Edited version of your written advice

Authorisation Number: 1012806975579

Ruling

Subject: CGT - lease premiums

Question 1

Is the Initial Payment ordinary income?

Answer

No

Question 2

Is the Initial Payment capital proceeds from capital gains tax (CGT) event F1?

Answer

Yes

This ruling applies for the following period:

Year ending 30 June 2014

The scheme commenced on:

1 July 2013

Relevant facts and circumstances

You own a property. Part of the property was subject to existing leases.

You entered into a Purchase Deed (the Deed) with X which granted the following to X:

• concurrent leases over part of your property

• an option to take a further concurrent lease over part of your property; and

• an exclusive right to receive current and future revenue in relation to you property.

Under the Deed, X are required to pay an initial payment (the Initial Payment) and, subject to X exercising the option, a subsequent payment.

The Initial Payment is described in the Deed as being a specific amount per annum.

The Deed provides that X assumes the obligations and responsibilities of the property, proportional to the part of the land covered by the lease.

The Deed provides that X is entitled to a refund on the Initial Payment if a lease under the Deed is terminated as a result of you breaching the terms of the lease. The refund is to be calculated on a pro-rata basis. If the lease is terminated for some other reason, there is no requirement to refund any of the Initial Payment.

You received the Initial Payment as a lump sum.

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 Paragraph 115-25(3)(e)

Income Tax Assessment Act 1997 Sub-section 116-20(2)

Reasons for decision

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.

Factors to be considered when determining whether a payment is prepaid rent or a lease premium are:

• the provision for a refund - if the lessee is entitled to receive a pro-rata refund of the payment on termination of the lease it may indicate the payment is of the nature of prepaid rent (Taxation Ruling TR 2002/14)

• the advantage sought by the lessee - 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; and

• the calculation of the payment - where a prepayment of rent has been made, it should be a capitalised amount that reflects a periodic outlay for the use of property for periods commensurate with the payment (FCT v. Creer 86 ATC 4318).

Application to your circumstances

In this case, it is considered that the entitlement to a refund of the Initial 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 (as described in TR 2002/14) which will generally allow for a refund in a wide variety of circumstances.

The length of time of the lease agreement is a significant amount of time; in addition the lease agreement gives the lessee the right to receive all benefits accruing to the owner of the land. The 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; it will have the advantage of the use and enjoyment of the land for a significant period.

You received a single lump sum payment in relation to the lease (and an additional lump sum if the option is exercised); the amount you will receive is not subject to review. The lease agreement does not provide any explanation of how the payment is calculated except to say that it is based on an amount per year.

It is not considered to be commercially realistic to receive prepaid rent for such a significant period 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 long term year lease without the chance to re-evaluate the rental as it is in this case.

This analysis indicates that the Initial Payment may not be commensurate to the advantage of the mere use of the land and the advantage sought by the payment may be some other advantage, this being the acquisition of the lease.

Consequently, on the basis of all of the factors identified above it is considered, in substance, that the Initial 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 Initial 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 have granted a lease and received 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.

Paragraph 115-25(3)(e) specifically states that the general discount will not apply to capital gains arising from CGT event F1. Accordingly, you can not apply the general discount when calculating any capital gain made from the CGT event.