Edited version of private ruling

Authorisation Number: 1011736040611

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Ruling

Subject: Lease prepayment

Question

Can you claim a deduction for the lease prepayment over ten years under section Part III Division 3 Sub-division H of the Income Tax Assessment Act 1936?

Answer

No

This ruling applies for the following periods:

Year ended 30 June 2007

Year ended 30 June 2008

Year ended 30 June 2009

Year ended 30 June 2010

Year ending 30 June 2011

Year ending 30 June 2012

Year ending 30 June 2013

Year ending 30 June 2014

Year ending 30 June 2015

Year ending 30 June 2016

Year ending 30 June 2017

The scheme commences on:

1 July 2006

Relevant facts and circumstances

You are a member of a group which carry on similar business activities.

You entered into a lease with Entity A for use of part of the property owned by them for a period exceeding 40 years.

Under the lease you will develop the premises and construct a building with the intent to carry on a business.

In consideration for use of the premises, you must pay the rent by way of a set number of instalments. All of the instalments are to be paid within two years of the commencement of the lease.

The lease does not contain details of how the amount of rent was calculated. The rent is not refundable to you in any circumstances.

The lease states you are required to vacate the premises at the end of the lease. If Entity A wishes to relet the premises within a set period of the end of the lease, you will have first option to obtain a new lease.

You are responsible for all outgoings relating to the premises.

You can sublet the premises with permission of Entity A.

You are required to maintain and repair the premises.

You have sublet the premises to a related party. The sublease will expire a day before the end of your lease with Entity A. The rent under the sublease is reviewed annually and indexed with reference to the Consumer Price Index (CPI).

Relevant legislative provisions

Income Tax Assessment Act 1936 Subsection 82KZL(1)

Income Tax Assessment Act 1936 Subsection 82KZMA(1)

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

You cannot claim a deduction for the lease prepayment over 10 years under Part III Division 3 Sub-division H of the Income Tax Assessment Act 1936 (ITAA 1936) as the lease prepayment is of a capital nature and therefore an excluded expenditure under subsection 82KZL(1) of the ITAA 1936.

Detailed reasoning 2

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income or a provision of the taxation legislation excludes it.

You have paid money to Entity A under a lease agreement. The payments are described in the lease as being rent for the use of the premises for a period exceeding 40 years.

If you make an advance payment for a service special prepayment rules may affect the timing of deductions. These prepayment rules are contained within Part III Division 3 Subdivision H of the ITAA 1936.

The prepayment rules apply where you incur expenditure for something to be done, in whole or in part, in a later income year. In these situations, the deduction for the expenditure is apportioned over the period covered by the service, up to a maximum of 10 years.

The prepayments rules do not apply to the following ('excluded expenditure'):

· amounts less than $1,000 excluding input credits

· amounts required to be paid by law or a court order

· payments of salary or wages

· amounts that are capital, private or domestic (section 82KZL of the ITAA 1936), or

· certain amounts incurred by a general insurer in connection with the issue of policies or the payment of reinsurance premiums.

The Commissioner accepts that the payments made by you to Entity A were incurred to gain or produce your assessable income. However, the issue to be determined is whether the payments are losses or outgoings of a capital nature or a revenue nature.

Where payments have been made under a lease, it is necessary to determine if all or any part of the payment was a payment of a lease premium or a payment of rent.

In Jupiters Limited v FC of T [2001] FCD 1869 it was clearly indicated that the description given to a payment by the parties is not determinative of the tax treatment of the expense.

Sun Newspapers Limited and Associated Newspapers Limited v FC of T [1938] 61 CLR 337 (Sun Newspapers) established three matters to take into consideration when making the distinction between capital and revenue:

(a) the character of the advantage sought, and in this its lasting qualities may play a part

(b) the manner in which it is used, relied upon or enjoyed, and in this and under the former head recurrence may play its part; and

(c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.

The following is a discussion of the matters identified in the Sun Newspapers case:

(a) The character of the advantage sought

A sum will be a premium where it is paid as consideration for the grant or acquisition of a lease. Rent is consideration payable under a lease for the right to use and occupation of leased premises during the term of the lease.

In Case C2 71 ATC 8 a partnership entered into a lease for 3 years 288 days. Total rent of £7,371.13.4 was payable as follows:

(a) £3,000 upon execution of the lease, and

(b) £101.13.4 payable on the 18th of each and every month during the remainder of the lease until the full amount of £7,371.13.4 is fully paid and satisfied.

Clause 19 of the lease provided an option of renewing the lease by payment of "...a further premium of Three Thousand Pounds (£3,000)...".

In determining whether the £3,000 payment was a premium or rent, Member Thompson referred to Earl Jowitt's Dictionary of English Law. At page 1390 the dictionary described a premium as "a consideration; something given to invite a loan or a bargain ... in granting a lease, part of the rent is sometimes capitalised and paid in a lump sum at the time the lease is granted".

It was held that the £3,000 paid represented consideration for the granting of the lease and was a premium. This was supported by clause 19 which referred to a further premium to be paid if the option to renew the lease was exercised. The instalments to be paid monthly during the whole term of the lease were held to be the true rent.

(b) Right to a refund

Premium payments are non-refundable whereas prepaid rent may be refundable where a lease is terminated early.

In FC of T v Krakos Investments Pty Ltd (1995) 96 ATC 4063 a taxpayer sold a licensed hotel on a leasehold basis. Part of the consideration was for goodwill. The taxpayer granted a five year lease with an option for two further renewals. One condition of the sale was that the purchasers could require the taxpayer to buyback the goodwill at the end of the five years (for the price paid).

