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Ruling

Subject: Lease payment

Question 1:

Can you include the lump sum payment as ordinary income in your assessable income on a pro rata basis over the term of the lease?

Answer:

No.

Question 2:

Does the lump sum payment represent capital proceeds in relation to a capital gains tax (GCT) event?

Answer:

Yes.

This ruling applies for the following period:

Year ending 30 June 2013

The scheme commences on:

1 July 2012

Relevant facts and circumstances

You own a property.

An unrelated party has offered to lease the property for X years.

The lease includes a prepayment of $X described as rent for the entire term of the lease.

The lease agreement includes a clause that states that in the event the lease is terminated due to a breach by you, the lessee will be entitled to a pro-rata refund for the unexpired portion of the lease.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 6-5(2)

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Section 104-110

Income Tax Assessment Act 1997 Subsection 116-20(2)

Reasons for decision

Summary

The lump sum payment you will receive from the lessee has the character of a lease premium as opposed to prepaid rent. Accordingly, the payment will represent capital proceeds in relation to the granting of the lease. This payment must be taken into account in accordance with the CGT provisions and cannot be returned as ordinary income on a pro-rata basis over the term of the lease.

Detailed reasoning

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident includes income according to ordinary concepts (ordinary income) derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

Under section 6-10 of the ITAA 1997 assessable income also includes statutory income. Statutory income is amounts that are not ordinary income but are included as assessable income by provisions of the tax law.

Rent vs lease premium

The terms of lease agreements entered into by a lessor and lessee are important, although not necessarily decisive, in determining the proper characterisation of an amount received by a lessor. The courts will look to the true nature of the transactions between the lessor and the lessee, and are not bound by the label which the lessor and lessee attribute to the transactions (Taxation Ruling TR 96/24).

A lease premium is not defined in Australian tax law. It is therefore necessary to consider its meaning from an ordinary or legal perspective. A lease premium is consideration paid to the lessor for the leasehold interest over the asset, that is, the grant of a lease. This is distinguishable from rent which is the remuneration for the use and enjoyment of the leased property.

Provision for refund

Taxation Ruling TR 2002/14 considers the taxation treatment of income received from retirement village operators. TR 2002/14 determines that an amount received from a resident will be treated as prepaid rent where:

· a resident is prepared to make a lump sum payment in exchange for the right to occupy a village dwelling for a fixed term;

· the resident is entitled to receive a pro-rata refund for the unexpired portion of the lease on termination; and

· the intention of the parties to the lease is that the lump sum payment in advance is for the use and enjoyment by the resident of a village dwelling for the fixed term.

In Frazier v. Commissioner of Stamp Duties (NSW) (1985) 17 ATR 64; 85 ATC 4735 the Court placed great significance on the provisions for abatement in deciding that advance payments in respect of a lease of a retirement village dwelling were rent rather than premiums.

However, the circumstances in the present case are not considered to be comparable to those of retirement village leases as far as refunds are concerned. The retirement village dwelling lessees commonly require an early termination of their leases. The refunding of advance payments is an integral part of the retirement village operator's business

In this case, it is considered that the entitlement to a refund of the up front payment is very limited. The lessee will only be entitled to a refund if you, as the lessor, breach the lease agreement. This can be contrasted to a retirement village lease which will generally allow for a refund in a wide variety of circumstances.

The advantage sought by the lessee

In making the distinction between a lease premium which is paid for the grant of a lease and rent which is paid for the use and enjoyment of the leased property, it is important to look at the advantage sought by the lessee under the agreement. Where a payment is made by a lessee to secure an enduring advantage, such as the future use and advantage of an asset, it will be in the nature of a lease premium.

Generally, the advantage sought under a lease may be characterised as recurrent in nature being for the continuous or recurrent provision of a service (use of land) for a certain term. However, the factual circumstances surrounding a lease transaction may be sufficient to displace this general proposition.

In BP Australia Ltd v. Federal Commissioner of Taxation (1964) 110 CLR 387 on appeal to the Privy Council, their Lordships asked themselves with respect to whether an outgoing was on revenue account:

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 years periods that fact would have pointed to recurrent revenue expenditure. Had they been for twenty years, that fact would have pointed 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.

