It is common for a lessor (landlord) or lessee (tenant) to make special payments to the other in respect of lease arrangements. Examples of these types of payments include:
- Lease surrender payments
- Lease incentive payments
- Lease variation payments
- Lease premium payments
When it comes to the taxation of these lease payments, it is worth understanding a few foundational concepts.
Firstly, for capital gains tax purposes (if CGT is relevant to a special lease payment), the lease itself is treated as a separate asset from the underlying property being leased. The lessee is the taxpayer that owns the lease which has been granted by the lessor. For example, the lease of a rental property is treated as a CGT asset owned by the lessee. Secondly, where a certain payment or receipt is assessable income under section 6-5 and part of a capital gain, the tax law reduces the capital gain accordingly to prevent a double-tax outcome. Thirdly, the taxation treatment of special lease payments may often hinge on whether the relevant taxation is the business of receiving or paying these special lease amounts. For the purposes of this article, it is assumed that taxpayers are not in the business of making or receiving these special lease payments.
Note that this article relates exclusively to special lease payments and not the payment and receipt of rent. The basic tax position on rent is that rental income received by the lessor is assessable income and that rental payments incurred by the lessee are deductible to the extent the property is used for an income-producing purpose.
Surrender of lease payments
A lease surrender payment involves the lessor or lessee making payment to the other as consideration for the ‘surrender’ of the lease. It is common where the lessor wants vacant possession of a property or where the lessee no longer desires the lease.
For a lessee (as recipient)
The receipt of a lease surrender payment by the lessee will generally be a capital receipt unless the lessee is in the business of trading in leases. The receipt will likely trigger either CGT event C2 or CGT event F5 and the capital gain (or loss) will need to be determined.
For the lessee (as payer)
If the lessee surrenders the lease and makes payment to the lessor, the payment will generally be capital in nature unless the lessee carries on a business of entering into and surrendering leases. The payment will likely trigger CGT event A1 and the capital gain (or loss) will need to be determined. The surrender payment may not be added to the cost base of the lease when determining the capital gain (or loss).
Note that section 25-110 does permit a deduction at a rate of 20% per income year for capital expenditure to terminate a lease. However, the expense must be incurred by the taxpayer in the course of carrying on a business. Therefore, this treatment would not be available to a taxpayer who is not carrying on a business. A lessor renting a residential rental property will generally not be carrying on a business.
For the lessor (as recipient)
If a lessee surrenders the lease and makes payment to the lessor, the receipt will generally be considered a capital receipt and CGT event C2 occurs for the lessor (the CGT asset being the right to lease). This will result in a capital gain where the surrender payment received exceeds the cost base of the CGT asset being the right to lease.
For the lessor (as payer)
If the lessor surrenders the lease and makes payment to the lessee, the payment will be capital in nature unless the lessor is in the business of granting and surrendering leases. For CGT purposes, the lessor is deemed to have acquired the lease and the surrender payment is added to the cost base of that new CGT asset. The cost base of the lease may in fact merge with the cost base of the land itself where there the lessor owns the reversionary interest. The effect of the above is that a lessor may not claim a capital loss for a lease surrender payment under the CGT regime.
The section 25-110 deduction (discussed above) is also available for a lessor carrying on a business.
Lease incentives
The lease incentive involves the lessor providing an incentive for someone to take up a lease.
For the lessee (as recipient)
A lease incentive payment is generally ordinary income (assessable) to a business lessee.
Any non-cash lease incentive that is convertible to cash (e.g. equipment or furniture) received by a business taxpayer will generally be assessable income at monetary value. Any non-cash lease incentive that is not convertible into cash (e.g. rent-free period, free fit-out, or payment of removal costs) will also be assessable under section 21A of the Income Tax Assessment Act 1936 unless certain exemptions apply.
The ATO in IT 2631 sets out the tax treatment of these incentive payments for the lessee as follows:
- Rent-free period = tax-free
- Interest-free loan = tax-free, on the provision that it is a genuine business loan.
- Free fit-out = if the fit-out will be owned by landlord is tax-free. If the fit-out is owned by tenant, the value of the fit-out is assessable but a deduction is available for any depreciation on the fit-out.
- Covering removal costs = taxable to the extent that the removal costs are included in the value of trading stock.
- Free holiday = tax-free to the tenant but obviously not deductible to the lessor.
- Paying the lessee the surrender value of the existing lease = taxable.
For the lessor
The payment of a lease incentive will generally be deductible to the lessor unless the benefit provided to the lessee is of an ‘entertainment’ nature e.g. a free holiday.
Lease variations
A lease variation payment involves the payment made or received by either a lessor or lessee to change or vary a lease term or waive a lease term.
For lessee (as recipient)
The payment (or monetary value of a benefit such as property applied as consideration) received by the lessee for agreeing to a variation of a lease will be considered a capital receipt and will trigger CGT event F4 for the lessee. CGT event F4 happens at the time the lease variation or waiver occurs. The lessee makes a capital gain if the amount received is more than the lessee’s cost base in the lease asset. The cost base of the lease itself will then need to be reduced by the lessor’s variation payment.
