Edited version of private advice

Authorisation Number: 1051982167387

Date of advice: 19 May 2022

Ruling

Subject: Derivation of pre-paid rent

Question 1

Will the prepaid rent be derived as income and included in assessable income by the taxpayer progressively over the term of the concurrent lease for the purposes of subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The existing lease arrangement

1.    The taxpayer ("Landlord") owns land ("Land").

2.    The Landlord is an Australian tax resident.

3.    A registered lease was entered into between the Landlord and the Existing Tenant setting out the terms for the lease of certain premises on the Land and the grant of easements over the Land to the Existing Tenant ("Existing Lease") for the purposes of carrying on a project ("Project").

4.    The Existing Lease was negotiated between independent parties acting at arm's length and has been provided.

5.    The key terms of the Existing Lease are as follows:

a. The Landlord leases the Land and grants associated easements to the Existing Tenant.

b. The Existing Lease will terminate on XX Month 20XX, with two X-year renewal periods.

c. The Existing Tenant is required to pay the Rent and Fees under the agreement, as adjusted under the terms of the lease. The Rent comprises various payments.

d. Rent and Fees are required to be paid in quarterly in advance.

e. Inter alia, the Existing Lease may be terminated in the following circumstances:

i. The term of the Existing Lease expires;

ii. The Existing Tenant materially breaches or defaults under the Existing Lease;

iii. The Landlord materially breaches under the Existing Lease; or

iv.  The Existing Tenant may terminate the Existing Lease at any time on 12 months prior written notice in writing to the Landlord.

Concurrent lease

6.    A tax consolidated group will set up a wholly owned subsidiary trust ("Concurrent Lessee") to enter a concurrent lease arrangement as follows.

7.    The Concurrent Lessee and the Landlord will enter into an Agreement for Lease ("AFL"), being an agreement between the parties to enter a concurrent lease, subject to the satisfaction of certain conditions.

8.    Subject to the satisfaction of the conditions, the Landlord will grant and the Concurrent Lessee will accept the concurrent lease, i.e., a lease of the reversionary interest in the Land until such time as the Existing Lease comes to an end ("Concurrent Lease"). It terminates on X Month 20XX. The effect of the Concurrent Lease is to provide the benefit of all rights (subject to limited exceptions) of the Landlord under the Existing Lease to the Concurrent Lessee.

9.    The key terms of the Concurrent Lease will be as follows:

a.    The Concurrent Lease entitles the Concurrent Lessee to receive all the relevant Rent payable under the Existing Lease, and to enforce all covenants on the part of the Landlord under the Existing Lease as if the Concurrent Lessee was itself the Landlord under the Existing Lease;

b.    The Landlord remains liable under the Existing Lease for all of the obligations under the Existing Lease, including but not limited to meeting any outgoings that are currently the responsibility of the Landlord and allowing the Project to occupy and use the premises without interruption or disruption;

c.     The Concurrent Lessee is required to pay rent to the Landlord, being an amount equal to the relevant Rent under the Existing Lease (representing market rent). There is an option to either pay the rent periodically or make a prepayment of the rent within XX days of the Concurrent Lease being executed. The periodic rent matches the rent payable under the Existing Lease. If the Concurrent Lessee elects to make a prepayment of the rent, then:

                              i.        the prepaid amount is calculated as being $X (excluding GST), calculated as the sum of the present values of each periodic future rental payment expected to be collected over the term of the lease;

                             ii.        the Landlord may elect to vary the proportion of each rental payment to be prepaid as Prepaid Rent by providing notice to the Tenant of the Landlord's chosen percentage which must be between X% and X%;

                            iii.        the prepaid amount is refundable in a number of prescribed circumstances, which include:

•         any default by the Landlord under the Existing Lease which results in a termination of the Existing Lease by the Existing Tenant,

•         an insolvency event occurs in respect if the Landlord, which leads to a termination of the Concurrent Lease,

•         resumption of the premises by any government agency where the Existing Lease is terminated as a result of the resumption, or

•         destruction of or damage to the premises which causes the Project to become inoperable and which results in the Existing Tenant terminating the Existing Lease; and

                           iv.        any amount of prepaid rent that is refunded is calculated based on the remaining lease term and is the unamortised portion of the prepaid rent.

10.  Copies of the draft AFL and Concurrent Lease have been provided and the applicant states that no material changes are expected to these documents.

Relevant legislative provisions

Income Tax Assessment Act 1997 subsection 6-5(2)

Income Tax Assessment Act 1997 subsection 6-5(4)

Reasons for decision

Summary

The prepaid rent will be derived as income by the taxpayer for the purposes of subsection 6-5(2) of the ITAA 1997 and included in assessable income of the taxpayer progressively over the term of the Concurrent Lease, in accordance with the principles outlined in Arthur Murray (NSW) Pty Ltd v FC of T (1965) 114 CLR 314.

Detailed reasoning

Ordinary income

1.    Under subsection 6-5(2) of the ITAA 1997, a taxpayer's assessable income includes *ordinary income (i.e., income according to ordinary concepts) derived directly or indirectly from all sources, during the income year.

2.    As the term "income" is not explicitly defined in the Australian tax legislation, it takes on its ordinary meaning. Characteristics have been determined through case law to help define the meaning of income according to ordinary concepts. Income that flows from property, including rent, is generally considered income according to ordinary concepts.

