Entities undertaking social infrastructure projects such as hospitals, schools, water treatment and sewerage plants should now be reviewing their traditional approach to asset financing arrangements, especially their debt funding structures, following the introduction of long-awaited changes to the tax laws.
The Tax Laws Amendment (2007 Measures No. 5) Bill 2007, which was introduced into Parliament yesterday, will introduce proposed new rules relating to asset financing arrangements involving tax preferred entities into Division 250 of the Income Tax Assessment Act 2007. Subject to certain transitional rules, they will replace section 51AD and Division 16D of the Income Tax Assessment Act 1936 with effect from 1 July 2007.
Broadly, the new rules will apply where there is an arrangement between a taxpayer and a tax preferred entity (that is, a tax exempt or a non-resident) under which the tax preferred entity uses or controls the use of an asset (the tax preferred use) and the taxpayer lacks a predominant economic interest in the asset.
As widely anticipated, the changes will mean that the asset financing provisions will no longer apply to certain arrangements, such as some long-term government tenancies. Moreover, infrastructure projects, such as toll roads, will be clearly outside the scope of the asset financing rules. Furthermore, even if arrangements are caught by the new laws, the consequences of Division 250 are far less punitive than those under section 51AD and Division 16D.
Limited recourse debt levels and the predominant economic interest
While Division 250 applies to the same types of arrangements that are currently caught by section 51AD and Division 16D, it introduces a requirement that a taxpayer establish that it has a predominant economic interest in an asset the subject of such an arrangement.
This means that ensuring that an arrangement is financed by less than 50 percent limited recourse debt will no longer be enough to avoid the application of the provisions.
Consequently, social infrastructure projects which have previously managed their limited recourse debt levels to ensure that they were excluded from section 51AD will now have to consider a wider range of criteria. Moreover, the use of contingent equity arrangements to re-characterise limited recourse debt has been curtailed by the apparent need for direct access to specific security.
What is now excluded?
Division 250 excludes a more extensive series of arrangements than section 51AD and Division 16D.
As well as de minimis exclusions relating to arrangements of less than 12 months duration or involving less than $5 million, Division 250 will not apply to:
- small business entities
- low value and relatively short-term arrangements which satisfy certain operating and finance risk tests
- arrangements where the assessable amount under Division 250 is less than the amount which would otherwise be assessable
- sale and leasebacks between private entities; and
- arrangements excluded at the Commissioner's discretion.
In addition, the effect of the "economic interest" test, discussed below, is to now exclude many more long-term tenancy arrangements with tax preferred entities (see below).
Use and control
Tax preferred usecovers the types of arrangements already caught by section 51AD and Division 16D, including the lease of assets and the production, delivery, provision or transmission of goods and services.
In addition, Division 250 will specifically apply to arrangements relating to the provision of facilities (defined to include infrastructure facilities such as hospitals, land and other transport and the supply of gas, water and electricity).
The concept of use and control in this context however is similar to that in section 51AD and Division 16D. The Explanatory Memorandum to the Bill contains several examples which suggest that infrastructure projects will not be subject to Division 250. For example, where a tax preferred entity has step-in-rights which temporarily allow it to take control of an asset, this will not be considered to mean the tax preferred entity has control of the asset. In addition, projects such as toll-roads will not be caught by Division 250 as the public rather than the tax preferred entity will be the user of the asset. Consequently, it is still possible to ensure that the asset financing provisions do not apply by managing the use and control of an asset.
A taxpayer will lack a predominant economic interest in an asset and thus be subject to Division 250 in any of the following circumstances:
- the cost of the acquisition or construction of the asset is funded by more than 80 percent limited recourse debt (55 percent where the tax preferred entity is a non-resident) - compared to a 50 percent limit under section 51AD; or
- the tax preferred entity has a right to acquire the asset for an amount other than market value at the time; or
- the arrangement exceeds the lesser of 30 years and 75 percent of the effective life of the asset; or
- the asset has a guaranteed residual value; or
- the arrangement (for example, the lease) is a debt interest for tax purposes - this is additional to the rules in section 51AD and Division 16D; or
- the present value of the financial benefits provided to the taxpayer (for example, any guaranteed residual value) exceed 70 percent of the market value of the asset or the deductible expenditure in relation to the asset - this is additional to the rules in section 51AD and Division 16D.
Notwithstanding the 80 percent limited recourse debt threshold, where a taxpayer which is a company funds the acquisition or construction of an asset with more than 80 percent limited recourse debt, that company will not be taken to lack a predominant economic interest where:
- if arrangement is not a lease of real property, the company does not receive any financial support (for example, guarantees) from any tax preferred entity; or
- if the arrangement is a lease of real property, less than 50 percent of the building is leased to tax preferred entities and the company does not receive any financial support from any tax preferred entity.
Furthermore, where a taxpayer which is a trustee funds the acquisition or construction of an asset with more than 80 percent limited recourse debt, that trustee will not be taken to lack a predominant economic interest where
- the trustee leases a building; and
- less than 50 percent of the building is leased to tax preferred entities; and
- the trustee does not receive any financial support from any tax preferred entity.
This can be contrasted with the current situation under section 51AD where the use of the building by tax preferred entities funded by more than 50 percent limited recourse debt will trigger the application of section 51AD.
What happens if Division 250 does apply?
If Division 250 does apply to an arrangement, the adverse consequences will be less extreme than those which currently apply under section 51AD and Division 16D:
- a taxpayer will be denied capital allowances relating to the asset, however, there is scope for an apportionment such that it will not necessarily be the case that all capital allowances are disallowed
- the arrangement will be treated as a loan and taxed as a financial arrangement on a compounding accruals basis. That is, the ultimate gain or loss on the notional loan will be spread over the period of the arrangement and will be either included in the taxpayer's assessable income or give rise to an allowable deduction. In addition, certain balancing adjustments will be triggered where a taxpayer disposes of their rights and obligations under an arrangement.
When does all this come into effect?
If enacted in its current form, Division 250 will apply as follows:
- where the tax preferred use of an asset starts on or after 1 July 2007 and the parties had not entered into a contract relating to the tax preferred use of that asset prior to 1 July 2007 - Division 250 applies;
- where a contract relating to the tax preferred use of an asset was entered into prior to 1 July 2007 but the tax preferred use of the asset does not commence until on or after 1 July 2007 and the taxpayer elects for Division 250 to apply - Division 250 applies instead of section 51AD and Division 16D; and
- where a contract relating to the tax preferred use of an asset was entered into prior to 1 July 2007 and immediately prior to 1 July 2007 section 51AD and Division 16D did not apply and then the contract is materially altered on or after 1 July 2007 (for example, by changing from full recourse debt to 90 percent limited recourse debt) such that section 51AD and Division 16D would otherwise apply - Division 250 applies instead of section 51AD and Division 16D.
In addition, section 51AD will cease to apply from 1 July 2007 where a contract relating to the tax preferred use of an asset was entered into before 1 July 2007 and the tax preferred use of that asset started on or after 1 July 2003 but before 1 July 2007.
In other words, as from 1 July 2007, arrangements entered into and commencing between 1 July 2003 and 1 July 2007 will no longer be subject to section 51AD and will also not be subject to Division 250. In these cases, it is likely that such arrangements will be subject to Division 16D from 1 July 2007.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.