Changes to the taxation of leases

Sections EE 28(4), EE 46(2), EE 52(7), EX 21(30), FC8H, FC 8I and OB 1 (definitions of "finance lease" and "lease") of the Income Tax Act 2004; sections CH 6, DB 51B, EE 35(4), EE 55(2), EE 61(8), FA 11, FA 11B and YA 1 (definition of "finance lease") of the Income Tax Act 2007

Changes to the taxation of leases mean that certain lease arrangements involving assets used overseas will be classified as finance leases, or that lessors will have allowable depreciation deductions for lease assets reduced.

Background

The changes are necessary to prevent depreciation losses being claimed on overseas assets in which the New Zealand taxpayer has no real economic interest. Such schemes undermine the New Zealand tax base.

Key features

The definition of "finance lease" has been widened to include certain lease arrangements that satisfy three conditions:

• they involve use of the lease asset wholly or mainly overseas; and
• they involve income of a person other than the lessor that is not subject to New Zealand income tax; and
• substantially all the risks and rewards incidental to ownership of the lease asset lie with a person other than the lessor.

Leases entered into on or after 20 June 2007 that are covered by the changes to the definition of "finance lease", either at inception or at a specified later time will be classified as finance leases for tax purposes. If the lease was an operating lease at inception, the change to a finance lease will require an adjustment to assessable income or deductions (almost certainly income rather than deductions) in the year of change.

Operating leases entered into before 20 June 2007 but covered by the new part of the definition of "finance lease" on that date may continue as operating leases. However, allowable depreciation deductions will be reduced by one-sixth, with one-sixth of any previously claimed depreciation recognised as additional assessable income in the income year beginning after 20 June 2007.

Application date

The new rules apply to all leases entered into on or after 20 May 1999 (being the date the finance lease rules became effective), and for the income year including 20 June 2007 and later income years.

Detailed analysis

Expanded definition of "finance lease" (section OB 1 of the Income Tax Act 2004 and section YA 1 of the Income Tax Act 2007)

A new paragraph (c) has been added to the definition of "finance lease" and contains three tests. The new paragraph applies to leases that were entered into on or after 20 May 1999, for income years including 20 June 2007 and later income years.

The remainder of the definition is unaffected by the change and continues to apply as normal.

The paragraph (c) tests

The three tests in paragraph (c) are:

• an "overseas use" test (subparagraph (i));
• an "income not subject to tax" test (subparagraph (ii)); and
• an "economic substance" test (subparagraph (iii)).

Overseas use test (subparagraph (i))

The lease, or an arrangement of which the lease is a part, must involve use of the lease asset outside New Zealand for all or most of the term of the lease.

Income not subject to tax test (subparagraph (ii))

The lease, or an arrangement that includes the lease, must involve a person other than the lessor who derives certain classes of income from the use - by any person - of the asset. The income must be excluded income, exempt income or non-residents' foreign-sourced income. The test may be satisfied by a sub-leasing arrangement, if any of the lessees in the chain of lessees derive these types of income.

The definition is not expected to be satisfied in relation to the lease when there are two parties to the lease and both are fully subject to New Zealand income tax.

Economic substance test (subparagraph (iii))

The lease, or an arrangement that includes the lease, must be:

• an arrangement under which substantially all the risks and rewards incidental to ownership, as if assessed at the beginning of the lease but taking account of all changes in terms which have actually occurred ²²are borne by persons other than the lessor; and/or
• a finance lease under NZ IAS 17, either for the taxpayer or for another company in the same group of companies that derives assessable income from the arrangement.

The two limbs of the economic substance test are similar. The test based on NZ IAS 17 is intended to reduce compliance costs. If a taxpayer (or group company that derives assessable income from the arrangement) is accounting for the lease as a finance lease under NZ IAS 17, there is no need to apply the other limb of the test; the lease is automatically a finance lease. It is expected that most taxpayers engaging in the leasing of assets overseas would be required to comply with NZ IAS 17.

