Changes to the taxation of leases

2007 changes mean lease arrangements involving overseas assets will be classified as finance leases or lessors will have allowable depreciation deductions reduced.

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.

Example 1: Overseas use not for most of the term

Air Wellington has an aeroplane which is surplus to requirements and leases it to Air Napier for five years. Air Napier uses the aircraft between Napier and Auckland for the first three years of the lease. In year 4 of the lease, the terms of the lease change in such a way that the definition of "finance lease" must be checked again (see Application of the tests below).21 At this time, Air Napier is using the aircraft between Sydney and Melbourne, under a contract with an Australian airline. It expects it will continue to be used abroad until the end of the lease. The lease asset should not be regarded as used wholly or mainly outside New Zealand, because for 60 percent of the lease it was used inside New Zealand.

Example 2: Overseas use for most of the term

The facts are as in Example 1, except that Air Napier uses the aircraft between Napier and Auckland only for the first two years of the lease. For the rest of the lease, it is expected to be used overseas. The lease asset should be regarded as used mainly outside New Zealand.

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.

Example 3: One party not subject to New Zealand income tax

NZ Co leases equipment to Aus Co, which derives income from use of the equipment in Australia. The income is non-residents' foreign-sourced income. The test in subparagraph (ii) is satisfied and the lease may be a finance lease if the other tests are also satisfied.

Example 4: Both parties subject to New Zealand income tax

Boat Co leases fishing vessels to Catch Co, which uses them for trawling. Catch Co is subject to New Zealand income tax on all its income, so the test in subparagraph (ii) is not satisfied and the lease is not a finance lease under paragraph (c) of the definition of finance lease (even if the boats are used mainly outside New Zealand).

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.

Example 5: Economic substance test not satisfied

XYZ Bank leases rolling stock to an Australian company for seven years. Lease payments are fixed and the lease cannot be cancelled. There is no guaranteed minimum residual value in the lease. Assume, for the sake of the example, that the lease is an operating lease for tax purposes. After six years, XYZ Bank notes that the market price for the asset is considerably higher than the residual value it is expecting, and so buys residual value insurance to lock in the likely profits on sale of the asset following the end of the lease. The lease would probably not be a finance lease at this point. Imagining oneself at the beginning of the lease, but knowing that XYZ will buy residual value insurance in year 6, substantial risk still remains with XYZ (the residual value could change unpredictably up to year 6).

Example 6: Economic substance test satisfied

The facts are as in Example 5, but with the insurance purchased after only three months of the lease term. This is likely to be a finance lease because, when viewed from the outset, XYZ has only insubstantial risk (three months of market price movement out of a seven-year lease).

Example 7: Economic substance test not satisfied

ABC Bank leases a ship to a Norwegian company for 11 years. The lease is a non-cancellable operating lease with fixed payments, but no guaranteed minimum residual value. Assume, for the sake of the example, that the lease is an operating lease. After 10 years, ABC signs a contract to sell the ship to an unrelated third party for the current market value of the ship, with settlement deferred until after the end of the lease, thereby removing any risk due to market-value fluctuations over the last year of the lease. ABC also changes the terms of the lease to require the Norwegian company to prevent the ship's railings from rusting, and this change of terms requires the new paragraph of the finance lease definition to be checked (see Application of the tests below). The lease would probably not be a finance lease, even though there is (essentially) no risk remaining for ABC at the point of checking. Viewed from the outset, and knowing about the change in terms in year 10, ABC still has significant risk over the lease term as a whole.

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)
Example 8: Applying the three tests - lease entered after 20 June 2007

A Co leases equipment to B Co. The lease was entered into on 1 August 2007. A Co must check if the lease meets the new paragraph (c) of the definition of "finance lease" on 1 August 2007. Assume it does not. A change in the terms of the lease, which requires B Co to purchase the equipment at the end of the lease for a fixed price, is made on 1 April 2008. A Co must again check if the lease meets the three tests.

Example 9: Applying the three tests - lease entered into before 20 June 2007

The facts are as in Example 8, except that the lease was entered into on 1 April 2006 and was an operating lease at that time. Once the new legislation applies, A Co must check if the lease met the tests in the new paragraph (c) of the definition of "finance lease" on 20 June 2007.

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).

Example 10: Finance lease at the outset of the lease - lease entered into after 20 June 2007

NZ Co leases equipment with an estimated useful life of 10 years to Aus Co for 7 years, to be used entirely in Australia. Aus Co is not subject to New Zealand income tax. Aus Co is responsible for all costs associated with the operation, maintenance and insurance of the equipment, and guarantees to pay $1 million to NZ Co at the conclusion of the lease, at which time NZ Co will regain possession.

At inception, the lease meets all three tests of the new paragraph (c) of the definition of "finance lease". The lease is a finance lease.

