Edited version of your written advice

Authorisation Number: 1051232402377

Date of advice: 2 June 2017

Ruling

Subject: Lease - deductibility of up-front payment

Question 1

Is the up-front lease payment deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

If the answer to question is yes, is the proportion of the up-front lease payment that is deductible in a relevant year of income determined in accordance with the formula set out in section 82KZMD of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

Not applicable - see reasons for decision.

This ruling applies for the following period

Year ending 30 June 2017

The scheme commences on

1 July 2016

Relevant facts and circumstances

You are the trustee of a self-managed superannuation fund.

You intend on entering into a lease for commercial premises.

Your purpose for entering into the lease is to derive rental income under an arms-length lease between you and one of your members.

A copy of the proposed lease has been provided with your private ruling application. The terms set out in this lease form part of the relevant facts upon which this ruling is made. Relevantly, the terms of the lease include:

● you must pay the Rent by one up-front lump sum payment on or before the Commencement Date of the lease, and

● you will be entitled to abatement/reimbursement of the up-front payment in certain circumstances.

The term of the lease will be several decades.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1936 section 82KZMA

Income Tax Assessment Act 1936 section 82KZMD

Question 1

You can deduct from your assessable income any loss or outgoing to the extent that it is incurred in gaining or producing your assessable income (subsection 8-1(1) of the ITAA 1997). However, you cannot deduct a loss or outgoing to the extent that it is a loss or outgoing of capital, or of a capital nature (subsection 8-1(2) of the ITAA 1997).

Whether the up-front payments are capital, or capital in nature

The core principles regarding the distinction between capital and revenue are those set out in Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337 (Sun Newspapers) and Colonial Mutual Life Assurance Society Ltd v Federal Commissioner of Taxation (1953) 89 CLR 428 (Colonial Mutual).

In the context of the acquisition of a land asset, Fullagar J in Colonial Mutual said that the common questions to consider are '(1) What is the money really paid for? - and (2) Is what is really paid for, in truth and in substance, a capital asset?'

In Sun Newspapers, Dixon J held that the critical distinction between outgoings on capital account and those on revenue account lay in the distinction between the 'profit yielding structure' and the process by which the profit yielding structure operates to derive profits. He said, at CLR 359:

The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organization set up or established for the earning of profit and the process by which such an organization operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss.

And at 363:

There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part; and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.

The enquiry must be made from a practical and business point of view. In Hallstroms Pty Ltd v. Federal Commissioner of Taxations (1946) 72 CLR 634, Dixon J observed, at 648, that:

What is an outgoing of capital and what is an outgoing on account of revenue depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process.

Character of the advantage sought

The importance of the 'character of the advantage sought' test was restated more recently by the High Court in Commissioner of Taxation v. Citylink Melbourne Limited (2006) 228 CLR 1 (Citylink). Crennan J (with whom Gleeson CJ, Callinan and Heydon JJ agreed) said, at 43:

The characterisation of an outgoing depends on what it “is calculated to effect”, to be judged from a “practical and business point of view”. The character of the advantage sought by the making of the expenditure is critical.

Leases are ordinarily capital assets. This follows from the nature of a lease in the context of the average business, where a lease is a significant structural component of the income-producing undertaking, and is employed as part of a process which produces income. Such a general characterisation was made clear by the High Court in Federal Commissioner of Taxation v Montgomery (1999) 198 CLR 639, where, in reference to a 12 year lease entered into by a firm of solicitors, it was said '[t]hat the lease of the premises was part of the profit-yielding structure of the firm's business is beyond question'.

There are circumstances where a lease might not be a capital asset, for example, if the lease was insignificant to a taxpayer's overall operations. Such circumstances do not, as we understand, exist in your case. Rather, the lease will be significant relative to your overall assets and activities. Therefore, the lease is a capital asset in your hands.

That being the case, the question becomes whether the payment you will make is for the lease, or for a period of use under the lease. Labels used by the parties to describe a payment are not determinative, and the surrounding circumstances may be taken into account to determine the true characterisation of a payment: see Goldberg J in FCT v. Star City Pty Limited [2009] FCAFC 19; (2009) 175 FCR 39 (Star City). The Courts 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.

The fact the payment is a single payment in respect of the whole period indicates that it is the former characterisation which is correct. This inference is supported by the length of the interest obtained, which makes it difficult to say that the payment is for use for the whole term rather than for the asset itself.

It must be thought, by way of illustration, that it is very uncertain what use you will be making of the lease in 40 years' time. There would be, it could be assumed, a significant probability that the lease will have been turned to account by way of assignment within that period, and that this would be in the contemplation of the parties at the time the lease is to be entered into. This suggests that it is the asset itself which the payment is for, not use, which leads to a capital characterisation.

