FINANCIAL ASSETS AND LIABILITIES
A comprehensive consideration of the taxation of financial assets and liabilities might include such esoteric issues as the debt/equity boundary, hedging and complex hybrid instruments. As is the case with all assets and liabilities involved with investments, however, the benchmark income tax base provides a framework for imposing income tax on the widely varying array of financial assets/liabilities.
It is usually very difficult, or impracticable, to attribute a particular net receipts stream to each individual item of plant and equipment in a business - hence the use of depreciation schedules to estimate annual changes in value of such assets. Individual financial assets/liabilities, however, often have their own clearly identifiable cash flows which allow ready application of the benchmark tax treatment.
Application of benchmark treatment to financial assets/liabilitiesSome financial assets/liabilities, like government bonds or annuities, involve fixed cash flows. In contrast, the future cash flows of bank accounts and other cash accounts depend directly on the changing interest rate environment and the cash flows of company shares depend to varying degrees on overall general market conditions. Yet other financial assets/liabilities, like indexed bonds, have their cash flows specified by formulae incorporating continually changing parameters such as the consumer price index (CPI) or the share price index (SPI). As usual, the key issue in applying the benchmark tax treatment to such differing types of financial assets/liabilities is the measurement or estimation of their annual change in value.
The benchmark tax treatment of Figure 1 can be readily applied to those traded financial assets/liabilities with easily-obtainable market values; such as, listed shares and trust units and bond or share price index (SPI) futures. Implementation of such treatment depends only on practical political considerations.
To apply the benchmark tax treatment to a financial asset/liability without readily-available market values, the minimum requirements for obtaining estimates of annual change in value are: (1) up-front value of the financial assets/liability; and (2) an appropriate interest rate for the financial arrangement. These two pieces of information plus the net receipts that actually occur within each tax year are sufficient to obtain an estimate of annual change in value of the financial arrangement using the methodology illustrated in Figure 4. The annual net receipts plus this change in value provide the benchmark taxable income for the year.
This change-in-value methodology enables annual taxable income to be determined year by year as the cash flows associated with a financial arrangement actually occur, regardless of whether or not those cash flows are known in advance. Those cash flows must be known when they occur even if they depend on parameters that are continually changing such as the consumer price index (CPI) or the SPI. How close the estimated change in value in a particular year is to actual value change will depend on such considerations as: the type of arrangement involved; whether the up-front valuation of an arrangement has been set by commercial negotiation or has to be estimated; whether the arrangement's value depends on future outcomes that may vary widely (eg the future value of shares subject to a convertible note); how the interest rate to be used to estimate value change is determined; and how much general interest rates have moved since the arrangement was first negotiated.
The way that the interest rate might be selected for value change determination varies depending on the type of financial arrangement.
As market interest rates change, the value of financial arrangements will change (as with all tangible assets as well). Leaving aside assets/liabilities whose readily-available market values are used year by year, incorporating effects of changing market interest rates on value for tax purposes is usually not attempted while an arrangement is held by the same investor. Nevertheless, once a financial arrangement is disposed of during its life, current value is often then available to be taken into account.
Consistent with the change-in-value methodology of Figure 4, the annual change in value of some financial instruments (eg deep discounted zero-coupon bonds) is commonly included in tax assessments. Estimated annual change in value is included even though there is no readily-available annual market price and even though the holders of the instruments have not disposed of them. In contrast, change in value is not assessed annually for some instruments that do have listed market prices, such as company shares held by non-traders. Instead, the capital gains or losses of these instruments are assessed under capital gains tax (CGT) arrangements on disposal of the instruments. Investment neutrality considerations are, no doubt, overridden by broader considerations such as the arguments that it is difficult to tax people on accrued gains when they have not sold the instruments and uncertainty in value means that taxing accrued gains one year could be followed by accrued losses the next.
Despite the usual approach to company shares, accrued gains and losses of financial arrangements are generally more likely to be accommodated in income tax laws than tangible assets. Unlike tangible assets, financial arrangements are fungible and can readily be transformed and re-packaged. Financial firms value their traded assets/liabilities even on a daily basis. If the tax law does not mirror changes in value of financial assets/liabilities, tax arbitrage opportunities may be presented both between instruments and different income tax administrations. It is notable, too, that the distinction between tangible and financial assets is becoming blurred with the growing securitisation of tangible assets.
Nominal or real benchmarkThe symmetrical treatment of nominal interest that is illustrated below in the bank account section is common around the world - that is, annual nominal interest receipts (or, more generally, annual increase in financial asset value before withdrawal) assessable and annual nominal interest payments (or, more generally, annual increase in financial liability value before payment) deductible for income tax purposes. This treatment is of central importance to income taxation as it sets the benchmark for income tax treatment of other assets and liabilities (net receipts plus change in nominal value of assets/liabilities). That is because general 'going' interest rates set the basis for the rate of discount to apply to investment cash flows (or the internal rate of return required from those flows) to determine the viability of investments: before tax the discount rate (or required return) is based on the going pre-tax interest rate; after tax, because of the symmetrical tax treatment of interest rates, the discount rate (or required return) is based on the going pre-tax interest rate reduced by the marginal tax rate of the investor. The benchmark treatment for neutral investment decision-making crucially depends on the effect that the tax rate has on the after-tax discount rate for assessing investment viability.
