Below is the results of a survey I commissioned PKF Worldwide to carry out on client art leasing. This is a definitive response on art and leasing, however we must announce that the laws and legislation on art and leasing are subject to change. Therefore we ask that you speak with your financial advisor about this issue. Mark Widdup   Information as at 18 May 1999   We refer to your recent discussions with Michael Grant of this office and your request for advice to assist you with the marketing of works of art. Our advice focuses on the tax implications associated with the leasing of works of art with specific reference to the prospective lessee.     A deduction will be available to a lessee for payments made under a commercial lease provided they have the necessary nexus with the lessee's production of assessable income or carrying on of a business.   In this regard, as outlined below, the lease must be drafted as a commercial lease with a commercially determined lease term and residual value.   Although experience shows that the lessee ultimately acquires the goods under lease, the terms of the lease must not expressly or impliedly provide the lessee with an option to purchase the artworks at the end of the lease term. The existence of such terms will colour the arrangement as a purchase of goods and affect the deductibility of the payments made.     -  The works of art will be sold to a finance company (eg. Interlease Capital Holding Pty Ltd (ICH)) (the lessor) which will lease the art to the interested buyer (the lessee).   -  The lessee and the lessor are not associated with each other and will be dealing with each other at arm's length. The lessor is also not associated with Mark Widdup Fine Art.   -  The works of art range in value from $10K to $200K.   -  None of the works of art have been or will be created by established "masters" where the value of the paintings would substantially exceed $200K.   -  Commercial experience has shown that the works of art appreciate in value over the terms of the lease.   -  It is an industry custom that the lessor will allow the lessee to purchase the goods at the end of the lease for the residual value regardless of the market value.       A tax deduction will be available where the payments have a nexus to the lessee's gaining or producing assessable income or carrying on of a business for the purpose of gaining or producing assessable income and the expense is not of a private or capital nature.   The tax deductibility of payments pursuant to a lease agreement depends on whether the agreement is in substance and form an ordinary commercial lease or whether it is an agreement for the purchase of the artwork.   The Commissioner of Taxation states in Income Tax Ruling IT 2215 (with reference to IT 28) that if an ordinary commercial lease agreement exists, the lease payments will qualify for an income tax deduction.   However, if the Commissioner is of the opinion that the arrangement is one that relates to the purchase of art works, payments relating to he repayment of principle will be of a capital nature and non-deductible. In this situation, a depreciation deduction may be available over the effective life of the artwork.     The Commissioner, in Income Tax Rulings IT 2215 and IT 28 and Taxation Ruling TR 98/15, provides numerous factors which he considers relevant in determining whether a commercial lease exists. Specifically, a commercial lease will exist where the agreement:   -  Does not contain an express or implied understanding that the artworks will pass from the lessor to lessee (eg the existence of an option to purchase).   -  Does not contain an option/right, express or implied, at the expiration of the lease for the lessee to retain the artworks.   -  Contains a residual value which reflects the commercial value of the goods at the expiration of the lease. In this regard, consideration must be had to the possibility that the art works' market value may appreciate over the term of the lease.   -  Does not provide an express or implied provision that the works of art be disposed of at the termination of the lease otherwise than by way of public auction.   -  Does not provide for one off payments to secure the use of the art for an extended period of time or to reduce subsequent payments under the lease.   -  Has terms and lease payments, which are in accordance with generally accepted, commercial practice and is not tax driven.   It is important that the above factors exist in order for the lessee to establish a reasonably arguable position thereby supporting the deductibility of the lease payments.   We emphasise that the terms of the lease agreement must not demand that the lessee pay the residual at the end of the lease term and then take ownership.     Recurring lease payments made pursuant to a commercial lease complying with the above terms, should be deductible to the lessee provided they have a necessary nexus with the production of the lessee's assessable income or the carrying on by the lessee of a business for that purpose.   Furthermore, balloon payments or prepayments should be deductible where they relate to upcoming commercial lease obligations relating to a period not exceeding 13 months. These payments must not reduce subsequent payments under the lease. If they do, there is a likelihood for the Commissioner to treat the arrangement as a purchase of the artwork.     The Commissioner considers that the residual value is an important element in determining whether or not the lease is commercial.   In Income Tax Rulings IT 28 and IT 174 the Commissioner considers the residual value should reflect the expected value of the item at the end of the lease term. However, in some cases the market value of the leased item may increase over the lease term. However, in IT 174 the commissioner indicates that he accepts that it will be very difficult to determine which items will go up and which items will go down in value. Therefore, he allows the residual value to be calculated under the guidelines in IT 28.   Income Tax Ruling IT 28 indicates that the residual value will be a function of the lease term and the expected effective life of the item. Generally the minimum residual value will be higher for shorter lease terms and also higher for longer effective life.   IT 28 also states that the residual value does not have to necessarily correspond with the depreciated value of the leased item but it should reflect a reduction of value over the effective life. As a guide IT 28 indicates that an item with an effective life of 20 years could have a minimum residual value of 60% and with a 5 year term a minimum residual value of 50%.   Note that the comments in IT 28 and IT 174 are not binding rulings and are guidelines only and the residual value must be in accordance with a generally accepted basis of commercial or industry valuation. Documentation should be retained in relation thereto.     We are of the view that such an arrangement whether express, implied or otherwise may be construed by the Commissioner as an indication that the lease is not an ordinary commercial lease.   In fact the Commissioner in IT 28 has stated "... I should not regard as a normal commercial lease an arrangement under which, on termination of the lease or any extensions thereof, the lessee was permitted or enabled to retain the use of the goods."   We understand that this does not mean that the item cannot be re-leased but there should be no provision in the lease agreement for the artwork to be re-leased for the residual. Any re-lease arrangement must be seen as a separate arrangement.     The expiry of the lease will constitute an "event" for the capital gains tax (CGT) provisions of the Income Tax Assessment Act (1997).   An analysis of the CGT provisions is beyond the scope of this paper. However, it is unlikely that, in light of information to the contrary, the expiry will have any CGT effect on the lessee.   It is important to note that the residual paid at the expiry of the lease will not be deductible to the lessee as it will be a capital outgoing for the acquisition of the artwork.   The residual paid should constitute the CGT cost base of the artwork and will be used in the determination of the capital gain or loss on subsequent disposal by the new owner (previous lessee). Accordingly, documentation evidencing the acquisition must be retained.     It is beyond the scope of this paper to provide an analysis of the GST implications associated with a lease agreement. It is however an issue that requires consideration by both the lessor and lessee. Broadly speaking, the Federal Government has proposed that the GST regime takes effect from 1 July 2001. Transitional provisions exist which address the application of the GST regime to arrangements entered into before 1 July 2001 but which span beyond 1 July 2001. These provisions may apply to the leasing arrangements.     We would be pleased to provide advice and assistance to the participants in relation to this issue. We trust that the above will be of assistance to you.   your sincerely, Michael Grant   Partner - Tax Consulting PKF Worldwide   If you are interested in more information about leasing artwork, please contact us.   to Art Advisor