Edited version of private advice

Authorisation Number: 1051991401265

Date of advice: 14 July 2022

Ruling

Subject: Capital loss and the 'make good' clause of a lease

Question 1

Did CGT event C2 under section 104-25 of the Income Tax Assessment Act 1997 (ITAA 1997) happen as a result of the ending of the lease?

Answer

Yes

Question 2

Do the relevant expenses form part of the cost base of the lease under subsection 110-25(5) of the ITAA 1997?

Answer

Yes

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The Taxpayer, a company, entered into a lease agreement for a commercial property on which to operate their business (the lease agreement).

At the beginning of the lease, the Taxpayer undertook renovations to the property (the renovations).

The lease agreement was initially set for a term of 3 years and one further term of 2 years. Before the end of this period, a verbal agreement was reached between the lessor and the Taxpayer to extend the lease to a particular date (expected end date). It was also agreed that the terms and conditions detailed in the lease agreement would continue to apply.

Around 3 months before the expected end date, the Taxpayer indicated to the lessor that they did not wish to renew the lease.

It was agreed verbally with the lessor that the Taxpayer would vacate the leased premises before the expected end date and that no further rent was to be paid from the date of the vacation. However, the remaining terms of the lease agreement, as originally extended, were to continue to apply; in particular, it was agreed that the Taxpayer would continue to meet its outstanding obligations as a lessee under the lease agreement, including the fulfillment of the 'make good' clause (outlined below).

After the vacation of the lease premises, the 'make good' clause became the only condition in the lease agreement that remained unsatisfied.

There was no written instrument or agreement entered by the Taxpayer and the lessor to terminate or surrender the lease.

Under the 'Make Good' clause, the tenant must, by the date the tenancy ends:

"..

• remove all its chattels, fixtures, other property and all rubbish from the premises;
• restore the premises alterations back to the condition upon commencement of the Lease, unless the landlord stipulates otherwise in writing (the stud and plaster wall and doorway erected near the server room is omitted from this make good condition);
• repair and replace floor coverings including carpets except where worn through fair wear and tear;
• remove external signage and make good any damage caused by erection and subsequent removal of such signage;
• restore the ceiling to open plan layout including lighting layout and air conditioning duct layout;
• leave the premises clean and tenantable...."

The Taxpayer incurred expenses to 'make good' the property as per the condition of the lease (the relevant expenses). This work was undertaken by two independent third parties to restore the leased premises to the original configuration and condition prior to the lease to the Taxpayer.

There were no requests from the lessor to perform any routine repairs to the premises. With the exception of the renovations, the Taxpayer did not undertake any works other than those to which the relevant expenses relate.

The works were completed several months after the expected end date.

After the completion of the works under the two invoices and the fulfillment of the 'make good' clause, the lease arrangement ended.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 subsection 110-25(5)

Income Tax Assessment Act 1997 subsection 110-25(8)

Income Tax Assessment Act 1997 section 116-75

Reasons for decision

Issue1

Question 1

Did CGT event C2 under section 104-25 of the Income Tax Assessment Act 1997 (ITAA 1997) happen as a result of the ending of the lease?

Summary

Yes, the ending of the lease resulted in CGT event C2 happening under section 104-25 of the ITAA 1997.

Detailed reasoning

The lessor agreed that the Taxpayer could vacate the leased premises before the expected end date and that no further rent was to be paid from the date of the vacation. However, the remaining terms of the lease agreement, as originally extended, were to continue to apply, primarily the 'make good' clause which required the restoration of the leased premises to its original condition. Hence, even though the Taxpayer had vacated the leased premises, it continued to access the premises in the performance of its 'make good' obligations. No other lessee was occupying the leased premises during that period.

Subsection 104-25(1) provides that:

Section 104-25 Cancellation, surrender and similar endings: CGT event C2

104-25(1)

CGT event C2 happens if your ownership of an intangible asset ends by the asset:

a)    Being redeemed or cancelled; or

b)    Being released, discharged or satisfied; or

c)    Expiring; or

d)    Being abandoned, surrendered or forfeited; or

e)    If the asset is an option - being exercised; or

f)     If the asset is a convertible interest- being converted..

104-25(2)

The time of the event is:

a)    When you enter into the contract that results in the asset ending; or

b)    If there is no contract- when the asset ends

104-25(3)

You make a capital gain if the capital proceeds from the ending are more than the asset's cost base. You make a capital loss if those capital proceeds from the ending are more than the asset's cost base. You make a capital loss if those capital proceeds are less than the asset's reduced cost base.

104-25(4)

A lease is taken to have expired even if it is extended or renewed.

