Edited version of your written advice

Authorisation Number: 1051195211196

Date of Advice: 24 February 2017

Ruling

Subject: Income v Capital

Question 1

Are the payments made to secure an option to lease premises considered to be capital or revenue in nature?

Answer

The payments are capital in nature.

This ruling applies for the following periods:

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

Year ended 30 June 2015

Year ended 30 June 2016

The scheme commences on:

1 July 2009

Relevant facts and circumstances

The Company collects medical samples from medical practitioners, medical centres and other providers of health services. In many cases it is necessary to sublet a dedicated part of the medical centre's premises in order to store and retrieve the medical samples in a controlled and regulated manner. In order to secure these subleases, it is often necessary to enter into a lease option agreement with the medical centre to secure the site's availability prior to establishing the site as a dedicated collection centre. The lease option agreement is often less expensive than entering into a full sublease during the site's initial evaluation and provides a greater level of flexibility in determining the site's practical needs. The sites are merely dedicated collection centres. They are not staffed and they do not display corporate livery. The sites do not represent any goodwill or capital value other than being necessary to allow the safe and controlled storage of medical samples for collection by the Company for subsequent analysis and testing. The analysis and testing is conducted at the Company's laboratory. The nature of these payments can be either a once off payment or made on a monthly basis. The option will generally be exercised to establish a full sublease or on occasions the option may lapse.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

The payments made to secure an option to lease premises are considered capital in nature. Therefore, a deduction is not allowable under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997).

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (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 or a provision of the taxation legislation excludes it.

The Commissioner accepts that the payments to secure an option to lease premises were incurred to gain or produce assessable income. However, the issue to be determined is whether the payments are losses or outgoings of a capital nature or a revenue nature.

Where payments have been made under a lease or an option to lease, it is necessary to determine if all or any part of the payment was a payment of a lease premium or a payment of rent.

Sun Newspapers Limited and Associated Newspapers Limited v Federal Commissioner of Taxation (1938) 61 CLR 337 (Sun Newspapers) established three matters to take into consideration when making the distinction between capital and revenue:

The character of the advantage sought, and in this its lasting qualities may play a part;

The manner in which it is used, relied upon or enjoyed, and in this and under the former head recurrence may play its part; and

The means adopted to obtain it; that is, by providing a periodical reward or outlay to cover it use or enjoyment for periods commensurate with the payment or by making a final provision so as to secure future use or enjoyment.

The following is a discussion of the matters identified in the Sun Newspapers case:

The character of the advantage sought

A sum will be a premium where it is paid as consideration for the grant or acquisition of a lease. Rent is consideration payable under a lease for the right to use and occupy leased premises during the term of the lease.

In Case C2 71 ATC 8, a partnership entered into a lease for 3 years 288 days. Total rent of ₤7,371.13.4 was payable as follows:

₤3,000 upon execution of the lease, and

₤101.13.4 payable on the 18th of each and every month during the remainder of the lease until the full amount of ₤7,371.13.4 is fully paid and satisfied.

Clause 19 of the lease provided an option of renewing the lease by payment of “...a further premium of Three Thousand Pounds (₤3,000)...”.

In determining whether the initial ₤3,000 payment was a premium or rent, Member Thompson referred to Earl Jowitt's Dictionary of English Law. At page 1390 the dictionary described a premium as “a consideration; something given to invite a loan or a bargain ... in granting a lease, part of the rent is sometimes capitalised and paid in a lump sum at the time the lease is granted”.

It was held that the ₤3,000 paid represented consideration for the grant of the lease and was a premium. This was supported by clause 19 which referred to a further premium to be paid if the option to renew the lease was exercised. The instalments that were to be paid monthly during the whole term of the lease were held to be the true rent.

In your case the payment of the Option Fee is akin to a premium which represents consideration for the grant of the option to lease.

(b) Right to a refund

Premium payments are non-refundable whereas prepaid rent may be refundable where a lease is terminated early.

In FC of T v Krakos Investments Pty Ltd (1995) 96 ATC 4063 a taxpayer sold a licensed hotel on a leasehold basis. Part of the consideration was for goodwill. The taxpayer granted a five year lease with an option for two further renewals. One condition of the sale was that the purchasers could require the taxpayer to buyback the goodwill at the end of the five years (for the price paid).

