Chapter 4 - Technical details

4.1 This chapter considers the technical details of how land-related lease payments would be treated for income tax purposes under the suggested approach.

4.2 If these changes proceed, all land-related lease payment provisions in the Income Tax Act 2007 would be replaced with new income, deduction and timing provisions.

4.3 Changes to current provisions in the Income Tax Act 2007 are summarised in the Appendix.

Income

4.4 Current section CC 1 would be replaced by a new comprehensive charging provision for land-related lease payments. New section CC 1 would broadly apply to treat all land-related lease payments derived by a person as assessable income.

4.5 The new charging provision would apply if the following conditions are met:

• a person (the payee) derives an amount in relation to a right (the land right) that is an estate in land or a licence to use land; and
• the payee is:
  • 
    the person who owns the estate in land from which the land right is granted; or
  • a person who owns the land right; or
  • a person who is obtaining the land right; or
  • a person who used to own the land right; and
• the amount is in the nature of rent or the land right has a period of less than 50 years.

4.6 These conditions and exceptions are explained in more detail below.

Amount derived by a person in relation to a land right

4.7 Proposed new section CC 1 would apply to a land right that is an estate in land or a licence to use land. The term “estate” is widely defined for land purposes in section YA 1 and includes both an estate and interest in land.[14]

4.8 The term “amount” is defined in section YA 1 to include any amount in money’s worth. Accordingly, consideration other than in cash would be included.

4.9 The new rules focus on a land right that payments relate to. Hence, identifying which land right the payments relate to would be crucial in determining the tax treatment.

The payee

4.10 The payee is a person who derives an amount in relation to a land right. However, if a person receives an amount on behalf of another person, the existing nominee rules in section YB 21 would apply to treat the amount as derived by that other person.

4.11 A person may derive amounts in different capacities depending on the land right that the payments relate to. For example, a tenant could derive a lease inducement payment from a landlord as a prospective tenant. The same tenant could also derive a lease premium payment from a sub-tenant.

Payments relating to land right with period of less than 50 years and rent payments

4.12 Rent payments would be included under proposed new section CC 1 regardless of the term of a land right.

4.13 Other payments that relate to a land right with a term of less than 50 years would be included under new section CC 1. Examples of an amount derived in relation to a land right would include various types of payments including a:

• fine;
• premium or an inducement payment to enter an agreement for the land right;
• payment for the goodwill of a business;[15]
• payment of the benefit of a statutory licence or privilege;
• payment of a liability for the breach of a covenant;
• payment for the termination of the land right; and
• payment for the transfer of the land right.

4.14 As explained in chapter 3, the 50-year threshold would place a new parameter on what is taxable under new section CC 1. Therefore, determining how many years the relevant land right is for is important when applying new section CC 1.

4.15 Note that the 50-year period would not include the period of renewal or extension. The period of renewal or extension of a land right would be regarded as a period relating to a separate land right. This approach is intended to avoid complexities around the tax treatment of leases that are perpetually renewable (that is, “Glasgow” leases) and modifying the spreading of income or deductions, which is discussed below.

“Glasgow” leases

4.16 Leases that last for a certain duration (7, 10 or 21 years) but are renewable in perpetuity by the lessees are commonly referred to as “Glasgow” leases. They are typically for a ground lease only. For example, a tenant pays rent regularly for the ground lease and they own improvements such as buildings.

4.17 The proposed new rules would generally apply to Glasgow leases because their initial fixed term typically lasts less than 50 years. Providing a different treatment for Glasgow leases from other leases is undesirable from a policy perspective because it would distort business decisions when entering into lease arrangements.

4.18 If the improvements on land are owned by a tenant, new section CC 1 would apply only to payments made in relation to the ground lease. Payments relating to the cost of acquiring improvements would be apportioned accordingly.

Exclusions

Tenant of residential premises

4.19 The income-charging provision in new section CC 1 would not apply to a person who is a natural person (an individual) and a tenant or licensee of residential premises. This is intended to provide symmetry of treatment for payments incurred or derived by a tenant of residential premises. The tenant would not be able to deduct lease payments or rent because they do not meet the general permission in section DA 1 and the private limitation in section DA 2(2) would apply.

