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Subject: Agreement for Sub-Lease

Question 1:

Does Lessee make a taxable supply to Developer under an Agreement for Sub-Lease ('Agreement') as a consequence of agreeing to enter into a lease ('Lease') with a third party investor ('Lessor')?

Answer:

Yes, the Lessee does make a taxable supply to the Developer under the Agreement as a consequence of agreeing to enter into the Lease with the Lessor.

Question 2:

If the Lessee does make a taxable supply to the Developer under the Agreement as a consequence of agreeing to enter into the Lease with the Lessor, is the non-monetary consideration for that taxable supply the Developer's corresponding obligation to procure the Lessor to grant and execute the Lease, the GST-inclusive market value of which is nominal?

Answer:

As the ruling request provides no details of the valuation method used by the Lessee, we are unable to confirm whether the GST-inclusive market value of that non-monetary consideration is a nominal amount.

Relevant facts and circumstances:

The Lessee is a professional services trust which is a lessee of office premises which the Lessee makes available to another entity.

The Developer proposes to have a commercial office tower constructed by Builder on land which is owned by the Authority.

The Date for Practical Completion of construction of the tower is 20xx (unless extended by agreement) and as from 20yy the Lessee intends to become the lessee of the 'Premises' (i.e. z levels of the tower) and 'Licensed Areas' (car parks etc.) and make them available to another entity.

In 20yy the Lessee entered into the Agreement for Sub-Lease ('Agreement') with the Developer. Pursuant to the Agreement the Developer agrees to design the Premises so as to meet agreed specifications, lodge the relevant Development Application, and deliver the 'Developer Works' by procuring the Builder to complete the Developer Works at the cost of the Developer. The Developer also agrees to procure the 'Fitout Works' to be completed and to bear the cost of the Fitout Works up to a specified 'Maximum Amount'. The Lessee agrees to pay the Developer for the Fitout Works to the extent that the cost of the Fitout Works exceeds the Maximum Amount.

Under the Agreement the Developer agrees to procure a nominee of the Developer ('Lessor') to grant a Lease of the Premises ('Lease') to the Lessee on the 'Lease Commencement Date' (i.e. not prior to 20yy) and the Lessee agrees to accept the grant of the Lease from the Lessor (clause 11.1) and to execute the Lease (clause 11.4). A copy of the Lease is attached to the Agreement. The Lessor will also enter into a Head Lease with the Authority so that, as from the Commencement Date there will be a Head Lease from the Authority to the Lessor and a sub-lease (i.e. the Lease) from the Lessor to the Lessee.

Although the Agreement has been executed, it does not become effective until two conditions precedent have been satisfied, i.e. the Developer obtains all the approvals and consents necessary to undertake the development and the Developer enters into an unconditional agreement with an investor (i.e. the Lessor) whereby the investor agrees to enter into both the Head Lease with the Authority and the Lease of Premises with the Lessee.

The ruling request described the arrangement as follows:

Consistent with the conditions precedent referred to…above, the Lessee understands that the Developer will supply to an investor the right to be nominated as the lessee under the Head Lease with ZZZ. In a commercial sense, this means that the Developer will nominate the investor and then construct the Premises (subject to the Agreement for Sub-Lease with the Lessee) for the investor who will become the Lessor under the Lease. It is through these supplies to the Lessor (i.e. the nomination and the construction services) that the Developer intends to receive monetary consideration for its development of the Premises.

Submissions in the ruling request:

In the ruling request it was submitted that the Lessee does not make a taxable supply to the Developer under the Agreement merely by agreeing to enter into the Lease or agreeing to execute the Lease because the Lessee's agreement to enter into the Lease is a standard term of all Agreements for Lease and not a supply of a right or obligation that has a separate economic value or identity.

