Tax reforms relevant to the property industry continue to be announced by the Government. The most recent is a proposal to tax lease inducement payments in the hands of lessees. The proposal will be of significance to commercial lessees and lessors alike.
Lease inducement payments are frequently made to encourage a lessee to enter into a lease or renew its existing tenancy. Usually the payments are non-taxable, capital, amounts in the hands of the lessee, while deductible to the lessor. The tax-free status of inducement payments to a lessee was confirmed by the Privy Council (then our highest court) in the 1998 Wattie case, and this area of the law has been reasonably settled since then. The Inland Revenue proposes to reverse that case law position by legislating that lease inducement payments will be taxable income to lessees.
The Inland Revenue cites as motivation for its proposal the risk to the revenue base posed by the asymmetric tax treatment of inducement payments (the fact that the payments are usually capital to the lessee while deductible to the lessor). This asymmetric treatment, argues the Inland Revenue, permits the sharing of tax benefits between the lease parties, by means of adjusting the level of the inducement payment and the periodic rent. Perceived sharing of tax benefits has always been a concern to the Inland Revenue.
Other forms of incentive, such as rent-free periods or reduced rent, do not pose the same risk to the revenue base, according to the Inland Revenue, because their tax treatment is symmetrical – the reduced rent or rent holiday reduces the deductible expenditure of the lessee but at the same time also reduces the income of the lessor.
Details of proposal
The Inland Revenue proposal would see inducement payments spread on a straight-line basis by the recipient lessee over either the period of the lease arrangement or the period to the first rent review, whichever is the shorter. A specific anti-avoidance rule would be introduced to counter what the Inland Revenue refers to as arbitrage opportunities in relation to the timing of income. It gives as an example a long term arrangement between associated parties which is designed to delay the recognition of income.
The exact scope of transactions to which the new rules will apply is not yet clear but it appears that subleases, licences and easements will be caught, as will transfers or extensions of interests in land, such as assignments or renewals of leases.
It is not just cash payments which will attract the new treatment. Non-cash benefits provided to a lessee will also be taxable income in the lessee's hands. Examples provided by the Inland Revenue include:
- contributions to a lessee's start-up costs or relocation costs (fit-out contributions, themselves the subject of recent reforms, will be excluded);
- meeting or forgiving a lessee's existing rent obligations or an early termination payment obligation under an existing lease; and
- other non-cash benefits (the Inland Revenue cites the transfer of shares to a lessee as an example).
Timing of reforms
Although the Inland Revenue paper is an issues paper for public comment, the Inland Revenue states that the proposed reforms will be included in a bill to be put before Parliament later this year. The message seems to be that submissions would be welcome on the detail, but don't expect any major changes on the substance of the reforms.
Notably, the changes when legislated are intended to apply to arrangements entered into on or after the date of the announcement (26 July 2012). No further detail is provided as to what is meant here and care will need to be taken if negotiation or documentation of an arrangement has spanned the July announcement date.
The Inland Revenue proposal is seen by many as a "tax grab". It clearly alters the capital / revenue boundary in this area, and is acknowledged as doing so by the Inland Revenue. The proposals are another example of the creeping introduction of capital gains taxation in the form of income tax legislation.
The "asymmetry" justification cited by the Inland Revenue is somewhat hollow, as it is a long-standing and accepted feature of our tax system that a symmetrical tax result need not follow from a transaction. Whether a receipt is taxable in the hands of one party to an arrangement is not determined by the deductibility of the amount to the other party.
Participants in the property industry may feel, with some justification, as if they have been targeted by yet another questionable reform. The proposal to tax lease inducement payments is part of a series of reforms impacting the industry. It follows the recent change to the tax treatment of fit-out contributions (which must now either be treated as taxable income spread over 10 years, or applied in reduction of the depreciable base of the fit-out assets), and the removal of the ability to claim depreciation deductions for buildings.
The apparent retrospective nature of the reforms has also been criticised by many as an example of the Inland Revenue in effect legislating by decree.
Nevertheless, it is most likely that the changes will be passed into law.