4.20 If there is a concurrent use of the land right for residential and business purposes, the amount would be apportioned so that only the amount relating to the business use is taxable.

Other exclusions

4.21 In addition, new section CC 1 would not apply to amounts if:

• The amount is a compensation payment for loss or injury in relation to a land right.
• The amount is royalty under section CC 9.
• Provisions relating to forestry, petroleum mining and other mining licences apply, in particular, subparts CB, CT and CU.

Land provisions

4.22 New section CC 1 would override the existing land provisions in sections CB 6 to CB 23B to provide a consistent tax treatment of land-related lease payments. In particular, this would clarify the tax treatment of lease transfer payments.

Tax treatment of contribution for fit-out costs

4.23 Under the proposed reforms in the Taxation (Livestock Valuation, Assets Expenditure, and Remedial Matters) Bill, the tax treatment of a contribution for fit-out costs continues to be determined under the existing capital contribution rules in sections CG 8 and DB 64.

4.24 However, excluding contributions for fit-out costs from the new rules would produce some inconsistencies between the existing timing rule for capital contributions (where the taxpayer can elect for the contribution to be income and spread over 10 years, or for the contribution to reduce the depreciable cost base of the relevant property) and the new timing rule (where income is spread over the term of the relevant land right).

4.25 A contribution for fit-out costs is a form of lease inducement provided by a landlord to an incoming tenant. It should therefore be treated as being similar to lease inducement payments that are covered in the new rules. Hence, under the new rules, the payee would be required to pay tax on contribution for fit-out costs under new section CC 1, but would not be required to reduce the depreciable cost base for fit-out under section DB 64. The tenant would be able to claim depreciation deductions over the life of the fit-out.

Deductions

4.26 Under the suggested new rules, a matching deduction provision would apply to provide symmetry in the tax treatment of land-related lease payments. To deduct these payments, the following conditions would need to be met:

• a person (the payer) incurs expenditure in relation to a right (the land right) that is an estate in land or a licence to use land; and
• the payer and the person (the payee) who derives the amount are each one of the following:
  • 
    the person who owns the estate in land from which the land right is granted; or
  • the person who owns the land right; or
  • a person who is obtaining the land right; or
  • a person who used to own the land right; and
• the land right has a period of less than 50 years.

4.27 These conditions are similar to proposed new section CC 1, except the deduction provision specifies both the payer and the payee. This is to sufficiently protect the tax base.

4.28 Note that deductions are allowed only for the cost incurred in relation to the land right and not for the cost of acquiring improvements on land (in particular, when there is a transfer of a Glasgow lease). Similar to the income provision, expenditure relating to the cost of acquiring improvements on land would be apportioned accordingly.

4.29 This deduction provision would not cover rent payments. These would continue to be deductible under the general permission in section DA 1. Neither is this provision intended to cover any transaction costs. Existing section DB 18 applies to any transaction cost incurred to prepare, register or renew a lease.

4.30 The new deduction provision would override the capital limitation in section DA 2(1). The general permission in section DA 1 would still need to be satisfied and the other general limitations in section DA 2 would also apply.

Timing of income and deductions

4.31 The proposed new timing rules for income and deductions would be similar to the timing rule currently proposed for lease inducement payments in clause 32B of the Taxation (Livestock Valuation, Assets Expenditure, and Remedial Matters) Bill. There would, however, be some modifications to the rules, as described below.

4.32 The rules would not apply to rent payments. These payments would be subject to the ordinary rules and be taxable when derived and deductible when incurred unless section EA 3 applies.

4.33 The rules would allocate income and deductions evenly over the term of the land right to which the amount of income or deductions relates (the spreading period). The spreading period for allocating income and deductions would be the period of a land right (which lasts less than 50 years). A period of renewal or extension would be treated as a separate spreading period.

4.34 To avoid complexities around allocating income and deductions to the number of days in an income year, it would be allocated proportionately to the number of months by using the following formula:

amount of income or deductions x (number of months in an income year for which the spreading period exists / total number of months in the spreading period)

4.35 This approach is consistent with the straight-line method in the depreciation rules.

4.36 The allocation of income and deductions would depend on the time when the income or expenditure is derived or incurred in relation to the spreading period. The rules would spread the amount derived or incurred before the end of the spreading period evenly over the remaining period of the land right.