In this case the length of time of the lease agreement is X years; in addition the lease agreement gives the lessee the right to receive all benefits accruing to the owner of the land. The X year lease is a structural solution that effectively transfers 'economic ownership', though not legal ownership, to the lessee. The advantage sought by the lessee is an enduring kind, as although the lessee will not be able to enjoy the right to the land forever, it will have the advantage of the use and enjoyment of the land for an extremely long period of time.

Calculation of the payment

In FCT v. Creer 86 ATC 4318 (Creer's case), the Courts stated that where a prepayment of rent has been made, it must be a capitalised amount that reflects a periodic outlay for the use of property for periods commensurate with the payment. It also stated that:

…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 '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. This conclusion is supported by the evidence of Mr Pursche as to the method he adopted in calculating the payments and to the effect that the only reason he provided for three instalments was that one payment appeared 'commercially unrealistic'.

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…

In this case, you will receive a single lump sum payment in relation to the lease; the amount you will receive is not subject to review and you will not receive any additional future rental payments. The lease agreement does not provide any indication that the 'rent payment' is calculated based on a periodical rental amount.

It is not considered to be commercially realistic to receive prepaid rent for a period of X years as the pricing of property would have considerable fluctuation during the period. In a standard lease contract, there will be a rent review clause (a periodic adjustment to reflect the market rate where rent is revised or indexed each year). It is therefore unusual that a lessor would lock themselves into a X year lease without the chance to re-evaluate the rental as it is in this case. This indicates that the 'rent payment' may not be commensurate to the advantage of the mere use of the land and the advantage sought by the 'rent payment' may be some other advantage, this being the acquisition of the lease.

Fisher J also stated in Creer's case:

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'?

Based on the facts and circumstances this case, it is considered that the advantage sought as a result of the lump sum payment is to secure an enduring benefit, that is, the future use and enjoyment of the land rather than a periodical outlay to cover its use and enjoyment for periods commensurate with the payment. Additionally, based on this analysis, it is reasonable to conclude that is 'commercial' to receive a premium payment (as opposed to rental payments) to provide the lessee with a long term right over the land.

Conclusion

Consequently, on the basis of all of the factors identified above it is considered, in substance, that the up front payment will not be in the nature of rent but will rather be full market value consideration for the granting of the lease for a certain period of time.

The true nature of the up front payment is best described as a lease premium and is capital in nature. A capital receipt is not ordinary income; however it may be assessable as statutory income under the CGT provisions.

Capital gains tax

CGT event F1 in subsection 104-110(1) of the ITAA 1997 happens when a taxpayer grants, renews or extends a lease. A capital gain or capital loss may arise from the CGT event happening. The CGT discount does not apply to CGT event F1.

The lessor makes a capital gain if the capital proceeds from the grant, renewal or extension are more than the expenditure it incurred on the grant, renewal or extension; conversely a capital loss occurs if the capital proceeds are less (subsection 104-110(3) of the ITAA 1997).

The capital proceeds are any premium paid or payable for the grant of the lease (sub-section 116-20(2) of the ITAA 1997). Expenditure incurred on the grant of the lease does not include any part of the cost of the underlying asset.

CGT event F1 occurs at the time the contract for the lease is entered into, or if there is no contract, at the start of the lease (subsection 104-110(2) of the ITAA 1997).

You will grant a lease and receive a lump sum lease premium payment. CGT event F1 will occur at the time the lease contract is entered into and the lease premium will form part of the capital proceeds of the event. The capital gain or loss that occurs following CGT event F1 will be included in your assessable income in the year the event occurs (unless you are eligible to choose and do choose for CGT event F2 to occur instead of CGT event F1, see further information below).

Further issues for you to consider

You can choose for CGT event F2 to apply (rather than CGT event F1) when you grant, renew or extend a long-term lease and satisfy certain conditions. It can apply if you are the owner of the underlying land or if you grant a sub-lease. The CGT discount does not apply to CGT event F2.

For the purposes of CGT event F2, a long-term lease over land is one where;

· the lease is for at least 50 years; and,

· at the time the lease is granted it is reasonable to expect that the lease will continue for at least 50 years; and,

· the terms of the lease as they apply to the lessee are substantially the same as those under which the lessor owned the land; and,

· the lessor chooses the grant of the lease to be a CGT event F2 rather than a CGT event F1.

There are special rules in regards to calculating the capital proceeds and cost base in relation for CGT event F2.

Further information on choosing CGT event F2 and special rules for the capital proceeds and cost base relating to this event are available on our website, www.ato.gov.au.