Edited version of your written advice

Authorisation Number: 1051457936721

Date of advice: 19 December 2018

Ruling

Subject: Lease surrender payment

Question 1

Is the lease termination receipt assessable to The Trust under section 6-5 of the Income Tax Assessment Act 1997 in the year ended 30 June 20XX?

Answer

No

Question 2

Is the lease termination receipt assessable to The Trust on capital account under the capital gains tax provisions for taxation purposes?

Answer

Yes

Question 3

If the answer to Question 2 is ‘yes’, can the general 50% CGT discount under subdivision 115-A of the Income Tax Assessment Act 1997 be applied to the net capital gain?

Answer

Yes

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

A Co Pty Ltd is the Trustee (the Trustee) for The Trust.

The Trustee acquired the head-lease for The Property in Western Australia as a commercial property holding comprising an anchor tenant and a small number of other retails shops.

On acquiring the Head-lease, The Trustee acquired all the tenant sub-leases associated at that time with the Head-lease.

The Trust has held the Head-lease for The Property since the 20XX income year as a commercial lease property (passive investment).

Since acquisition, The Trust has engaged and incurred considerable management fees to another entity, who manage the lease of the property, including maintenance management and outgoings. This includes responsibility for maintenance contracts and payment of the same, collection of rents and attending to tenant queries.

In the 20XX income year the Trustee entered into a covenant to assume landlord obligations in respect of a 20 year sub-lease agreement with the anchor sub-tenant of the plaza.

Due to commercial reasons The Anchor Tenant closed its store in 20XX.

The Anchor Tenant requested leave to surrender its 20 year sub lease with The Trust.

The Anchor Tenant vacated the premises in 20XX prior to the completion of a Deed of Surrender and Mutual Release Agreement.

A Deed of Surrender and Mutual Release agreement was signed by the Trustee and The Anchor Tenant on 1 July 20XX.

The Anchor Tenant paid the Trustee a surrender sum of $X,000,000 plus GST.

Relevant legislative provisions

section 6-5 of the ITAA 1997

section 104-25 of the ITAA 1997

subsection 116-30(2) of the ITAA 1997

subdivision 115-A of the ITAA 1997

section 115-5 of the ITAA

section 115-10 of the ITAA 1997

section 115-15 of the ITAA 1997

section 115-20 of the ITAA 1997

section 115-25 of the ITAA 1997

section 995-1 of the ITAA 1997

Question 1

Summary

The lease termination receipt is not assessable to The Trust under section 6-5 of the Income Tax Assessment Act 1997 in the year ended 30 June 20XX.

Detailed reasoning

According to section 6-5 of the ITAA 1997, the assessable income of a resident includes ordinary income, derived directly or indirectly from all sources, during an income year.

The tax consequences for a lessor who derives a lease surrender receipt are detailed in Taxation Ruling 2005/6 Income tax: lease surrender receipts and payments (TR 2005/6). Paragraph 17 states:

“A lease surrender receipt of a lessor would constitute assessable income under section 6-5 if received:

In the ordinary course of carrying on a business of granting and surrendering leases;

As an ordinary incident of business activity (even though it was unusual or extraordinary compared to the usual transactions of the business); or

As a profit or gain from an isolated business operation or commercial transaction entered into by the lessor (otherwise than in the ordinary course of carrying on a business), with the intention or purpose of making the relevant profit or gain.

Otherwise the lease surrender receipt is of a capital nature”

A lease surrender receipt of a lessor received for consenting to the surrender of the lease would be assessable income under section 6-5 if received in the ordinary course of carrying on a business of granting and surrendering leases. This is a question of fact and degree to be determined in the particular circumstances of each case.

The definition of “business” is provided in section 995-1 of the ITAA 1997 to mean:

“any profession, trade, employment, vocation or calling, but does not include occupation as an employee”

Guidance on whether a company is carrying on a business is taken from TR 2017/D7 Income tax: when does a company carry on a business within the meaning of section 23AA of the Income Tax Rates Act 1986? At paragraph 8 it states:

“There is extensive case law considering whether a company is carrying on a business. It highlights that companies have different underlying characteristics to individuals and trusts that lead to the conclusion that the same activities carried on by an individual or trust may not amount to the carrying on of a business, whereas they may when carried out by a company.”

In determining whether an entity is “carrying on a business”, guidance is taken from the indicia considered by the courts. Although the current circumstances involve a Trust, the indicia considered by the courts that have been highlighted in TR 2017/D7 still have relevance. These are summarised at paragraph 12:

“12. The indicia considered by the courts in determining whether activities carried on by a person amount to the carrying on of a business by them are:

● the nature of the activities, particularly whether they have a profit-making purpose

● whether the person intends to carry on a business

● whether the activities are:

● repeated and regular

● organised in a business-like manner, including the keeping of books, records and the use of a system

● the amount of capital employed in those activities, and

● whether the activity is better described as a hobby, or recreation.”

The profit making purpose of the activities.

The position that the activities of a trust are less likely to amount to carrying on a business than a company was upheld in London Australia Investment Company Limited v FCT (1977) 138 CLR 106 whereby Gibbs J. observed:

“The position of an investment company is materially different from that of an individual managing his own portfolio of shares. It is different also from that of a trustee managing a portfolio of shares in a trust fund. In Charles V FC of T (1954) 90 C.L.R. 598 the moneys said to be taxable were received by the beneficiaries of a unit trust and derived from the realization of investments held by the trustees. Evidence was given that at no time were securities acquired for the express purpose of resale at a profit, and that sales were normally made when the managers anticipated a fall in the value of shares.”

