Transfer of depreciable property between associated persons - section EE 33 of the Income Tax Act 2004 (September 07)

This statement also appears in Tax Information Bulletin, Vol. 19, No. 9 (October 2007).

Introduction

1. When a taxpayer acquires depreciable property from an associated vendor the taxpayer's depreciation base is generally limited to the original cost of the property incurred by the associated vendor. The Commissioner of Inland Revenue ("the Commissioner") can however exercise a statutory discretion to allow depreciation based on the cost to the taxpayer if the Commissioner considers that such treatment is "appropriate".
   
   
2. This Standard Practice Statement ("SPS") sets out various factors that the Commissioner will consider in deciding whether the taxpayer should be permitted depreciation based on the taxpayer's cost when acquiring depreciable property from an associated person.

Application

3. This SPS applies to decisions made by the Commissioner from 14 September 2007. It replaces the item "Depreciation on secondhand assets" published in Tax Information Bulletin, Vol. 4, No. 5 (December 1992) and other past Inland Revenue practices regarding section EE 34 of the Income Tax Act 2004 (Please note: the order of former sections EE 33 and EE 34 was reversed as a result of section 40 of the Taxation (Savings Investment and Miscellaneous Provisions) Act 2006. The amendment was made to better reflect the generally applicable rule first. It also provides that in a non-qualifying amalgamation, the rule in the current section EE 34 will override the general rule in the current section EE 33.)
   
   
4. Unless specified otherwise, all legislative references in this SPS refer to the Income Tax Act 2004 ("ITA 04").

Standard Practice

5. Section EE 33(3) limits the basis on which a taxpayer can calculate depreciation on depreciable property that has been transferred from an associated person. However, the Commissioner has the discretion to permit depreciation to be based on the actual cost price of the depreciable property to the taxpayer when the Commissioner considers that such treatment is appropriate in the circumstances.
   
   
6. The Commissioner may exercise the discretion under section EE 33(4)(a)(ii) in the taxpayer's favour in accordance with the criteria explained below. Primarily, these are based on matters considered in New Zealand and Australian cases on equivalent legislation, but also include other criteria that the Commissioner considers relevant, including the overall commercial context in which the transfer takes place and the obligation to protect the integrity of the tax system under section 6 of the Tax Administration Act 1994 ("the TAA").
   
   
7. The discretion cannot be exercised as of right. In deciding whether or not to exercise the discretion under section EE 33(4)(a)(ii), the Commissioner will consider all relevant factors in the context in which the transfer has taken place, including a full analysis of the following factors:
   
   
   1. Whether the transfer is genuine,
      
      
   2. Whether the transfer is made at no more than the fair market value,
      
      
   3. Whether there is a permanent transfer of legal ownership of the property,
      
      
   4. Whether the associated vendor (or its controllers) continues to retain virtual ownership of, or beneficial interest in, the transferred property:
      
      
      1. Through power over or control of the associated purchaser, or
         
         
      2. Through a leaseback or similar agreement, or
         
         
      3. Through continued actual use of the transferred property for income-producing purposes, and
         
         
   5. The commercial or non tax-related reasons for the transfer of the property.
      
      
8. It is important to note that none of the above factors are decisive on their own. The Commissioner will give appropriate weight to each factor on a case-by-case basis before deciding whether or not to exercise the discretion.

Background

9. Inland Revenue's practice on the transfer of depreciable property between associated persons was published in Tax Information Bulletin, Vol. 4, No. 5 (December 1992). The practice referred to section 111(2) of the Income Tax Act 1976, which was the predecessor to the repealed section EG 17(2) of the Income Tax Act 1994 and the current section EE 33(4)(a)(ii). The practice reflects the High Court decision in CIR v Lys & Others (1988) 10 NZTC 5,107.
   
   
10. It is recognised that the past practice did not fully reflect the law that developed from the case law in New Zealand and Australia, and did not address every factor that might be relevant. The Commissioner has now taken the opportunity after the rewrite of the Income Tax Act 2004 to fully review the criteria that are relevant to the exercise of the discretion. The updated guidelines produced in this SPS will ensure that consistent decisions are made in relation to the exercise of the discretion.

Legislation

11. Sections EE 33 is relevant to this SPS. Section EE 33 applies for the 2005-06 and later income years, except for subsection (3)(a)(ii). The subsection applies for the 2006-07 and later income years. Section EE 33 reads:
    
    EE 33 Transfer of depreciable property on or after 24 September 1997
    
    EE 33(1) WHEN THIS SECTION APPLIES This section applies when, on or after 24 September 1997, a person (person A) acquires, directly or indirectly, an item of property from an associated person to whom 1 of the paragraphs in subsection (2) applies. The income year referred to in the paragraphs is the income year of the associated person.
    
