Further Reforms to the Tax Treatment of Land-Related Lease Payments: Shifting the Capital-Revenue Boundary?
An Officials’ Issues Paper released on 24 April 2013 by Inland Revenue seeks feedback on options to reform the tax treatment of land related-lease payments, following up the proposed changes introduced last year in relation to the tax treatment of lease inducement and lease surrender payments (refer our Special Tax Alert in December 2012). If you have a lease of land then these proposals are relevant to you.
Inland Revenue notes that the taxation of land-related lease payments has been the subject of ad hoc reforms over the years which have resulted in inconsistencies and incoherent outcomes for taxpayers. These proposed new reforms apply to a wide range of payments made in relation to leases of land including lease premium, inducement, modification, surrender, transfer, breach of covenant and make-good payments.
Put simply, under the new rules, any land-related lease payment subject to the rules would be treated as taxable to the recipient and deductible to the payer. In effect, as the Inland Revenue states, leases (or licenses) of land would be put on revenue account. New timing rules would be introduced to spread income and deductions over the term of the relevant land right in a consistent fashion.
Land-related lease transfer payments
Lease transfer payments are consideration received by an existing tenant (transferor) from a new incoming tenant (transferee) for the transfer or assignment of the lease. The issues paper notes that these payments are typically recognised as a non-taxable capital receipt to the exiting tenant (the rationale being that the lease is typically a capital asset of the lessee), and tax deductible for the incoming tenant under the depreciation rules.
The concern articulated in the Issues Paper is that this asymmetrical treatment (non-taxable to the recipient but deductible to the payer), and the fact that lease surrender payments will become taxable in the hands of a lessee (assuming the current draft legislation is enacted), may lead to distortions in taxpayer behaviour (i.e. it would be tax advantageous for a tenant to exit a lease by transferring the lease to a third party for a tax-free payment rather than surrendering it to a landlord for a taxable payment). The Issues Paper therefore proposes that lease transfer payments should be taxable to the recipient (transferor), therefore in effect legislating away their “capital” nature. The deductibility of the payment to the incoming lessee (transferee) would be legislatively confirmed.
Land-related lease payments
The Issues Paper also notes that the overall tax treatment of land-related lease payments should be reviewed “for a more consistent and coherent tax treatment of these payments”. Inland Revenue therefore proposes to rationalise the tax treatment of land-related lease payments under one set of rules.
It is suggested that generic income, deduction and timing rules for these payments be introduced for all land-related lease payments. Under these rules land-related lease payments would be treated as deductible to the payer and taxable to the recipient.
The rules would apply to a land right (leases or licences of land) if the land right has a term of less than 50 years. The 50 year period would not include a period of renewal or extension (these would be regarded as relating to a separate land right). Payments made in relation to a land right that lasts 50 years or more would be treated similarly to payments made in relation to a freehold estate. In effect, leases or licences that last less than 50 years would be put on revenue account.
This proposal would change the tax treatment of land-related lease payments so that, for example, a payment for the right to use land (under Schedule 14 of the Income Tax Act 2007) which would currently be depreciable would not be deductible if the land right lasted 50 years or more. Conversely, some payments that are currently non-deductible would be deductible as long as the lease is for less than 50 years.
A separate timing rule would be introduced to allocate income and deductions evenly over the term of the land right to which the amount of income or deductions relates.
The current ability to depreciate a “right to use land” under Schedule 14 would be repealed and replaced with the new deductibility and timing provisions, although there would be transitional rules for expenditure incurred on rights to use land before the application date of these proposals.
To effect the reforms the Inland Revenue proposes to also replace the existing section CC 1 of the Income Tax Act 2007 with a new charging provision. That provision would treat all land-related lease payments derived by a person as taxable income. The provision would apply where a person derives an amount in relation to a right in land that is an estate in, or a license to use, land (the “land right”) and that person:
- Owns the land right or the land in respect of which that right is granted; or
- Obtains the land right or used to own the land right,
and where the amount is in the nature of rent or the land right has a period of less than 50 years.
Examples noted by the Inland Revenue of amounts derived in connection with a land right include a fine, a premium or inducement payment, a payment for breach of covenant and a payment for termination or transfer of the land right. Fit-out contributions are also specifically noted by the Inland Revenue as payments that will be covered by the new rules. As a consequence, the option of reducing the cost base of the relevant depreciable asset for tax purposes will be removed. The contribution will simply be spread over the period of the relevant lease.
The reforms would not apply to payments derived by most lessees of residential premises.
The proposals are expected to apply to payments derived or incurred on or after the 1 April following the date of enactment.
The proposals are a significant change in the tax treatment of land-related lease payments and alter the current capital-revenue boundary. There is a risk, under the proposals, that certain transactions which would currently result in a capital gain to the taxpayer may become subject to income tax. As a result, the proposals, in conjunction with the lease inducement and lease surrender payment proposals, could have a significant impact on those entering, exiting and modifying leases.
It is questionable whether the policy reason for the proposed changes to lease inducement payments and lease termination payments should apply to lease transfer payments. Lease termination / surrender payments are generally referable to and in substitution for rent that would otherwise be payable and on that basis there is support for including them within the tax net. By contrast, it is not considered that lease transfer payments represent a substitution for alternative rent arrangements because they do not involve the landlord (i.e. the payment is made by the new tenant to the existing tenant for the transfer of a lease). It is therefore debatable whether a lease transfer payment should now be considered a revenue receipt if it relates to the transfer of a capital asset (i.e. a lease) of the recipient.
In terms of depreciation, in our view, there should be further consideration of whether the right to use land, where that right is for a finite term of 50 years or longer, should remain depreciable property. If the policy intent is linked to the removal of the right to depreciate buildings for tax purposes (where the Government believed there was no actual depreciation) then the rationale should not necessarily apply to fixed term land rights. A right to use land will always decline in value as the end of its term approaches (and will eventually have nil value) and, therefore, it would appear appropriate that the depreciation rules should continue to apply to a right to use land for a finite period of 50 years or more.
These proposals will need to be considered carefully when entering into business asset sale transactions. If no value is attributed to a lease being transferred as part of the business sale then there is a risk this will be challenged by Inland Revenue. Therefore, once the new proposals apply, the preference would be to allocate a value to leases being transferred. However, this may lead to additional transaction costs if the parties are then required to obtain a valuation of the lease(s) to support the allocation of the purchase price.
Submissions on the Issues Paper were requested by Inland Revenue by 4 June 2013. If you have any questions regarding the proposals, please contact your usual Deloitte adviser.
Tax Alert June 2013 contents:
- Tax Alert June 2013
- Further Reforms to the Tax Treatment of Land-Related Lease Payments: Shifting the Capital-Revenue Boundary?
- Do your facts stack up? Don’t Google it!
- New foreign super and mineral mining bill introduced
- Foreign superannuation rules overhauled
- Clarifying the acquisition date of land: Certainty please
- Confirmed legislative changes for the taxation of mining