Chapter 2 - Tax problem

2.1 This chapter explains how lease inducement payments represent a risk to the tax base.

Lease inducement payments

2.2 A lease inducement payment is typically an unconditional lump sum cash payment from a landlord to a prospective tenant as an inducement to enter into a commercial lease.

2.3 Lease inducement payments usually proliferate when there is an oversupply of business premises during an economic downturn. The payments are used as an effective bargaining tool for landlords to entice tenants to enter into a lease without needing to reduce the rent. In this way, landlords can maintain a consistent and unimpaired flow of rental income from their property unlike other forms of inducements, such as reduced rent or a rent-free holiday.

2.4 Even in economic upturns, when there may be a shortage of business premises, lease inducement payments can enable landlords to secure major tenants in large buildings or for a longer term for the reasons outlined above.

Tax treatment of lease inducement payments

2.5 There are no specific legislative provisions that deal with lease inducement cash payments. Therefore, the taxation of lease inducement payments is determined under general principles and provisions in the Income Tax Act 2007.

2.6 Currently, lease inducement payments can be characterised differently for a payer and a recipient for income tax purposes. This is because the quality of a payment is determined separately for the payer and the recipient.

2.7 For the payer (normally the landlord), the payment would typically be tax deductible if the payer incurs the expenditure in the course of carrying on a business. For the recipient (the tenant), the payment is generally a non-taxable capital receipt if the payment is received in relation to a lease that relates to the structure of the tenant’s business. Also, the payment is a “negative” premium, and premium payments are usually recognised by the courts as capital rather than revenue. The capital nature of a lease inducement payment was confirmed by the Privy Council in Wattie.[1]

Revenue risk

2.8 The current asymmetric tax treatment of lease inducement payments in being generally tax deductible for the landlord and a non-taxable receipt for the tenant is systematic in a commercial context and poses a risk to the revenue base. The tax cash value of deductible but non-taxable payments can be highly sensitive to both commercial and tax implications.

2.9 The systematic deductible/non-taxable tax treatment of lease inducement payments creates an incentive for contracting parties to sign up to a lease agreement that results in a tax advantage. These payments are tax-effective when inducing a tenant to enter into a lease arrangement compared with other forms of inducement, such as reduced rent and contributions for fit-out costs. As the payments are treated as a non-taxable capital receipt for the tenant, they effectively increase the total after-tax income for the tenant.

2.10 For example, a commercial landlord with premises that are used to generate $1,000,000 of rental income per year during an economic upturn would struggle to do so in a downturn. To induce a tenant to enter into a lease for a term of one year, the landlord could either reduce the rent from $1,000,000 to $600,000, or offer a lease inducement payment of $400,000 while maintaining the rent of $1,000,000.

2.11 Under the latter arrangement, it is mostly the tenant who receives the tax advantage as they do not pay income tax on the amount of lease inducement of $400,000, and can claim a tax deduction for rental income expense of $1,000,000 against their taxable income. As the lease inducement payment is deductible for the landlord, the landlord receives the same amount of after-tax income of $432,000 ($1,000,000 minus $400,000 lease inducement resulting in taxable income of $600,000 less income tax at 28%) while maintaining an unimpaired rental flow.

2.12 Although the tenant primarily receives the tax benefit in the above example, the benefit could be shared in practice between the tenant and the landlord through the level of the rent and the lease inducement payment.

2.13 The asymmetric tax treatment of lease inducement payments encourages taxpayers to convert revenue receipts into non-taxable capital receipts.[2]

2.14 Other forms of lease inducements, such as reduced rent or a rent-free holiday, do not pose the same risk to the revenue base because the tax treatment of these inducements is symmetrical. The reduced rent or rent-free holiday reduces the deductible expenses of the tenant as well as the taxable income of the landlord.[3]

Case for specific legislative solution

2.15 In the past, specific legislative provisions were provided to deal with types of payments that posed similar revenue risks. The legislative provisions modified the judicially delineated capital/revenue boundary to counter arrangements based on converting revenue receipts into capital receipts.

2.16 For example, contributions for fit-out costs previously presented a similar revenue risk to cash lease inducement payments, as the amount was non-taxable to the tenant and tax deductible for the landlord. The problem was addressed in Budget 2010, which introduced new capital contribution rules.[4] The amount is either included as income of the recipient or reduces the cost basis of the depreciable property.

2.17 Cash lease inducement payments are the only form of lease inducement that confers a tax advantage; and as such, could distort commercial decision-making processes. It is also not sensible for cash lease inducement payments, which could be used by tenants to pay for the fit-out of their premises, to be treated differently for tax purposes from payments that are contractually required to be spent on the same fit-out.

2.18 The suggested solution of making lease inducement payments taxable would result in a consistent tax treatment of premiums paid in relation to leases of land. Premiums paid to landlords are already taxable under section CC 1 of the Income Tax Act 2007.

2.19 Other examples where Parliament has modified the capital/revenue boundary include redundancy payments,[5] payments received for restrictive covenants[6] and exit inducements[7].

2.20 Given the revenue risks associated with lease inducement payments, other countries such as the United Kingdom, Ireland and Canada have enacted legislation to make these payments taxable. Making lease inducement payments taxable would therefore be in line with international norms.


1Commissioner of Inland Revenue v Wattie [1999] 1 NZLR 529.

2However, a lump sum rent subsidy paid by a landlord would remain taxable under the current law.

3Also, section GC 5 of the Income Tax Act 2007 prevents avoidance opportunities from properties being rented out for inadequate rents.

4See sections CG 8, DB 64, EE 48 and the definition of “capital contribution” in section YA 1 of the Income Tax Act 2007.

5Section CE 1(1)(f) of the Income Tax Act 2007.

6Section CE 9 of the Income Tax Act 2007.

7Section CE 10 of the Income Tax Act 2007.