The Full Federal Court held the payment for the goodwill was not a premium. In reaching the conclusion, Hill JJ stated:

The conclusion that the payment in this case was not to be characterised as a “premium” was facilitated by the provisions of the special circumstances which provided an obligation on the taxpayer to buy back the goodwill for $420,000 if required by the purchasers. If the amount was a premium for the grant of the lease, once paid it would not be returnable. Yet the parties bargained for a put option, pursuant to which the amount might come to be repaid to the purchasers at the expiration of the lease. That was inconsistent with the amount of $420,000 being treated as a premium.

Essentially, the conclusion that the payment was not characterised as a 'premium' was facilitated by the fact that the taxpayer had an obligation to buy back the goodwill if required by the purchasers. If the amount was a premium for the grant of a lease, once paid it would not be returnable. The put option was inconsistent with the payment being treated as a premium.

In your case as per the Option to Lease “the Option may be exercised at any time within (the prescribed time) from the date of this Agreement by the Company giving written notice to the Lessor that it is exercising the Option. If the Option is not exercised within the time stipulated in this clause, it will lapse and the Option Fee will not be refunded). There is no right to a refund if the option is not exercised within the prescribed time.

(c) Purpose of the expenditure

Where expenditure is made to secure an asset or an advantage of an enduring kind, the expenditure is capital in nature.

In Sun Newspapers it was stated that 'enduring' did not mean the advantage obtained would last forever.

The purpose of your expenditure appears to be to secure the option to lease the premises over a prescribed term. The payment in advance appears to be to secure an advantage of an enduring kind, that being the option to lease the premises during the prescribed term nominated in the contract.

(d) Calculation of payment can help determine the true nature of the outlay

How the amount of the payment is calculated can assist in determining its true nature. Where the payment is calculated with reference to the day by day usage of the premises, it is more likely to be considered in the nature of rent.

In FC of T v Creer (1986) 86 ATC 4318 the taxpayer leased four home units from their owners. A related company purchased the units the following day, at a reduced price. Under the lease, the taxpayer paid the total rent for the five year term in advance - 80% on commencement on the lease and then 10% on the following two anniversaries. The taxpayer made three payments as he had received the advice that making one payment would be commercially unsound.

Fisher J in giving the lead judgement, with which both Wilcox J and Jackson J agreed, commented as follows:

To my mind the first question for determination in this matter is whether the sum called rent and which is described as the “total rent” and is payable by three instalments is an outgoing on revenue account. Alternatively, is it more correctly to be seen as a capitalized amount and thus an outgoing of a capital nature? [page 4323]

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”? [page 4324]

In my opinion, 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 [in FC of T v South Australian Battery Makers Pty Ltd at ATC page 4417;] “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. [page 4324]

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 and thus not an allowable deduction. [page 4324]

The Court held that the amount of the total rent was a capitalised sum payable by instalments and not rent accruing from, and referrable to, the day to day usage of the premises.

The Company pays by way of lump sum upfront or alternatively, in some cases, on a monthly repetitive basis as outlined under the option to lease agreement. The Lessor grants the Company the option to lease the premises for the term and on the conditions set out in the lease. The payment (whether upfront or on a monthly basis) is more correctly classified as a final provision or payment required to secure the premise's future use and enjoyment. The payment is to secure the option to lease as opposed to a periodical reward or outlay to cover the use or enjoyment of the premises for periods commensurate with the payments during the term of the lease.

(e) Means to obtain it

Numerous cases have stated that a once and for all lump sum payment is indicative of capital expenditure whilst recurrent payments are indicative of revenue expenditure.

However, as can be seen from Creer's case it is possible for a sum paid in instalments to be considered capital in nature.

You have advised that the payment to secure the option to lease is either paid as a lump sum or on a repetitive monthly basis. The nature of the payment indicates it is capital expenditure as it is a payment to secure the option to lease. It is not a periodical reward or outlay to cover the use or enjoyment of the premises for periods commensurate with the payments during the term of the lease.

Application to your circumstances

The legislation and relevant cases have been considered with regard to the factual circumstances surrounding your Option to Lease agreements. Based on the facts and your submissions, the Option Fee paid on entering these Option to Lease agreements is considered to be of a capital nature on the bases that:

The Option Fee is a payment of a premium which represents consideration from the Lessor to the Company the option to lease the premises for the term and on the conditions set out in the lease.

There is no right to a refund if the option to lease is not exercised within the prescribed time.

The payment appears to be to secure an advantage of an enduring kind, that being, the option to lease the premises during the prescribed term nominated in the contract.

The payment is to secure the option to lease premises as opposed to a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payments during a lease.

Based on the above, the payments made to secure an option to lease premises are considered capital in nature. Therefore, a deduction is not allowable under section 8-1 of the ITAA 1997.