It was submitted that although the 'supply' definition includes an entry into, or release from, an obligation to do anything (sub-paragraph 9-10(2)(g)(i) of the GST Act), the ATO has accepted that it is not necessary to treat every obligation entered into under an agreement as a separate supply or as non-monetary consideration for a supply. The ruling request referred to Goods and Services Tax Ruling GSTR 2003/16 (Para 19):

Lease transactions involve the granting of various rights and entry into various obligations by the parties to the transaction. However, not every obligation that arises under a lease is a separate supply made for consideration.

and Goods and Services Tax Ruling GSTR 2001/6 (Para 83):

For example, in many cases, agreeing to enter into a contract to receive a supply for a specific period of time is not non-monetary consideration for that supply.

However, it was acknowledged that the Developer received a benefit from the Agreement:

As explained…above, the Developer is expected to economically benefit from having entered the Agreement, because it will be able to use the existence of the Agreement to successfully negotiate with investors (with regard to the terms and price for which the Developer will nominate an investor to be the Lessee under the Head Lease and Lessor under the Lease, and then construct the Premises for it).

The Developer will only receive monetary consideration from the Lessee under the Agreement if the value of the Fitout Works exceeds the Maximum Amount and in that case the payment will be for the Lessee's Items of Equipment. We are instructed that this is likely to be the case.

In the event that the ATO determined that the Lessee does make a taxable supply to the Developer by agreeing to enter into the Lease, it was submitted that the non-monetary consideration for that supply is the Developer's corresponding obligation to procure the Lessor to grant the Lease, that the GST-inclusive market values of both the supply made by the Lessee and the supply made by the Developer should be equal (GSTR 2001/6, Para 138) and determined by a method which produces a reasonable outcome (GSTR 2001/6, Para 141), and should be a nominal amount.

It was noted that if the Developer and Lessee do make corresponding supplies to each other under the Agreement, both supplies are taxable, both parties are entitled to full input tax credits on the corresponding creditable acquisitions and that no revenue leakage arises.

Relevant legislative provision:

A New Tax System (Goods and Services Tax) Act 1999 section 9-10.

Reasons for decisions:

Question 1 - Does the Lessee make a taxable supply?

Supply:

GSTR 2003/16 deals with inducements to enter into either an agreement for lease or a lease, sets out an example where a tenant enters into an agreement for lease (Para 38):

Example 1 - non-monetary consideration and separate supplies

The terms of an agreement for lease provide that a landlord will supply commercial premises for a specified monthly rental. The terms of the agreement also provide that the landlord will supply a motor vehicle to the tenant as consideration for the tenant agreeing to enter into the lease agreement…

and states (Para 39):

The tenant makes a supply by agreeing to enter into the lease (subparagraph 9-10(2)(g)(i)).

Subparagraph 9-10(2)(g) (i) of the GST Act provides that 'supply' includes an entry into, or release from, an obligation to do anything.

Example 1 in GSTR 2003/16 treats the tenant's agreement to enter into the lease as a supply falling within sub-paragraph 9-10(2)(g)(i) of the GST Act.

In addition Goods and Services Tax Advice GST TPP 009 states that there are two distinct supplies where an owner of premises which are not yet in a state ready to be leased enters into an agreement to lease and then a formal lease with a prospective tenant:

The definition of 'supply' in section 9-10 of the A New Tax System (Goods and Services Tax) Act 1999 means that there are two supplies, one upon entering into the contract (the agreement to lease) and again when the underlying asset is delivered (the underlying lease).

In the present case the Lessee agrees to accept the grant of the Lease and to execute the Lease. In our view the Lessee makes supplies which fall within sub-paragraph 9-10(2)(g)(i) of the GST Act.

GSTR 2006/13 refers (Para 28) to two court decisions of the Court of Justice of the European Communities ('ECJ') as examples of a lease inducement provided to a prospective tenant being consideration for a supply made by the tenant. One of those decisions, C&E Commrs v Mirror Group plc [2001] STC 1453, held that an undertaking to enter into a lease and pay rent by a prospective anchor tenant in return for a payment from a landlord was not a supply of services for United Kingdom VAT purposes, but may be a supply of advertising services.