This view is also supported by the fact that the price paid was not arrived at by reference to what rent would be payable for each period, but rather a lump sum was presented as what was required for the lease to be granted. This indicates the acquisition of the asset is what was in mind, and that the terms of the lease did not follow a desire for use for consecutive periods which might sum to the total duration of the lease; rather, the possibility of the premises being used for the total period follow from the fact what is acquired is an asset.

These factors suggest what is sought is the lease itself, which will be a significant structural addition to the assets you own. This implies a capital characterisation. This is subject, however, to the possibility of repayment of the lump sum in certain circumstances.

Repayment Clauses

The lease agreement provides for repayment of a proportion of the amount paid in the following circumstances:

1) if the agreement ends before the expiry date of the lease, and

2) in the case of damage and destruction to the property which means that you cannot use or gain access to the premises, or access to the premises is substantially affected.

In either case, the amounts repayable are calculated by reference to the present value of the money paid at the relevant time, and the period which the premises are not usable or will not be used. Otherwise, the amount payable for the lease will not vary. There is no rent review clause, for example.

Initially there were no repayment clauses in the lease. Rather, a price for obtaining the lease for the full term was set. Repayment clauses were imposed over that lump sum. This suggests the character of the advantage sought was in fact the acquisition of a lease of long duration, not any period of use under that lease, and that the repayment clauses were a measure of protection in respect of what is sought, not something actually changing the nature of the end in mind.

We note, also, that the grounds on which the agreement may end are limited. The lease agreement gives you the power to end the agreement where (1) the property has been damaged, (2) you give notice to the landlord that the damage must be rectified, and (3) the landlord does not notify you that the damage will be rectified. Otherwise, termination by you depends on a breach of a fundamental term of the lease by the landlord or a serious breach of an intermediate term, under general contractual law.

We question whether the protection offered by the clauses goes beyond what is otherwise available at law. There is some authority that a lease ending after prepayment of rent where there is a significant unexpired term may allow the lessee to recover part of the amount prepaid, under principles similar to the equitable doctrine of relief against forfeiture. If the clauses merely grant a contractual basis to seek equivalent relief, then these clauses are comparable to liquidated damages clauses, which provide for efficacious settlement of disputes, avoiding court costs.

Viewed in this way, it is unlikely that these clauses could affect the character of the advantage sought where a capital characterisation seems otherwise likely, although, admittedly, this depends on an analogy to legal relief the availability of which could be disputed.

Following from the foregoing, we consider that the possibility of repayment does not alter the essential character of what is sought, which is the asset itself, not use of that asset.

We therefore conclude that the advantage sought is capital in nature. In reaching this conclusion, we do not consider the following statement, relied on in your submissions and made by Crennan J in Citylink, to be persuasive:

Unlike periodic instalments paid on the purchase price of a capital asset, the concession fees are periodic licence fees in respect of the Link infrastructure assets, from which the respondent derives its income, but which are ultimately 'surrendered back' to the State. Accordingly, they are on revenue account.

Citylink concerned an agreement under which the taxpayer paid to a state government amounts for rights to operate a toll road. The central issue was whether an obligation was 'incurred' under promissory notes issued to satisfy the payment obligations, even though those promissory notes were not in fact payable until later years. Justice Crennan's statement follows from her finding that the notes were obligations incurred in the year to which they related - that is, they constituted actual periodic outgoings.

In that context, her Honour is clarifying that there was no advantage which was acquired by the payments going beyond each period to which the payments related, and therefore there was no other advantage sought beyond one which was revenue in nature, an advantage which would come to an end with the final licence period. She is not implying that in all cases a permanent asset is required in order for an outgoing to be capital in nature.

Use of Advantage and Means of Obtainment

Although in most cases the finding that a payment was for a capital asset is sufficient to conclude the question of whether an outgoing is capital, the other factors identified by Dixon J in Sun Newspapers can sometimes displace this conclusion and must also be considered.

Ordinarily, leased premises are used by a taxpayer as a site from which to conduct activities which generate income. The payments in respect of such leases are regular, recurrent, and are required as each period to which a payment relates arises or expires. These elements make the relationship between a payment and the period of use direct, such that the inference that the payment is in fact for the use in that time is clear, and the payment is thus not a price paid by way of instalment for the lease itself; in this respect it is relevant that it has been said that in the absence of these features any presumption that payments in respect of a lease are revenue in nature is dispensed with.

In your circumstances, while the lease acquired will be used, broadly, in obtaining assessable income, it will not be used in the ordinary way in which leases are used by a business. Instead, it will be employed by way of sublease, providing you with an income stream. This tends to suggest a capital characterisation, as it indicates what is paid for is not something which forms an element within a process by which returns are earned, within Dixon J's explanation of what is 'revenue', but instead something which itself generates income.

The means adopted to obtain the lease will be an up-front payment and there is a significant probability it is once-and-for-all. While there is a prospect of repayment in certain circumstances, they are limited, and there is no possibility of the amount paid varying commensurate with market movements. These factors also suggest a capital characterisation.