4.37 For example, lease premiums and lease inducement payments are generally made at the beginning of a lease, therefore the amount would be spread evenly over the lease. Lease surrender payments that are generally made at the end of a lease would typically be allocated to the income year in which the amount is derived or incurred. This is because 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.

4.38 If the amount is derived or incurred before the commencement of the land right, the amount would be allocated over the spreading period, not to the time when the amount is incurred or derived. If the amount is derived or incurred half-way through the spreading period (for example, as a lease modification payment), the amount would be spread evenly over the remaining period.

4.39 Note that, under the new rules, the timing of deductions and income would be different for the payer and payee of lease transfer payments, for example. Expenditure incurred by the payer (new tenant) for the transfer of a lease would be spread over the remaining term of the transferred lease. Income derived by the payee (exiting tenant) would be taxable when derived because the payee exits the lease and has no remaining period over which to spread the income.

Disposal of the land right part-way through the spreading period

4.40 An exception would apply to the 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 would generally be a “wash-up” calculation of income and deductions for a person if the 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.

4.41 This “wash-up” solution would be almost identical to the one proposed for lease inducement payments in clause 32B of the Taxation (Livestock Valuation, Assets Expenditure, and Remedial Matters) Bill.

Timing of income

4.42 For income, if there is a remaining amount to be allocated under the main spreading rule, the amount of income would 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.

Timing of deductions

4.43 For deductions, if there is a remaining amount to be allocated under the main spreading rule, the amount of deductions would 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 the land right nor the estate in land from which the land right is granted are held by the person or an associated person.

4.44 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 would continue to be allocated over the spreading period. 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.

4.45 Note that 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.

4.46 As proposed in the Taxation (Livestock Valuation, Assets Expenditure, and Remedial Matters) Bill, the definition of “associated person” applicable to land provisions would apply for the purpose of this timing rule.

Relationship with financial arrangement rules

4.47 Leases are currently excluded from the financial arrangement rules because they are excepted financial arrangements.[18] Therefore, the new timing rules suggested in this paper would apply to leases of land.

4.48 However, licences to occupy land are currently regarded as financial arrangements because they are not a lease for the purposes of financial arrangement rules in the definition of “lease” in section YA 1. The existing distinction between leases and licences to occupy (that are commonly used in the context of retirement villages) is considered undesirable from a policy perspective.

4.49 For consistency, we suggest treating licences to occupy land, which are an “occupation right agreement” as defined in section 5 of the Retirement Villages Act 2003, as excepted financial arrangements. This would align the treatment of leases and these licences to occupy land for the purpose of financial arrangement rules.

4.50 In addition to the above suggestion, we would like to receive submissions on whether a wider set of licences (for example, licences to use land) should be treated as excepted financial arrangements.

Treatment of certain transactions

Consecutive leases

4.51 Under the proposed changes, if two or more land rights are granted to the same person or an associated person and are linked to take effect immediately after one terminates, these land rights would be treated as one land right. An exception to this would be the extension or renewal of an existing land right.

4.52 This suggested treatment of consecutive leases is intended to prevent the timing of deductions being accelerated by entering into multiple leases. A similar treatment is currently applied for the purposes of personal property lease payments.[19]

14 Section YA 1 provides that “interest” has the same meaning as “estate” for land purposes.

15 Note that a payment for the goodwill of a business referred to in existing section CC 1 of the Income Tax Act 2007 relates to the goodwill attached to land rather than personal goodwill. See Romanos Motels Ltd v Commissioner of Inland Revenue [1973] 1 NZLR 435 (CA).

16 The example is based on an assumption that the new rules apply from 1 April 2014.

17 Ibid.

18 See section EW 5(9) of the Income Tax Act 2007. Finance leases are excepted from this exclusion; the definition of “finance lease” in section YA 1 applies only to personal property. Hence, a lease of land is an excepted financial arrangement.

19 See paragraph (d)(v) of the definition of “lease” in section YA 1 of the Income Tax Act 2007.