In Mirror Group Mirror Group signed a Principal Agreement with the landlord (O&Y) whereby Mirror Group agreed to lease five floors of an office tower and an Option Agreement whereby Mirror Group could lease further floors in the same tower within a specified period. O&Y agreed to pay Mirror Group an inducement payment of about $12 million plus $2.1 million VAT, half in respect of the Principal Agreement and half in respect of the Option Agreement.

When O&Y paid the first half of the inducement payment to Mirror Group, the VAT was paid into an escrow account. The C&E Commissioners subsequently refused to repay the VAT to Mirror Group, and Mirror Group appealed to the VAT Tribunal.

The VAT Tribunal held that the acceptance of the terms of the Principal Agreement and execution of the lease were 'things done' by Mirror Group in return for the inducement and that Mirror Group therefore made a supply of services for consideration (Para 14), but that supply was exempt from VAT under article 13B(b) of EC Council Directive 77/388, i.e. 'the leasing or letting of immovable property'. The VAT Tribunal applied Lubbock Fine & Co v C&E Commissioners [1994] STC 101 which held that the surrender of a lease by a tenant in return for a payment from the landlord fell within the article 13B(b) exemption, i.e. as Lubbock Fine & Co held that a surrender of a lease by a tenant in return for a payment from a landlord fell within article 13B(b) then entry into a lease by a tenant in return for a payment from a landlord should also be exempt under article 13B(b).

The C&E Commissioners appealed to the High Court. The High Court sought a preliminary ruling from the ECJ as to whether the supply made by Mirror Group fell within the exemption in article 13B(b).

The ECJ held that the exemption in article 13B(b) did not apply to the supply made by Mirror Group because 'the leasing or letting of immovable property' in article 13B(b) essentially involved a landlord assigning the right to occupy the property to the tenant for an agreed period in return for rent so that the landlord makes the taxable supply of services and the tenant pays the consideration and that was not the situation with Mirror Group (Paras 31-2). The ECJ explained that the assignment by the tenant back to the landlord of the right to occupy the property in Lubbock Fine & Co had to be exempt under article 13B(b) because the original supply of the right to occupy the property by the landlord to the tenant was exempt under that article (Para 34). The ECJ also stated (Paras 26-28):

As to whether a supply of services was made, it must be noted that a taxable person who only pays the consideration in cash due in respect of services, or who undertakes to do so, does not himself make a supply of services for the purposes of article 2(1) of the Sixth Directive. It follows that a tenant who undertakes, even in return for payment from the landlord, solely to become a tenant and to pay rent does not, so far as that action is concerned, make a supply of services to the landlord.

However, the future tenant would make a supply of services for consideration if the landlord, taking the view that the presence of an anchor tenant in the building containing the leased premises will attract other tenants, were to make a payment by way of consideration for the future tenant's undertaking to transfer its business to the building concerned. In those circumstances, the undertaking of such a tenant could be qualified, as the Untied Kingdom government in essence submits, as a taxable supply of advertising services.

In that context, it is appropriate to point out that it is for the national court, in the light of the guidance given by the court, to ascertain whether, in the case before it, Mirror Group made a supply of services for consideration to the landlord, and if it did, what that supply was.

In the present case we note that the 'Premises' which the Lessee has agreed to lease comprise XX levels of the office tower, which suggests that the Lessee may be an anchor tenant (and we note that the Lessee has first refusal in relation to any naming rights). In addition, the ruling request suggests that the Agreement allows the Developer to increase the price charged by the Developer to an investor for nominating the investor as Lessor:

As explained…above, the Developer is expected to economically benefit from having entered into the Agreement, because it will be able to use the existence of the Agreement to successfully negotiate with investors (with regard to the terms and price for which the Developer will nominate the investor to be the Lessee under the Head Lease and Lessor under the Lease, and then constructs the Premises for it).

We therefore consider that, in addition to entry into the obligations in clauses of the Agreement, the Lessee may make other supplies to the Developer under the Agreement.

In the ruling request it was submitted that it is not necessary to treat every obligation entered into under an agreement as a separate supply and reference was made GSTR 2003/16 (Para 19):

Lease transactions involve the granting of various rights and entry into various obligations by the parties to the transaction. However, not every obligation that arises under a lease is a separate supply made for consideration.

