Lease inducement payments and lease surrender payments

OVERVIEW

An officials’ issues paper, The taxation of lease inducement payments, was released in July 2012, seeking feedback on proposals to tax lease inducement payments.

Lease inducement payments are unconditional lump sum cash payments generally made by landlords to induce tenants to enter into a commercial lease. For income tax purposes, these payments are typically non-taxable to a recipient (tenant) and deductible to a payer (commercial landlord). The risk identified in the issues paper was the tax asymmetry, which created an opportunity for taxpayers to substitute tax deductible rent payments with non-taxable cash lease inducement payments.

Following public consultation, the Government decided to tax lease inducement payments. However, the scope of the reform was extended to include another type of lease-related payment – lease surrender payments. For income tax purposes, lease surrender payments that are generally made by tenants to landlords to surrender existing lease arrangements are typically taxable to the recipient (commercial landlord) and non-deductible to the payer (tenant). These payments are currently regarded as “black hole” expenditure to the commercial tenant – that is, non-deductible business expenditure.

Measures introduced in this Supplementary Order Paper treat lease inducement payments and lease surrender payments as taxable to the recipient and tax deductible expenditure for the payer under the Income Tax Act 2007 from 1 April 2013. Generally, income and expenditure derived or incurred from these payments will be spread over the term of a lease.

The proposed measures are designed to improve fairness and business efficiency by removing existing tax treatments that distort business decisions such as non-taxable lease inducement payments and non-deductible lease surrender payments.

There will be a further review on the tax treatment of other commercial land-related lease payments, such as lease transfer payments. This review will consider the general tax treatment of commercial land-related lease payments, with a view to achieving a coherent and consistent tax treatment of these payments. It is expected that an officials’ issues paper will be released for public consultation early next year seeking feedback on the review.


THE TAX TREATMENT OF LEASE INDUCEMENT PAYMENTS AND LEASE SURRENDER PAYMENTS

(Clauses 4B, 17B, 25B, 32B and 57(19B))

Summary of proposed amendments

Measures introduced in this Supplementary Order Paper modify the capital-revenue boundary for two specific land-related payments, namely lease inducement payments and lease surrender payments. Lease inducement payments are unconditional lump sum cash payments generally made by landlords to induce tenants to enter into a commercial lease. Lease surrender payments are generally made by tenants to landlords to surrender existing lease arrangements.

From 1 April 2013, these payments will be treated as taxable to the recipient and deductible to the payer under the Income Tax Act 2007.

Application date

The reform will apply to an amount that is:

  • derived or incurred from 1 April 2013; and
  • not derived or incurred as consideration for the agreement, before 1 April 2013, to a lease of land or a licence to use land.

The income tax treatment of an amount derived or incurred as consideration for the agreement before 1 April 2013 to a lease of land or a licence to use land will continue to be determined under general principles and provisions in the Income Tax Act 2007.

Key features

There are two main groups of amendments. The first group includes amendments relating to the tax treatment of lease inducement payments, namely the charging provision (new section CC 1B), the deduction provision (new section DB 20B), and the timing provision (new section EI 4B). The second group includes amendments relating to the tax treatment of lease surrender payments, namely the charging provision (new section CC 1C) and the deduction provision (new section DB 20C).

Under the amendments relating to lease inducement payments:

  • If a person (the payee) derives an amount as consideration for the agreement by the payee to the grant, renewal, extension, or transfer of a right (the land right) that is a leasehold estate or a licence to use land, the amount will be taxable to the payee. An amount derived by a tenant of residential premises will be specifically excluded from the charging provision (new section CC 1B).
  • A matching deduction provision will be provided. If a person (the payer) incurs an amount of expenditure as consideration for the agreement by another person (the payee) to the grant, renewal, extension, or transfer of a right (the land right) that is a leasehold estate or a licence to use land, the payer will be allowed a deduction for the amount (new section DB 20B).
  • A new timing rule will allocate the income and deductions from a lease inducement payment evenly over the term of the land right to which the payment relates. An exception will apply when the person ceases to hold the relevant land right, or the estate in land from which the land right is granted, during an income year. For income, the remaining amount to be spread under the general timing rule will be allocated to that income year. For deductions, the remaining amount to be spread will be allocated to that income year if the land right, and the estate in land from which the land right is granted, are not held by the person or an associated person (new section EI 4B).