Were, instead, the symmetrical treatment of real interest to apply, the benchmark treatment of other assets/liabilities would change commensurately to net receipts plus change in real value of assets/liabilities. As discussed in Mayo (1984) and Australian Government (1985), Chapter 18, the move from nominal to real change in asset/liability value (including for financial assets/liabilities) involves an annual adjustment equal to the value of the asset/liability at the start of the year times the going general rate of inflation. The taxing of real income may be analysed with the MyProject package
If interest were excluded entirely from the tax base so that 'normal' income (income commensurate with the going interest rate) was not really being taxed, the discount rate for investment viability is unchanged by the tax (making such tax arrangements suitable for individual projects or industry sectors). Because the discount rate is unchanged by the tax, the required treatment of assets for neutral decision-making moves from including their annual change in value in the tax base to directly including their associated cash flows - the conceptual basis for rent taxes/royalties (see Mayo (1984)).
SOME EXAMPLESThe easiest way of getting a good feel of the taxation of financial arrangements is to work through a number of examples. A selection of examples follows. The selection is arbitrary but chosen to illustrate a variety of different circumstances that arise with different types of instruments. Despite the variety of instruments in the examples, the benchmark tax treatment provides the conceptual framework for taxing them all. Included in the examples are some involving offshore instruments - and therefore exchange rate effects.
If the cash flows in the examples (beyond the up-front values) are not fixed in the arrangement, they can be viewed as expected flows. Alternatively, each example might be viewed as just one possible outcome in the associated investment's range of possible outcomes. Risk associated with these cash flows does not affect the benchmark tax treatment.
Bank accountFigure 22 shows the cash flows of a $1000 deposit into a bank account (or cash account with any financial institution) that provides 10% pa interest on the account. The depositor withdraws the annual $100 interest payments and, therefore, the value of the account stays at $1000. The depositor is taxed on the $100 of income each year at his or her 47% tax rate, reducing the 10% pre-tax return to 5.3%.
The same cash account as in Figure 22 is shown in Figure 23 but with the depositor reinvesting the $100 of interest income back into the same account. Thus, the value of the account increases by 10% each year. The depositor can be viewed as being taxed at 47% on the annual increase in value of the account (or, in practice, compound interest earned) with no funds being withdrawn.
The pre-tax cash flows and chart in Figure 23 showing actual value increasing at 10% look identical to those of the appreciating asset (land) used in the negative gearing discussion. Differences are obvious, however, in the tax values of the two: the tax values of the cash account increase by 10% a year with the annual difference taxed at 47%; the tax value of land stays at $1000 until it is sold and then only half of the realised capital gain is taxed.
A feel for the distortions in post-tax decision-making created by such differences in tax treatment of assets with identical pre-tax cash flows (and the same 10% pre-tax return) can be obtained from the large differences in the post-tax returns of the land (8.0%) and of the bank account in Figure 23 (5.3%). These comparisons are summarised in Figure 10 in the discussion on negative gearing. The distortive effect of such differences can further be appreciated by noting that investment in land can be funded by borrowing from a financial institution with annual interest payments on the debt fully deductible for income tax purposes - providing annual tax savings. Figure 24 shows $1000 debt funding as a liability in the form of a 10% simple interest loan (the 'mirror image' of the bank account in Figure 22).
Before tax, the funding costs are 10% for land acquisition that offers a 10% return. Post-tax, funding costs are 5.3% for land offering an 8.0% return (if half realised gains are taxed) - a nice opportunity to 'gear up' the concessional tax treatment of land. The discussion on negative gearing analyses this situation further.
Analysis of bank accounts and the benchmark tax treatment is unchanged by variable interest being involved - as illustrated in Figure 25 with interest rates declining from 10% in Year 1 to 5% in Year 3 and then increasing back to 10% in Year 5.
An annuity certain is a series of equal payments made at equal periods of time with the payments beginning and ending on fixed dates. Figure 26 shows the cash flows associated with an ordinary annuity certain where the investor places $1000 with a financial institution at the start of Year 1 in return for a series of five payments of $264 at the end of Year 1 and the ensuing four years. The pre-tax rate of return of the investment is 10% - that is, discounting the stream of $264 payments to the start of Year 1 equals $1000 which matches the up-front outlay, resulting in a net present value (NPV) of zero. Given that the payments are known up front, presumably the 10% corresponds with the going interest rate - though expectations about future changes in interest rates would have an impact on the deal struck.
If the annual change in value of the annuity included in tax assessments is computed from the known cash flows (using the annuity's 10% pre-tax rate of return), the after-tax return to the investor on a 47% tax rate will be the 10% pre-tax return reduced by 47%, or 5.3%. Annual change in value is computed (as per Figure 4) by taking the value at the start of the year (say the $1000 at the start of Year 1), multiplying it by the 10% rate (to give $1100), subtracting the annuity payment at the end of the year ($264) to give the annuity value at that time ($836) and, finally, subtracting the value at the start of the year from this end-of-year value to give annual value change (-$164). Thus, the annuity declines in value over Year 1 by $164. In Year2, the annuity's value declines by $180, more than the $164, and this increased rate of decline continues year by year. With value declining, 10% applied to start-of-year value gives a lower positive amount each year which after subtraction of the constant annual $264 results in increasingly higher negative amounts for annual change in value.
