the end of the term. In broad terms, those Subdivisions do the same thing in both cases, so the rewrite merges them into a single Subdivision that explains what happens whenever the lease ends . [Schedule 3, item 2, Subdivision 242-E]

4.28 Schedule 2E frequently mentions the 'end of the lease'. By this, Schedule 2E generally means the end of the whole transaction (that is, after all extensions or renewals of the lease have ended). There are some cases, however, where it means the end of the current lease period (whether the original lease period or a period for which the lease was extended or renewed). The rewrite makes clearer which is meant in those cases . [Schedule 3, item 2, paragraph 242-90(5)(a) and subsections 242-80(1), (4), (7) and (8)]

4.29 Paragraph 42A-80(3)(a) refers to an arrangement 'of a kind mentioned in paragraph (b) of the definition of lease'. Those arrangements are subleases. Because the ordinary meaning of 'lease' is already used extensively in the ITAA 1997, the rewrite is not able to replicate the current definition. Therefore, the rewrite replaces the reference to paragraph (b) of the definition with the term 'sublease' . [Schedule 3, item 2, subsection 242-80(3)]

4.30 Subsection 42A-80(4) provides that the notional loan is taken to have been repaid when a lease is extended or renewed. It also provides that Subdivision 42A-D (about balancing adjustments) applies at that time. As Subdivision 42A-D is self-applying, the second part of the subsection is purely advisory. Therefore, the rewrite converts it into an inoperative note . [Schedule 3, item 2, subsection 242-80(4) (note)]

4.31 Subsection 42A-80(5) refers to an amount worked out under subsection 42A-80(7). That subsection makes the cost or value of the car for purposes of the extension or renewal, the value stated in an arm's-length lease, or the amount that would reasonably have been expected to have been paid had the agreement been an arm's-length agreement for the sale of the car. The rewrite simplifies those rules by making the consideration the car's market value. Because there is no difference between the arm's-length sale price used by the existing provision and a market value sale price, there should be no difference in the substantive effect of the provisions . [Schedule 3, item 2, subsection 242-80(5)]

4.32 Subsections 42A-90(1) and 42A-105(1) specify the conditions for sections 42A-90 and 42A-105 to apply. The rewrite combines those conditions into a single provision . [Schedule 3, item 2, subsection 242-90(1)]

4.33 Subsections 42A-90(3) and (6) and 42A-105(3) and (5) provide formulas for working out the consideration for the sale of the car by the lessee back to the lessor that is taken to have occurred when the lease comes to an end. The formulas are complex and take into account variables that might not always be known, so paragraphs 42A-90(3)(b) and 42A-105(3)(b) allow market value to be used if it is not practicable to apply the full formula. The rewrite simplifies the provisions by using the market value as the consideration in all cases . [Schedule 3, item 2, subsection 242-90(3)]

4.34 There should be little difference from that change because the existing formulas aim to achieve the same broad outcome by adopting particular figures specified in the lease agreement. Division 240 applies a similar 'sale and loan' approach to hire purchase arrangements and always treats the consideration as being the market value, so, for that reason too, it is reasonable to conclude that the results are similar.

4.35 Subsections 42A-90(4) and 42A-105(4) determine the cost of the car for capital allowance purposes for an associate of the lessee who later acquires the car. In describing the capital allowance purposes, the subsection refers to the current capital allowance provision and to the provisions under the two previous capital allowance regimes. The rewrite moves the references to the two previous regimes into the IT(TP)A 1997 because of their limited future relevance . [Schedule 3, items 2 and 74, subsection 242-90(4) and section 242-20 of the IT(TP)A 1997]

Differences in Subdivision G - Interpretation

4.36 Subdivision 42A-G defines many of the terms used in Schedule 2E. Consistent with the approach used in the ITAA 1997 to not define terms for only a part of the Act, the Subdivision is not rewritten. The definitions in the Subdivision are instead dealt with in other ways.

Incorporating the content directly into operative provisions

4.37 For some definitions, the content is incorporated directly into the operative provisions [Schedule 3, item 2, paragraphs 242-10(1)(a), (b) and (d), 242-15(2)(b), 242-20(2)(a) and (b), subsections 242-10(3), 242-35(2) and (3), 242-80(3) and 242-90(4)]. For example, the definition of 'associate' starts with the same meaning as in the ITAA 1997 but is expanded to include employees and employers, so the rewrite replaces all references to associates with references to associates, employees and employers.

Relying on existing definitions in the ITAA 1997

4.38 For some definitions, existing definitions in the ITAA 1997 cover the same ground. These include the definitions of 'hire purchase agreement', 'motor car or car', 'right to use' and 'short-term hire agreement'.