The footnote to GSTR 2003/16 (Para 19) refers to Goods and Services Tax Ruling GSTR 2001/6 (Paras 80 to 85) which discusses whether a payment is consideration for a supply. However GSTR 2001/6 also discusses whether an obligation merely defines a supply or forms a separate supply, including (Paras 86 and 87):

Particular terms that form part of a transaction need to go beyond merely defining or describing the supply, or specifying rights that are to be retained by the entity making the supply, before the terms form a separate supply or additional consideration for a supply under the transaction. This principle also applies in overseas jurisdictions.

In our view the Lessee's entry into obligations to accept the grant of the Lease of the Premises and execute the Lease go beyond merely defining or describing a supply and form separate supplies made by the Lessee.

The ruling request also referred to the following statement in GSTR 2001/6 (Para 83):

For example, in many cases, agreeing to enter into a contract to receive a supply for a specified period of time is not non-monetary consideration for that supply.

In our view this portion (Paras 80 to 85) of GSTR 2001/6 discusses whether things such as obligations are non-monetary consideration for a supply, not whether such things constitute separate supplies.

Supply for consideration:

Section 9-5 of the GST Act provides that an entity makes a taxable supply if, inter alia, that entity makes the supply for consideration. Section 9-15 provides that 'consideration' includes any payment or any act or forbearance in connection with, in response to or for the inducement of a supply of anything.

In the ruling request it was submitted that if the Lessee did make a supply pursuant to the Agreement by agreeing to accept the grant of the Lease, the consideration for that supply took the form of non-monetary consideration, i.e. the Developer's corresponding obligation under a clause of the Agreement to procure the Lessor to grant the Lease. In terms of the 'consideration' definition in section 9-15 of the GST Act, this is an 'act' in connection with, in response to or for the inducement of the supply made by the Lessee under the Agreement.

In our view the Developer enters into several obligations under the Agreement:

To procure the Developer Works to be carried out and completed by the Builder so that the Premises are reasonably capable of being used by the Lessee and Practical Completion is achieved by the Date for Practical Completion;

To procure the Fitout Works to be carried out and completed by the Date for Practical Completion;

To pay the Fitout Works Cost up to the Maximum Amount;

To ensure that the Lessee can continue to occupy (at the Developer's cost) the Lessee's existing premises or alternative accommodation from 20yy until 30 days after the Date of Practical Completion;

To rectify or cause the Builder to make good any Defects in the Developer Works; and

To procure the Lessor to grant the Lease to the Lessee on the Lease Commencement Date.

We consider that at least two of these obligations satisfy the requirements in GSTR 2001/6 that non-monetary consideration needs to have a clearly independent identity (Para 85) and (Para 86):

Particular terms that form part of a transaction need to go beyond merely defining or describing the supply, or specifying rights that are to be retained by the entity making the supply, before the terms form a separate supply or additional consideration for a supply under the transaction.

The Developer can only ensure that the Premises become available for the Lessee to occupy if the Developer fulfils both the obligation to procure the Developer Works to be carried out by the Builder and the separate obligation to procure the Lessor to grant the Lease to the Lessee and we consider that these obligations have clearly independent identities. The Agreement also treats the Developer's obligation to procure the Fitout Works to be completed as separate from the Developer's obligation to procure the Developer Works to be carried out. The Developer's obligation to make good any defects in the Developer Works is similar to the assumption by a purchaser of a business of the unquantified product warranty liabilities of the vendor which is stated in Goods and Services Tax Ruling GSTR 2004/9 to be non-monetary consideration because unquantified product warranty liabilities have economic value and independent identity (Para 111).

Are the Fitout Works consideration?

GSTR 2003/16 discusses a situation where a landlord agrees to provide a fitout as an inducement to a tenant to agree to enter into a lease and states (Paras 58 and 59):

The GST treatment may be affected by who has ownership of the fitout as a result of the transaction.

