Edited version of your private ruling

Authorisation Number: 1012479011177

Ruling

Subject: Lease premium

Question 1

Is the lump sum payment deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

If the answer to question 1 is yes, can the deduction be calculated under section 82KZM of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

Not applicable - see reasons for decision

Question 3

If the answer to question 1 is no, can a deduction for decline in value be claimed under Division 40 of the ITAA 1997?

Answer

Yes

This ruling applies for the following period:

Year ended 30 June 2011

The scheme commenced on:

1 July 2010

Relevant facts and circumstances

The trust entered into a lease agreement.

The lease related to land and was for a X year period.

The lease agreement specified that rent was to be paid as one lump sum payment of $X plus GST on commencement of the lease.

The permitted use of the land under the lease was raw material extraction, processing and removal.

The trust entered into an agreement with a third party to mine materials from the land in return for a royalty payment. Any royalties received are reported as taxable income in the trust's tax return.

The trust's aggregated turnover was below $2 million in the relevant year and subsequent financial year.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 82KZM

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Division 40

Income Tax Assessment Act 1997 Subsection 40-25(1)

Income Tax Assessment Act 1997 Subsection 40-30(2)

Income Tax Assessment Act 1997 Section 995-1

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.

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 paid by a lessee. 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.

In this case, the lease agreement does not include a provision for a refund of any portion of the lump sum payment in the event that the lease is terminated early.

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. 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 extensive 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, the trust paid a single lump sum payment in relation to the lease; the amount paid is not subject to review and the trust is not required to pay 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 rent payments 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. Accordingly, the payment is not deductible under section 8-1 of the ITAA 1997.

Prepayment rules

Section 82KZM of the ITAA 1936 provides special rules for small business entities to calculate deductions for certain prepaid expenditure. As the payment is not deductible under section 8-1 of the ITAA 1997, the prepayment rules under section 82KZM of the ITAA 1936 do not apply.

Decline in value

Subsection 40-25(1) of the ITAA1997 provides that a taxpayer is entitled to deduct an amount worked out under Division 40 of the ITAA 1997 for the decline in value of the cost of depreciating assets that are used to produce assessable income.

A depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used. Mining, quarrying and prospecting rights are specifically included as depreciating assets under subsection 40-30(2) of the ITAA 1997.

The definition of the term 'mining, quarrying or prospecting rights' under section 995-1 of the ITAA 1997 includes a lease of land that allows the lessee to mine, quarry or prospect for minerals, petroleum or quarry materials on the land

Accordingly, as the rights under the lease produce assessable income for the trust in the form of royalty payments, the trust can claim a deduction for the decline in value of those rights.