3.    While the factors identified through case law typically include periodicity, recurrence, regularity or services performed, an amount received in a lump sum can also be ordinary income depending on the nature of the lump sum payment. Particularly, if the purpose of the lump sum is to provide a substitute for an income stream then that lump sum may take on the character of those payments it is intended to replace.

4.    ATO ID 2003/526 Assessability of lump sum payment - for life-time right to reside in property - rent in advance, says:

...A lump sum received by the taxpayer, for granting a life time right for a relative to reside in their investment property, is ordinary income for the purposes of section 6-5 of the ITAA 1997 where the tenant has a right to a pro rata refund if they leave the property.

5.    ATO ID 2003/526 further references TR 2002/14 Income Tax: taxation of retirement village operators, which states at paragraph 129 that a lump sum should be accounted for as prepaid rent where:

a. a person is prepared to make a lump sum payment in exchange for the right to occupy a dwelling for a fixed term;

b. the person is entitled to receive a pro-rata refund for the unexpired portion of the term (if any); and

c. the intention of the parties is that the lump sum payment in advance is for the use and enjoyment of the dwelling for the fixed term.

6.    In setting out these principles, the Commissioner considered the decision in Frazier v Commissioner of Stamp Duties (NSW) 85 ATC 4735. In determining whether a lump sum was paid by a resident of retirement village was consideration for the granting of the lease or intended as rent for the use of the premise, the Court was swayed by the provisions for abatement in the lease in circumstances when the premises become "unfit for the occupation and use of the lessee'' in whole or in part, which were considered entirely consistent with the payment of rent in advance.

7.    Under the Concurrent Lease, the prepayment of rent is made in advance for the rights attached to the reversionary interest, in substitution for and calculated by reference to the periodic rent that would otherwise be paid over the term. Further, the Concurrent Lessee is entitled to a refund of the prepaid rent for the unexpired portion of the term in various circumstances, including:

a.    any default by the Landlord under the Existing Lease, which results in a termination of the Existing Lease by the Existing Tenant;

b.    an insolvency event occurs in respect to the Landlord, which leads to a termination of the Concurrent Lease;

c.     resumption of the premises by any government agency where the Existing Lease is terminated as a result of the resumption; and

d.    destruction of or damage to the premises which causes the Project to become inoperable and which results in the Existing Tenant terminating the Existing Lease.

8.    Therefore, the prepayment of rent made by the Concurrent Lessee to the Landlord constitutes ordinary income of the Landlord.

Timing of derivation

9.    Subsection 6-5(4) of the ITAA 1997 provides that you derive an amount of ordinary income as soon as it is applied or dealt with in any way on your behalf, or as you direct. That is, income is derived when it "comes home" to the taxpayer in a realised or immediately realisable form (Commissioner of Taxes (SA) v. Executor Trustee and Agency Co of South Australia Ltd (1938) 63 CLR 108; [1938] HCA 69).

10.  The decision in Arthur Murray (NSW) Pty Ltd v FC of T (1965) 114 CLR 314 (Arthur Murray) sets out the principles in relation to the derivation of prepaid income from a contract straddling several tax years. In this case, their Honour relevantly held:

It is true that in a case like the present the circumstances of the receipt do not prevent the amount received from becoming immediately the beneficial property of the company; for the fact that it has been paid in advance is not enough to affect it with any trust or charge, or to place any legal impediment in the way of the recipient's dealing with it as he will. But those circumstances nevertheless make it surely necessary, as a matter of business good sense, that the recipient should treat each amount of fees received but not yet earned as subject to the contingency that the whole or some part of it may have in effect to be paid back, even if only as damages, should the agreed quid pro quo not be rendered in due course. The possibility of having to make such a payment back (we speak, of course, in practical terms) is an inherent characteristic of the receipt itself. In our opinion it would be out of accord with the realities of the situation to hold, while the possibility remains, that the amount received has the quality of income derived by the company.

11.  The principles of Arthur Murray were captured In Taxation Ruling TR 2014/1 Income tax: commercial software licencing and hosted agreements: derivation of income from agreements for the right to use proprietary software and the provision of related services, in the context of income derived from software licencing arrangements, through the phrase 'contingency of repayment':

Where an amount properly attributable to a contractual obligation is subject to a 'contingency of repayment', the amount is derived for the purposes of section 6-5 of the ITAA 1997 when the obligation is fully performed or the contingency of repayment otherwise lapses.

12.  The Commissioner considered that such contingencies include a contractual obligation to make a refund, a demonstrated commercial practice to make a refund, or the existence of contractual exposure for damages in respect of non-performance. When the underlying obligation is fully performed, or such contingency otherwise lapses, the amount allocated to the obligation converts from 'unearned income' to 'earned income' in the sense contemplated in Arthur Murray.

13.  Taxation Ruling TR 2002/14 Income Tax: taxation of retirement village operators, which deals with the characterisation of receipts on the granting of occupancy rights in the context of retirement villages states that rent received in advance, where the taxpayer will be required to refund any unexpired portion of the prepaid rent, should be brought to account over the period for which the payment is made in accordance with the Arthur Murray principle.

14.  In the case of the Concurrent Lease, the prepaid rent received by the Landlord is subject to the contingency that the whole or some part of it may have to be paid back. In accordance with the principles outlined above, this contingency means that the prepaid rent should not be viewed as having "come home" to the Landlord at the time of receipt. This income will be derived once those contingencies no longer remain, i.e., when the period to which the prepaid rent relates has lapsed.

15.  Therefore, the rent should be brought to account by the Landlord progressively over the term of the Concurrent Lease.