Under the amendments relating to lease surrender payments:

  • If a person (the payee) derives an amount as consideration for the agreement by the payee to the surrender of a leasehold estate or the termination of a licence to use land, the amount will be taxable to the payee. An amount derived by a tenant of residential premises will be specifically excluded from the charging provision (new section CC 1C).
  • A matching deduction provision will be provided. If a person (the payer) incurs an amount of expenditure as consideration for the agreement by another person (the payee) to the surrender of a leasehold estate or the termination of a licence to use land, the payer will be allowed a deduction for the amount (new section DB 20C).
  • There is no specific timing rule for lease surrender payments. The general principles and provisions of the Income Tax Act 2007 will apply to determine the timing of income and deductions for lease surrender payments. Generally, income and deductions arising from lease surrender payments will be allocated to the income year in which the amount is derived or incurred.

Background

In July 2012, an officials’ issues paper, The taxation of lease inducement payments, was released which proposed to address the revenue risk posed by lease inducement payments by making them taxable.

Lease inducement payments are unconditional lump sum cash payments generally paid by landlords to tenants as an inducement to enter into a commercial lease. For the recipient, the payment is generally a non-taxable capital receipt because the payment is received in relation to a lease that relates to the structure of the tenant’s business. The capital nature of a lease inducement payment was confirmed by the Privy Council in Wattie. For the payer, the payment is generally tax deductible if the payer incurs the expenditure in the course of carrying on a business of leasing.

The revenue risk identified in the issues paper was the deductible and non-taxable tax treatment of lease inducement payments in a commercial context. This created an opportunity for taxpayers to substitute tax deductible rent payments with non-taxable cash lease inducement payments. Also, compared with other forms of lease inducements such as a rent-free holiday or a contribution for fit-out costs, these payments provided a tax advantage which distorted business decisions on leases.

Example

A commercial landlord with premises that are used to generate $100,000 of rental income a year during an economic upturn would struggle to do so in a downturn. To induce a tenant to enter into a lease, the landlord could either reduce the rent from $100,000 to $60,000 or offer a lease inducement payment of $40,000 while maintaining the rent of $100,000.

Under the latter arrangement, the landlord receives the same amount of after-tax income of $43,200 ($100,000 minus $40,000 lease inducement resulting in taxable income of $60,000 less income tax at 28%). The tenant receives the tax advantage as they do not pay income tax on the amount of lease inducement of $40,000, while claiming a tax deduction for rental income expenses of $100,000 against their income. The tenant is $11,200 (tax cash value of non-taxable lease inducement payment of $40,000 at 28%) better off than simply paying the rent of $60,000. The deduction of $40,000 extra rent shelters income of the same amount.


Following public consultation, the Government decided to tax lease inducement payments as a base-protection measure. However, the scope of the reform was extended to address another existing asymmetry in the tax system that is “taxpayer-unfriendly” – the non-deductibility of lease surrender payments.

Lease surrender payments are generally made by tenants to landlords to surrender existing lease arrangements. Lease surrender payments are typically taxable to the landlord recipient if they are in the business of leasing, but non-deductible to the tenant payer if the lease premises relate to the structure of the tenant’s business; the latter treatment has been confirmed by the Court of Appeal in McKenzies. These payments are currently regarded as “black hole” expenditure to the commercial tenant – that is, non-deductible business expenditure.

This reform is limited in scope by addressing existing tax asymmetries relating only to lease inducement payments and lease surrender payments. However, there are other existing tax asymmetries in the tax system in relation to other land-related lease payments such as lease transfer payments. Currently, lease transfer payments are generally non-taxable to the commercial tenant recipient and deductible to the incoming commercial tenant under the depreciation rules.

