Law Watch – Manufacturers’ Credits Under Threat

Examples of the goods and services for which a credit memorandum may be applied include: airframes; engines; simulators; aircraft specifications ordered by a buyer, spare parts; maintenance support; service and repairs; and computer support.

A credit memorandum issued by the manufacturer will have a dollar value and may be converted to cash or applied against any existing or later debt owing to the manufacturer. In some instances, the manufacturer’s credit voucher may be applied against a debt owed by the buyer to a third party supplier.

Manufacturers also offer non cash incentives. These are usually made available other than by the issue of credit memoranda and include goods and services provided to the buyer for no cost or a reduced cost. Goods and services in this category may include: computer software/hardware; pilot training; spare parts/equipment; and engines.

The ATO’s Position

The ATO believes that a buyer of new aircraft has derived assessable income if the buyer receives a manufacturer’s credit. This is regardless of what form the credit takes (cash incentive or non-cash incentive), how the buyer may apply the credit, or whether the manufacturer allows the buyer to trans- fer the credit to a related entity or third person. So, unless the buyer can demonstrate that the credit was really a discount on the aircraft’s purchase price (and the ATO will be reluctant to accept such a proposition), the buyer will be taxed on the credit given by the manufacturer.

If an aircraft is purchased for business use and a manufacturer issues credits, whether or not the purchaser is considered an operator in the ordinary sense, the operator will be taxed on the credits. In other words, if an airline or flying school or corporation engages in the type of business that requires the purchase of a new aircraft, the credits received are an ordinary incident of carrying on that business.

The ATO has expressed doubt about manufacturers giving credits to reduce an aircraft’s purchase or order price. The ATO believes that manufacturer’s credits are characteristically different from discounts: a credit provides a positive benefit to the recipient while a discount reduces the buyer’s contractual obligations. As a consequence, a buyer will now be required to demonstrate to the ATO that there is a direct reduction in the amount payable for the aircraft by the credits issued by the manufacturer. The ATO will examine the parties’ intention and conduct by referring to any agreements entered on Australian Aviation May 1993 into. It may be that the ATO will require an immediate application of the credit against the purchase price or an existing debt. Perhaps the easiest way to illustrate the ATO’s position is by the following examples.

Example 1 Suppose a manufacturer agrees to provide a buyer with a credit that may be taken in cash or used to cover the cost of other goods and services provided by the manufacturer. The buyer, a commuter operator, agrees to buy two turboprop commuter aircraft for $US5 million per aircraft. The parties enter into a purchase agreement for the aircraft and a separate letter agreement for the credits.

The manufacturer agrees to give airframe credits of $US300,000 per aircraft and engine credits of $US50,000 per aircraft. The manufacturer permits the buyer to use the credits in various ways upon delivery of the aircraft.

The buyer decides to take a portion of the credits in cash, a portion to be applied to the purchase of spare parts and the remainder as reimbursement for goods and services purchased from an unrelated manufacturer. Under this example, the ATO would treat the airframe credits and the engine credits totalling $US700,000 as assessable income to be included as part of the buyer’s gross income.

Example 2 Let’s take an example that applies the ATO’s reasoning on discounts. A manufacturer offers a flying school a credit that may be applied against the cost of goods and services. The flying school has decided to update its existing fleet and agrees to buy seven new training aircraft from the manufacturer at a cost of $US250,000 each.

As an incentive, the manufacturer agrees to give a credit of $US25,000 for each aircraft the buyer purchases. The letter agreement provides that the credits may be taken in cash, used for spare parts or taken off the cost of the aircraft.

Of the total $US175,000 credit the flying school receives, it decides to apply half of the credit against one aircraft and the other half against a second aircraft. The ATO would only recognise the $US25,000 credit applicable to the first aircraft and the $US25,000 applicable to the second aircraft as a “discount” in the cost price. The balance of the credits ($US5,000) would be assessable income for the flying school. Example 3 What if a manufacturer agrees to supply a buyer with two additional engines at no cost rather than a credit if the buyer agrees to purchase a certain number of aircraft? Each engine is worth $US40,000. The ATO would consider this benefit to be readily convertible to cash and would consider the total value (SUS80,000) as income to the buyer.

Example 4 Finally, suppose an operator buys some aircraft and, as an inducement, the manufacturer provides computer software tailored to the operator’s needs for pilot training on this type of aircraft. These incentives are not convertible to cash. However, the ATO would treat the incentives as assessable and convertible to cash. The ATO would value the benefit of the computer software at its arm’s length value. This value would then be taxable income to the operator.

Where To From Here?

The period for submissions on the draft ruling closed on February 1 1993 with surprisingly few comments from the aviation industry.

If the final ruling follows the draft ruling in substance, manufacturers will be forced to re-evaluate the practice of issuing credits to buyers. Buyers will insist on discounts on the primary equipment they purchase and they will then separately acquire the add on services or equipment they require.

The final ruling will have a wide scope. It will have a retro-spective operation since it purports to explain the existing tax law. The open time frame could mean an unrealistic level of exposure for an aircraft purchaser. What is more likely is at retrospective application to August 31 1988, the enactment date of legislation which treats non convertible property as convertible to cash in determining taxpayer’s income. There is some question as to how the ATO will effectively enforce the position it has taken regarding manufacturer’s credits. Although the tax system is based on self-assessment, there will be every temptation by purchasers or lessees to ignore the potential assessability of any incentives received from manufacturers. Along with targeting aircraft operators with audits, the ATO will certainly avail itself of the public nature of the aircraft register to review recent acquisitions.

The ruling will require recent purchasers or lessees of aircraft to calculate what the cost will be of the incentives they have accepted. They will also have to refigure tax returns in which they have taken depreciation for equipment given to them as an incentive. Future transactions will either not include incentives to purchasers/lessees, or will require the parties to ensure the recipient does not face adverse tax consequences without avoiding tax that should be properly paid.

Although the Draft Taxation Ruling is meant to clarify the ATO’s position regarding manufacturer’s credits for new aircraft sales, there is every reason to believe the ATO will apply the same thinking to aircraft leasing. Certainly, the ATO has judicial support in a recent ruling that considered incentives taxable to business taxpayers who are induced to enter leases for business premises. A ruling on sales tax held that if the sale value of goods was reduced because of an incentive, the amount of sales tax payable is not reduced unless it is attributable to a particular item.

It certainly appears that the ATO is seeking to attack what it perceives as a problem from all sides.

Kim Todt is an aviation law specialist with Minter Ellison -Morris Fletcher, Melbourne.