It is generally recognised that the expiry or termination of a lease results in CGT event C2 happening. It is stated in Tax Determination TD 98/23 Income tax: capital gains: what are the CGT consequences of a lessee incurring capital expenditure on improvements to leased property? that:

...On expiry or termination of the lease, CGT event C2 in section 104-25 - about cancellations, surrenders and similar endings of intangible assets- happened to the lease and the amount of capital proceeds, if any, will determine whether a capital gain or loss is made by the lessee (see in particular 116-75).

In this case, C2 happened when the lease ended, as it resulted in the rights and obligations of the parties under the lease agreement 'being released, discharged or satisfied' as per paragraph 104-25(1)(b).

The time of the event, as prescribed under paragraph 104-25(2)(b), is the time in which the lease ended. In this case, this was the point in time at which the remaining condition in the agreement (the 'make good' condition) was satisfied.

Question 2

Do the relevant expenses form part of the cost base of the lease under subsection 110-25(5) of the ITAA 1997?

Summary

Yes, the relevant expenses form part of the cost base of the lease under subsection 110-25(5) of ITAA 1997.

Detailed reasoning

The Taxpayer incurred expenses under the 'make good' clause of the lease to restore the leased premises to its original state at the beginning of the lease. The work was done prior to the termination of the Taxpayer's lease.

Subsection 110-25(5) of the ITAA 1997 provides that the fourth element of the cost base is the capital expenditure a taxpayer incurs with the purpose or expected effect of increasing or preserving the CGT asset's value or that relates to installing or moving the CGT asset.

Subsection 110-25(5) of the ITAA 1997 states:

The fourth element is capital expenditure you incurred:

(a)         The purpose or the expected effect of which is to increase or preserve the asset's value: or

(b)         That relates to installing or moving the asset.

The expenditure can include giving property: see section 103-5.

The explanatory memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 explains why section 110-25(5) was amended:

Fourth element

2.140 At present, the fourth element of cost base and reduced cost base is capital expenditure incurred to increase the asset's value (subsection 110-25(5)). There is also at present a requirement that the expenditure be reflected in the state or nature of the asset at the time of the CGT event. The amendments make four changes to the fourth element.

2.141 The first change is that it is no longer necessary that the purpose of the expenditure be to increase the asset's value. Instead, it is now sufficient that the purpose or expected effect be to increase or preserve the asset's value. An example of expenditure that would now qualify for inclusion in the fourth element would be legal and other expenses incurred to preserve the value of a rental property by opposing a nearby development that would adversely affect the rental property's value. Another example would be the costs incurred in unsuccessfully applying for zoning changes.

2.142 The second change is that there is no longer a requirement that the expenditure be reflected in the state or nature of the asset at the time of the CGT event.

2.143 The third change is that the element now includes capital expenditure that relates to installing or moving the asset.

2.144 The fourth change is that the element does not apply to capital expenditure incurred in relation to goodwill. A consequence of this exclusion is that expenditure in relation to goodwill already attracting deductibility over five years does not receive less generous CGT treatment by reason of the enlargement of the fourth element. [Schedule 2, items 36 and 38, subsections 110-25(5) and (5A) and subsection 110-25(1), note 1]

It is noted that neither section 112-80 nor section 132-1 applies in this case, as there was no expenditure incurred for a variation or waiver of the term of the lease.

The Taxpayer incurred the relevant expenses to 'make good' the property as per the condition of the lease. It is accepted that the relevant expenses were, at the latest, 'incurred' upon the performance of the building works by the builders, because the Taxpayer was definitely committed and was completely subject to these liabilities at this time (or before this point in time): see FC of T v James Flood Pty Ltd (1953) 10 ATD 240. As the expenses were incurred prior to the full satisfaction of the 'make good' clause, they were incurred prior to the end of the lease.

Expenses incurred by a lessor under a 'make good' clause is recognised as being within the scope of the 4^th element in Taxation Ruling TR 2011/6 Income tax: business related capital expenditure- section 40-880 of the Income Tax Assessment Act 1997 core issues (TR 2011/6), which states the following in paragraph 229:

...coincidentally with the enactment of section 25-110, subsection 110-25(5) was amended to relax the test for inclusion of capital expenditure in the fourth element of cost base of a CGT asset, including a lease. Consequently, certain capital expenditure incurred by a lessee, such as expenditure under a 'make good' clause, may now be eligible for inclusion in the cost base of a lease.

As such, the Taxpayer will be able to include the relevant expenses as the 4^th element of the lease's cost base in accordance with subsection 110-25(5) of the ITAA 1997.