Following the limited reforms included in this Supplementary Order Paper, there will be a further review of the taxation of other commercial lease-related payments. The objective of the review is to provide a consistent and coherent tax treatment of all commercial land-related lease payments that is consistent with the broad-base, low-rate tax framework. It is expected that an officials’ issues paper will be released for public consultation early next year seeking feedback on the review.

Detailed analysis

The tax treatment of lease inducement payments

Income

New section CC 1B provides that if a person (the payee) derives an amount as a consideration for the agreement by the payee to the grant, renewal, extension or transfer of a land right, the amount will be taxable to the payee. The land right must be a right that is a leasehold estate or a licence to use land.

The charging provision will not apply to an amount derived in relation to a freehold estate in land, such as the proceeds from the sale of land. However, the charging provision will apply broadly to include amounts derived in relation to leases, including subleases, and other estates or interests in land. The term “leasehold estate” is defined in section YA 1 to include any estate, however created, other than a freehold estate.

An exception applies for residential tenants. A lease inducement payment is not income of the payee to the extent that the payee derives the amount as a tenant of residential premises. If there is a concurrent use of the land right for residential and business purposes, the amount will be apportioned so that only the amount relating to the business use is taxable (subsection (4)).

The charging provision will apply broadly to include amounts derived in relation to the entry into an agreement for the grant, renewal, extension or a transfer of the land right. For example, the provision will apply to an amount paid by a grantor of the land right (landlord) to induce a grantee (tenant) to agree to the grant, renewal or extension of a lease. Also, an amount paid by an assignor to induce an assignee to receive an assignment of a lease will be covered by the provision. Note that the transfer of the affected land right would include both registered and unregistered transfers.

The charging provision will not apply to an amount derived by the payee as the holder of a land right and as consideration for the transfer of the land right to the person paying the amount. This will exclude an amount paid by an assignee to an assignor for the transfer of an existing lease from the charging provision (subsection (2)).

The charging provision will apply to any person who derives the amount in relation to the land right. If a person receives a lease inducement payment on behalf of another person, the existing nominee rules in section YB 21 will apply to treat the amount as derived by that other person.

The reference to “amount” in section CC 1B uses the definition of “amount” in section YA 1, which includes any amount in money’s worth. The charging provision therefore includes consideration other than cash.

Deductions

A matching deduction provision will provide symmetry in the tax treatment of lease inducement payments. New section DB 20B provides that lease inducement payments are deductible to a person (the payer) if the following conditions are met:

  • the payer incurs an amount of expenditure as consideration for the agreement by another person (the payee) to the grant, renewal, extension or transfer of a right (the land right) that is a leasehold estate or a licence to use land;
  • the payer is the person who owns the land right or the estate in land from which the land right is granted; and
  • the payee is the person who is obtaining the land right.

Note that this deduction provision will cover other lease inducements, in particular, contributions for fit-out costs. A consequence of this is that the timing rule for deductions in new section EI 4B (discussed below) will apply to such other lease inducements.

New section DB 20B overrides the capital limitation in section DA 2(1). The general permission in section DA 1 must still be satisfied and the other general limitations in section DA 2 will still apply.

Timing of income and deductions

New section EI 4B is a timing provision for lease inducement payments. The timing provision will allocate the amount of income under section CC 1B or deductions under section DB 20B from a lease inducement payment evenly over the term of the land right (that is, a leasehold estate or a licence to use land) to which the amount of income or deductions relates (the spreading period).

The spreading period is the period after which a land right may be terminated, or expires, if not extended or renewed, that begins with the commencement, or the most recent renewal or extension, of the land right.