When the lease is not treated as a finance lease under NZIAS 17, the other limb of the test must be evaluated. The assessment of risks and rewards under that limb is done as if at the time of entering the lease, but taking account of all changes in terms that are known about when the evaluation takes place.

As in NZ IAS 17, it is intended that risks include (but not be limited to) "the possibilities of losses from idle capacity or technological obsolescence and of variations in return because of changing economic conditions" and that rewards include (but not be limited to) "the expectation of profitable operation over the asset's economic life and of gain from appreciation in value or realisation of a residual value" (see paragraph 7 of that standard). Paragraphs 10 to 12 of that standard provide some further guidance.

A "group of companies" is defined in section IG 1(2) of the Income Tax Act 2004 (section IC 3(1) of the Income Tax Act 2007) essentially as "any group of companies having a 66 percent or greater common shareholding". When another company in the same group classifies the lease as a finance lease under NZ IAS 17, the economic substance test is taken to be satisfied, even if the taxpayer does not classify the lease as a finance lease under NZ IAS 17. This might occur, for example, when a company enters into the lease and a parent company contemporaneously enters into a transaction with the lessee to make a residual value payment (it is likely that in such cases the other limb of the economic substance test will be satisfied anyway).

Group companies that do not derive assessable income from the lease (or an arrangement of which the lease is a part) are excluded from the test. However, existing transfer pricing rules in the Income Tax Act may apply when these companies are involved in the lease arrangement, if there are non-arm's length terms. (The role of these companies may also be considered as part of a wider review of leasing rules, which was signalled in the announcement of the government's tax policy work programme on 26 October 2007.)

Application of the tests

The three tests in paragraph (c) are applied:

• If the lease is entered into on or after 20 June 2007, when the lease is entered into and again whenever the terms of the lease (or of an arrangement of which the lease is a part) change in a way which changes the allocation or size of the risks and rewards incidental to ownership of the lease asset.
• If the lease is an operating lease entered into before 20 June 2007, on 20 June 2007 (in this case the three tests are invoked by section FC 8I(1) in the Income Tax Act 2004 or section FA 11B(1) in the Income Tax Act 2007, and the text before subparagraph (i) in the definition is ignored)

Leases entered into on or after 20 June 2007 (section FC 8H of the Income Tax Act 2004 and sections CH 6, DB 51B and FA 11 of the Income Tax Act 2007)

Most leases entered into on or after 20 June 2007:

• will be classified as finance leases from the outset if the three tests in paragraph (c) of the definition of "finance lease" are satisfied at the outset; or
• will have to be reclassified as finance leases from a date the three tests are satisfied, if they are not satisfied at the outset.

In the case of reclassification, there will be a consequential adjustment to income or deductions (almost certainly income rather than deductions).

The consequential adjustment to income or deductions, in the case of reclassification, is determined according to section FC 8H of the Income Tax Act 2004 (formerly section FC 8H/8I) or section FA 11 of the Income Tax Act 2007. The adjustment is assessable income or a deduction in the income year in which the reclassification occurs. In the Income Tax Act 2007, sections CH 6 and DB 51B deem the income or deduction to exist, consistent with the structure of the new Act.

Section FC 8H of the Income Tax Act 2004 and section FA 11 of the Income Tax Act 2007 are intended to have the same practical consequences for leases not affected by paragraph (c) of the definition of "finance lease" as sections FC 8H/8I and FA 11 (respectively) had before the rule change.

A lease which becomes a finance lease remains a finance lease until the end of the lease term (which may include the term of consecutive or successive leases).

