Edited version of private advice

Authorisation Number: 1051811715931

Date of advice: 2 March 2021

Ruling

Subject: Deductibility of incentive payments to the assignee of an agreement for lease

Question 1

Is the Incentive incurred by T Co under the Incentive Deed for the assignment of the Agreement for Lease deductible under section 8-1?

Answer

No.

Question 2

If the answer to Question 1 is "No", is the Incentive incurred by T Co in the assignment of the Agreement for Lease deductible under section 25-110?

Answer

No.

Question 3

Does the assignment of the Agreement for Lease from T Co to the Incoming Tenant, give rise to any capital gain or capital loss in respect to a CGT event?

Answer

Yes.

Question 4

If the answer to Questions 1, 2 and 3 are "No", is the Incentive incurred by T Co in the assignment of the Agreement for Lease deductible under section 40-880?

Answer

Not applicable.

This ruling applies for the following period:

1/1/20XX to 31/12/20XX

The scheme commences on:

XX/XX/20XX

Relevant facts and circumstances

1. T Co is a private company incorporated in Australia.
2. On X1/XX/20XX, T Co entered into an Agreement for Lease with a developer to lease office space upon completion.
3. T Co sought to assign the Agreement for Lease to a third party prior to the completion of the premises. In this regard, T Co never occupied the premises and never subleased the premises to other parties.
4. Following negotiations with the Landlord and during the year ended 31 December 20XX, T Co paid an Incentive to a third party, to induce them to accept an assignment of the Agreement for Lease. This payment was made under an Incentive Deed entered into between the two parties.

Relevant legislative provisions

Section 8-1 of the Income Tax Assessment Act 1997

Section 25-110 of the Income Tax Assessment Act 1997

Section 108-5 of the Income Tax Assessment Act 1997

Section 104-10 of the Income Tax Assessment Act 1997

Section 110-35 of the Income Tax Assessment Act 1997

Section 110-55 of the Income Tax Assessment Act 1997

Section 40-880 of the Income Tax Assessment Act 1997

Reasons for decision

Question 1

Is the Incentive incurred by T Co under the Incentive Deed for the assignment of the Agreement for Lease deductible under section 8-1 of the ITAA 1997?

Summary

The Incentive is not deductible under section 8-1 of the ITAA 1997 as it is capital to T Co given the nature of its business.

Detailed reasoning

Section 8-1 of the ITAA 1997 allows deductions for losses or outgoings to the extent that they are:

(a)  incurred in gaining or producing your assessable income, or

(b)  necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

Despite this, deductions are precluded under paragraph 8-1(2)(a) where it is a loss or outgoing of capital, or of a capital nature.

The payment of an incentive to exit an Agreement for Lease has a sufficient nexus or connection to the production of assessable income for the purposes of paragraph 8-1(1)(a).

In Taxation Ruling 2005/6 - Income tax: lease surrender receipts and payments (TR 2005/6) we took the view, with reference to Tucker v Granada Motorway Services Ltd [1972] 2 All ER 801, that:

Even though rent paid under a lease is on revenue account, a lease surrender payment made by a lessee is not like rent. It takes its character from the character of the lease, and this is so even if the advantage sought by the lessee is a reduction in future rental outgoings.

In Mount Isa Mines Ltd v FCT (1992) 176 CLR 141, the High Court cited the same decision in support of the proposition that expenditure on the removal of a disadvantageous asset or modification of a taxpayer's capital structure will generally be capital in nature.

However, TR 2005/6 notes at paragraph 59 that an exception to the capital characterisation of surrender payments made by lessees exists where they carry on a business of dealing in leases.

Although T Co only had an agreement to lease, with the lease not yet granted at the time it made the incentive payment, for similar reasons the payment should take the character of the agreed lease. As T Co is not in the business of dealing with leases, the incentive payment is capital in nature. As such, the paragraph 8-1(2)(a) precludes T Co from claiming a deduction under section 8-1.