The timing provision will spread the amount derived or incurred before the end of the spreading period evenly over the spreading period. Given lease inducement payments are generally made at the commencement of the land right, the amount will be spread evenly over the relevant land right. Even when the amount is derived or incurred before the commencement of the land right, the amount will be allocated in relation to the spreading period, not when the amount is incurred or derived.

Example

On 1 April 2013, a tenant receives $100,000 from a landlord as consideration for the agreement to enter into a 10-year lease that commences on the same day. The tenant and the landlord both have a 31 March balance date.

The tenant

Under section CC 1B, $100,000 is taxable to the tenant. Under section EI 4B, the income is spread evenly over the 10-year period from the 2013–14 to the 2022–23 income years inclusive (i.e. $10,000 income is allocated to the tenant in each income year).

The landlord

Under section DB 20B, $100,000 is deductible for the landlord. Under section EI 4B, the deductions are spread evenly over the 10-year period from the 2013–14 to the 2022–23 income years inclusive (i.e. a deduction of $10,000 is allocated to the landlord in each income year).

The timing of income and deductions under section EI 4B is affected by when the income or expenditure is derived or incurred. For example, if the amount is derived or incurred half-way through the spreading period, the amount will be spread evenly over the remaining period. If the amount is derived or incurred at or after the end of the spreading period, the amount will be allocated to the income year in which it is incurred or derived.

Note that, under the timing provision, an amount of expenditure incurred by an assignor to induce an assignee to receive an assignment of a lease would be allocated to the income year in which the amount is incurred. By assigning the lease, the assignor has no remaining period over which to spread the expenditure. On the other hand, the assignee would spread the amount of income evenly over the remaining period of the lease.

If the spreading period is more than 50 years, the amount is allocated evenly over the first 50 years of the spreading period.

The timing provision will not apply to an amount that is income under section CC 1 or CG 8, which relates to income from land or capital contributions respectively. Income under section CC 1 would be taxable when derived unless section EI 7 applies. Income under section CG 8 would be spread evenly over 10 years unless the payee chooses to reduce the cost base of the depreciable property under section DB 64.

An exception applies to this new timing rule if the person ceases to hold the relevant land right, or the estate in land from which the land right is granted. There will generally be a “wash-up” calculation of income and deductions if a person ceases to hold the land right or the estate in land from which the land right is granted, part-way through the spreading period (subsections (4) and (5)).

For income, if there is a remaining amount to be allocated under the main spreading provision in section EI 4B(3), the amount of income will be allocated to an income year (the balance year) ending before the end of the spreading period, if –

  • at the beginning of the balance year, the person holds the land right or the estate in land from which the land right is granted; and
  • in the balance year, the person ceases to hold the land right or the estate in land from which the land right is granted (subsection (4)).

Example

On 1 April 2013, a landlord pays a tenant $100,000 as an inducement to enter into a 10-year lease. On 6 June 2016, the tenant transfers the lease to a new tenant. Both the landlord and the tenant have a balance date of 31 March.

The $100,000 payment is taxable to the tenant under section CC 1B and deductible to the landlord under section DB 20B.

The timing of income for the tenant under section EI 4B(4) is illustrated in the table below:

Income year Tenant
  Deduction Income
2013–14 $10,000
2014–15 $10,000
2015–16 $10,000
2016–17 $70,000
2017–18
2018–19
2019–20
2020–21
2021–22
2022–23

The landlord continues to allocate the $100,000 deduction under the main spreading provision in section EI 4B(3).

For deductions, if there is a remaining amount to be allocated under the main spreading provision in section EI 4B(3), the amount of deductions will be allocated to an income year (the balance year) ending before the end of the spreading period if –

  • at the beginning of the balance year, either or both the land right and the estate in land from which the land right is granted are held by the person or an associated person; and
  • at the end of the balance year, neither of the land right and the estate in land from which the land right is granted are held by the person or an associated person (subsection (5)).

