Edited version of private advice

Authorisation Number: 1012654413524

Ruling

Subject: Assessability of prepaid rent

Question and answer:

Is refundable rental income received as a lump sum assessable in each financial year on a pro-rata basis over the term of the lease?

Yes

This ruling applies for the following period:

Year ended 30 June 2014

Year ended 30 June 2015

Year ended 30 June 2016

Year ended 30 June 2017

The scheme commenced on:

1 July 2013

Relevant facts and circumstances

You and your spouse (you) are the owners of a block of land (the land).

You have entered into a number of lease agreements in relation to the land. For the purpose of this ruling application, the lease agreements have been dissected into two groups, the 'original leases' and the 'new lease'.

The original leases

Lease 1

You entered into a lease agreement (Lease 1) with an entity (Company A) which entitled Company A to use a specified portion of the land.

Under the terms of Lease1, a certain amount plus GST, with annual rental increases at the rate of r% per annum, was payable to you over the term on the lease, being a period of m years.

A few years later, Company A assigned its rights and obligations under Lease 1 to Company B.

Lease 2

You entered into a lease agreement (Lease 2) with another entity (Entity C) which entitled Entity C to use a specified portion of the land.

Under the terms of Lease 2, an amount plus GST, with annual rental increases at the rate of r% per annum, was payable to you over the term of the least, being a period of n years.

For the remainder of this ruling, the part of the land subject to Lease 1 and Lease 2 will be collectively be referred to as the 'premises'.

The new lease

Lease 3

You entered into a new lease (Lease 3) with Entity D. The relevant terms of Lease 3 are as follows:

• The premises were leased to Entity D.

• Lease 3 provides Entity D with various rights, including the rights to the premises.

• A number of sequential lease agreements were entered into, each for a period of p years.

• The total term of Lease 3 is q years.

• Lease 3 was concurrent with and subject to the original two leases. This means that:

- Entity D is entitled to receive all rent and other payments payable under the original leases for the term of Lease 3; and

- Entity D assumes all obligations and responsibilities under the original leases for the term of Lease 3.

• Rent was paid as a lump sum at the date of entering into the lease agreement. The amount of rent to be paid was $X plus GST (the lump sum). No further rental payments are required for the remainder of the term of Lease 3.

• A schedule to the lease agreement specifies an amount of rent payable on an annual basis under the terms of the lease agreement, being the equivalent to $Y (plus GST) per annum. The lease agreement specifies that the lump sum represents $Y plus GST per annum over the term of the sequential leases.

• The lease agreement specifies that the amount payable by the lessee is rent for the use of the property over a fixed term.

• The lease agreement provides for a pro-rata refund of rent to Entity D if there is a breach of any fundamental terms of the lease and the lease agreement is terminated as a consequence.

• Upon entering into the lease agreement, you received a sum less than $X plus GST to reflect the fact that you had received in advance rental payments in respect of Lease 1 and Lease 2. Therefore you had already received rent under Lease 1 and Lease 2 for a period of time when Entity D was entitled to receive the rents.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Reasons for decision

Subsection 6-5(2) of the Income Taxation Assessment Act 1997 (ITAA 1997) provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources during the income year.

Ordinary income is defined as income according to ordinary concepts. Factors like periodicity, recurrence, regularity or services performed have been identified by the courts as indicating that an amount is income according to ordinary concepts. However an amount received in a lump sum can also be ordinary income depending on the nature of the lump sum payment.

If the purpose of the lump sum payment is to provide a substitute for an income stream then that lump sum may take on the character of those payments it is intended to replace.

In your case you received a lump sum at the time of entering into Lease 3. We need to determine the extent to which the lump sum represents:

• Proceeds from the grant of the lease (ie a lease premium)

• Rental income for the use of the land under the lease agreement (ie prepaid rent)

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 Income tax: capital gains: guidelines to determine whether an amount described in a sale of business agreement as consideration for goodwill is properly characterised as a lease premium).

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

We can take some guidance on this issue from Taxation Ruling TR 2002/14 Income tax: taxation of retirement village operators which deals with the characterisation of receipts on the granting of occupancy rights in the context of retirement villages. Although this ruling applies to the taxation of retirement village operators the principles discussed in determining whether an amount is prepaid rent are relevant here. Paragraph 129 of TR 2002/14 summarises the circumstances where a lump sum should be accounted for as prepaid rent as being 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.

Pro-rata rent

According to TR 2002/14, an advance payment should generally be accounted for as rent in advance and be brought to account over the period for which the payment is made. If a person is paid a lump sum in lieu of a monthly rent under a 10 year lease and the tenant is entitled to a pro-rata refund of this lump sum if the lease is broken early, the person may return the rent as income each year over the term of the lease in accordance with the principles laid down in Arthur Murray (NSW) Pty Ltd v. Federal Commissioner of Taxation 114 CLR 314; 14 ATD 98; (1965) 9 AITR 673.

However, amounts representing rent in advance that are non-refundable are assessable in full in advance (Paragraph 23 of TR 2002/14).

Application to your circumstances:

In your case:

• The lease agreement specifies that the amount payable by the lessee is rent for the use of the property over a fixed term.

• A Schedule to the lease agreement specifies an amount of rent payable on an annual basis under the terms of the lease agreement, being the equivalent to $Y (plus GST) per annum. The lease agreement specifies that the lump sum represents $Y plus GST per annum over the term of the sequential leases.

• The lease agreement provides for a pro-rata refund of rent upon termination of the lease if there is a breach of any fundamental term of the lease by the lessor.

• The amount of rent paid upon entering into the lease agreement was subject to a settlement adjustment, reflecting the fact that part of the current year's rent from Lease 1 and Lease 2 already had been received by you prior to entering into the lease agreement.

Based on the terms of the agreement for Lease 3, and consistent with the decision in Frazier and TR 2002/14, the lump sum you received on entering into Lease 3 is in the nature of prepaid rent.

In addition, as the lease provides for a pro-rata refund of rent to Entity D if there is a breach of any fundamental term of the lease and the lease agreement is terminated as a consequence, the rent is assessable over the term of the lease in accordance with the Arthur Murray principle.