Hire purchase agreement: notional sale - 'start of the arrangement'

Where a taxpayer is taken to have acquired an asset pursuant to section 240-20 of the Income Tax Assessment Act 1997 (ITAA 1997), is the 'start of the arrangement' when the lease term commences?

Yes. Where a taxpayer is taken to have acquired an asset pursuant to section 240-20 of the ITAA 1997, the 'start of the arrangement' is when the lease term commences.

The taxpayer enters into a written agreement, titled a lease, with another entity.

Under the terms of the agreement the taxpayer agrees to lease an asset from the other entity. Before the lease period can commence the other entity must perform the following obligations: • substantial conversion works (including design, construction and testing) to an existing asset resulting in an asset with a significantly different form and function • delivery of the modified asset to the taxpayer • installation of the asset; and • testing and certification that the asset is ready for use

The agreement is executed approximately 18 months before the lease period is due to commence. The agreement sets out the terms and conditions of the design, construction and thereafter, the lease of the asset to the taxpayer. The lease period is 5 years commencing on the date that the asset is ready for use.

The agreement satisfies the definition of 'hire purchase agreement' in subsection 995-1(1) of the ITAA 1997.

(All legislative references are to the ITAA 1997)

The broad policy objective of Division 240 is to treat 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.

In this case the lease agreement entered into by the taxpayer is an arrangement to which Division 240 applies because it satisfies the definition of 'hire purchase agreement' in subsection 995-1(1) and section 240-10 applies to the arrangement.

Subsection 240-20(1) provides that the notional seller is taken to have disposed of the property by way of sale to the notional buyer, and the notional buyer is taken to have acquired it at the start of the arrangement. The notional sale has the following consequences: • the notional buyer becomes the holder of a depreciating asset and may therefore be entitled to capital allowance deductions under Division 40. • if the property is not trading stock of the notional seller and the consideration for the notional sale exceeds the notional seller's acquisition cost the excess is included in the notional seller's assessable income in the income year of the notional sale (subsection 240-35(2)).

Division 240 does not expressly deal with contracts of the type under consideration here, where goods are provided under an agreement that includes hire purchase terms as well as terms that impose obligations on the notional seller to provide services in relation to the goods.

In applying section 240-20 to such an agreement it is therefore necessary to determine the meaning of the expression 'start of the arrangement'.

'Start of the arrangement' is not defined for the purposes of the ITAA 1997. If the words in subsection 240-20(1) are read literally and in isolation the word 'start' could refer to the form of the arrangement or to the substance of the arrangement. In other words, if the word 'start' relates to form then the start of the arrangement would be the date on which the contract is executed. On the other hand, if it relates to the substance it would be the date on which the terms of the contract, directly referable to hiring the asset, begin to be performed, that is when the lease term commences.

Division 240 re-characterises some arrangements as a sale and a loan for tax purposes. The division changes the substance of those arrangements rather than their form. Interpreting the 'start of the arrangement' to mean when the lease term commences rather than the earlier time when the contract is executed is consistent with the object of the legislation to recast a hire purchase transaction as a sale of property by the financier to a buyer financed by a loan by the financier to the buyer (refer to paragraphs 2.10 to 2.14 of the Explanatory Memorandum to the Tax Laws Amendment Bill (No.5) 1999). It is for this reason that the preferred interpretation is that 'start of the arrangement' means when the lease term commences.

In interpreting a provision the whole of the statute in which it appears, including the context, the general purpose and policy of the provision and its consistency and fairness need to be considered. ( Commissioner for Railways (NSW) v. Agalianos (1955) 92 CLR 390 at 397, Project Blue Sky Inc v. Australian Broadcasting Authority (1998) 194 CLR 355 at 381).

Interpreting 'start of the arrangement' to mean when the lease term commences aligns the time when the notional buyer is taken to acquire the asset with the time when the asset starts to decline in value under section 40-60 - that is when it is first used or installed ready for use. It is consistent with the purpose of Divisions 40 and 240 to allow the hirer of a depreciating asset under a hire purchase agreement to claim deductions for the decline in value of the asset where the arrangement is substantially one to acquire the asset.

Taxation Ruling TR 2005/20 explains the interaction of deemed ownership under Division 240 with the holding rules in Division 40. Paragraph 21 of that ruling states: The Commissioner's view is that the notional buyer can be taken to be the holder of the goods under either item 6 or item 10. The requirements to 'hold' under item 6 and to own under Division 240 were intended by the drafters to achieve the same result namely to entitle the economic owner (as opposed to the legal owner) to any deductions for the decline in value of the goods. Although there are two mechanisms in the ITAA 1997 for ascertaining whether the notional buyer is the holder, in the great majority of cases, both mechanisms achieve precisely the same result, and so it does not really matter which item is taken to be satisfied

As stated at paragraph 23 of the Ruling, item 6 and Division 240 cumulatively express the circumstances in which a hirer of the asset is entitled to a decline in value deduction.

It follows that: (i) subsection 240-20(1) applies to depreciating assets which start to be held under item 6 that is, those assets which the hirer possesses or has the right to possess immediately; and (ii) the start of the arrangement does not occur until the hirer possesses the asset or has the right to possess the asset immediately.

In this case the hirer obtains the right to immediately possess the asset when the lease term commences. This matches the time when the asset is ready for use and commences to decline in value under section 40-60.

Although the explanatory memorandum does not contain an example on all fours with this case, the example in paragraph 2.63 is consistent with this interpretation. In the context of those particular facts it is concluded that the arrangement starts when the first payment is due and payable.

Another reason to prefer this interpretation is that if the start of the arrangement is the date the contract is executed, the conversion costs incurred by the notional seller after this date would be excluded from the cost of acquisition of the property under subsection 240-35(2). This would subject the notional seller to an inflated profit on the notional sale and is an outcome that the legislature could not have intended.

In contrast, if the start of the arrangement is when the lease term commences then the cost of acquisition by the notional seller of the converted asset will include all the costs incurred prior to that date. This interpretation results in a fairer outcome, conforms with the general legislative intent and is therefore the preferred interpretation.