Edited version of your written advice

Authorisation Number: 1013116020368

Date of advice: 28 October 2016

Ruling

Subject: Capital gains tax

Issue 1 - Capital gains tax

Question 1

Will CGT event A1 occur when a lease surrender payment is received?

Answer

Yes.

Question 2

If the answer to Question 1 is yes, will amounts incurred for 'lease improvements' to the property be included in the cost base?

Answer

No.

Question 3

Can the active asset reduction be applied to a capital gain from the receipt of the lease surrender payment?

Answer

Yes.

Issue 2 - Goods and Services Tax

Question 1

Does the payment received in relation to the surrender of commercial lease, include GST?

Answer

Yes.

This ruling applies for the following period

Year ending 30 June 20YY

The scheme commences on

1 July 20XX

Relevant facts and circumstances

The Company leases the property.

The lease commenced in 20WW and terminates in 20ZZ. The company has used the lease in the carrying on of their business since the lease commenced.

The lease payment per annum is exclusive of GST.

The Company is a small business entity registered for GST.

The Company runs a recreational centre in the property.

The landlord recently sold the property to a property developer.

The developer intends to terminate the lease early. The Company will receive a lease surrender payment for the early termination.

The Company has incurred expenses for capital works during the lease period. The Company will be maintaining ownership and removing all capital improvements.

The Company has claimed capital works depreciation deductions for the capital improvements.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 110-35

Income Tax Assessment Act 1997 subsection 110-25(5)

Income Tax Assessment Act 1997 subsection 110-45(1B)

Income Tax Assessment Act 1997 section 152-10

Income Tax Assessment Act 1997 section 152-15

Income Tax Assessment Act 1997 section 152-35

Income Tax Assessment Act 1997 section 152-40

A New Tax System (Goods and Service Tax) Act 1999 (GST Act) sections 9-5, 9-10

Further issues for you to consider

Cost base

Any amount that is already deducted or deductible cannot be included in the cost base for an asset. For example, if you claim deductions for depreciating capital assets, these amounts cannot be included in the cost base when you dispose of the capital assets. This is specified in subsection 110-45(1B) of the Income Tax Assessment Act 1997.

Depreciating assets

When calculating the decline in value for a depreciating asset, it is based on the assets cost. The first element of cost is the amount you are taken to have paid to hold the asset. This includes all amounts you have paid, but excludes amounts that are deductible under other provisions. The ATO has produced a Guide to depreciating assets.

Reasons for decision

Issue 1

Question 1

Summary

Lease surrender constitutes a disposal of a CGT asset (the lease), therefore capital gains tax (CGT) event A1 will occur.

Detailed reasoning

Section 104-10 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that a CGT event A1 occurs when a CGT asset is disposed of.  Generally, an asset is disposed of if a change of ownership occurs.

Taxation Ruling TR 2005/6 Income Tax: lease surrender receipts and payments addresses a number of situations involving lease surrender receipts and payments, establishing the Commissioner's treatment of these payments.

Paragraph 10 of Taxation Ruling TR 2005/6 introduces the Commissioner's position on the most relevant CGT event in the event of lease surrender:

A lessee makes a capital gain from surrendering a lease acquired after 19 September 1985 as it is CGT event A1, to the extent that the surrender receipt exceeds the cost base of the lease.

In this case, when The Company receives a lease surrender payment, CGT event A1 will occur.

Question 2

Summary

Where you hold ownership of the 'lease improvements', their cost base is only included when you dispose of the improvements.

Detailed reasoning

Very broadly the cost base of a CGT asset is what a taxpayer paid to acquire that asset. However it may include certain other costs associated with acquiring, holding or disposing of the asset.

The cost base is made up of the following five elements:

● first element: total of the money paid, and the market value of any other property given to acquire the asset.

● second element: incidental costs incurred to acquire the CGT asset or that relate to the CGT event - that is, it includes costs that relate to both the acquisition and disposal of the asset. Section 110-35 outlines the nine categories of these incidental costs.

● third element: costs of owning the CGT asset, provided it was acquired after 20 August 1991 - for example non-deductible interest, non-deductible repairs or maintenance costs, non-deductible rates and land tax. (The requirement that the expenditure be non-deductible is the result of subsection 110-45(1B)).

● fourth element: capital expenditure incurred, the purpose or the expected effect of which is to increase or preserve the value of the asset, or that relates to installing or removing the asset. Capital expenditure incurred in relation to goodwill is excluded.

● fifth element: capital expenditure incurred to establish, preserve or defend the title to an asset, or a right over the asset.