Example 11: Finance lease after the outset of the lease - lease entered into after 20 June 2007

NZ Co leases equipment to Aus Co, which is not subject to New Zealand income tax, to be used entirely in Australia. The lease is an operating lease because NZ Co bears (substantial) residual value risk in relation to the lease asset, because NZ Co will regain possession of the asset at the end of the lease, and because the lease period is less than 75 percent of the asset's estimated useful life. After six months, NZ Co and Aus Co change the terms of the lease so that Aus Co guarantees to purchase the equipment for $1 million at the conclusion of the lease, being the expected residual value when the lease was entered into.

The lease becomes a finance lease because of the change of terms. If the risks and rewards incidental to ownership of the asset were assessed on entry to the lease, taking into account the guaranteed residual value to be paid by Aus Co, it would be concluded that Aus Co faced substantially all the risks and rewards.

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.

Example 12: Consequential adjustment to income - lease entered into after 20 June 2007

The facts are as in Example 11. Suppose that net income for the first six months under the operating lease was $500,000, and $750,000 for the second six months under the finance lease, and that the total of $1,250,000 was included in the return of income for the relevant year. Under a finance lease, net income for the whole of that year would have been $1,500,000. Under sections FC 8H of the Income Tax Act 2004 or FA 11 of the Income Tax Act 2007, NZ Co must include further income of $250,000 in its return of income. In total, NZ Co recognises $1,500,000 of net income in the return.

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.

Example 13: Consequential adjustment to income where new part of definition does not apply

A car, used entirely within New Zealand, is leased by A Co to B Co under an operating lease for two years. At the end of the two-year period, the lease term is extended to eight years. The net income of A Co under the operating lease in the first two years is calculated as $10,000. The net income under a finance lease would have been $15,000

Paragraph (c) of the definition does not apply - the asset is not used outside New Zealand. Section FC 8H of the Income Tax Act 2004 (or section FA 11 of the Income Tax 2007) still applies, however, because of paragraph (b) of the definition of finance lease and the extended term of the lease (section FC 8H(1)(a) or FA 11(1)(a) respectively). Net income of $5,000 will be recognised by A Co in the year of the change, as would have occurred in the absence of the new legislation.

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.

Example 14: Tests satisfied on 20 June 2007- lease entered into before 20 June 2007

NZ Co leases equipment to Aus Co under a lease which did not meet the definition of "finance lease" before new paragraph (c) was added. The lease was entered into on 1 April 2000, and the terms of the lease have not changed since. On 20 June 2007, the lease satisfied the three tests in paragraph (c) of the definition - the asset was used wholly overseas by a company which was not subject to New Zealand income tax, and Aus Co had substantially all the risks and rewards incidental to ownership of the lease asset.

NZ Co must make the adjustments in sections FC 8I(3) and (7) of the Income Tax Act 2004 or sections FA 11B(3) and (6) of the Income Tax 2007, and reduce depreciation in subsequent income years according to section FC 8I(8) of the Income Tax Act 2004 or section FA 11B(7) of the Income Tax Act 2007.

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.

Example 15: Consequential adjustment to income - lease entered into before 20 June 2007

The facts are as in Example 14. NZ Co was allowed deductions for depreciation losses in relation to the leased equipment of $29,127,974 over the period 1April 2000 to 31 March 2008 (the end of the income year including 20 June 2007). The adjusted tax value of the equipment is $5,872,026 after subtracting all depreciation allowed up to 31 March 2008.

NZ Co recognises additional income in the 2008-09 income year of $29,127,974 ÷ 6 = $4,854,662. The adjusted tax value of the equipment on 1 April 2008 is $5,872,026 + $4,854,662 = $10,726,688

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.

Example 16: Reduction of depreciation deductions - lease entered into before 20 June 2007

The facts are as in Examples 14 and 15. The economic rate used by NZ Co for the equipment would be 20 percent (DV) in the absence of section FC 8I (or FA 11B). In the 2008-09 year, using the ATV determined under section FC 8I (or FA 11B) but otherwise ignoring section FC 8I (or FA 11B), NZ Co would be allowed a depreciation deduction of $10,726,688 x 20% = $2,145,338. This is reduced by one-sixth under section FC 8I (or FA 11B), so that a deduction of $1,787,782 is actually allowed. The ATV is then adjusted down in the normal way to $10,726,688 - $1,787,782 = $8,938,906. In the 2009-10 year, the deduction allowed is $8,938,906 x 20% x 5 divided by 6 = $1,489,818 and the ATV is adjusted down to $7,449,088.

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.

Example 17: Depreciation recovery income or loss on sale - lease entered into before 20 June 2007

The facts are as in Examples 14, 15 and 16. If the equipment is sold in the 2010-11 year, for $10,000,000, NZ Co will have depreciation recovery income under section EE 41(1) of $10,000,000 - $7,449,088 = $2,550,912. If, instead, the sale price is $5,000,000, the taxpayer will be allowed a deduction for depreciation losses under section EE 41(2) of $2,449,088.

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