Edited version of private advice

Authorisation Number: 1051693054037

Date of advice: 4 June 2020

Ruling

Subject: Income tax - lease surrender

Question 1

Is the lease surrender receipt assessable to the Taxpayer on capital account under the Capital Gains Tax (CGT) provisions under Part 3-1 of the Income Tax Assessment Act 1997 rather than as a revenue gain under section 6-5 of the Income Tax Assessment Act 1997?

Answer

Yes

Question 2

Can the general 50% CGT discount under Subdivision 115-A of the Income Tax Assessment Act 1997 be applied to the gross capital gain?

Answer

Yes

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commences on:

30 November 20XX

Relevant facts and circumstances

The Taxpayer is a discretionary trust and part of a wider group of entities which hold properties on a long-term basis for the purposes of deriving passive rental income.

The Taxpayer holds one commercial property. Since acquiring the Property, the Taxpayer's intention has always been to hold the Property indefinitely to derive passive rental income.

This is the Taxpayer's primary source of income.

The Taxpayer entered into a lease agreement with the Original Tenant who carried on a business (the Lease).

The Lease commenced on 20XX with a term of XX years.

The Lease was the only lease entered into by the Taxpayer.

Prior to the expiry of the Lease, the Tenant requested leave from the Taxpayer for the surrender of the Lease in exchange for a fee.

The Taxpayer and the Tenant entered into a Surrender of Lease Deed under which the Tenant agreed to pay an amount to the Taxpayer for the early termination of the Lease (the Payment).

The Taxpayer accepted the offer of the Payment after taking into consideration the following bundle of items:

• costs of repurposing the Property,
• urgent repairs required as a result of the Tenant vacating the building
• forfeited rental income and recovery of outgoings for the remaining term of the Lease, and
• costs of finding a replacement tenant.

During the period of the Lease, the Taxpayer employed the services of a Leasing Services Entity, which is a related entity that provides leasing services (including the collection of rental income, tenant communication, preparing relevant legal and accounting records, ongoing maintenance and management of the Property).

Although it has been a difficult process, the Taxpayer has been able to find a replacement tenant for the Property and as a result, is required to repurpose the Property.

There is significant work in splitting the Property into multiple tenanted areas, including substantial changes to services throughout the building (such as air conditioning, power, fire services and amenities).

No non-resident or temporary resident beneficiaries would be receiving the gain.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 Subdivision 115-A

Income Tax Assessment Act 1997 Subdivision 115-B

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

All references made in these reasons for decision are to the Income Tax Assessment Act 1997 (ITAA 1997)unless otherwise stated.

Question 1

Summary

The lease surrender receipt is assessable to the Taxpayer on capital account under the CGT provisions under Part 3-1 rather than as a revenue gain under section 6-5.

Detailed reasoning

According to section 6-5 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:

(a)  in the ordinary course of carrying on a business of granting and surrendering leases;

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

(c)   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 circumstances of each case.

The definition of the term business is provided in section 995-1 to mean:

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

The key indicia considered by the courts in determining whether the activities carried on by an entity amount to the carrying on of a business are:

• whether the person intends to carry on a business
• the nature of the activities, particularly whether they have a profit-making purpose
• 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 size and scale of a company's activities including the amount of capital employed in them, and
• whether the activity is better described as a hobby, or recreation.

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, but instead would generally be the passive receipt of income from property.

The Taxpayer is part of a wider group of entities which hold properties on a long-term basis for the purposes of deriving passive rental income.

The Taxpayer holds a commercial property to derive passive rental income over a long-term period. This is the Taxpayer's primary source of income and the Lease was the only lease that they held.

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 Commissioner of Taxation (Cth) [1977] HCA 50 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.

The business activity of the Taxpayer is one of long term holding of a property to lease for the purpose of deriving passive income.

Given that the Taxpayer has employed the services of the Leasing Services Entity indicates that their rental activity is predominately passive in nature. Income was derived passively from the lease of property.

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.

The Taxpayer's circumstances indicate that the receipt was an isolated transaction dictated by the circumstances of the tenant. Also, at the time the Lease was the only lease they held. There is no indication of repetition and regularity of similar transactions.

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.

Having considered the key indicia the facts lend weight to the conclusion that the Taxpayer:

• does not carry on a business of granting and surrendering leases
• the receipt from the surrendering of the lease is not an ordinary incident of a business activity, and
• they did not enter into the lease surrender with the intention or purpose of making the relevant profit or gain.

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.

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.

The rights of the Taxpayer under the Lease are legally enforceable rights and therefore, in their totality, a CGT asset according to the definition in subsection 108-5(1).

On the surrender or termination of the Lease, the Taxpayer's ownership of the contractual rights under the Lease were discharged or satisfied, and this is 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 pursuant to paragraph 104-25(1)(b).

Therefore, the lease surrender receipt is assessable to the Taxpayer on capital account under the CGT provisions under Part 3-1.

Question 2

Summary

The general 50% CGT discount canbe applied to the gross capital gain.

Detailed reasoning

Section 115-5 provides that:

A discount capital gain is a *capital gain that meets the requirements of sections 115-10, 115-15, 115-20 and 115-25.

The capital gain meets the requirements of sections 115-10, 115-15, 115-20 and 115-25 as:

• the Taxpayer is a trust
• the capital gain is a result of a CGT event occurring after 21 September 1999
• the CGT asset was held for greater than 12 months, and
• indexation is not relevant as expenditure relating to the CGT asset was incurred after 21 September 1999.

Therefore, the capital gain is a discount capital gain in accordance with section 115-5.

Section 115-100 provides that the discount percentage for an amount of a discount capital gain is 50% if the gain is made by a trust and section 115-120 (about foreign or temporary residents) does not apply to the gain.

As no non-resident or temporary resident beneficiaries will be receiving the gain the Taxpayer can apply the 50% CGT discount to the capital gain arising from the lease surrender payment.