Note that if the land right or the estate in land from which the land right is granted is transferred to an associated person, there will be no “wash-up” calculation for deductions. The remaining amount of deductions will continue to be allocated over the spreading period under section EI 4B(3). This is intended as an anti-avoidance measure to prevent the timing of deductions being accelerated by transferring the land right or the estate in land from which the land right is granted to an associated person. The general anti-avoidance provision in section BG 1 will also apply to counter any tax-driven transactions that attempt to exploit the new timing provision contrary to the policy intent.

The definition of “land provision” in section YA 1 is being amended so that the definition of “associated person” applying in section EI 4B is the version applicable to land provisions.

Example

On 1 April 2013, a landlord pays a tenant $100,000 as an inducement to enter into a 10-year lease. On 6 June 2016, the landlord sells the freehold estate to an unassociated third party for $3,000,000. Both the landlord and the tenant have a balance date of 31 March.

The $100,000 payment is taxable to the tenant under section CC 1B and deductible to the landlord under section DB 20B.

The timing of deductions for the landlord under section EI 4B(5) is illustrated in the table below:

Income year Landlord
  Deduction Income
2013–14 $10,000
2014–15 $10,000
2015–16 $10,000
2016–17 $70,000
2017–18
2018–19
2019–20
2020–21
2021–22
2022–23

If the landlord had transferred the land to their spouse, the landlord would continue to allocate $10,000 of deductions to each income year until the 2022–23 income year.

The tenant continues to allocate the $100,000 amount of income under the main spreading provision in section EI 4B(3).

To prevent overlap, section EA 3, which relates to the timing of prepayments, is being amended to exclude any amounts subject to this timing provision.

The tax treatment of lease surrender payments

Income

New section CC 1C provides that if a person (the payee) derives an amount as a consideration for the agreement by the payee to the surrender of a leasehold estate or the termination of a licence to use land, the amount will be taxable to the payee. The payee must be one of the following:

  • the person who owns the estate in land from which the leasehold estate or licence is granted; and/or
  • the person who owns the leasehold estate or licence.

In most cases, lease surrender payments will be made by a tenant to a landlord to surrender an existing lease. However, the charging provision will also apply if the payment is made by the landlord to the tenant for them to surrender an existing lease. The existing nominee rules in section YB 21 will apply if a person acts on behalf of the payee.

The charging provision will not apply to an amount derived in relation to a freehold estate in land, such as the proceeds from the sale of land. However, the charging provision will apply broadly to include amounts derived in relation to leases, including subleases and other estates or interests in land. The term “leasehold estate” is defined in section YA 1 to include any estate, however created, other than a freehold estate.

An exception applies for residential tenants. A lease surrender payment will not be income of the payee to the extent that the payee derives the amount as a tenant of residential premises. If there is a concurrent use of the land right for residential and business purposes, the amount will be apportioned so that only the amount relating to the business use is taxable (subsection (3)).

Deductions

A matching deduction provision will provide symmetry in the tax treatment of lease surrender payments. New section DB 20C provides that lease inducement payments will be deductible to a person (the payer) if the following conditions are met:

  • the payer incurs an amount of expenditure as consideration for the agreement by another person (the payee) to the surrender of a leasehold estate or the termination of a licence to use land;
  • the payer is a person who owns the leasehold estate or licence, or the estate in land from which the leasehold estate or licence is granted; and
  • the payee is a person who owns the leasehold estate or licence, or the estate in land from which the leasehold estate or licence is granted.

Section DB 20C overrides the capital limitation in section DA 2(1). The general permission in section DA 1 must still be satisfied and the other general limitations in section DA 2 will still apply.

Timing of income and deductions

No specific timing provision is provided for lease surrender payments. The timing of the amount derived or incurred under sections CC 1C and DB 20C will, therefore, be determined under the general provisions of the Income Tax Act 2007.

Generally, income and deductions for lease surrender payments will be allocated to the income year in which the amount is derived or incurred. This is considered appropriate for lease surrender payments as there would normally be no remaining period of the land right over which the amount can be spread at the time the lease surrender payments are derived or incurred.