Leases entered into before 20 June 2007 (sections EE 28(4), EE 46(2), EE 52(7) and FC8I of the Income Tax Act 2004, and sectionsEE35(4), EE 55(2), EE 61(8) and FC 11B of the Income Tax Act 2007)

For most operating leases entered into before June 2007:

• the leases will continue to be operating leases (unless they become finance leases at a later date other than under paragraph (c) of the definition of "finance lease");
• the New Zealand lessor will have to reduce the depreciation deductions that would normally be allowed for the lease asset by one-sixth; and
• the New Zealand lessor will have to recognise, as income, one-sixth of depreciation deductions already allowed for the lease asset over the lease term.

If the three tests in paragraph (c) of the definition of "finance lease" are satisfied by the lease on 20 June 2007 (ignoring the requirements that the lease be entered into on or after 20 June and that the lease is being entered into or the terms of the lease are changing) then the lessor must make an adjustment to income and to future depreciation deductions.

No effect on some leases (section FC 8I(1) of the Income Tax Act 2004 and section FA 11B(1) of the Income Tax Act 2007)

Section FC 8I of the Income Tax Act 2004 and section FA 11B of the Income Tax Act 2007 apply only to leases entered into on or after 20 May 1999. It has no effect on leases entered into before 20 May 1999.

The new rules will also have no effect on leases that are entered into before 20 June 2007 that either end before the beginning of the income year following 20 June 2007, or become finance leases before the end of the income year following 20 June 2007. In the former case, the existing depreciation rules will ensure that any excess depreciation is recovered (provided there is disposal of the asset). In the latter case, section FC 8H of the Income Tax Act 2004 or section FC 11 of the Income Tax Act 2007 will apply.

Adjustment relating to past deductions

In the income year following 20 June 2007, the lessor must recognise an adjustment to income equal to one-sixth of depreciation deductions previously allowed for the lease asset. Deductions allowed for depreciation losses for periods before the start of the lease are not included. The adjusted tax value (ATV) of the lease asset, at the beginning of the income year following 20 June 2007, is increased by the amount of the adjustment to income.

Subsequent depreciation deductions reduced

In income years following 20 June 2007, and while the lease remains an operating lease, the depreciation losses which would otherwise be allowed are reduced by one-sixth. The losses which would otherwise be allowed are taken to be the deductions which would have been allowed in the absence of section FC 8I of the Income Tax Act 2004 (section FA 11B of the Income Tax Act 2007), except that the adjusted tax value calculated under that section should apply.

There are consequential amendments to sections EE 28(4), EE 46(2) and EE 52(7) of the Income Tax Act 2004, and to sections EE 35(4), EE 55(2) and EE 61(8) of the Income Tax Act 2007. These are effectively prompts to readers of the depreciation rules that the lease provisions may affect the allowable deduction.

Depreciation recovery income under section EE 41(1) of the Income Tax Act 2004 or section EE 48(1) of the Income Tax Act 2007, and deductions allowed for loss on sale under section EE 41(2) of the Income Tax Act 2004 or section EE 48(2) of the Income Tax Act 2007, are not reduced by one-sixth by the new rules.

When section FC 8I of the Income Tax Act 2004 or section FA 11B of the Income Tax Act 2007 applies to a lease, it will continue to apply until the end of the lease term unless the lease becomes a finance lease. Such a lease may become a finance lease, for example, because an extension of the lease term means paragraph (b) of the definition of "finance lease" is satisfied. In this case, section FC 8H of the Income Tax Act 2004 or section FA 11 of the Income Tax Act 2007 would apply.

Other consequential amendments

In the Income Tax Act 2004, there is a consequential amendment to the definition of "lease", because the former sections FC 8H and FC 8I have now been consolidated into section FC 8H. A similar change has been made in section EX 21(30) of that Act. These changes are not required in the Income Tax Act 2007.

²¹ When the terms of the lease change, the examples assume, for simplicity, that the same lease continues with the changed terms. In reality, taxpayers will need to assess whether for tax purposes the existing lease continues (including as a consecutive or successive lease) or a new lease is created. The examples should not be taken as providing any guidance for this assessment.

²²...determined as at the time the person enters into the lease and taking into account later changes to the arrangement