For example, assume the cost base of the lease is $1,500 and the lessee agrees to waive a term in the lease and gets paid $2,000 for doing so. In this instance, the lessee makes a capital gain under CGT event F4 of $500. The cost base of the lease is reduced to nil.
Note that a capital gain from CGT event F4 will be disregarded if the relevant lease asset was granted prior to the commencement of capital gains tax on 20 September 1985 and a subsequent CGT event has not occurred in respect of the lease.
For lessee (as payer)
The payment for variation is generally characterised as a capital payment which effectively enhances the value of the lease. Therefore, the lessee will generally not be entitled to a deduction for the lease premium payment. Instead, the capital payment should be included in the cost base of the lease.
For a lessor (as recipient)
For a lessor, a payment received for agreeing to vary a lease or waive a term will generally be considered a capital receipt which triggers CGT event F5. CGT event F5 happens for the lessor at the time of the variation of waiver. The calculated capital gain (if any) will be the payment for variation less the lessor’s costs incurred to effect the lease variation.
For example, Ciana Pty Ltd owns a shopping centre and a tenant of the centre pays Ciana Pty Ltd $10,000 for agreeing to change a terms of its lease. Ciana Pty Ltd incurs $1,000 in expenses for the engagement of a solicitor and $500 for a valuation specialist. The capital gain is therefore $8,500 ($10,000 – $1,000 – $500).
The gain or loss is disregarded if the lease was granted before the commencement of capital gains tax on 20 September 1985.
Note also that a capital gain from CGT event F5 is not discountable under the CGT discount.
For a lessor (as payer)
For the lessor, the payment (or monetary value of a benefit such as property issued as consideration) to a lessee to have a lease varied or a term waived will generally be considered a capital payment and trigger CGT event F3. CGT event F3 happens at the time that variation or waiver to a term of the lease occurs. The payment will result in a capital loss for the lessor for the amount of the payment. That is, the CGT event may only result in capital loss outcome (not a capital gain).
You may have noticed that the treatment of a lease variation payment is generally more favourable for tax purposes than a lease surrender payment. This is because the lease surrender payment does not allow an immediate capital loss to be recognised as with a variation payment. Rather, the lease surrender payment is added to the cost base of the lease with no other immediate tax benefit available to the taxpayer. The ATO warns taxpayers against lease surrender payments which are ‘dressed-up’ as variation payments in pursuit of favourable tax outcomes. Refer to Taxation Ruling 2005/6 for further information.
Lease premiums
A lease premium payment involves the payment by someone to a lessor to either secure a lease or have a lease renewed or extended. Such premiums are common in a competitive lessee market where there is a shortage of available premises for lease.
For the Lessor (as recipient)
The payment of the lease premium to the lessor is generally considered to be a capital receipt for the lessor. A lease being granted, renewed or extended is considered a new asset which is being disposed by the lessor to the lessee. The disposal of the ‘lease’ triggers CGT event F1 for the lessor. In respect of the grant of a lease, the CGT event generally happens at the time the contract is entered into. Otherwise, for the renewal of extension of a lease, it generally happens at the time the renewal or extension starts. To calculate the capital gain from CGT event F1, take the premium received by the lessor and subtract any expenditure incurred by the lessor to grant, renew or extend the lease.
As an example, take Ellie who grants a lease to James for $30,000. Ellie incurs $2,000 in legal fees to grant the lease. In this instance, the receipt is capital (not ordinary income) and CGT event F1 occurs. The capital gain for Ellie is $28,000, being the capital proceeds of $30,000 less the asset cost base of $2,000.
Note that there is no market value substitution rule if a premium is not charged or is less than market rates.
Note also that that a capital gain from CGT event F1 is not discountable under the CGT discount.
For the lessee (as payer)
The payment of the lease premium is generally not deductible for the lessee under s 8-1.
Long-term lease
A long-term lease involves the lessor granting (or renewing or extending) a lease for a period of at least 50 years. Effectively, the lessor is treating the transaction as a disposal of the land.
For the Lessor (as recipient)
The payment of a premium from the lessee to the lessor for the grant, renewal or extension of long-term lease is generally considered to be a capital receipt for the lessor. The lease is considered a new asset which is being disposed by the lessor to the lessee. The disposal of the ‘lease’ as a CGT asset triggers both CGT event F2 and CGT event F1 for the lessor. The taxpayer can elect to apply event F2, otherwise event F1 occurs. To calculate the capital gain from CGT event F2, take the premium received by the lessor and subtract any expenditure incurred by the lessor to grant, renew or extend the lease at the time the lease or granted or at the time when the renewal of extension commences.
Note that a capital gain from CGT event F2 is not discountable under the CGT discount.
For the lessee (as payer)
The payment of the lease premium is generally not deductible for the lessee under s 8-1.
CGT discount
The CGT discount is available in respect of the following CGT events relevant to lease special payments, and which satisfy the requirements of the discount contained in Division 115 of the Income Tax Assessment Act 1997:
- CGT event A1
- CGT event C2
- CGT event F3
- CGT event F4
The CGT discount is not available in respect of the following CGT events relevant to lease special payments:
- CGT event D1
- CGT event F1
- CGT event F2
- CGT event F5
This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.