Analogous Cases

In your submissions a number of cases were cited and argued as being relevant, including Frazier v. Commissioner of Stamp Duties (NSW) (1985) 17 ATR 64; 85 ATC 4735, a case which features in Taxation Ruling TR 2002/14. The issue in Frazier was whether a lump sum paid to a retirement village operator for a 20 year lease was a premium or rent. If it was a premium, it was dutiable under stamp duty legislation, while if it was rent it was not. The Court found that the lump sum was the prepayment of rent, and not a premium. This conclusion was supported by the fact that there were provisions for repayment of the amount in the case of destruction or damage to the premises, or early termination of the lease.

The problem with applying Frazier to the present circumstances is that it is a decision made in the context of legislation which required a determination as to whether something is rent or a premium, which were mutually exclusive categories. Some other taxation cases have been decided in similar legislative contexts.

While it can be accepted that premiums are usually capital, the meaning of 'premium' adopted in Frazier is not the only meaning of the word. Premiums can be the prepayment of rent, which reduce later rental obligations, and notwithstanding that such a premium is a genuine prepayment of rent; such a payment can be capital. The amount paid not being a premium within the meaning of Frazier, therefore, does not mean that an outgoing is revenue in nature. To the contrary, there is authority that a payment being a premium in a sense which includes the prepayment of rent capitalises the amount.

The Capitalisation of Prepayments of Rent

In Australia, the proposition that a prepayment of rent for a lease of long duration is a premium and therefore capital, is illustrated by the case of Clarke v Federal Commissioner of Taxation (1932) 48 CLR 56. In that case, the taxpayer acquired a ten year lease of a hotel owned by brewers, for which he paid £12,000 at the commencement of the lease, and £42 per week rent. The taxpayer was also required to tie the trade of the premises to the owner's brewery. To acquire the lease, the taxpayer also obtained the residue of the previous tenant's lease, which had only a very short time to run.

The High Court found that the payment on the commencement of the lease was capital, notwithstanding that it was a prepayment of rent. They said:

[The payment] represented the present price of the future enjoyment of an interest in land of long duration. It is quite true that the premium is an anticipated rent. That means, however, that what otherwise might have been part of the rent reserved has been capitalised. No doubt it is capital expended in the acquisition of an asset of a diminishing or wasting nature and therefore required in a proper account a provision for depreciation. But the annual loss which would so be provided for out of revenue would none the less be a loss of capital.

A prepayment of rent in respect of a lengthy period can therefore capitalise the amount paid, and the mere fact that a similar outcome could have been achieved by periodic payments does not make the amount revenue in nature.

You have also submitted that some cases suggest a revenue characterisation by way of contradistinction, including Sun Newspapers, BP Australia Ltd v Commissioner of Taxation (1964) 110 CLR 387 (BP) and Star City.

We consider Sun Newspapers and BP to have little application to your facts beyond their explanation of the overarching law. These cases were examples of the application of general principles to specific circumstances. For the reasons given above, we consider these principles favour a capital characterisation, and, without analogous facts, these cases are not determinative.

Star City is closer, factually, to your matter, as it relates to a prepayment for a long-term lease. We acknowledge that comments made by the Full Federal Court, and the decision at first instance, suggest that a prepayment for a long-term lease may be revenue in nature, particularly in light of the importance Gordon J at first instance placed on the possibility of repayment.

However, these comments have to be viewed in the context that the lease component of what was being acquired was relatively insignificant to the other assets being obtained, diminishing the structural importance of the lease itself. We also have some misgivings about Gordon J's analysis and its conformity with established principle. As her Honour was overruled, until further cases arise which inform further analysis, we think her Honour's judgment should be treated with caution.

Following the above analysis, we consider that the application of the foundational principles of capital and revenue, together with the case law, support a finding that the up-front payment is capital in nature. As such, it is not deductible under section 8-1 of the ITAA 1997.

Question 2

Where expenditure qualifies for deduction under section 8-1 of the ITAA 1997, the deduction is generally allowable in full in the year the expenditure is incurred. However, the timing of deductions for certain types of expenditure is subject to the advance payment rules in sections 82KZL to 82KZO of the ITAA 1936.

Relevantly, subsection 82KZMA(1) of the ITAA 1936 provides:

Section 82KZMD sets the amount and timing of deductions for expenditure that a taxpayer incurs in a year of income (the expenditure year), if:

(a) apart from that section, the taxpayer could deduct the expenditure for the expenditure year under:

(i) section 8-1; or

(ii) …

of the Income Tax Assessment Act 1997; and

(b) the requirements in subsections (2),(3), (4) and (5) are met.

For the reasons given above, the up-front lease payment is capital in nature and will not be deductible under section 8-1 of the ITAA 1997. As such, the advance payment rules do not apply.