Edited version of your written advice

Authorisation Number: 1051305039939

Date of advice: 10 November 2017

Ruling

Subject: Derivation of Pre-paid rent

Question 1

Will the Sub-Lessor derive the Prepayment Amount under the Sublease in the income year the amount is received and therefore be required to include this amount in the Sub-Lessor’s assessable income under section 6-5 of the Income Tax Assessment Act 1997 (‘ITAA 97’)?

Answer

No. See ‘Reasons for Decision.’

This ruling applies for the following periods:

The income year ended 30 June 201X to the income year ended 30 June 204X.

Relevant facts and circumstances

1. The Sub-Lessor is an Australian resident company.

2. The Landlord granted the Sub-Lessor a long-term lease (the ‘Head Lease’) over land.

3. The Head Lease has an initial term and an option to renew for a further period.

4. A commercial development is proposed to occur on a site in the Head Lease area.

5. The Sub-Lessor proposes to grant a sublease (the ‘Sublease’) to the ‘Tenant’ over an area of land on the site.

6. The proposed Sublease has the following terms:

a. The Term of the Sublease is for an initial term and an option period that is aligned with the initial term and option period of the Head Lease.

b. The option period under the Sublease is subject to the Sub-Lessor exercising its option to renew under the Head Lease.

c. The Tenant will pay an amount of Rent to the Sub-Lessor by monthly instalments in advance.

d. The Rent is calculated by applying a rate to the Sublease Area.

e. The Rent will increase on each anniversary of the Lease Commencement Date at a fixed rate.

f. The Tenant may, at its absolute discretion, elect to pre-pay the Rent on or after the date 12 months after the Lease Commencement Date by payment of the Prepayment Amount.

g. The Prepayment Amount has been calculated based on the net present value (NPV) of all rent payments scheduled for the remainder of the Term, less a discount for early payment.

h. The Prepayment Amount remains the same throughout the Term, even where the Tenant makes the election on a date which is after the 12 month anniversary of the Lease Commencement Date.

i. Where paid, the Prepayment amount will be applied by the Sub-Lessor in satisfaction of the Tenant’s liability to pay the Rent during the Term. However:

i. The Prepayment Amount will not be applied against rental liabilities that arise after the first twelve months of the Lease Commencement Date, but before the Prepayment Amount is paid (i.e. if the Prepayment Amount is not paid immediately after the first twelve months of the Sublease).

ii. Part of the Prepayment Amount may be applied against overdue rent relating to the first year of the Sublease.

j. In the event the Sublease is terminated before the end of the Term due to ‘prescribed circumstances’, then a proportionate amount of the paid Prepayment Amount, having regard to that part of the Term remaining at the date of termination, will be refunded to the Tenant.

k. The ‘prescribed circumstances’ are:

i. Insolvency of the Sub-Lessor

ii. The Sub-Lessor failing to exercise its option to extend the Head Lease term

iii. A material and substantial breach of the lease by the Sub-Lessor which is capable of being remedied and has not been remedied within 12 months of a notice from the tenant detailing the default and requiring the Sub-Lessor to remedy the default.

l. If the Sublease area becomes inaccessible – for example, due to fire or flood – the Sub-Lessor will be obliged to restore access to the premises.

m. The Tenant will construct and own the buildings and improvements on the Sublease area and will bear any risk of loss – for example, due to fire or flood – of the buildings and improvements.

n. At the end of the Term, any Prepayment Amount should be exhausted (i.e. reduced to nil).

7. The Sub-Lessor will account for the Rent and the Prepayment Amount in its books on an accruals basis throughout the Term.

Relevant legislative provisions

Income Tax Assessment Act 1997 s 6-5

Reasons for decision

Summary

The Prepayment Amount is an ‘advance payment,’ within the meaning of the Arthur Murray case, to the extent that it is applied to rental liabilities that fall due after that amount is paid. To this extent, the Prepayment Amount will be ‘derived’ by the Sub-Lessor progressively on an accruals basis throughout the Term. The Prepayment Amount is consideration for the future right to use and occupy the Sublease area. The proportion of the Prepayment Amount that is applied to rental liabilities that accrued prior to payment of the amount (such as overdue rent relating to the first year of the Sublease) will not be an ‘advance payment.’