4.39 The existing ITAA 1997 definition of 'hire purchase agreement' is slightly different from that in Schedule 2E. Schedule 2E requires that amounts paid under an agreement for hiring property are taken into account in working out how much the lessee has to pay to exercise the option to acquire the property. The existing ITAA 1997 definition instead requires that the hire charge plus the amount payable to exercise the option total more than the price of the property. This difference is largely one of form, not substance, so the ITAA 1997 definition can be used without affecting the result.

4.40 The Schedule 2E definition of 'motor car or car' is based on the ITAA 1997 definition of 'car' but excludes certain cars modified to carry the disabled. The rewrite incorporates that exclusion directly into the operative provisions . [Schedule 3, item 2, paragraph 242-10(1)(d)]

4.41 The Schedule 2E definition of 'short-term hire agreement' relies, in part, on the rule in section 42A-125 about treating consecutive short-term hiring agreements as leases. The existing definition of 'short-term hire agreement' in the ITAA 1997 already broadly captures that idea, so section 42A-125 is omitted. A small difference is that section 42A-125 applies to consecutive periods totalling over six months, while the ITAA 1997 definition refers to agreements that add up to 'longer than a short-term basis'. The explanatory memorandum that added that definition referred to that period as being 'longer than a few months' (see paragraph 5.26 of the explanatory memorandum to the New Business Tax System (Simplified Tax System) Bill 2000), so the two ideas are substantially the same.

Relying on the ordinary meaning of the term

4.42 Some definitions (for example, the definition of 'lessee' of a leased car) simply restate the term's ordinary meaning and are omitted for that reason. The definitions omitted for this reason are: 'extension', 'finance charge', most of the definition of 'lease', 'leased car', 'lease term', 'lessee', 'lessor', and part of the definition of 'implicit interest rate'.

4.43 The definition of 'lease' describes the ordinary meaning of lease but then adds that hire-purchase agreements and short-term hire agreements are not leases. The rewrite omits the definition of 'lease', thus relying on its ordinary meaning, but incorporates the restriction on hire-purchase agreements and short-term hire agreements directly into the operative rules . [Schedule 3, item 2, paragraph 242-10(1)(a)]

4.44 'Implicit interest rate' is defined to mean the rate of compound interest for the accrual period at which the present values of actual payments equal the notional loan principal. In the rewrite, this content is incorporated (in slightly different words) in the formula for working out the lessor's accrual amounts [Schedule 3, item 2, subsection 242-35(2)]. The current definition then provides rules that require a reasonable estimate to be made when the present values of the actual payments are not known at the start of the lease. The rewrite omits those rules on the basis that this is the course that would be taken anyway when applying the definition in such circumstances.

Not using the term in a defined way

4.45 For some defined terms, the provisions are rewritten to avoid having to use the terms in a defined way at all (for example, the rewrite continues the current use of 'notional loan' as a label for the loan the lessor is taken to have made to the lessee but no longer makes it into a definition). The definitions omitted for this reason are: 'accrual period', 'notional loan' and 'notional loan principal'.

Adding definitions to the ITAA 1997 Dictionary

4.46 The remaining definitions are moved into the ITAA 1997 Dictionary to apply across the Act. The definitions moved in this way are: 'lease payment', part of the definition of 'lease payment period', part of the definition of 'luxury car', and 'termination amount'. In some cases, the labels are altered . [Schedule 3, items 51 to 53 and 59, 'luxury car lease payment', 'luxury car lease payment period', 'luxury car' and 'termination amount' in subsection 995-1(1)]

4.47 The core definition of 'lease payment period' is moved into the Dictionary (as the term 'luxury car lease payment period') but the special rules that ensure payment periods can be no longer than six months are incorporated directly into the operative rules . [Schedule 3, items 2 and 52, subsection 242-35(3) and 'luxury car lease payment period' in subsection 995-1(1)]

4.48 The core definition of 'luxury car' (which looks to whether the capital allowance provisions would reduce depreciation deductions) is moved into the Dictionary. It is written by reference to the time at which it is necessary to know whether the car is a luxury car, while the Schedule 2E definition asks whether the car was a luxury car when the current owner first leased it. That allows the definition to be used for purposes other than the leasing provisions. The timing rule in the Schedule 2E definition is instead located in the operative rules . [Schedule 3, items 2 and 53, paragraph 242-10(1)(b) and 'luxury car' in subsection 995-1(1)]

4.49 The Schedule 2E definition of 'luxury car' asks whether the capital allowance deductions for the car would be reduced by Division 40 but also asks whether it would have been reduced by the predecessors of Division 40. The rewrite moves the references to those earlier provisions into the IT(TP)A 1997 because of their limited future relevance . [Schedule 3, item 60, subsection 242-10(3) of the IT(TP)A 1997]

