BREPI and an Equipment Leasing Company

We recently received a query from a client regarding whether a company that carried on an active business of leasing equipment (‘Leasing Company’) was a base rate entity (‘BRE’) and therefore eligible for the lower corporate tax rate. As the Leasing Company’s turnover was under $50 million the key consideration in determining whether the company was a BRE revolved around the first criterion, whether its base rate entity passive income (‘BREPI’) was more than 80% of its assessable income for the year.

By way of background BREPI, broadly, includes the following types of assessable income:

1. dividends (other non-portfolio dividends);
2. an amount of a franking credit (within the meaning of the Income Tax Assessment Act 1997) on such a distribution;
3. a non-share dividend by a company;
4. interest (or a payment in the nature of interest), royalties and rent;
5. a gain on a qualifying security;
6. a net capital gain;
7. an amount included in the assessable income of a partner in a partnership or of a beneficiary of a trust estate, to the extent that the amount is referable (either directly or indirectly) to another amount mentioned above.

Based on the items of BREPI listed above, the intuitive view would be that the Leasing Company’s income derived from leasing the equipment would not be BREPI. However, as practitioners are aware the income tax law can, at times, be far from intuitive.

The Definition of Royalties

The ATO’s view on what amounts of assessable income it considers are BREPI is contained in the ruling LCR 2019/5 Base rate entities and base rate entity passive income (‘the LCR’).

Of particular concern for the Leasing Company is the ATO’s view (contained in paragraphs 13 and 14 of the LCR) that the term ‘royalties’ for the purposes of the Income Tax Rates Act 1986 (‘the Rates Act’) takes on the same meaning as it does in section 6 of the Income Tax Assessment Act 1936 (‘the Assessment Act’). This view is based on section 4 of the Rates Act requiring the Assessment Act to be incorporated and read as one with the Rates Act.

The section 6 definition of Royalties is partially replicated below:

“royalty or royalties” includes any amount paid or credited, however described or computed, and whether the payment or credit is periodical or not, to the extent to which it is paid or credited, as the case may be, as consideration for:

…

(b)  the use of, or the right to use, any industrial, commercial or scientific equipment;

…

In IT 2660 Income tax: definition of royalties the ATO explains that the term ‘equipment’ does not have a narrow meaning and goes on to state that a payment for the rental of a confectionary wrapping plant or a payment for the hire of a computer would both fall within the definition of ‘royalties’.

The ATO also explains in TR 98/21 Income tax: withholding tax implications of cross border leasing arrangements that the definitions of the terms ‘industrial’, ‘commercial’ and ‘scientific equipment’ also have a broad meaning.

The appendix to the LCR contains a list of public rulings in relation to royalties which all touch on the meaning used in the Assessment Act to some extent (which may be relevant to a taxpayer’s circumstances):

• Taxation Ruling IT 2660 Income tax: definition of royalties;
• Taxation Ruling TR 2008/7 Income tax: royalty withholding tax and the assignment of copyright;
• Taxation Ruling TR 93/12 Income tax: computer software;
• Taxation Ruling TR 95/6 Income tax: primary production and forestry;
• Taxation Ruling TR 2004/17 Income tax: indemnification of royalty withholding tax.

Unfortunately for Leasing Company, the payments it receives for the leasing of its equipment to its customers falls within the definition of a royalty and therefore is BREPI. On the basis that more than 80% of its assessable income is royalties, Leasing Company is not a BRE and is therefore subject to the 30% corporate tax rate.

Like Leasing Company, there are many companies who lease equipment (including to related parties) who find themselves on the wrong side of the ATO’s view on the meaning of royalties. For example, it is not uncommon for groups in the construction industry or medical field to ‘ring-fence’ equipment into a special purpose leasing company.

Financing Leases

The ATO’s view on finance leases and royalties is contained in  TR 98/21 Income tax: withholding tax implications of cross border leasing arrangements. That ruling explains that where it is clear from the outset of the leasing arrangement that the purchase of equipment is the main purpose of the arrangement, then the lease payments are not payments of royalties, rather the implicit interest component will be considered to be a payment of interest or in the nature of interest. The ruling also explains that where the main object of the arrangement is for the hire of equipment (including arrangements where there is an option to purchase the equipment), the lease payments will fall within the definition of a royalty. Although the abovementioned ruling does not directly deal with the BREPI provisions, the ATO applied the ruling in PBR 1051573620646 when ruling on the BREPI provisions.

Whilst the interest component will still be BREPI, the principal repayment component of the lease payment is not BREPI. If a company’s sole income is derived from providing financing lease arrangements, the distinction will be of little consequence. However, if the company also has other income that is non-BREPI, the distinction may result in the BREPI not exceeding the 80% threshold (compared to if the entirety of the lease payment was BREPI).

Alternative Definition of Royalties

As you are aware, the Commissioner’s interpretation of the law is not the law, even if at times it is treated as such due to commercial or practical reasons. Therefore, for completeness, we note that an alternative position on the definition of royalties does exist.

During consultation for the draft version of the LCR, it was put to the ATO (via a CAANZ submission) that the term ‘royalties’, as used in section 23AB of the Rates Act (which contains the definition of BREPI), should take its ordinary meaning and not the section 6 definition.

The basis for this alternative view is that the definitions in section 6 do not apply when interpreting the Assessment Act (and by extension the Rates Act) where a contrary intention to use a meaning other than the defined meaning of a term (e.g., ordinary meaning) is evident. It was also put to the ATO that the extensive direct referencing (to both the Assessment Act and the Income Tax Assessment Act 1997) in section 23AB to import definitions of certain terms used in that section suggests that a contrary intention is evident in respect of the terms that do not directly reference a definition contained in the Assessment Act or the Income Tax Assessment Act 1997 (noting that one of the terms that does not contain a direct reference is ‘royalties’).

However, in the compendium to the LCR, the ATO acknowledged the above argument was included in submissions it received, but reaffirmed its view that the section 6 definition was applicable.

In the author’s view the ATO’s position is likely to be correct. This is because a requirement for a contrary intention is for such intention to be clearly indicated, which does not appear to be the case in section 23AB as each explicit reference made to the Assessment Act in that section, is to a definition that is not present in section 6. Rather, each direct reference is to a definition that is contained in another section that only applies to a specific Part, Division or Section of the Assessment Act. Therefore, without section 23AB directly referencing those definitions not contained in section 6 of the Assessment Act the various terms that do contain direct referencing in that section would be incapable of taking on their intended meaning as the mere incorporation of the Assessment Act into the Rates Act (through the operation of section 4) does not expand the scope of definitions contained in sections other than section 6 that are only applicable to a specific Part, Division or Section of the Assessment Act.

However, the author does acknowledge it does appear that there may be a reasonably arguable position that section 23AB does indicate contrary intention in respect of the definition of the term ‘royalties’.

Conclusion

The conclusion that equipment leasing fits within the definition of a royalty does seem to be unfair in many cases where an active leasing business is being carried on. It also appears to be inconsistent with the intentions of the introduction of the BREPI provisions to limit the reduced corporate tax rate solely to active businesses.

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