In the circumstances, the business activity of the Trust is one of long term holding of property lease agreements (being a capital asset) for the purpose of deriving passive income.

Given that the Trust has engaged another entity to manage the lease of the property, the Trusts rental activity is predominately passive in nature. The income was derived passively from the lease of property rather than from the regular activity of the company.

Intention to carry on a business

The receipt of income from the lease of an asset does not of itself amount to the carrying on of a business (see FC of T v. McDonald 87 ATC 4541; (1987) 18 ATR 957), but instead would generally be the passive receipt of income from property.

In the circumstances The Trust entered the lease with the anchor tenant (without which the Trust would not be in a position to tenant the remainder of the property).There was no intention of making a significant commercial or financial gain from the surrender of the lease. Nor was it the intention of The Trust to carry on the business of lease surrender.

Repetition and regularity

In light of determining whether or not the activities of a taxpayer constitute carrying on of a business, the Commissioner notes the importance of repetition and regularity in undertaking business operations and further illustrates that an isolated act or one off transaction may amount to carrying on a business, “if it is intended to be repeated”, or it can be shown that the transaction was the first step in the carrying on of a business.

Taxation Ruling TR 92/3 Income Tax: whether profits on isolated transactions are income; the term ‘isolated transaction’ refers to:

“a) those transactions outside the ordinary course of business of the taxpayer carrying on a business; and

b) those transactions entered into by non-business taxpayers”.

Moreover, an isolated or one-off transaction may amount to carrying on a business if it is intended to be repeated, as was the case in Re Griffin Ex Parte Board of Trade (1890) 60 LJQB 235 where it stated:

“ the test to be this: if an isolated transaction, which if repeated would be a transaction in a business, is proved to have been undertaken with the intent that it should be the first of several transactions, that is, with the intent of carrying on a business, then it is a first transaction in an existing business”.

In this circumstance the Trust is not in the business of lease surrender and accordingly repetition and regularity of similar transactions is not established. The receipt was an isolated transaction dictated by the circumstances of the tenant.

Activities conducted in a systematic and business-like manner

Where activities are conducted in a systematic and business-like manner, the Commissioner is more likely than not to view that a business is being carried on. This may involve keeping detailed records of income, preparing formal business plans or budgets, or seeking professional advice.

However, the Commissioner does observe that the natural structure and regulations that a taxpayer may be required to follow, may lead to the perception that some activities whilst still being systematic and business-like appear to be carrying on a business, are in essence not representative of carrying on a business for some entities.

Referring to the background facts the Trust does not undertake business like activities in respect of the lease surrender. Although records have been kept they are more akin to the fulfilling of regulations, such as tax record keeping, rather than to business plans.

Conclusion

The Trust does not carry on the business of granting and surrendering leases. They hold a capital asset and receive passive income from it. These activities may amount to carrying on a business if The Trust were a company. As The Trust is a trust, the activities are not considered to constitute the carrying on of a business.

As a result, the criteria listed at paragraph 17 of TR 2005/6 have not been met and the receipt would not constitute assessable income under section 6-5 of the ITAA 1997.

Question 2

Summary

The lease termination receipt is assessable to the Trust on capital account under the capital gains tax provisions.

Detailed reasoning

The entry into a lease by a lessor and lessee constitutes the acquisition of an asset by the lessor. The asset comprises the contractual rights vested in the lessor under the lease agreement, including the right to receive the nominated rent, but subject to possession. As detailed in TR 2005/6 at paragraph 19:

“Upon the surrender of the lease by the lessee, CGT Event C2 under section 104-25 of the ITAA 1997 happens to the lessor in relation to the discharge of its rights (as a single asset) under the lease agreement.”

The rights of the Trust under the Anchor Tenant sub-lease are legally enforceable rights and therefore, in their totality, a CGT asset according to the definition in subsection 108-5(1) of the ITAA 1997. On the surrender or termination of the Anchor Tenant sub-lease, the trust’s ownership of the contractual rights under the sub-lease were discharged or satisfied and in the regard considered to be a mere realisation of a capital asset. This discharge or satisfaction of the contractual rights gives rise to CGT Event C2 from the cancellation of a CGT asset (being the sub-lease in question) pursuant to paragraph 104-25(1)(b) of the ITAA 1997.

On the basis The Trust’s capital proceeds of $X,000,000 from the ending of the ownership of the asset (the Anchor Tenant sub-lease), were more than the asset’s cost base a capital gain arises from this CGT event (subsection 104-25(3)).

As The Trust received market value capital proceeds for the satisfaction of their rights under the sub-lease on surrender, the market value substitution rule in subsection 116-30(2) has no application

Conclusion

Accordingly, pursuant to the specific ordering rules, the lease surrender payment received represents capital proceeds for the happening of CGT event C2 of the ITAA 1997.

Question 3

Summary

The general 50% CGT discount under subdivision 115-A of the Income Tax Assessment Act 1997 can be applied to the net capital gain made on the surrender of the lease.

Detailed reasoning

A capital gain can be a discounted capital gain if the requirements of section 115-5 of the ITAA 1997 are met.

The Trust is a trust which has made a capital gain as a result of a CGT event, occurring after 21 September 1999, on an asset they have held for greater than 12 months. The cost base of the asset (the Anchor Tenant sub-lease) has been calculated without reference to indexation. Therefore the requirements of sections 115-10, 115-15, 115-20 and 115-25 of the ITAA 1997 have been met. As a result, the capital gain meets the requirements of a discount capital gain in section 115-5 of the ITAA 1997.

Conclusion

The Trust is entitled to apply the 50% CGT discount to the net capital gain arising from the lease surrender payment pursuant to subdivision 115-A of the ITAA 1997.