    EE 33(2) ASSOCIATED PERSON The associated person must be a person to whom 1 of the following paragraphs applies:
    
    
    1. the associated person is allowed a deduction for an amount of depreciation loss for the item for the income year in which person A acquires it:
       
       
    2. the associated person would have been allowed a deduction for an amount of depreciation loss for the item for the income year in which person A acquired it, if section EE 11(1) had not applied:
       
       
    3. the associated person was allowed a deduction for an amount of depreciation loss for the item for the income year before the income year in which person A acquired it:
       
       
    4. the associated person has been allowed a deduction for the item under section DZ 9 (Premium paid on land leased before 1 April 1993) for the income year in which person A acquired it:
       
       
    5. the associated person has been allowed a deduction for the item under section DZ 9 for the income year before the income year in which person A acquired it:
       
       
    6. the associated person would have been allowed a deduction for an amount of depreciation loss for the item for the income year in which person A acquired it, if the associated person had incurred a cost for the item for which the person was denied any other deduction and if section EE 11(1) had not applied:
       
       
    7. the associated person would have been allowed a deduction for an amount of deprecation loss for the item for the income year before the income year in which person A acquired it, if the associated person had incurred a cost for the item for which the person was denied any other deduction:
       
       
    8. the associated person would have been allowed a deduction for the item under section DZ 9 for the income year in which person A acquired it, if the associated person had incurred a cost for the item for which the person was denied any other deduction:
       
       
    9. the associated person would have been allowed a deduction for the item under section DZ 9 for the income year before the income year in which person A acquired it, if the associated person had incurred a cost for the item for which the person was denied any other deduction:
       
       
    10. the associated person would have been a person to whom any of paragraphs (a) to (i) applied, if the associated person had not made an election under section EE 8.
        
        
    EE 33(3) COST OF ITEM TO PERSON A For the purpose of determining the amount of depreciation loss that person A has, the cost of the item to person A is treated as 1 of the following:
    
    
    1. if section EE 49 applies for the associated person and the item, the lesser of-
       
       1. the cost of the item to person A:
          
       2. the item's market value when the associated person starts to use it, or to have it available for use, for the purpose of deriving assessable income or carrying on a business for the purpose of deriving assessable income; or
          
          
    2. if section EE 49 does not apply for the associated person and the item, the lesser of-
       
       1. the cost of the item to person A:
          
       2. the cost of the item to the associated person.
          

EE 33(4) EXCLUSIONS Subsection (3) does not apply-

1. if-
   
   1. the item is not depreciable intangible property; and
      
   2. the Commissioner decides that it is appropriate to use the cost of the item to person A for the purposes of determining the amount of depreciation loss that person A has for the item:
      
      
2. if the cost to person A is income of the associated person, other than under section EE 41(1):
   
   
3. if person A acquires the item under a relationship agreement or a matrimonial agreement to which section FF 16 (Depreciable property) applies.
   

EE 33(5) RATE The annual rate that person A applies to the item must be 1 of the following (not including an item of fixed life intangible property, for which the rate is set in section EE 27):

1. if person A uses the same depreciation method for the item as that used by the associated person for it, the annual rate that person A applies to it must not be more than the annual rate that the associated person applied to it:
   
   
2. if person A uses a depreciation method for the item different from the method that the associated person used for it, the annual rate that person A applies to it must not be more than a rate equivalent to the rate that the associated person applied to it, as determined by schedule 10 (Straight-line equivalents of diminishing value rates of depreciation).
   

EE 33(6) RELATIONSHIP WITH SECTION EE 34 AND SUBPART FI This section-

1. is overridden by section EE 34:
   
   
2. does not apply to a bequest of property, if it is property to which subpart FI (Effect of certain disposals and resulting acquisitions) applies and the property is disposed of at market value.

12. Sections EE 6, EE 7, EE 34, FF 16, OB 1 and subpart FI are also mentioned in this SPS. These legislative provisions are not cited here, as the primary focus of the SPS is on section EE 33(4)(a)(ii).

Discussion

13. Section EE 33 is concerned with the depreciation base that applies when depreciable property is transferred between associated persons on or after 24 September 1997 in circumstances to which subsection (2) applies. For the purposes of section EE 33, the term "associated persons" is defined in section OB 1.
    
    
14. Taxpayers should not take a tax position by claiming tax depreciation on the basis of the transfer price of the depreciable property until the Commissioner confirms that the discretion will be exercised.

General

15. The Commissioner may exercise the discretion under section EE 33(4)(a)(ii) at any time. However, taxpayers seeking the exercise of the Commissioner's discretion should make requests in writing with supporting documentation to the appropriate Inland Revenue offices. Alternatively, taxpayers may apply to the Office of Chief Tax Counsel for a private binding ruling. Requests can be made either when taxpayers are committed to the completion of the transfer of depreciable property between associated persons or when the transfer has been completed and before a tax position is taken in respect of the matter.
    
    
16. The supporting documentation should include all relevant transaction documents, correspondence and a summary of any unwritten terms of understandings between the parties. These may include:
    
    
    1. certificates of title,
       
       
    2. sale and purchase agreements,
       
       
    3. financial, gifting and legal documents relating to the transaction,
       
       
    4. independent valuation reports,
       
       
    5. acknowledgements of debt,
       
       
    6. loan agreements,
       
       
    7. constitutional documents such as trust deeds, and
       
       
    8. any other relevant information.
       

Taxpayers should also address the factors as set out in paragraphs 20 to 71 below when requesting that the Commissioner exercise the discretion.

17. In deciding whether to exercise the discretion, the Commissioner will look objectively at the substance of the transaction in the commercial or business context in which it takes place. That is, the Commissioner will need to be satisfied that the transaction is undertaken for business or commercial reasons and not just to achieve a tax advantage.
    
    
18. Particular focus will be given to whether in substance the transferred property continues to fall under the control of, form part of the assets of, or be used by the vendor or by an entity or a group of entities over which the associated vendor (or its controllers) has control or power. The presence of "virtual ownership" or a "beneficial interest" will be weighed against other factors such as any legitimate non tax-related reasons for the transfer in accordance with normal commercial and conveyancing practices, the obligation to protect the integrity of the tax system under section 6 and the Commissioner's responsibilities under the care and management provisions under section 6A of the Tax Administration Act 1994. For example, when a taxpayer's request is incomplete or ambiguous, the Commissioner will not apply a large amount of resources to elicit the information from the taxpayer for the purpose of deciding whether or not to exercise the discretion under section EE 33(4)(a)(i).
    
    
19. The expression "associated vendor" when used in this SPS includes persons who are associated with, or who have control over the associated vendor.

Factors to be applied in deciding whether the discretion should be exercised

20. In determining whether there are appropriate circumstances for the Commissioner to exercise the discretion in favour of a taxpayer, the following factors will be considered along with any other relevant factors (see paragraphs 23 to 71 of this SPS):
    
    
    1. Whether the transfer is genuine,
       
       
    2. Whether the transfer price is at no more than the fair market value,
       
       
    3. Whether there is a permanent transfer of legal ownership of the property,
       
       
    4. Whether the associated vendor (or its controllers) continues to retain virtual ownership of, or beneficial interest in, the transferred property:
       
       
       1. Through power over, or control of the associated purchaser, or
          
          
       2. Through a leaseback or similar agreement, or
          
          
       3. Through continued actual use of the transferred property for income-producing purposes, and
          
          
    5. The commercial or non tax-related reasons for the transfer of the property.
       
       
21. The Commissioner has reviewed the relevant case law, including CIR v Lys & Others, relevant Australian cases, and the policy basis for the general discretion in section EE 33(4)(a)(ii).
    
    
22. Further discussion of the relevant criteria taking into account the findings in the case law is set out below.

Factor One: whether the transfer is genuine

23. The property must be acquired as though it were an arm's length transaction and in accordance with normal commercial and conveyancing practices. The transfer of property must not be a contrivance or artifice that involves the insertion of artificial persons for the purpose of obtaining depreciation uplift.
    
    
24. The price (also see paragraphs 30 to 35 of this SPS) and other terms relating to the transfer should be consistent with an arm's length transaction. That is, they should reflect genuine bargaining between the associated parties. The separate minds and the will of the parties should have been applied to the bargaining process and be reflected in the documentation. Generally, there should be a willing seller and a willing purchaser. The associated parties should be able to demonstrate that the contract under which the transfer takes place has been negotiated in a manner that takes into account their own interests. (See Granby Pty Ltd v FC of T 95 ATC 4,240 and Mansworth (HMIT) v Jelly [2002] BTC 270.)
    
    
25. However, it is appropriate to consider the general context of the transaction. In particular, the Commissioner accepts that family dealings may be conducted in a less formal way. For example, there may not be appropriately executed documentation in family dealings. The Commissioner will then consider the totality of the circumstances in which the property is transferred in family dealings, including the evidence of the associated vendor and purchaser.
    
    
26. In Lys, the sale and purchase of a farm property from Mr Lys to his family trust involved a "Marshall" clause. The clause related to a loan between the parties that was subject to interest but only if it was demanded. The right to demand the interest avoids a gift arising even if the interest is never demanded (Re Marshall (dec'd); C of IR v Public Trustee [1965] NZLR 851). The High Court held that the transaction from Mr Lys to the family trust was nevertheless made in an arm's length manner given that the trust was properly settled and also operated at arm's length from Mr Lys, on the facts of the case. The use of the "Marshall" clause and the debt forgiveness did not mean that the transaction was inconsistent with normal commercial and conveyancing practices in that context.
    
    
27. However, if the transaction in Lys were a commercial or industrial transaction instead of a family transaction, the presence of the "Marshall" clause and debt forgiveness might be inconsistent with normal commercial and conveyancing practices. Therefore, the context of the transaction is important.
    
    
28. The Commissioner accepts that common terms of transfers within family groups will be regarded as genuine, even if financed with interest-free loans and fairly informal documentation, provided appropriately executed documentation is available that indicates a genuine intention to permanently transfer title to the property.
    
    
29. However, if a "Marshall" clause is used, it is expected that the interest rate which may be applied is set at a market rate, and not at a rate or formula allowing excess profits derived from the asset to be transferred to the vendor in the form of interest.
    

Factor Two: whether the transfer price exceeds fair market value

30. The Commissioner will not exercise the discretion if the transfer price exceeds fair market value. The term "fair market value" means that the assets are valued at a price that an arm's length third party would pay and that the association of the parties to the transfer do not influence the price. In order to show that the transfer price is at fair market value, an independent and current valuation of the assets transferred should be undertaken at the time of transfer by a professionally qualified valuer and provided to the Commissioner. The valuation result should represent a sufficiently objective approximation of the consideration in money that could be obtained for the type of depreciable property concerned.
    
    
31. The Commissioner will not accept rating or insurance valuations if they do not represent the fair market value of the depreciable property. The Commissioner is also unlikely to accept a valuation that exceeds the replacement cost of the depreciable property transferred. The Commissioner may require that a separate valuation from an independent valuer be provided in cases when there is doubt regarding the transfer price.
    
    
32. The Commissioner expects the taxpayer to use recognised and acceptable commercial asset valuation methodologies for the type of property concerned. Where applicable, the valuation methodologies should not conflict with generally accepted accounting principles and New Zealand Equivalents to International Accounting Standards ("NZ IAS").
    
    
33. Please note that the definition of "depreciable property" in sections EE 6, EE 7 and OB 1 excludes intangible property except for depreciable intangible property. On this basis, the value of the asset should not usually reflect intangible factors such as dominant market positions, brand values or be based on assumed future cash flows attributable to the use of the property.
    
    
34. The Commissioner may choose to disregard a valuation if that valuation method is not appropriate for the depreciable property transferred. (See Erris Promotions Ltd v CIR [2004] 1 NZLR 811; (2003) 21 NZTC 18,330.) The Commissioner may not accept valuations under the "discounted cash flow" or the "net present value" methods if intangibles such as the associated vendor's dominant market position and business goodwill have been included in the value of the depreciable property. It is observed that in some cases, the net present value methodology has limitations, such as not providing an appropriate basis for measuring fair wear and tear or obsolescence and the calculation of depreciation.

Partial transfers

35. In the situation when the associated vendor transfers only part of the depreciable property, issues surrounding the apportionment of the cost of the transferred part of the property may arise. In cases of partial transfers, the taxpayer must provide arm's length valuation advice in respect of that apportionment to the Commissioner to support the request for the exercise of the discretion.

Factor Three: whether there is permanent transfer of legal ownership in the property

36. Legal ownership of the property must be permanently transferred to the associated purchaser. The requirements for transfer of legal ownership differ, depending on the type of property in question. For example, in respect of land that comes under the Land Transfer Act 1952, a memorandum of transfer must be registered before transferring legal ownership. Other legal documents such as the sale and purchase agreement or title to the property may also be required to evidence a transfer of legal ownership in the property. In some cases involving chattels, possession may be sufficient evidence of a transfer of legal ownership.
    
    
37. Legal formality is only one factor. If the facts suggest that the transfer may be intended to be temporary, this test may not be met. The Commissioner may consider the transfer to be temporary if, for example, the sale agreement contains a provision that allows the associated vendor to repurchase the property at any time or if the associated vendor has expressed a clear intention that they will repurchase the property.
    
    
38. When the associated parties have negotiated for the transfer to include an option (whether formal or informal) for the associated vendor to repurchase the transferred property at a future date, these circumstances must be drawn to the attention of the Commissioner, and the Commissioner will consider the terms of the option, and the likelihood of its exercise, in determining whether the factor of permanent transfer of legal ownership is satisfied.

Factor Four: whether the associated vendor continues to benefit directly or indirectly from the transferred property

39. Lys and some Australian cases that were decided on the counterpart of section EE 33(4)(a)(ii) found that retention of virtual ownership or beneficial interest in the transferred property by the associated vendor is a factor that should be given considerable weight when deciding whether the discretion should be exercised.
    
    
40. The Commissioner considers that in the absence of evidence that would otherwise constitute strong commercial (or non tax-related) justifications for the transaction or normal business practice, the retention of virtual ownership may indicate that exercising the Commissioner's discretion under section EE 33(4)(a)(ii) would be inappropriate.
    
    
41. This is, however, not to say that retention of some degree of ownership interest by the associated vendor will always be fatal to the exercise of the discretion. Firstly, retention of a minority beneficial interest is insufficient to outweigh other factors that are in favour of exercising the discretion. (See Case X8 90 ATC 132.)
    
    
42. The findings in Case X8 are consistent with those in Case 107 (1964) 11 CTBR (NS) 640, in which the Commonwealth Taxation Board of Review in Australia held that the discretion should not be exercised because the associated vendor retained "the larger proportion of the ownership of the assets after the formation of the partnership." The decision in Case 107 implies that retention of a minority beneficial interest by the associated vendor will not be a sufficient reason in itself for the Commissioner to refuse to exercise the discretion.
    
    
43. Secondly, the Commissioner considers that in rare circumstances, the discretion may still be exercised even though there is retention of the majority ownership or beneficial interest in the transferred property. However, the taxpayer has the onus to prove that the transaction can be justified in accordance with normal commercial and conveyancing practices. (Also please see paragraphs 62 to 71 of the SPS.)
    
    
44. For example, in Case 21 (1956) 7 CTBR 106, the Commonwealth Taxation Board of Review considered that the commercial justifications for the transfer of the building, namely for the purpose of expanding its own manufacturing processes, were sufficient to outweigh the factor that the purchaser owned 98% of the associated vendor.
    
    
45. Thirdly, as shown in Case 107, the Commissioner will ascertain the potential tax advantages that would flow to the associated vendor as a result of retaining some interest in the transferred property and if the discretion was exercised. The Commissioner will then compare these potential advantages with the disadvantages borne by the purchaser of the transferred property (for example, in Case 107, the disadvantages were measured by the difference between the transfer price paid by the purchaser and the share of tax depreciation claimable on the original historical cost). If the above potential advantages far outweighed the disadvantages, this is an indicator that the discretion should not be exercised.
    

What is "virtual ownership"?

46. The concept of "virtual ownership" is referred to in the cases but not fully explained. The Commissioner considers that the following circumstances are indicative of the existence of this factor:
    
    
    1. If the vendor (or its controllers) holds power over or control of the associated purchaser,
       
       
    2. If the vendor benefits through a leaseback or similar arrangement, and/or
       
       
    3. If the vendor benefits through continued actual use of the transferred property for income-producing activity.
       
       
47. Any reference to the vendor in the following discussion is intended to also refer, where appropriate, to any persons who control the vendor. This recognises that where material economic interests in the property are retained and none of the exceptions in paragraphs 43 to 45 apply, the discretion should not be exercised.
    
    

1. Whether the vendor (or its controllers) holds power over or control of the associated purchaser
   
   

48. When the associated vendor (or its controllers) has control of the purchaser (either directly or indirectly), it is considered that the associated vendor has a material degree of virtual ownership of the transferred property.
    
    
49. The general control tests in the ITA 04 may be applied but, because they usually only apply to companies, the Commissioner will, for the purpose of section EE 33(4)(a)(ii), apply a modified set of rules based on accounting principles by reference to NZ IAS and New Zealand Financial Reporting Standards, the latter of which may continue to apply to some public benefit entities after 31 March 2007.
    
    
50. In Related Party Disclosures (NZ IAS 24) and Consolidated and Separate Financial Statements (NZ IAS 27), "control" is defined as "the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities." The Commissioner considers that both the "power" and the "benefit" elements are relevant when determining whether there is a continued economic interest in the transferred property.
    
    
51. In essence, if the vendor (or its controllers) holds power over or control the associated purchaser, it is assumed that there is potential capacity to benefit and that the benefits will extend to any increased economic advantages flowing from the exercise of the section EE 33(4)(a)(ii) discretion.
    
    
52. Having the potential capacity to benefit from the property means the associated vendor is entitled to a significant level of current or future benefits arising from the activities of the associated purchaser. The "benefit" element can exist independently of a power to influence, for example, as a beneficiary under a trust or as a non-controlling shareholder. However, the critical factor is that the vendor must ultimately have the potential to receive those benefits, for example, as a shareholder or a beneficiary. It is irrelevant whether the vendor actually receives the benefits (for example, a beneficiary in a discretionary trust.)
    
    
53. These circumstances will give rise to a presumption of control or power over the associated purchaser by the associated vendor:
    
    
    1. A direct or indirect majority voting interest in the associated purchaser,
       
       
    2. A power to obtain a majority voting interest through the ownership of options or convertible rights,
       
       
    3. A power to appoint or remove a majority of the members of the governing body of the associated purchaser,
       
       
    4. A power to set or modify the financing and operating policies that guide the activities of the associated purchaser,
       
       
    5. A power to extract distributions of economic benefits from the associated purchaser,
       
       
    6. A right that is directly attributable to the ownership interest in the associated purchaser, to a majority of the economic benefits arising from the associated purchaser, irrespective of the timing or the mode of distributions of the benefits, or
       
       
    7. A unilateral power to dissolve the associated purchaser and obtain a significant level of the residual economic benefits.
       
       
54. When the transfer is made to a party in which non-associated persons have a material beneficial interest or virtual ownership of the transferred property (for example, by shareholding or otherwise), the Commissioner will take that circumstance into account when deciding whether or not to exercise the discretion. (Please see paragraphs 39 to 45 of this SPS for details.)

2. Benefiting through a sale and leaseback arrangement
   
   

55. Another issue to be considered in exercising the discretion under section EE 33(4)(a)(ii) (even when the purchaser is not controlled by the associated vendor through the tests discussed above and in the examples of this SPS) is whether the property is still used by the associated vendor.
    
    
56. A sale and leaseback arrangement involves the sale of a property by a vendor and the leasing of the same property back to the vendor (or an associate controlled by the vendor or its controllers) for use. Some arrangements can be much more complex. In deciding whether to exercise the discretion in a situation when there is a leaseback arrangement, the Commissioner will consider whether the arrangement is on arm's length market terms and properly documented, and also whether, in substance, the property has returned to the effective ownership of the vendor. The Commissioner may also consider whether the effective risk and rewards associated with ownership of the transferred property are passed back to the associated vendor (or an associate) through the leaseback arrangement.
    
    
57. Under generally accepted accounting principles (including those stated in Leases (NZ IAS 17)), leases are classified according to the extent to which the risks and rewards incidental to ownership of a leased property lie with the lessor or the lessee. A lease that transfers substantially all the risks and rewards incidental to ownership of a property to the lessee is described as a finance lease (see paragraph 4 of NZ IAS 17). Title to the property may or may not eventually be transferred to the lessee. A lease that is not a finance lease is called an operating lease.
    
    
58. When the leaseback is a finance lease, most of the risks and rewards incidental to ownership are transferred back to the associated vendor who is considered to continue to benefit from the transferred property.
    
    
59. If the leaseback is an operating lease, the accounting treatment is that in effect a normal sale transaction has occurred and it is considered that the associated vendor does not continue to benefit from the transferred asset/property, assuming that the operating lease payments have been struck at market value.
    
    
60. The fact that property is returned to the possession of the associated vendor through leasebacks or similar arrangements is therefore not in itself normally decisive in terms of exercise of the discretion if the arrangements are at arm's length and all the rewards and risks incidental to the ownership of properties are not transferred back to the associated vendor. However, other factors mentioned in this SPS may remain relevant.

3. Benefiting through continued use of the transferred property for income- producing purposes
   
   

61. Consideration has been given to the test set out in the withdrawn statement in Tax Information Bulletin, Vol. 4, No. 5 (December 1992) - where the purchaser buys the property for use in income-producing activities and the vendor no longer uses it for income-producing activities. While it is considered that the other factors set out above should normally be adequate to guide decision-making, consideration of this factor is potentially useful in some circumstances, such as sale and leaseback arrangements, described above, and as indication of the commercial reality of the transfer. The Commissioner will consider any continued actual use (for income production or otherwise) by the vendor to be a relevant factor.

Factor Five: the commercial or non tax-related reasons for undertaking the transfer of the property between parties

62. Taxpayers should demonstrate that the transfer of property between associated persons is driven by material commercial or non tax-related reasons. Examples of such non tax-related reasons could be business restructuring (such as consolidations, mergers and takeovers), asset protection and estate planning. (Please note: the treatment of transfers of property in a non-qualifying amalgamation is discussed in paragraphs 67 to 71 of the SPS.) The Commissioner will take these reasons into account when deciding whether to exercise the discretion under section EE 33(4)(a)(ii). In appropriate cases, it may be necessary to consider any wider arrangement relating to the transfer and compare the non tax-related or commercial reasons given with those for the purpose of obtaining depreciation uplift under section EE 33(4)(a)(ii).
    
    
63. Some factors may indicate that exercising the Commissioner's discretion will be inappropriate. Clearly, if:
    
    
    1. no commercial reasons at all can be put forward for the transaction, or
       
       
    2. an artificial structure is used without commercial justification, or
       
       
    3. the transfer of property is part of a wider tax avoidance arrangement,
       

the Commissioner's discretion will not be exercised in the taxpayer's favour.

64. Furthermore, the Commissioner will not exercise the discretion to assist the taxpayers in their tax planning, such as "refreshing" of tax losses to reflect movements in market value.
    
    
65. For example, the associated vendor is a company that carries forward large amounts of tax losses from previous tax years. The company expects a breach of shareholding continuity in 2007 due to shareholder changes. Immediately before the breach, the associated vendor transfers the whole business operation to an associated company at market value. The result is that some of the existing losses can be utilised and offset against the depreciation claw back. The Commissioner will not exercise the discretion, as a principal purpose of the transfer of property is to avoid forfeiture of tax losses in the associated vendor.
    
    
66. In some instances, the taxpayer may have had no choice but to undertake a transfer, through circumstances beyond its control, such as a law change, or pursuant to the terms of a binding arrangement enforced by a non-associated third party. In such cases, and provided that the first four criteria above are met, the Commissioner will usually exercise the discretion in favour of the transferee.

Transfer of depreciable property in non-qualifying amalgamation on or after 14 May 2002

67. Section EE 34 sets out the tax treatment of depreciable property transferred in a non-qualifying amalgamation on or after 14 May 2002. The provision overrides section EE 33.
    
    
68. Section EE 34(3)(a)(ii) confers a discretion on the Commissioner. The exercise of the discretion means that the amalgamated company can depreciate the property at the transfer value, rather than at the original cost of the property to the amalgamating company.
    
    
69. Given the similarity to the discretion under section EE 33(4)(a)(ii), the Commissioner will apply similar principles as set out in this SPS when exercising the discretion under section EE 34(3)(a)(ii). Examples of factors that may be considered are:
    
    
    1. The degree of shareholding commonality between the amalgamating companies and the amalgamated company,
       
       
    2. Whether the amalgamation exhibits an attempt to manipulate the depreciation provisions in the ITA 04,
       
       
    3. Whether the amalgamation process involves the introduction of an "artificial person" as a contrivance,
       
       
    4. Whether the beneficial interests of the amalgamated company materially differ from the beneficial interests in the amalgamating companies, and
       
       
    5. Whether the amalgamation arrangement was entered into for commercial purposes or for the purpose of obtaining a tax advantage.
       
       
70. The Commissioner notes that amalgamations for the purposes of operational and financial efficiencies are consistent with normal commercial practices. It is also observed that some degree of shareholding commonality between amalgamating and amalgamated companies may represent a normal commercial situation. This, by itself, will not negate the exercise of the Commissioner's discretion under section EE 34(3)(a)(ii).
    
    
71. Even if the shareholding commonality between amalgamating and amalgamated companies exceeds 50%, the Commissioner may still exercise the discretion under section EE 34(3)(a)(ii) provided that other legitimate non tax-related reasons exist and outweigh this factor.

Miscellaneous matters

Relationship property

72. When depreciable property is transferred pursuant to a relationship agreement or matrimonial agreement, section EE 33(4)(c) sets out the situations in which section EE 33 does not apply. Instead, section FF 16(7) provides for the associated purchaser to be allowed a depreciation deduction that is not more than the amount that would have been allowed to the associated vendor, had the associated vendor retained the asset.

Disposal of depreciable property on the death of a taxpayer

73. Section EE 33(6)(b) states that the section does not apply to the disposal and resulting acquisitions of depreciable property on the death of a taxpayer under subpart FI, notwithstanding that the transfer of property is deemed to be at market value.

Examples

74. These examples help to clarify the application of the standard practice in this SPS:
    
    Example 1: transfer from individual taxpayers to a loss-attributing qualifying company ("LAQC")
    
    Mr and Mrs H bought a house in Wellington ten years ago for $260,000 and have been living there ever since. Mr H has recently been promoted in his employment and Mr and Mrs H have relocated to Auckland.
    
    Mr and Mrs H have decided to commence a rental activity. The house in Wellington is rented out to an unrelated third party.
    
    Mr and Mrs H have obtained an independent valuation from a registered valuer, who advises that the property has a market value of $650,000. Instead of carrying on the rental activity themselves, they set up a LAQC and sell the house to the LAQC. Mr, Mrs H and the H Family Trust are equal shareholders of the LAQC. H Family trust has been settled with Mr H as one of the trustees and the beneficiaries are Mr and Mrs H's children.
    
    The legal title of the property in Wellington is transferred to the LAQC. The LAQC is responsible for paying the interest on the mortgage, rates, insurance and any repairs. The unrelated tenant pays their weekly rents by direct credit to the LAQC's bank account.
    
    The LAQC seeks to depreciate the property based on its acquisition cost for $650,000, which is also the market value of the house. A request has been made under section EE 33(4)(a)(ii).
    
    The Commissioner will not exercise the discretion under section EE 33(4)(a)(ii) in this example, although the transfer of the depreciable property is genuine and permanent and the transfer price does not exceed the fair market value. The reasons are as follows:
    
    
    1. Mr and Mrs H continue to benefit indirectly from the transferred property: Mr and Mrs H have a legal and equitable interest in the LAQC. If the LAQC makes a profit or a loss from the rental activity, Mr and Mrs H, in their capacity as shareholders of the LAQC, will receive a distribution of the profit or an allocation of the loss.
       
       
    2. The non tax-related reasons for the transfer of the real property do not outweigh the factor that the transferors retain significant beneficial interests in the transferred property: Mr H's promotion in his employment and family relocation seem to be the only non tax-related reasons for the transfer in this example. The Commissioner considers that these reasons are not sufficient to displace the transferors' significant beneficial interest in the transferred property.
       

Example 2: transfer between individual taxpayers

Jack, a 70-year-old sole trader operating a dairy decides to sell the business assets to his grandson, Johnny. Johnny will take over Jack's dairy business. Jack and Johnny enter into a sale and purchase agreement, whereby all the business assets in the dairy will be sold to Johnny at a price based on an independent valuation. The payment consists of an Acknowledgment of Debt for 75% of the transferred price and cash for the remaining 25%.

Jack retires after the transfer. Johnny carries on the dairy business. Jack helps out in the dairy occasionally but is not otherwise involved in the business. Jack forgives some of the debt annually. Johnny requests that the Commissioner exercises the discretion under section EE 33(4)(a)(ii).

Jack and Johnny are associated persons in accordance with the definition of "relative" in section OB 1.

The Commissioner will exercise the discretion under section EE 33(4)(a)(ii) to allow Johnny to claim tax depreciation on the basis of the assets' transferred price. This is because:

1. The transaction is genuine: the transfer of the assets is the result of genuine negotiation between Jack and Johnny. Consideration has passed by Johnny to Jack for the transfer of business assets.
   
   
2. The transferred price is at a fair market value: the transferred price does not exceed the fair market value of the business assets.
   
   
3. The transfer of business assets is permanent: the parties to the transaction do not intend to lease or transfer the business assets of the dairy back to Jack.
   
   
4. The transferor does not continue to benefit from the transferred property: Jack does not have any control over the transferred assets in the dairy. Johnny runs the dairy business by himself. Jack only helps out occasionally.
   
   
5. The transfer is not tax driven: the main reasons for the transaction are to enable Jack to retire due to his old age and for succession planning.
   
   

However, Jack is required to calculate depreciation claw back or gain on disposal at the time of the transfer.

Example 3: transfer from a partnership to a trust

Jack and Jill (husband and wife) have a partnership which owns ten rental properties (which originally cost $3 million), all of which are currently leased. They decide to sell the properties to a family trust - JJ Family Trust, for $3.8 million. The transfer price is based on independent valuations. The sale and purchase agreement contains a loan with a Marshall clause allowing interest to be charged at current bank lending rates, if demanded.

Jack, Jill and Mr Y (an independent solicitor) are the trustees of JJ Family Trust. Only Jack and Jill have the power to appoint and remove trustees. Jack and Jill are also the beneficiaries of the trust along with their two children and their parents. A request has been made by the trustees of JJ Family Trust under section EE 33(4)(a)(ii) to depreciate the properties based on the cost of the properties to the trust.

The Commissioner will not exercise the discretion under section EE 33(4)(a)(ii) in this example although the transfer of the depreciable property is genuine and permanent and the transfer price does not exceed the fair market value. The reasons are as follows:

1. Jack and Jill continue to benefit indirectly from the transferred properties: this example can be distinguished from the Lys case. In that case, the vendor in the transfer of depreciable property to the family trust was not a beneficiary of the trust. Thus, the vendor did not retain any virtual ownership of or beneficial interest in the transferred property.
   
   In the current example, Jack and Jill are the beneficiaries of the JJ Family Trust. Furthermore, they have control over the family trust by being the trustees and having the sole power to appoint and remove trustees. Thus, Jack and Jill can potentially remove Mr Y as the trustee, cast majority votes in trustees' meetings and make decisions to distribute a large proportion of economic benefits to them in their capacity as beneficiaries.
   
   
2. The taxpayers have not provided any non tax-related reasons for transferring the real properties from the partnership to JJ Family Trust: the Commissioner accepts that a sale by a partnership to a family trust does not necessarily mean that the transaction is something less than an ordinary commercial transaction. However, in this example, Jack and Jill did not explain the reasons for the transfer.
   

The Commissioner acknowledges that if Jack and Jill provided details on non tax-related reasons for the transaction, the Commissioner would need to consider them and weigh these reasons against the factor that the indirect benefits derived by Jack and Jill from JJ Family Trust. For example, both Jack and Jill are barristers sole. They decide to use a family trust to protect the real properties against possible claims by their clients in their legal practice.

However, the Commissioner may still refuse to exercise the discretion because their non tax-related reasons for the transaction cannot outweigh their significant beneficial interest in JJ Family Trust.

This Standard Practice Statement is signed on 14 September 2007.

Graham Tubb
Group Tax Counsel
Legal and Technical Services