4.50 The Schedule 2E definition of 'termination amount' is substantially the same as the existing definition in the ITAA 1997 (in section 240-78). The difference is that the ITAA 1997 definition expressly covers insurance payments on loss or destruction of property while the Schedule 2E definition uses the 'value of the car' as the default amount in all non-acquisition cases. Given the way insurance payments for loss or destruction are usually calculated, there is little or no difference in result. Therefore, the rewrite retains the ITAA 1997 definition but relocates it from section 240-78 to the Dictionary . [Schedule 3, items 30 and 59, section 240-78 and 'termination amount' in subsection 995-1(1)]

Application and transitional provisions

Application

4.51 The rewrite applies to assessments for the 2010-11 income year and later income years. For most taxpayers, the 2010-11 income year starts on 1 July 2010. For taxpayers with a substituted accounting period, their 2010-11 income year will start on a different day . [Schedule 3, item 60, subsection 242-10(1) of the IT(TP)A 1997]

Consequential amendments

4.52 The amendments update references in the law to Schedule 2E provisions that are rewritten into the ITAA 1997 . [Schedule 3, items 3 to 5, 7, 11 to 13, 15, 16, 19, 20, 38, 46 and 56, subparagraphs 118-12(2)(a)(vii), 118-12(2)(b)(viii), 118-12(2)(b)(ix) and 974-130(4)(a)(iii), paragraph 240-115(2)(b), subsections 25-35(4A), 28-12(1) (note 2), 28-45(1) (note 1), 28-90(6) (note 1), 40-185(1) (note), 40-305(1) (note) and 'special accrual amount' in subsection 995-1(1), and 'leases of luxury cars' in section 10-5, 'notional sale and loan' in section 11-55 and 'leases of luxury cars' in section 12-5]

4.53 References to a 'finance charge' in Schedule 2E and in Division 240 of the ITAA 1997 (which uses a similar 'sale and loan' approach for hire purchase) are replaced with references to 'interest'. This adopts a more intuitive label; it does not change the substance of the provisions. Other provisions that refer to the Schedule 2E or Division 240 finance charge have been changed accordingly . [Schedule 3, items 8, 24 to 26, 35, 36 and 48, heading to Subdivision 240-G, paragraph 240-30(a), subsections 25-35(4B), 240-25(4), 240-25(6) and 'finance charge' in subsection 995-1(1), and section 240-100]

4.54 Asterisks are used in the ITAA 1997 to help readers by marking defined terms. The amendments add some asterisks, and remove others, mostly because undefined terms are converted into defined terms and vice versa . [Schedule 3, items 6, 9, 17, 18, 23, 25, 27, 29, 31 to 34, 37, 39 to 42, 45, 47, 49 and 50, paragraphs 40-755(4)(b), 43-175(2)(a) and 240-90(4)(a), subsections 25-35(4A) and (4B), 240-25(6), 240-60(1) (steps 1 and 4 in the method statement), 240-80(4), 240-80(5), 240-105(4) (formula), 243-15(5), 243-20(4), 243-25(2), 243-30(2), 855-55(4) and 'depreciating asset', 'in-house software' and 'IRU' in subsection 995-1(1), and section 240-10]

4.55 A number of amendments are made as a consequence of assimilating terms used in Schedule 2E into the definitional structure used in the ITAA 1997 . [Schedule 3, items 10, 14, 30, 39 to 42, 54, 55 and 59, subsections 25-35(4C), 243-15(5), 243-20(4), 243-25(2), 243-30(2) and 'notional loan', 'notional loan principal' and 'termination amount' in subsection 995-1(1), and sections 40-40 (item 1 in the table) and 240-78]

4.56 The expression 'subject to tax' is defined in the ITAA 1997 to mean subject to tax in certain foreign countries, but is used frequently within its (undefined) ordinary meaning. This is inconsistent with the ITAA 1997 approach to definitions, which requires that a defined expression not also be used in an undefined way. The amendments change the label for the definition to 'subject to foreign tax' and update the references in each case where it is intended to be used in the defined way . [Schedule 3, items 43 to 45, 57 and 58, heading to section 830-75, subsections 855-55(4) and 'subject to tax' and 'subject to foreign tax' in subsection 995-1(1), and section 83-75]

Legislative history of Schedule 2E

4.57 Schedule 2E to the ITAA 1936 was added by the Taxation Laws Amendment Act (No. 2) 1997 [ Act No. 95 of 1997].

4.58 These Acts have amended Schedule 2E: