Chapter 3 - Tax treatment of land-related lease payments
3.1 This chapter examines the tax treatment of land-related lease transfer payments and suggests making them taxable to remove existing distortions. It further examines the overall tax treatment of land-related lease payments more generally and suggests rationalising the rules.
Land-related lease transfer payments
3.2 After a lease begins, a tenant may transfer or assign their lease to another person. Generally, lease transfer payments are consideration received by an exiting tenant (transferor) from a new incoming tenant (transferee) for the transfer or assignment of the lease. These payments generally relate to goodwill that is closely related to a particular site or locality (known as “site goodwill”) and may occur when there is a transfer of business, such as the transfer of a hotel business, from one person to another.
3.3 Under the current tax rules, amounts derived by an owner of land from a lease are taxable under section CC 1 of the Income Tax Act 2007. However, it does not apply to lease transfer payments. In the absence of a specific provision in the Act, lease transfer payments are typically recognised as a non-taxable capital receipt to the exiting tenant unless they are in the business of leasing property or acquired the lease with a view to sell it. Note that lease transfer payments received by the exiting tenant may be taken into account under the depreciation rules in certain circumstances.
3.4 Lease transfer payments are generally tax deductible for the incoming tenant under the depreciation rules. A lease is included in the list of depreciable intangible property in schedule 14 of the Act, being “the right to use land”. Consequently, a tenant can usually claim depreciation deductions for its cost to acquire a lease (i.e. a lease premium or transfer payment) over the remaining term of the lease.
Inconsistent tax treatment between similar payments
3.5 As part of extending the lease inducement payments reform to include lease surrender payments to achieve a balanced reform in response to concerns raised in submissions, a further policy problem involving the current tax treatment of lease transfer payments was identified.
3.6 If the lease inducement and lease surrender payments reforms are implemented and the current tax treatment of generally deductible but non-taxable lease transfer payments is retained, it would be tax advantageous for a tenant to exit a lease by transferring the lease to a third party for a tax-free payment rather than surrendering it to a landlord for a taxable payment. The tax advantage of receiving a non-taxable lease transfer payment would distort a tenant’s commercial decisions when exiting a lease. An example of the problem is illustrated below:
On 1 April 2014, a landlord and a tenant enter into a 10-year lease. After three years, the landlord expands its business to retail, by setting up a subsidiary company. The landlord wishes the tenant to exit the lease so that the subsidiary company can use the premises to carry on its retail business.
If the landlord pays a lease surrender payment to the tenant, the payment would be taxable to the tenant and deductible to the landlord under the proposed rules in the Taxation (Livestock Valuation, Assets Expenditure, and Remedial Matters) Bill (proposed new sections CC 1C and DB 20C).
To induce the tenant to exit the lease, the subsidiary company and the tenant enter into an agreement to transfer the lease. The subsidiary company pays the tenant $100,000 for the transfer.
Under the current rules, the lease transfer payment of $100,000 is deductible to the subsidiary company over the remaining seven years under the depreciation rules. The lease transfer payment is non-taxable to the exiting tenant. The exiting tenant is $28,000 ($100,000 x 28%) better off than receiving a lease surrender payment from the landlord.
3.7 Although lease transfers and lease surrenders are different in form, from the exiting tenant’s perspective there is no economic difference between surrendering the lease to the landlord and transferring it to a third party. The effect is the same – the tenant exits the lease and receives consideration for it. The exiting tenant is indifferent between receiving a lease surrender or a lease transfer payment. Treating similar payments differently for income tax purposes distorts business decisions and results in economic inefficiency and unfairness.
Rationale for change
3.8 The McLeod tax review in 2001 considered the income tax base in New Zealand. Instead of introducing a traditional capital gains tax, it found that the tax base should continue to be protected by dealing with specific capital gains issues as they arise. There are a number of situations when Parliament modified the judicially delineated capital/revenue boundary to address a particular risk to the tax base. Examples include redundancy payments, payments received for restrictive covenants and exit inducements, capital contribution payments and most recently, proposed changes to lease inducement payments included in the Taxation (Livestock Valuation, Assets Expenditure, and Remedial Matters) Bill.
3.9 Along with the proposed changes to lease surrender payments, the capital-revenue boundary for lease transfer payments should be modified so that similar payments are treated the same for income tax purposes – that is, treated as taxable to the recipient and deductible to the payer. As a result of this proposal, the exiting tenant would be taxed on a lease transfer payment received from the new tenant that is currently not taxed.
3.10 Retaining the current tax treatment of lease transfer payments would continue to distort commercial decisions of tenants when exiting a lease. Reforms are necessary to maintain the robustness and integrity of the tax system.
3.11 The suggested changes to the tax treatment of lease transfer payments are part of a balanced package of reforms including lease surrender payments. Making lease transfer payments taxable would result in a more consistent and coherent tax treatment of different types of payments received by a tenant when they exit the lease regardless of their legal form.
Land-related lease payments
3.12 Following the above suggestion to make lease transfer payments taxable, officials consider the tax treatment of land-related lease payments more generally should also be reviewed for a more consistent and coherent tax treatment of these payments.
Overview of current law
3.13 Land-related lease payments that are revenue in nature, such as amounts derived in the ordinary course of business (that is, the business of leasing property), are treated as income and are therefore taxable. Unless specifically taxed under the Income Tax Act 2007, payments that are capital in nature, such as receipts derived outside the ordinary course of business, are not treated as income and are therefore not taxed.
3.14 Under the general permission in section DA 1 of the Income Tax Act 2007, expenditure incurred in deriving income, or in the course of carrying on a business for the purpose of deriving income, is deductible. However, the general permission is subject to the capital limitation rule in section DA 2, which prohibits deductions for expenditure of a capital nature. Other specific deduction provisions are subject to the capital limitation rule unless they expressly override it.
3.15 There are also a number of provisions in the Income Tax Act 2007 that specifically provide for the tax treatment of certain land-related lease payments for income, deduction and timing purposes.
3.16 The table below summarises how the current provisions in the Act apply to certain payments for income, deduction and timing purposes. Note that this table includes changes proposed for lease inducement and lease surrender payments contained in Supplementary Order Paper No. 167 to the Taxation (Livestock Valuation, Assets Expenditure, and Remedial Matters) Bill. If implemented, these changes will apply from 1 April 2013.
|Payments relating to a lease or licence to use land such as rents, fines, premiums or other revenues||
Taxable to a landowner under section CC 1.
Income derived in anticipation from fines, premiums, a payment of goodwill on the grant of a lease can be allocated over six years under section EI 7 if the Commissioner approves.
Generally deductible if the payment is revenue in nature (such as rent) and the general permission in section DA 1 is satisfied. Unless there is an unexpired portion of the expenditure (section EA 3), the payment is deductible in the year the person incurs the expenditure.
The cost incurred for acquiring “the right to use land” is generally tax deductible over the term of the lease under the depreciation rules.
|Payments for non-compliance with covenant to repair||
Taxable under section CC 2.
Income could be spread over five years if the lessor chooses to under section EI 5.
Note that section EI 6 provides a special timing rule for income when the lessor ceases to own land.
Generally deductible under section DB 21.
A specific timing rule in section EJ 11 may apply, which allows the lessee to either claim the deduction in the income year in which the amount is incurred or spread it over three earlier income years provided the lessee used the land for deriving income.
Note that there is a special deduction provision in section DB 22 that deals with restoration costs for a lessor who changes the use of the land.
|Contributions for fit-out costs||
Taxable under section CG 8.
Income is spread over 10 years unless the recipient chooses to reduce, for depreciation purposes, the cost of the new capital asset under section DB 64.
|Generally deductible if the general permission is satisfied – i.e. a commercial landlord who is in the business of leasing property and the payment is not of a capital nature.|
|Lease inducement payments||Taxable over the term of the lease.||Generally deductible if the general permission is satisfied. The payment is spread over the term of the lease.|
|Lease surrender payments||Taxable in the year of receipt.||Generally deductible in the year the expenditure is incurred.|
3.17 Also, section DB 18 specifically allows deductions for costs incurred for the preparation and registration, or the renewal, of a lease.
Inconsistent tax treatment of payments
3.18 Over the years, tax rules for land-related lease payments have been implemented in an ad hoc manner, which has produced inconsistent and incoherent outcomes for taxpayers.
3.19 Current provisions in the Act may therefore produce gaps, which mean that similar payments can be treated differently. For example, payments for the grant of a lease (lease premium payments) are generally deductible to a tenant but payments to modify or waive terms of a lease (lease modification payments) are generally non-deductible to the tenant. Also, payments for the transfer of a lease (lease transfer payments) are generally non-taxable to an exiting tenant but payments to induce the transfer of a lease (lease inducement payments) would be taxable to an incoming tenant, if the lease inducement payments reform is implemented.
3.20 Moreover, the existing timing rules provided for different types of payments vary because they were developed separately over the years. For example, a landowner receiving lease premium payments may spread the income over six years under section EI 7 instead of over the term of the lease which would be a more rational basis for timing the recognition of this income. These payments are deductible to a tenant making these payments over the term of the lease under the depreciation rules.
Suggested approach for all land-related lease payments
3.21 Together with the lease inducement and lease surrender payments reforms and the suggested reform to tax lease transfer payments discussed in this chapter, the existing tax treatment of land-related lease payments could be significantly improved if the rules are rationalised.
3.22 To treat land-related lease payments consistently and coherently, generic income and deduction rules for these payments could be introduced.
3.23 Under the suggested new rules, any land-related lease payments would be treated as taxable to the recipient and deductible to the payer under the Income Tax Act 2007. Note that payments derived by a tenant of residential premises would be excluded from the new rules.
3.24 Also, as part of this rationalisation, a separate timing rule would be introduced to spread income and deductions over the term of the relevant land right (leases or licences of land).
3.25 To provide certainty about when land-related lease payments are on capital or revenue account, we suggest a 50-year threshold for applying the new rules. For example, the new rules would treat all land-related lease payments, other than rent, made in relation to a “land right” (that is, leases or licences of land) with a term of less than 50 years as income to the recipient and deductible expenditure to the payer under the Income Tax Act 2007.
3.26 In effect, leases or licences that last less than 50 years would be put on revenue account. It is envisaged that the 50-year threshold would mean the new rules would apply to most commercial leases, which generally expire before 50 years. Payments, other than rent, made in relation to a land right that lasts 50 years or more would be treated similarly to payments made in relation to a sale of freehold land.
3.27 As a result of introducing the 50-year threshold, the new rules would change the tax treatment of land-related lease payments from the status quo. For example, payments received by a landowner for the grant of a permanent easement are currently taxable under section CC 1 even though the easement may last indefinitely. These payments would be treated as non-taxable receipts to the landowner under the new rules. Also, some payments that are currently non-taxable to the recipient would become taxable under the proposed new rules – for example, lease transfer payments.
3.28 Another example is the cost of “the right to use land” (that is, a lease premium). These payments, which are currently deductible under the depreciation rules would not be deductible under the new rules if the relevant land right lasts 50 years or more – for example, payments to acquire a lease that lasts 99 years would be non-deductible to a tenant under the new rules.
3.29 The 50-year threshold is consistent with the current 50-year threshold on buildings for depreciation purposes. It would align the tax treatment of the cost of a building that lasts 50 years or more with the cost of acquiring the right to use that building – that is, a lease premium. This would therefore eliminate an existing tension between the cost of a building that is generally non-depreciable and the cost of acquiring the right to use land that is currently generally depreciable.
3.30 Conversely, some payments that are currently non-deductible to the payer would become deductible under the new rules. For example, lease modification payments or other lease-related payments that are generally non-deductible to tenants would be deductible if the lease lasts less than 50 years.
3.31 Rationalising the existing rules would result in a consistent and coherent tax treatment of land-related lease payments that is aligned with New Zealand’s broad-base, low-rate tax framework. It would also improve fairness and business efficiency.
Section YA 1 of the Income Tax Act 2007 defines “own” for land as having an estate or interest in land, and therefore includes holding a leasehold estate.
For example, if the lease transfer payment received by a tenant is more than the adjusted tax value of the cost of acquiring the lease (lease premium payments), the rules recognise that there has been excess depreciation deducted over the term of the lease. As result, the excess depreciation deductions are clawed back as income.
4 For example, if the lease transfer payment received by a tenant is more than the adjusted tax value of the cost of acquiring the lease (lease premium payments), the rules recognise that there has been excess depreciation deducted over the term of the lease. As result, the excess depreciation deductions are clawed back as income.
9 See sections CA 1(2) and CB 1 of the Income Tax Act 2007. Also note that there is a land disposal rule in section CB 6 that if a person acquired land (which includes a lease) with a view to selling or disposing of it, the amount is taxable.
13 Note that Supplementary Order Paper No. 167 to the Taxation (Livestock Valuation, Assets Expenditure, and Remedial Matters) Bill proposes to codify deductibility of these costs.