Other types of assets that might be expected to exhibit increasing rates of value decline include light globes and one horse shays - or any asset that produces constant benefits or net receipts until collapse.
With investments like the annuity with fixed future net receipts a change in the interest rate environment would change the year-by-year value of the annuity. For example, if at end of Year 1 interest rates dropped to 8% from 10%, the annuity's value at that time would be would be $874 (the then four future payments of $264 discounted to end Year 1 at 8%), not the $836 computed above. If the tax laws in the investor's country did not attempt to adjust the annuity's change in value for general interest rate changes, balancing adjustments would pick up such interest related changes to value if our investor were to sell the annuity to someone else before expiry at end of Year 5 (and the sale value and changed internal rate of return of the new arrangement for computing tax value change would be used for the new owner of the remaining annuity stream).
Bonds with known future cash flowsA bond offering $1000 at the end of year 5 is on offer. It has a zero coupon rate so that no interest payments are to be made over the life of the bond. Risk of the bond aside, an investor, taking into account 10% interest rates available from banks, offers $621 for the bond at the start of Year 1. $621 compounded forward at 10% over five years to end Year 5 gives $1000.
If the annual change in value of the bond (value at year start times 10%) is included in the investor's tax assessment, the investor should still offer $621 for the bond because after tax the return from the bond will still match what the investor can get from banks. If the investor's tax rate is 47%, the after-tax return from the bond and bank interest would be 5.3%.
Again, the pre-tax cash flows and chart in Figure 27 with asset value increasing at 10% look similar to those of the appreciating asset (land) used in the negative gearing discussion - though, unlike the bond, the value of land at end Year 5 is not known with certainty. Typically, the annual accrued capital gain of the discounted bond is included in tax assessments but that of land is not.
If a bond with a face value of $1000 (like that in Figure 27) also had a coupon rate of 5% pa with the $50 coupon payments ($1000 face value times 5%) made at the end of each year, the investor in deciding what to pay for the bond at the start of Year 1 would take into account not only the $1000 face value payable at end of Year 5 and the going interest rate but also the annual $50 coupon payments. In a 5% interest rate environment, the investor offers $1000 - as shown in Figure 28 (ignoring any risk associated with the bond payments). Figure 28 looks just like the bank account of Figure 22 with 5% interest on offer rather than the 10% in Figure 22. The up-front value of the bond is $1000 both before tax with discounting at 5% and after tax (under the benchmark tax treatment) with discounting at the investor's after-tax discount rate of 2.65%.
The year-by-year tax value of the bond in Figure 28 matches that of the specification in the draft legislation of the Review of Business Taxation (1999) (Draft legislation, pg 145) of the tax value at a particular time of a financial asset with known cash flows:
In a 10% bank interest rate environment, because the coupons on the bond stay at 5%, the investor offers $810 as shown in Figure 29. The future payments associated with the bond (annual $50 coupons plus $1000 face value at end) and the 10% internal rate of return of the arrangement (reflecting current interest rate environment) are known. Therefore, change in annual tax value can again be obtained year by year from start of year value times the going 10% rate less any net receipts withdrawn (consistent with the general methodology of Figure 4). Because of the equal annual $50 coupon payments, the rate of annual increase in tax value increases year by year. Risk aside and with this change in tax value included in the investor's tax assessment (together with the coupons), the investor values the bond the same before and after tax.
With a change in the interest rate environment, the value of the bond would change. Such change is given quantitative expression if the bond is sold before maturity. For income tax purposes, the sale price would feed into a balancing adjustment (or, more directly, into final tax value) in the seller's assessment and into starting tax value for the buyer with year-by-year tax value change determined as per Figure 29 with associated interest rate then reflecting the general change to the interest rate environment. Because future cash flows of this bond are known, it would be possible to incorporate into tax value estimated changes to the value of the bond caused by general interest rate movements even when the bond does not change hands (ie administrative 'marking to market') - but that would require the added complexity of discounting the future known flows at a rate of discount determined to reflect the changed interest rate environment.
An alternative method of determining annual change in tax value shown in Figure 30 just looks at the annual increase from the $810 discount price and the $1000 face value of the bond - using the compound interest rate (4.29%) that lifts the discount price to face value over the five years of the bond. While this procedure does reflect some effect of the going interest rate because it uses the market-based discount price, it does not fully incorporate the effect on annual value change of the coupon payments. The year-by-year income for tax purposes in Figure 30 is noticeably different to that in Figure 29. Despite this, in this particular example, the post-tax return varies only slightly from the 'ideal' 5.3%.
This alternative method of estimating value change for tax purposes does have application in cases where variable parameters change bond payments and where choosing a suitable 'going' interest rate for estimating value change is not considered desirable.
Bonds with future flows dependent on changing parametersFigure 31 shows an indexed bond whose $1000 face value at start of Year 1 is increased year by year on the basis of the annual increase in the CPI and annual coupon payments are determined by the bond's coupon rate (5% in this example) times the start-of-year (indexed) face value. Though in practice the annual CPI increase (inflation rate) would vary from year to year, Figure 31 assumes the annual inflation rate remains at 5%. In these circumstances, the pre-tax return of the bond acquired at start of Year 1 for $1000 is 10% pa.