Detailed reasoning

Statutory Framework

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (‘ITAA 97’) provides that your assessable income includes ordinary income you derive from all sources, whether in or out of Australia, during the income year.

Where income is earned in one year of tax but received in another, the issue is: what is an appropriate method of determining when income is ‘derived’ under subsection 6-5(2) in a relevant year of income?

Taxation Ruling TR 98/1 Income Tax: determination of income; receipts versus earnings (‘TR 98/1’)

Two methods of determining when income is derived in a relevant year of income are the receipts method and the earnings (or accruals) method.

Under the receipts method, income is derived when it is received, either actually or constructively under subsection 6-5(4) of the ITAA 1997. Subsection 6-5(4) of the ITAA 97 provides that, in working out whether and when a taxpayer has ‘derived’ an amount of ordinary income, a taxpayer is taken to have received the amount as soon as it is applied or dealt with in any way on the taxpayer's behalf or as the taxpayer directs. The concept of ‘constructive receipt’ will not be relevant if the Prepayment Amount is ‘derived’ on an accruals basis.

Under the earnings method, income is derived when it is earned. The point of derivation occurs when a ‘recoverable debt’ is created. A debt is ‘recoverable’ at the point of time at which a taxpayer is legally entitled to an ascertainable amount as the result of having performed an agreed task: see TR 98/1, [2], [8]-[11].

A taxpayer must adopt the method that, in the circumstances of the case, is the most appropriate. A method of accounting is appropriate if it gives a substantially correct reflex of income. Whether a particular method is appropriate to account for the income derived is a conclusion to be made from all the circumstances relevant to the taxpayer and the income, having regard to ordinary accounting and commercial principles: see TR 98/1, [17]. Only one method of accounting is appropriate to any one item of income. There is no choice available: see TR 98/1, [30].

A substantially correct reflex of a company’s business income would usually be given by the earnings method, except where that method was an ‘... artificial, unreal and unreasonably burdensome method of arriving at the income derived:’ TR 98/1, [39]. Rent is generally assessable when received or applied at the taxpayer’s direction. However, where rent is business income, a substantially correct reflex of that income may be given by use of the earnings basis: TR 98/1, [48].

Advanced Payments for Services – Arthur Murray

Generally, in the assessment of income, the object is to discover what ‘gains’ have during the period of account come home to the taxpayer in a realised or immediately realisable form: The Commissioner of Taxes (South Australia) v. The Executor Trustee and Agency Company of South Australia Limited (1938) 63 CLR 108 (the ‘Cardens’ case), 155. ‘Gains’ refers to amounts which have not only been received but have ‘come home’ to the taxpayer; and this involves, not only that the amounts received are unaffected by legal restrictions (e.g. by reason of a trust or charge), but that they may properly be counted as gains completely made, so that there is neither legal nor business unsoundness in regarding them without qualification as income derived: Arthur Murray (NSW) Pty Ltd v FC of T (1965) 114 CLR 314 (the ‘Arthur Murray case’).

In the Arthur Murray case, the High Court held that, according to established accounting and commercial principles, amounts received in advance of services to be rendered in the future (‘advanced payments’) are not ‘derived’ at the time of payment; rather, the amounts are ‘derived’ as income at the time the services are rendered. In that case, while there was no contractual right to a refund in the event of not completing the course, refunds were sometimes given in practice. The High Court in the Arthur Murray case provided the following reasons:

● While commercial and accountancy practice may assist in ascertaining the true nature and incidence of an item as a step towards determining whether the item answers the test laid down in the Act for allowable deductions, it cannot be substituted for the test.

● In so far as the ITAA 97 lays down a test for the inclusion of particular kinds of receipts in assessable income it is likewise true that commercial and accountancy practice cannot be substituted for the test.