For example, it may be a condition of an agreement to enter into a lease that the landlord will fit out the premises to an agreed standard, and the landlord retains ownership of the fitout. In the absence of contrary evidence in the agreement or other relevant circumstances, we would not regard the fitting out of the premises as consideration for the tenant's entry, or agreement to enter, into the lease. The landlord is only making a supply of premises, albeit fitted out to specifications agreed with the tenant, in return for rental consideration. The fitout is not separate consideration provided by the landlord to the tenant. It is merely part and parcel of the supply of the leased premises.

Pursuant to the Agreement, the Developer agrees to procure the Fitout Works to be carried out and completed by the Builder and to bear the cost to the extent that the cost of the Fitout Works does not exceed the Maximum Amount. The Agreement states, however, that title to 'Fitout Equipment' (i.e. fixtures, fittings etc. installed as part of the Fitout Works to the extent that the 'Fitout Works Cost' is less than or equal to the Maximum Amount) remains with the Lessor or Developer from the time it is installed. Similarly, the Lease annexed to the Agreement states that the Fitout Equipment is part of the Premises and that title to the Fitout Equipment remains with the Lessor. Although the present case differs from the scenario discussed in GSTR 2003/16, the Fitout Works are owned by the Developer or the Lessor but never by the Lessee and we do not consider that there are any 'other relevant circumstances' which suggest that the Fitout Works are consideration for the supply made by the Lessee under the Agreement.

Is any Surplus Amount consideration?

Where the aggregate of Fitout Works Costs is less than the Maximum Amount, the Agreement provides that the resulting 'Surplus Amount':

…will be provided to the Lessee as a reduction in the amount payable by the Lessee by way of Base Rent under the Lease in respect of the Premises in respect of the first year of the Lease.

We note that the ruling request states that the aggregate of Fitout Work Costs is likely to exceed the Maximum Amount so that a Surplus Amount is unlikely to arise. However, if the Base Rent under the Lease was reduced by a Surplus Amount, GSTR 2003/16 suggests that, for GST reporting purposes, the Base Rent should not be reduced by the Surplus Amount and the Surplus Amount should be treated as consideration for a taxable supply made by the Lessee (Paras 26 and 27):

Where a landlord provides an incentive as an inducement for the tenant's entry, or agreement to enter, into a lease of commercial premises, the consideration for the supply of the premises by the landlord is not reduced by the incentive (15).

It has been argued that a lease incentive is really a payment to the tenant to accept a higher level of rent. In rejecting the treatment of a lease incentive as having the nature of a repayment of rent, the High Court stated in Montgomery's case that the market had 'produced an arrangement under which the lessee agreed to pay rent and the lessor agreed to pay an incentive'.

Footnote 15 to Para 26 refers to GSTR 2001/6 (Para 125) which states:

Where there are mutual supplies for consideration, the GST law does not allow the price for one supply to be reduced by the price of another.

The reference in Footnote 15 to 'mutual supplies for consideration' suggests that although the Base Rent would not be reduced by the Surplus Amount for the Lessor's GST reporting purposes, the Surplus Amount would be monetary consideration for a taxable supply made by the Lessee to the Lessor in respect of which the Lessor would be entitled to claim an input tax credit.

Question 2 - Is the GST-inclusive market value of the non-monetary consideration for the taxable supply made by the Lessee to the Developer a nominal amount?

Summary of decision:

GSTR 2001/6 requires the Lessee to use a reasonable method (such as the market value of a good, service or thing that is identical or similar to the non-monetary consideration) or a reasonable valuation method as determined between the Lessee and the Developer to determine the GST-inclusive market value of non-monetary consideration. As the ruling request provides no details about the method used by the Lessee to determine that the GST-inclusive market value of the non-monetary consideration is a nominal amount, we are unable to confirm whether that value is correct.