If the going interest rate of 10% were used by the bond investor to discount the expected future cash flows from the bond in Figure 31 (ignoring risk of changing inflation and interest rates), the value of the bond at start of Year 1 would indeed be the then $1000 face value of the bond. That is because the 5% coupon rate plus the annual 5% inflation rate (the two determinants of income from the bond) equal the 10% discount rate.
Change in annual tax value of the indexed bond can again be obtained year by year from start of year value times the going 10% rate less any net receipts withdrawn (consistent with the general methodology of Figure 4). With annual change in tax value (matching actual value) plus coupon payments included in the tax assessments of the bond investor on a 47% tax rate, the investor's 5.3% post-tax return from the indexed bond equals the going 5.3% post-tax interest rate return available to the investor. The investor values the bond at $1000 both before and after tax.
If, however, the going interest rate were 8%, rather than 10%, the investor would value the bond differently. Assume that, despite the interest rate difference, annual inflation remains at 5% pa. In such circumstances where the inflation and coupon rates were independent of the going interest rate, the investor would offer more for the bond. In Figure 32, absent tax, the investor offers $1088 at start of Year 1 with the pre-tax cash flows of the bond - annual coupon payments (net receipts) plus final $1276 payment of indexed face value - discounting at 8% to that amount. The final capital payment remains at $1276 ($1000 increased by inflation rate each year) because inflation remains at 5% pa (and regardless of the coupon rate the annual coupon payments are withdrawn by the investor).
As noted, the annual change in tax value in Figure 32 is determined according to the general methodology of Figure 4: tax value at start of year times the going 8% interest rate less annual coupon payments withdrawn by the investor. Using this approach, no separate calculations are required of the effect of premiums (or discounts) to face value on annual tax value. Moreover, it is not necessary to estimate in advance the future cash flows from the bond, varying cash flows that will be determined by the known CPI figures year by year. In practice, however, this approach does require the determination of the 'going' interest rate to be applied in the calculation of annual tax value change over the period that the bond is held by the investor paying $1088 for it. (A baseline for the 'going' rate with such bonds could be the internal rate of return of cash flows assuming the rate inflation rate remains at current levels.)
Under the assumptions imposed, tax value matches actual value and with the benchmark tax treatment applied (change in annual tax value plus net receipts), the post-tax return to the investor on a 47% tax rate equals 8% reduced by 47%, or 4.24%. Discounting the after-tax cash flows at this after-tax rate, the investor still values the bond at $1088.
Should tax authorities not wish to determine the interest rate to apply to annual computation of the indexed bond's tax value, Figure 33 illustrates an alternative methodology. Under this approach, while annual change in tax value is still determined by 'income' less coupon payments (net receipts), 'income' is not computed from last tax value times a specified interest rate. Under this alternative, annual 'income' is measured directly by adding:
The change in tax value under this approach is different to that in Figure 32. This procedure does reflect some effect of the going interest rate because it uses the market-based price at a premium to face value. It does not, however, fully incorporate the effect on annual value change of the coupon payments. Nevertheless, in this particular example, the post-tax return varies only slightly from the 'ideal' 4.24%. Tax value change under both approaches will diverge from actual value change as the interest rate environment changes. The approach of Figure 33 is set out in the draft legislation of the Review of Business Taxation (1999) (Draft legislation, pg 147). Example 5 in the set of Kyscope Examples uses the same indexed bond and tax value methodology as that of Figure 33.
LeasingThe holder of an asset may decide to sell some or all of the associated future cash flows to someone else in return for a single payment or stream of payments. Similarly, the holder of a liability may decide to pay someone to take over responsibility for future obligations associated with the liability.
Where the holder of a tangible asset (building, vineyard, computer, power station, etc) provides someone else the right to access some or all of the asset's future cash flows for a time in exchange for payment or payments the arrangement is usually termed a 'lease'. The asset owner/lessor allows the lessee to access cash flows that the owner would have otherwise earned directly from the asset in return for lease payment or payments made by the lessee.
From the owner/lessor’s perspective, there are potentially three assets and liabilities involved in such a leasing arrangement:
Some view leasing simply as a financing arrangement or as a vehicle for transferring tax benefits to others who can make better use of those benefits. A traditional approach to the treatment of leases for income tax purposes simply has lease rentals assessable to the lessor and deductible to the lessee (perhaps with CGT provisions dealing with lease 'premiums') with the owner/lessor continuing to attract depreciation/CGT arrangements to deal with the changing value of the underlying asset. Alternatives, often introduced in response to tax revenue concerns relating to the transfer of tax benefits, involve recasting leasing arrangements as debt financing arrangements. These approaches, however, usually do not incorporate any attempt to estimate the annual change in value of the lease itself.
Leasing, rather than buying, an asset may be undertaken for a variety of commercial reasons. A principled approach to the taxation of leases that seeks to keep the decision to lease or buy largely independent of tax considerations would require the tax base to include estimates of annual changes in value (ie economic depreciation) of all assets/liabilities involved in the leasing arrangement - as per Figure 1, drawing on Figure 4 where possible to determine annual change in tax values. Different tax rates of the lessor and lessee would not matter and complex ‘at risk’ rules would not need to be considered.