The Full Federal Court held the payment for the goodwill was not a premium. In reaching the conclusion, Hill JJ stated:

The conclusion that the payment in this case was not to be characterised as a "premium" was facilitated by the provisions of the special circumstances which provided an obligation on the taxpayer to buy back the goodwill for $420,000 if required by the purchasers. If the amount was a premium for the grant of the lease, once paid it would not be returnable. Yet the parties bargained for a put option, pursuant to which the amount might come to be repaid to the purchasers at the expiration of the lease. That was inconsistent with the amount of $420,000 being treated as a premium.

Essentially, the conclusion that the payment was not characterised as a 'premium' was facilitated by the fact that the taxpayer had an obligation to buy back the goodwill if required by the purchasers. If the amount was a premium for the grant of a lease, once paid it would not be returnable. The put option was inconsistent with the payment being treated as a premium.

(c) Purpose of the expenditure

Where expenditure is made to secure an asset or an advantage of an enduring kind, the expenditure is capital in nature.

In Sun Newspapers it was stated that 'enduring' did not mean the advantage obtained would last forever.

(d) Calculation of payment can help determine the true nature of the outlay

How the amount of the payment is calculated can assist in determining its' true nature. Where the payment is calculated with reference to the day by day usage of the premises it is more likely to be considered in the nature of rent.

In FC of T v Creer (1986) 86 ATC 4318 the taxpayer leased four home units from their owners. His family company purchased the units the following day, at a reduced price. Under the lease, the taxpayer paid the total rent for the five year term in advance - 80% on commencement on the lease and then 10% on the following two anniversaries. The taxpayer made three payments as he had received the advice that making one payment would be commercially unsound.

Fisher J in giving the lead judgement, with which both Wilcox J and Jackson J agreed, commented as follows:

To my mind the first question for determination in this matter is whether the sum called rent and which is described as the "total rent" and is payable by three instalments is an outgoing on revenue account. Alternatively, is it more correctly to be seen as a capitalized amount and thus an outgoing of a capital nature? [page 4323]

Did the payment of $18,260 in three instalments as provided by the lease amount to a "periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payments" or was it more correctly "a final provision or payment so as to secure its future use or enjoyment"? [page 4324]

In my opinion, on the true construction of the lease aided by the evidence as the manner in which the total payment was calculated, it is apparent that the amount called "total rent" is in the words used by Sir Owen Dixon [in FC of T v South Australian Battery Makers Pty Ltd at ATC page 4417;] "a capitalized sum" which was made payable as to 80% forthwith and thereafter by two instalments each of 10% on the anniversaries of the first payment. [page 4324]

I do not see the amount of the "total rent", whether payable as one lump sum or by instalments, as rent "accruing per die in diem" or as a "periodic outlay" covering the use of the premises for "periods commensurate with the payments". It is a capitalized sum and thus not an allowable deduction. [page 4324]

The Court held that the amount of the total rent was a capitalised sum payable by instalments and not rent accruing from, and referrable to, the day to day usage of the premises.

(d) The manner in which the rights are used, relied upon or enjoyed

Usually the advantage sought under a lease may be characterised as recurrent in nature being for the continuous or recurrent provision of a service for a certain term.

In BP Australia Ltd v Federal Commissioner of Taxation (1965) 112 CLR 386 the taxpayer entered into contracts with services stations whereby the service station would only purchase petrol from BP and would promote BP products. The length of the contracts ranged from 3 to 15 years with an average of five years. Each service station received an up-front payment for entering the contracts. The payment amount was determined by the length of the contract, the positioning of the service station and competitors. The Commissioner considered the payments to be capital whilst BP Australia believed them to be on revenue account.

The Privy Council gave consideration to the length of the agreement as an indicator of the nature of the payment. It stated

What additional indication is given by the actual length of the agreements? That must be a question of degree. Had the agreements been only for two or three year periods that fact would have pointed to recurrent revenue expenditure. Had they been for twenty years, that fact would have painted to a non-recurring payment of a capital nature. Length of time, though theoretically not a deciding factor, does in practice she a light on the nature of the advantage sought. The longer the duration of the agreements, the greater the indication that a structural solution was being sought.

The Privy Council determined the payments to be revenue on the balance of all the relevant considerations.

(e) Means to obtain it

Numerous cases have stated that a once and for all lump sum payment is indicative of capital expenditure whilst recurrent payments are indicative of revenue expenditure.

However, as can be seen from Creer's case it is possible for a sum paid in instalments to be considered capital in nature.

Application to your circumstances

The legislation and relevant cases have been considered with the factual circumstances surrounding your agreement to lease an area of land from Entity A. Based on the facts and your submission the payments made on entering and the first 18 months of the lease are of a capital nature.

Subparagraph 8-1(2)(a) of the ITAA 1997 would disallow the deductions in respect of the payment as they are of a capital nature on the basis that:

· the payments, although classified as rent by the parties, are more appropriately payments to obtain a grant of a lease

· the advantage sought is to obtain a long term right over a parcel of land to allow you to undertake a commercial development, rather than for the actual use of the land

· the payment is not refundable upon early termination of the lease

· the rights associated with the lease agreement are of an enduring nature and form part of the capital structure of your business

· the agreement is for in excess of 40 years with a possibility of a new lease if Entity A decides to lease the premises again

· the rent is essentially a payment to secure the future use or enjoyment of a right, even though the payment was made in four instalments

Additionally, it is commercially unrealistic to incur prepaid rent for a period in excess of 40 years without a rent review clause to reflect the market fluctuation of the price of property.

However, it is commercially realistic for both parties to agree to a fixed payment to secure a long term interest in the property and to ensure the commercial development rights.

Based on the above you cannot claim a deduction for the lease prepayment over 10 years under Part III Division 3 Sub-division H of the ITAA 1936 as the lease prepayment is of a capital nature and therefore an excluded expenditure under subsection 82KZL(1) of the ITAA 1936.

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