Paragraph 43 of TR 2005/6 discusses the cost base of a lease:

The cost base of the lease is typically constituted by incidental costs paid by the lessee on the grant and surrender of the lease, but will also include any non-deductible premium paid to the lessor to acquire the lease. Rent payable under the lease is not considered to be money paid or required to be paid in respect of acquiring the lease.

Generally incidental costs are included in the cost base for lease surrender payments. This includes costs such as remuneration for the services of a surveyor, valuer, accountant, broker agent, consultant or legal advisor. Rent paid throughout the lease term is not included in the cost base.

The treatment of capital improvements by the lessee when the property is owned by the lessee is addressed in Tax Determination TD 98/23 Income tax: capital gains: what are the CGT consequences of a lessee incurring capital expenditure on improvements to leased property? Paragraph 2 states:

If the lessee owns the improvements the cost base of the improvements includes the amount of capital expenditure incurred in making the improvements. On a CGT event happening to the improvements, the amount of any capital proceeds received will determine whether a capital gain or loss is made.

Where the improvements remain affixed to the land on the expiry or termination of the lease, CGT event A1 happens to the improvements.

In this case, The Company will be removing all the improvements that they have made when The Company leaves the property, maintaining their ownership. As there is no disposal of the improvements, there is no CGT event for the improvements.

The Company cannot include in the cost base for the lease expenses for the capital improvements.

Question 3

Summary

The Company is a small business entity, the lease has been an active asset for The Company's entire ownership period, and therefore, The Company can apply the active asset reduction to the capital gains from the lease surrender payment.

Detailed reasoning

Section 152-10 of the ITAA 1997 contains the basic conditions you must satisfy to be eligible for the small business capital gains tax (CGT) concessions. These conditions are:

(a) a CGT event happens in relation to a CGT asset in an income year.

(b) the event would have resulted in the gain

(c) at least one of the following applies:

(i) you are a small business entity for the income year

(ii) you satisfy the maximum net asset value test in section 152-15 of the ITAA 1997

(a) the CGT asset satisfies the active asset test in section 152-35 of the ITAA 1997.

Section 152-40 of the ITAA 1997 provides the meaning of 'active asset'. A CGT asset will be an active asset at a time if, at that time, you own the asset and the asset was used or held ready for use by you, in the course of carrying on a business.

Section 152-35 of the ITAA 1997 explains that an asset will be an active asset if you have owned the asset for 15 years or less and the asset was an active asset of yours for a total of at least half of the time from when you acquired the asset until the CGT event.

The Company is a small business entity and has used the lease since 20WW in the course of carrying on their business. The lease is an active asset. The Company can apply the active asset reduction to the capital gain received from the lease surrender payment.

Issue 2

Question 1

Summary

The payment received in relation to the surrender of commercial lease will include GST as the surrender of commercial lease will satisfy all the elements of section 9-5 of the GST Act.

Reasons for decision

Taxable supply

Section 9-5 of the GST Act provides that an entity makes a taxable supply if the supply is made for consideration, in the course or furtherance of the entity's enterprise, the supply is connected with the indirect tax zone and the entity is registered or required to be registered.

However, the supply is not a taxable supply to the extent it is GST-free or input taxed.

If all the elements of section 9-5 of the GST Act are satisfied then a supply will be taxable.

Supply

Section 9-10 of the GST Act defines 'supply'. Subsection 9-10(1) of the GST Act provides that a supply is any type of supply whatsoever.

Paragraph 9-10(2)(e) of the GST Act provides that a supply includes the creation, grant, transfer, assignment or surrender of any right.

Paragraph 9-10(2)(g) of the GST Act provides that a supply includes an entry into, or release from an obligation to do anything, or to refrain from an act or to tolerate an act or situation.

Consideration

● Consideration is defined in subsection 9-15(1) of the GST Act to include any payment, act or forbearance in connection with, in response to or for the inducement of a supply of anything. You will receive an amount of money from the developer for early surrendering of the lease. This payment from the landlord is in connection with and for the inducement of your surrender of the lease.

Therefore, The Company is making a taxable supply when they surrender their rights to lease the commercial property.

ATO ID 2002/1055 is about GST and a tenant's surrender of a commercial lease.

ATO ID 2002/1055 explains that a GST registered tenant make a taxable supply when it surrendered its rights to lease a commercial property. The same reasoning applies to The Company's surrender of the commercial lease.

Consequently, as The Company is registered for GST and all the other elements of section 9-5 of the GST Act are present, the supply is neither GST-free nor input taxed. The Company's surrender of a commercial lease will be a taxable supply and must be included in the calculation of your GST liability.

Note: ATO ID 2002/1055 is available on our website at www.ato.gov.au.

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