● However, nothing in the ITAA 97 is contradicted or ignored when a receipt of money as a prepayment under a contract for future services is said not to constitute by itself a derivation of assessable income.

● The possibility of having to make a repayment is an inherent characteristic of the receipt itself. It would be out of accord with the realities of the situation to hold, while the possibility remains, that the amount received has the quality of income derived by the company.

● According to established accountancy and commercial principles, the books of a business are kept with respect to amounts received in advance of services being provided so that the amounts are not entered to the credit of a revenue account until the services are rendered: in the meantime they are effectively credited to a suspense account, and they transfer to an income account upon discharge of the relevant obligation.

The Arthur Murray case has also been applied to cases involving prepaid rent.

In Case B47 70 ATC 237, the taxpayer (lessor) and lessee agreed to a weekly rental of £25, with the total rental of £13,000 for the 10-year to be paid in advance on signing. In the event of the earlier termination of the lease other than by reason of the lessee's default or breach, the lessor was liable on demand to refund £25 for each week of the term then unexpired. In the event of destruction of the premises by fire, some or all of the rent reserved was to be suspended and refunded weekly to the lessee pending rebuilding or repairs.

The issue was whether the amount of £11,500 rent (£1,500 being retained for repairs) in advance received by the taxpayer during the year was ‘derived' by him in that year. Guided by the above principles from the Cardens and Arthur Murray cases, the majority found that the taxpayer should be deemed to have ‘derived’ assessable income week by week at the rate of £25 per week in the form of rent which accrued to him from 1 March 1965 to 30 June 1965 under the terms of the lease agreement of 31 March 1965. The main consideration in making this decision was the possibility of the taxpayer’s liability to refund the advanced payment.

By contrast, in Case B51 70 ATC 253, the advanced rent payment was ‘derived’ in the year of receipt as there was no provision for refund in the event of termination of the lease before expiration.

Characterisation of Pre-Payment Amount

In the present case, the proposed Sublease requires the Tenant to pay the Sub-Lessor the Rent by monthly instalments in advance throughout the Term. The Tenant can elect to pre-pay the Rent on or after the date 12 months after the Lease Commencement Date by payment of a Prepayment Amount. The Prepayment Amount has been calculated based on the net present value (NPV) of all rent payments scheduled for the remainder of the Term, less a discount for early payment.

When paid, the Prepayment Amount will be applied by the Sub-Lessor in satisfaction of the Tenant’s liability to pay the Rent during the Term. Part of the Prepayment Amount may be applied against overdue rent relating to the first year of the Sublease. However, the Prepayment Amount will not be applied against rental liabilities that arise after the first twelve months of the Lease Commencement Date, but before the Prepayment Amount is paid (i.e. if the Prepayment Amount is not paid immediately after the first twelve months of the Sublease). In the event the Sublease is terminated before the end of the term due to ‘prescribed circumstances’ (e.g. substantial breach by the Sub-Lessor), then a proportionate amount of the Prepayment Amount, having regard to that part of the Term remaining at the date of termination, will be refunded to the Tenant. The Sub-Lessor will account for the Rent and the Prepayment Amount in its books on an accruals basis over the Term.

The Prepayment Amount is an ‘advance payment,’ within the meaning of the Arthur Murray case, to the extent that it is applied to rental liabilities that fall due after that amount is paid. To this extent, the Prepayment Amount will therefore be ‘derived’ by the Sub-Lessor progressively on an accruals basis throughout the Term. The Prepayment Amount is consideration for the future right to use and occupy the sublease area. The proportion of the Prepayment Amount that is applied to rental liabilities that accrued prior to payment of the amount (such as overdue rent relating to the first year of the Sublease) will not be an ‘advance payment.’

Other relevant comments

It is noted that where the Sublease is terminated before the end of the Term, and the Tenant is not entitled to a pro-rata refund of the Prepayment Amount (i.e. no ‘prescribed circumstance’ applies), then the part of the Prepayment Amount that has not accrued to the Sub-lessor may be ‘derived’ in the income year that the Lease terminated.

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