To illustrate the principled approach, take the depreciating asset in Figure 34. It represents an asset in the form of horticultural plants (like those in an vineyard, orchard, etc) or a mining operation with a delay before first net receipts are realised.
The owner of the asset on a 47% tax rate decides at the start of Year 3 to lease the asset to someone else,
also on a 47% tax rate, from Year 3
to Year 7 in return for a stream of lease rentals of $231 in each of those five years. The lessee has the right to the
net receipts from the underlying depreciating asset in Years 3 to 7.
The owner/lessor judges that the 'bite' taken out of the underlying asset's value by the lease will be compensated
for by the stream of lease rentals.
In this case, the lease is paid for by the stream of $231 annual lease rentals. There is not a single up-front payment providing the up-front value and tax value of the lease. Nevertheless, the stream of rental payments can be used with a selected 'going' interest rate to estimate up-front value. Using a 10% interest rate to discount the equal $231 lease rentals to start of Year 3 produces a $877 starting tax value (with no tax implications as the $877 balances the value of what the lessor has agreed to give up). From that starting tax value, the change in tax value in the ensuing five years is determined in the usual way using the 10% interest rate and the annual $231 lease rental. That is shown in Figure 35 from the lessor's perspective - looking just like the annuity example. This same approach handles any structure of lease rentals, including at the extreme, a single up-back payment.
Because of the known stream of lease rentals, the tax value schedule in Figure 35 estimates directly the profile of value change of the owner/lessor's lease payment asset. Thus, with annual change in tax value and lease payment included in the lessor's tax assessments, the pre-tax 10% return of the asset is reduced by the lessor's 47% tax rate to 5.3%. In contrast, the net receipts produced by the depreciating asset during the lease period may not be known by the lessor. While the $877 up-front value of the lease itself can be taken from the discounted value of the lease rental stream, where the net receipts from the leased asset are not known by the lessor during the lease, alternative estimates of changing tax value need to be made. This is helped by the knowledge that the lease has no value at its end.
Figure 36 shows the lease itself from the lessor's perspective (a liability for the lessor) with its tax value taken to be increasing from the computed -$877 value at start of Year 3 to zero at end of Year 7 on a straight-line basis. For the liability, annual reduction in tax value adds to the lessor's assessable income. For illustrative purposes only, the after-tax return of 5.1% for the lease incorporating this straight-line approximation is computed using annual net receipts drawn from the underlying depreciating asset in Figure 34 as the annual net receipts that the lessor is obliged to allow the lessee to access - even though, given the type of asset involved, the lessor may not know what those net receipts are from year to year. Whether or not the lessor knows these year-by-year net receipts, they are no longer included in the lessor's tax assessments - but their estimated changes in value are.
The cash flows from Figures 34 to 36 are added together to get the year-by-year cash flows across the ten years that the owner/lessor holds the underlying depreciating asset and leases it for five of those years. Thus, the negative net receipts from the depreciating asset in the lessor's lease liability (Figure 36) negate the unchanged cash flows of the depreciating asset during the period of the lease (Figure 34), and provide the required 'bite' of net receipts out of the lessor's pre- and post-tax flows.
From the lessee's perspective, the leasing arrangement comprises an amalgamation of the 'mirror images' of Figures 35 and 36. The mirror image of Figure 35 makes the payment stream a liability for the lessee with the sign of all cash flows in Figure 35 reversed. Thus, the net receipts (lease rentals) are a deductible outflow, the annual change in value of the liability is positive (increasing year by year) and therefore adding to assessable income and the liability results in an overall tax savings of $131.
Similarly, the mirror image of Figure 36 makes the lease an asset of the lessee with the sign of all cash flows in Figure 36 reversed. Thus, the net receipts (produced by the depreciating asset) add to assessable income, the annual 'Change in Value' of the asset is negative (decreasing year by year) and therefore adding to income tax deductions. In addition, on the assumption that the lessee can determine the net receipts from the depreciating asset during each year, the year-by-year change in tax value of the lease is better determined according to the methodology in Figure 4 than the use of a straight-line approximation. Thus, the 'mirror image' of the benchmark tax treatment of Figure 36 could apply to the lessee producing an after-tax return of 5.3% along with $131 total tax revenue.
Drawing all of this together, for tax assessment purposes during the lease period:
If the lease were paid for in full up front, there would be no delayed lease payments to take into account and a market-based value of the lease would be available on which to base annual changes in value of the lease. In addition, if the underlying asset (or liability) were a financial asset (or liability) with known future cash flows at the time of the 'leasing' (or financial assignment or defeasance) arrangement, the general change in tax value methodology could be applied to the arrangement from the lessor's perspective (ie no straight line approximation required), as well as the lessee's perspective. Such an situation is covered in the example of a capital repayment assignment.
The aggregate tax revenue outcome of the leasing arrangement can be summarised as follows (the separate assets/liabilities from the lessor's perspective and the amalgamation of all their flows is included in Example 8 in the set of Kyscope Examples):
As noted, absent tax, leasing (and financial assignment/defeasance) arrangements are undertaken for a variety of commercial reasons. Those commercial decisions should not be much affected after tax if the taxation of these arrangements takes into account good approximations of annual changes in value of all associated assets and liabilities (including the underlying assets/liabilities). For example, not much affected would be, on the one hand, a decision whether to lease an asset or borrow to buy a similar asset or, on the other hand, a decision whether to sell an asset and re-purchase an equivalent asset at the end of a period or to lease it to someone else over that same period.
Tax revenue implications of leasingTax revenue outcomes from leasing are often compared with those of the alternative of borrowing and buying the asset being leased. Some argue simplistically that because lease rental are deductible in full but only the interest component of loans are deductible, the extra tax savings mean that leasing must always be preferred.
In terms of the decision whether to lease or buy, our leasing example shows that, if the tax treatment incorporates the annual change in value of the underlying asset and of the assets/liabilities involved in the lease (and full loss offset applies), both the decision to buy (Figure 34) and the decision to lease will be unaffected by income tax. With either buying of leasing, pre-tax 10% returns available in financial markets will become 5.3% returns after tax for the 47% tax rate asset user - with after-tax returns changing commensurately with the asset user's tax rate. In either case, borrowing as per Figure 24 will not affect this outcome. That is underlined in the negative gearing discussion by Figure 13 that involves 95% debt funding of assets taxed according to the benchmark treatment.
Similarly, taxing on the basis of the benchmark treatment will also have no tax revenue implications associated with leasing versus borrowing to buy, regardless of the tax rates of the lender/lessor and asset user. The tax payable by the lender/lessor and asset user will accord with the benchmark tax base regardless of respective tax rates.
Even if the benchmark treatment is breached by say the asset in question attracting tax concessions in the form of accelerated depreciation and/or investment allowances, there are no tax revenue implications if the lender/lessor and asset user are both in a profitable position and face the same tax rates. In these circumstances, tax savings for the lessor from these concessions are the same for the asset user who buys the asset. If, however, the asset user is on a lower tax rate than the lender/lessor (at the extreme, tax exempt) or in a loss situation (with no full loss offset available), the lessor has the opportunity to share the lessor's tax savings from the tax concessions with the asset user via reduced lease rentals - making the lease alternative more attractive to the asset user at a cost to revenue relative to the borrowing to buy alternative.
One way to visualise this is to observe that the annual costs associated with owning an asset comprise (1) the annual interest cost of tying money up in the asset rather than putting the money in the financial market and (2) the annual depreciation or loss in value of the asset. Thus, before tax in a competitive environment, lease rentals for using someone else’s asset would reflect the interest plus depreciation costs faced by the asset owner/lessor. If the asset user bought the asset rather than leased it, the user would face the same interest plus depreciation costs directly - with the possibility of 'swapping' some or all of these costs by borrowing and repaying the principal (equal to the loss in value of the loan over its life) plus interest on the loan.
Assume for purposes of illustration that the choice is between, on the one hand, buying an asset with a loan covering the full price of the asset and, on the other, leasing the asset. And competitive markets and benchmark tax treatment result in equal annual loan repayments and lease rentals which, in turn, equal the annual interest and depreciation cost of the asset. Each annual loan and lease payment comprises an interest ('income' in our examples) and principal ('change in value' in our examples) component. Against this stylised situation, Table 3 illustrates the income tax treatment of interest and principal components of the loan and lease payments.
| Transaction | Lender/Lessor | Borrower/Lessee (asset user) | Loan | Interest taxable Principal non-taxable | Interest deductible Depreciation deductible |
|---|---|---|
| Lease | Rentals (interest & principal) taxable Depreciation deductible | Rentals (principal & interest) deductible |
Looking across the rows of Table 3, with a loan the asset user gets a deduction for both the interest and depreciation costs and the loan interest is taxed in the hands of the lender. With a lease, the net result is the same as with the loan: the lessee gets a deduction for the interest and depreciation costs reflected in the lease rentals; the lessor, after deducting the asset depreciation (doubling for the principal component of lease rentals), pays tax on the interest (or income) component of the rentals. For the asset user, beyond these deductible asset costs are the net receipts from the asset to be included in assessable income.
No tax revenue implications are associated with the situation depicted in Table 3. Regardless of the tax rates of the lender/lessor and asset user, each faces the same tax treatment on interest and principal components of both the loan and the lease. Where the asset attracts taxation allowances more generous than economic depreciation, however, the lessor has the opportunity to pass associated tax savings by way of reduce lease rentals to lessees on lower tax rates (or facing tax losses) who are less able to generate similar tax savings. The result is a cost to tax revenue (driven by the tax preferences, not leasing per se) and a bias towards leasing.
Where it is not possible to remove the tax preferences themselves, governments sometimes legislate to avoid tax losses associated with some leasing arrangements. Two such approaches are the ‘actuarial’ option and the ‘sale and loan’ option.
With the actuarial option:
The actuarial option translates the tax position of the lessor into one that equates with that of a lender of finance – effectively assessing lease rentals in the hands of the lessor but allowing as a deduction estimates of the annual change in value of the lease rental stream (leaving the net ‘interest’ component assessable).
With the ‘sale and loan’ option:
Both the actuarial and sale and loan options are artificial constructs that collapse the assets and liabilities associated with a leasing arrangement into a simple debt financing arrangement. They may be analysed with the MyProject package.
Capital repayment assignmentSomeone holding a financial asset may give up some or all the asset's future cash flows in return for a single payment or stream of payments (an 'assignment'). The assets and liabilities involved in such assignments are conceptually the same as with a lease over a depreciating asset. One practical difference is that the future cash flows of financial assets subject to an assignment are known at the time of the assignment - making it theoretically possible to estimate annual change in value of the assignment liability of the assignor on the basis of known year-by-year flows (instead of choosing say straight line value increases as was done in the leasing example).
Similarly, someone holding a financial liability may pay someone else to take over responsibility for some or all of the future obligations associated with the liability (a 'defeasance'). Again, the analytical framework for determining the income tax treatment of a defeasance is the same as for a lease over a depreciating asset - except that each asset in the leasing analysis is a liability in the defeasance analysis, and vice-versa with liabilities in leasing.
To illustrate a financial assignment, take a taxpayer on a 47% tax rate who holds the bond shown in Figure 37 with a face value of $1000 and annual coupons of 10%. The bondholder acquires the bond at start of Year 1 for $1000 as the 'going' pre-tax 10% interest rate used for discounting future flows matches the bond's coupon rate. The year-by-year change in tax value of the bond is determined according to the methodology in Figure 4. Risk aside, with discounting after-tax future flows at the bondholder's after-tax discount rate (5.3%), the bondholder still values the bond at $1000 after tax.
At the start of Year 2 when the 'going' interest rate has increased from 10% to 12%, a third party pays the bondholder $636 in return for receiving the $1000 face value at end Year 5 instead of the bondholder. Thus, the bondholder accepts the assignment liability shown in Figure 38.
From the assignee's perspective, at start of Year 2 the assignee has paid $636 up-front for the right to receive $1000
at end Year 5. The associated asset is the 'mirror image' of Figure 38 increasing in value from $636 to $1000 over four
years. Unlike the leasing example, with the payment for the assignment all up front there are
no assets/liabilities associated with a stream of delayed payments for the assignment.
Risk aside and with the assignment taxed according to the benchmark (Figures 1 and Figure 4), regardless of their tax rates, the bondholder/assignor and assignee value the assignment at $636 both before and after tax.
Before the assignment, the bondholder pays $235 tax under the tax treatment in Figure 38. Despite the change in the 'going' interest rate from 10% to 12% in Year 2, the annual change in tax value of the bond in the bondholder's tax assessment would continue to be determined over the life of the bond using the 10% interest rate applicable at start of Year 1. That would be the tax outcome unless the bond is either (1) listed with market value readily available and taxed on a 'mark-to-market' basis (Figure 1) or (2) taxed on an administrative 'mark-to-market' basis (changes in 'going' interest rates factored into annual tax value, drawing on the bond's known future cash flows).
After the assignment, change in tax value of the assignment is determined using the changed 12% interest rate. The assignor realises a total $171 of tax savings in recognition of the assignor's foregoing the $1000 capital repayment for $636 up front. The assignee, also on a 47% tax rate, pays a total of $171 tax on the annual income of the assignment asset acquired for $636 and ultimately rising to $1000. With the assignor and assignee both on a 47% tax rate, the net overall tax paid is $235, the same total tax paid without the assignment (the income from the bond itself is not changed by the assignment).
Foreign bonds and bank accountsInvestment in financial assets issued offshore immediately raises such issues as the rate of currency exchange between the investor's home country and the offshore country, interest rate relativities between the two countries, differences in the tax treatment of the financial arrangement between the two countries and foreign tax crediting arrangements in the home country. Movements in the exchange rate over the life of the arrangement puts a focus on risk which, in turn, raises the possibility of hedging arrangements (like forward exchange arrangements) to lock in particular exchange rates in the future.
In tax assessments in the home country, when actual cash flows take place between the two countries (investment flows from home country offshore and cash flows back from offshore to home country) those flows are converted into home country dollars at the current spot exchange rate. The key issue is how to deal with year-by-year tax values of the associated investments. That issue applies to all foreign assets and liabilities.
Take the case of the discounted zero coupon bond of Figure 27. It is now issued offshore in circumstances where the 'going' offshore interest rate is 10% but the rate of exchange of home country dollars for offshore dollars is expected to appreciate at 2.5% a year from parity - $1 offshore (O$) per $1 home (H$) - at start Year 1 to O$1.1314/H$ at end Year 5. In other words, an offshore dollar at start Year 1 translates to one home dollar and at end Year 5 translates to 1/1.1314 home dollars or $0.88. The appreciation of the forward exchange rate could be expected to be accompanied by lower home country interest rates relative to the offshore country (the higher rates on offer offshore offset by the expected currency appreciation): the forward exchange rate changing at a constant rate over time reflecting expectations of a constant interest rate differential.
This offshore investment viewed in home country dollars is illustrated in Figure 39. In the offshore country the discounted zero coupon bond looks just like that in Figure 27. In the home country, Figure 39 shows the $621 initial outlay on the bond at start Year 1 (the same amount in offshore currency because the exchange rate is at parity at that time) and the $884 face value payout at end Year 5 ($1000 in offshore currency times 1/1.1314, as reflected in the forward exchange rate). Those flows equate to a pre-tax return of 7.32% (lower than the offshore 10% reflecting the lower interest rate structure at home).