Question 2

If the answer to Question 1 is "No", is the Incentive incurred by T Co in the assignment of the Agreement for Lease deductible under section 25-110 of the ITAA 1997?

Summary

The Incentive is not deductible under section 25-110 of the ITAA 1997 as no lease was terminated by way of the Deed of Assignment.

Detailed reasoning

Section 25-110 of the ITAA 1997 allows taxpayers to deduct capital expenditure over five income years in equal proportions when it results in the termination of a lease or license if the expense is incurred in the carrying on of or ceasing of a business.

At the time the Incentive was incurred, no lease had been granted pursuant to the Agreement to Lease as the Premises was not yet completed nor had T Co entered into occupation of the premises. Pursuant to the Deed of Assignment, T Co assigned to the Incoming Tenant all its rights to be granted the lease.

As the Deed of Assignment did not result in the termination of any lease and the Agreement to Lease itself was only assigned rather than terminated, the Incentive incurred by T Co is not deductible under section 25-110.

Question 3

Does the assignment of the Agreement for Lease from T Co to the Incoming Tenant, give rise to any capital gain or capital loss in respect to a CGT event of the ITAA 1997?

Summary

The assignment of the Agreement for Lease gave rise to CGT Event A1 which would have produced a capital loss at the time of the event.

Detailed reasoning

According to section 108-5 of the ITAA 1997, a right to enforce a contractual obligation is an example of CGT asset, and CGT Event A1, under section 104-10 of the ITAA 1997, will occur at the time ownership of such a right transfers from one entity to another. Under this CGT event, a capital gain is made if the capital proceeds from the disposal are more than the asset's cost base.

Conversely, a capital loss is made if capital proceeds arising from the transfer are less than the asset's reduced cost base.

In this case, the right to be granted a lease is a CGT asset and CGT Event A1 happened upon assignment as ownership of this right was transferred from T Co to an unrelated third party.

T Co received no capital proceeds from the assignment although an incentive payment was made in respect of the CGT event.

According to sections 110-35 and 110-55 of the ITAA 1997, incidental costs are included as part of the second element of its cost base or reduced cost base.

In particular, subsection 110-35(11) provides that one instance of incidental costs "is termination or other similar fees incurred as a direct result of your ownership of a CGT asset ending".

Subsection 110-35(11) was added in 2010 in relation to which the Explanatory Memorandum to the Tax Laws Amendment (2010 Measures No. 4) Bill 2010 notes that:

2.84 Typically, termination fees (and exit fees) are contractual fees imposed by one party on the other as a result of the second party breaking the contract.

The payment of the incentive was similar to a termination fee in that it was a one-off amount required by the assignee as inducement to accept the assignment of the agreement by T Co.

Paying the incentive also directly resulted in T Co exiting the agreement it had with the Landlord. Consequently, the payment should be regarded as an incidental cost that forms part of the agreement's cost base under subsection 110-35(11).

Since it was the only cost incurred as part of the CGT event A1 and the capital proceeds received was nil, a capital loss equal to the full amount of the incentive is produced in accordance with section 104-10 since the reduced cost base exceeds capital proceeds.

Question 4

If the answer to Questions 1, 2 and 3 are "No", is the Incentive incurred by T Co in the assignment of the Agreement for Lease deductible under section 40-880 of the ITAA 1997?

Summary

Section 40-880 of the ITAA 1997 is not applicable in this instance as a capital loss arose upon the assignment of the Agreement for Lease.

Detailed reasoning

Section 40-880 of the ITAA 1997 enables taxpayers to deduct certain business capital expenditure over a period of five income years in even proportions if:

a)    the expenditure is not otherwise taken into account; and

b)    a deduction is not denied by some other provision; and

c)    the business is, was or is proposed to be carried on for a taxable purpose.

As the lease incentive payment is taken into account as the cost base of a CGT asset, the question whether section 40-880 applies does not arise.

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