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Ruling

Subject: Prepayment of rent

Question

Are you entitled to 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)?

Answer

No

This ruling applies for the following periods:

Year ended 30 June 2010

Year ended 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

Year ending 30 June 2018

Year ending 30 June 2019

The scheme commences on:

1 July 2009

Relevant facts and circumstances

You signed a lease agreement in 2009 with a lessor for the use of a space.

The term of the lease was for 25 years commencing in 2009 (commencement date)

The rent is an amount per annum being a lump sum for the whole term payable on or before the commencement date in accordance with the agreement for lease.

You paid the lump sum on the commencement date.

In addition to the rent you are also required to pay a variety of levies in accordance with the agreement for lease.

You have subsequently sublet the space to the lessor for a fixed rent per annum for a number of years. Once that period has finished the space will be put back into the rental pool to be sublet again.

You were advised by the lessor that the lump sum you paid upfront for the lease is tax deductible over 10 years under the prepaid expenses rules

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

Section 8-1 of the 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 paid a lump sum to the lessor under a lease agreement. The payment is described in the lease as being rent for 25 years commencing on the commencement date.

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 prepayment 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 the lessor 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 in relation to your 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 initial £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.

In your case the payment of an upfront rent payment more appropriately represents a premium which represents consideration for the granting of the lease. There are no instalments paid periodically which would be considered 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.

In your case the lease could be terminated by either the lessor or yourself under certain circumstances

(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.

The purpose of the expenditure appears to be to secure the use of the asset over the longer term which in this case is 25 years. The rent in advance payment appears to be to secure an advantage of an enduring kind.

(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.

You paid a lump sum upfront on the commencement day as outlined under the lease agreement which was to cover the total rent payable over the 25 year period of the lease. It appears that the upfront lump sum payment of rent was more correctly classified as a final provision or payment so as to secure its future use of enjoyment as opposed to a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payments.

(e) 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 shed 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.

In your case the fact that the upfront payment was to cover the period of the lease which was 25 years indicates that the nature of the payment is a non-recurring payment of a capital nature.

(f) 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.

In your case the fact that there was only one upfront lump sum payment of rent and not recurrent payments indicates that the payment was of a capital expenditure.

Application to your circumstances

You signed a lease agreement in 2009 with the lessor for a space.

The term of the lease was for 25 years commencing in 2009 (commencement date)

The rent is an amount per annum being a lump sum for the whole term payable on or before the commencement date in accordance with the agreement for lease.

You paid a lump sum on the commencement date.

The legislation and relevant cases have been considered with the factual circumstances surrounding your agreement to lease a space from the lessor. Based on the facts and your submission, the payment made on entering the lease agreement is considered to be 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 payment, although classified as rent by both parties, is more appropriately a payment of a premium which represents consideration for the granting of the lease. There are no instalments paid periodically which would be considered true rent and on revenue account.

· Under very limited circumstances, the unused portion of the premium may be refundable.

· the purpose of the expenditure appears to be to secure the use of the space over the longer term, which in this case, is 25 years.

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

· the fact that there was only one upfront lump sum payment and not recurrent payments indicates that the payment was of a capital nature.

Additionally, it is commercially unrealistic to incur prepaid rent for a period of 25 years without a rent review clause to reflect the market fluctuation of the price of property.

The fact that in certain very limited circumstances the amount prepaid can be refunded does not detract from all the points outlines above.

Based on the above you are not entitled to 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.