Figure 39 includes three alternative ways of specifying in the home country the tax values of the investment year by year. Each uses the methodology of Figure 4 but with differing ways of applying currency conversion:
In practice, the spot O$/H$ exchange rate in each of the years of the investment undoubtedly will not match the forward exchange rates for those years viewed at the start of Year 1. Underpinning Figure 40 are all the same investment details as Figure 39 except that in Year 3 the O$/H$ spot exchange rate is $0.75. In that year, one H$ buys only O$0.75 rather than the O$1.0769 expected from forward rates at start Year 1.
Approach (2) is shown in Figure 40 as the 'benchmark' treatment. The large swings in tax value in Years 3 and 4, and consequently in local tax paid in those years, follow the large depreciation in the H$ in Year 3 and bounce back in Year 4. Approaches (1) and (3) would be unaffected. Total tax (local and foreign) is the same under all three approaches.
The issues are not much changed if the $1000 foreign bond has annual 10% coupons attached, providing an overall 10% pre-tax return in the foreign country, and with forward exchange rates again increasing at 2.5% a year, from O$1.0/H$ at start Year 1 to end Year 5 (1.0, 1.025, 1.0506, 1.0769, 1.1038 and 1.1314), as shown in Figure 41. Under the three different approaches of H$ tax value determination of Figure 39, annual taxable H$ income in Figure 41 comes from:
Again approaches (1) and (2) reduce the H$ pre-tax 7.32% return by the home investor's 47% tax rate to 3.88% and approach (3) by somewhat more than 47%.
Figure 42 shows what happens during the investment if in Year 3 the spot exchange rate turns out to be different than expected up front: O$0.75/H$ rather than the forward rate of O$1.1314/H$.
Again approach (2) is shown in Figure 42 as the 'benchmark' treatment. The large increase in H$ coupon payments in Year 3 plus the large swings in tax value in Years 3 and 4, and consequently in local tax paid in those years, follow the large depreciation in the H$ in Year 3 and bounce back in Year 4. Under approach (1) - not shown in Figure 42 - the year-by-year tax values would be computed using the 7.32% pre-tax return and year-by-year O$ coupons converted to H$ using Year 1 forward exchange rates as per Figure 41. However, the difference between H$ net receipts expected on the basis of forward exchange rates and the actual H$ net receipts received given year-by-year spot rates (in the case of Figure 42, H$133-H$93 or H$40 in Year 3) is added to home tax assessments (providing an extra H$19 of tax in Year 3 over the $164 total in Figure 41). Under approach (3), shown in Figure 42 as the selected 'tax treatment', the spot exchange rate change in Year 3 would not affect the constant H$1000 tax value but would again increase assessable income in that year by $40. Thus, again total tax (local and foreign) is the same under all three approaches but $19 higher in Figure 42 than in Figure 41 because of the higher $H coupons in Year 3 caused by the unexpected currency depreciation.
Overall, approaches (1) and (2) fit well with the general investment neutrality framework. In practice, however, approach (1) would involve a good deal of complexity (keeping track of annual forward rates across the life of investments and making additional adjustments for different spot rates). Approach (2) would involve much volatility in tax assessments with varying spot exchange rates. Approach (3) offers simplicity but with greater variance from the general investment neutrality framework.
What if, instead of a investing in a foreign O$1000 bond with 10% coupons over 5 years, the local investor opens a foreign bank account providing 10% pa interest in the foreign country and closes the account and brings all funds back home after 5 years? In foreign dollars, if the investor brings the bank interest back home each year, the bank account would have the same numbers as Figure 22. In these circumstances, the analysis of the bank account in home dollars under each of the three tax treatment alternatives would look exactly like Figure 41 if annual spot exchange rates turned out the same as the forward rates underlying that figure and exactly like Figure 42 if the spot rates included the unexpected depreciation of the home currency in Year 3 that underlies that figure.
If, however, the local investor leaves the foreign interest in the foreign bank account each year, the analysis under each of the three tax treatment alternatives would parallel that of the zero coupon bond in Figures 39 and 40. The bank account with reinvested interest is shown in Figure 43 in the circumstances where spot exchange rates vary from forward rates a only by the depreciation to O$0.75/H$ in Year 3.
Again approach (2) - the 'benchmark' tax treatment in the figure - results in very large variations in annual tax payable caused by the unexpected exchange rate depreciation in Year 3. Approach (1) - not shown in figure - would produce smoothly increasing annual tax payments ($34, $37, $40, $43, $46). The simple approach (3) - the selected 'tax treatment' in the figure - essentially ignores year-by-year exchange rate variations and again requires a large balancing adjustment in the final year (-H$188) to make up for excessive taxation over previous years.
Exchange rate riskThe examples of offshore financial assets highlight the following general points relating to the neutrality relationship between pre- and post-tax rates of return of offshore assets/liabilities expressed in currency of the offshore country (O$) or of the home country (H$).
For a discussion of risk in the context of the investment neutrality framework see
Mayo (1984).
Version 1.0 © Copyright Wayne Mayo 2009