Detailed reasoning:

We have already set out the obligations (in addition to the obligation to procure the Lessor to grant the Lease to the Lessee) which the Developer enters into pursuant to the Agreement and the extent to which those obligations constitute non-monetary consideration for the supply made by the Lessee. We have also referred to the remote possibility that the Lessor may provide monetary consideration for the supply made by the Lessee in the event that there is a Surplus Amount.

Paragraph 9-75(1)(b) of the GST Act provides that so far as the consideration for a taxable supply is non-monetary consideration, the value of that supply is 10/11^ths of the GST-inclusive market value of that consideration. GSTR 2001/6 states that in most circumstances where parties are dealing at arm's length the ATO considers that the goods, services, or other things exchanged are of equal GST-inclusive market value (Para 138) and that the onus for determining the GST-inclusive market value of the consideration for a supply rests with the supplier because the supplier must show that amount as the price on the relevant tax invoice issued by the supplier (Para 139).

In the ruling request it was submitted:

The Commissioner is also of the view that the GST-inclusive market value of non-monetary consideration can be determined by applying a method that produces a reasonable outcome (refer paragraph 144 of public ruling GSTR 2001/6). We submit that, in the circumstances of this transaction, it would be reasonable to treat the GST-inclusive market value of the consideration to be a nominal amount.

Paragraph 144 appears in a section (Paras 138-158) of GSTR 2001/6 entitled 'Reasonable valuation of non-monetary consideration' and requires an entity to use a 'reasonable method' to determine the GST-inclusive market value of non-monetary consideration. Paragraph 144 sets out four examples of 'reasonable methods', i.e. using the price of a good, service, or thing which exists in the market and is identical to the good, service or thing supplied, the market value of a similar good, service or thing, the market value of the supply, or a professional appraisal. GSTR 2001/6 then states (Para 155):

Other reasonable methods:

Where you are making a taxable supply and you are dealing with another party at arm's length, you can use a reasonable valuation method as determined between you and the other party. Also, where both the supply and the consideration are difficult to value (for example, a forbearance may have no identifiable market), you can calculate a reasonable market value for the non-monetary consideration (for example, a 'cost plus margin' method'.

The ruling request seeks a ruling confirming that the GST-inclusive market value of the non-monetary consideration for the taxable supply made by the Lessee under the Agreement is nominal. However the ruling request does not specify the valuation method used by the Lessee to arrive at that valuation.

If the Lessee is relying upon either of the first two of the four 'reasonable methods' discussed in GSTR 2001/6 (Paras 144-154) then we consider that the market value of goods, services, or things that are identical or similar to the non-monetary consideration provided by the Developer (i.e. entry into obligations to procure the Lessor to grant the Lease, procure the Developer Works to be completed by the Builder, procure the Fitout Works to be completed, ensure the Lessee can continue to occupy) would be likely to be greater than a nominal amount.

If the Lessee is relying on the third 'reasonable method', i.e. determining the market value of the non-monetary consideration by reference to the market value of the supply made by the Lessee (GSTR 2001/6, Para 151), we consider that the value of entry by the Lessee into obligations to enter into and execute the Lease in respect of XX floors of an office tower for a term of TT years at a substantial Base Rent is likely to be greater than a nominal amount.

If the Lessee is relying on 'other reasonable methods' (GSTR 2001/6, Para 155), i.e. a reasonable valuation method determined between the Lessee and the Developer, the Lessee did not include details of that method in the ruling request.

We note that, in the discussion in GSTR 2004/9 of a situation where the purchaser of a business provides non-monetary consideration in the form of agreeing to assume the vendor's unquantified product warranty liabilities, GSTR 2004/9 states (Para 114):

If a vendor and purchaser, dealing with each other at arm's length, agree to allow a set-off or reduction in the purchase price of the enterprise for the estimated amount of a product warranty liability, this amount is likely to represent the GST-inclusive market value of the non-monetary consideration provided.

This supports the view that a reasonable method of calculating the GST-inclusive value of non-monetary consideration is required.

As the ruling request provides no details as to the method used to determine that the GST-inclusive market value of the non-monetary consideration for the supply made by the Lessee is a nominal amount, we are unable to confirm whether that value is correct.