The IRD and Treasury are proposing that any lease inducement payment be treated as assessable income in the hands of the recipient, reversing by legislation the long-standing, non-taxable (capital) status of such payments. This is the latest in a series of recent proposals aimed at raising new revenue, without increasing headline tax rates. In this instance, what is being proposed is nothing less than a targeted capital gains tax.
Status of the proposal
An Issues Paper titled "The Taxation of Lease Inducement Payments" sets out the proposal (view it here). Although it calls for submissions, the paper states that officials' recommendations will be included in a tax bill introduced in Parliament later this year.
The officials controversially say the new rule, if adopted, would apply to commercial lease arrangements entered into on, or after, 26 July 2012 (the date the Issues Paper was released). However, no proposal has been put to, or considered by, Parliament. This makes the officials' announcement constitutionally improper and will create uncertainty about the law to apply in the interim.
How will it work?
A landlord is in many cases currently able to claim an income tax deduction for a LIP it pays, while the LIP recipient would treat it as a non-taxable capital receipt. In return, the tenant may agree to a higher level of rent than they might otherwise pay. This results in a better after-tax position for the tenant, while the landlord's after-tax position is not changed.
Where the LIP is deductible but not taxable, what the officials call an "asymmetric" tax advantage arises. They say this distorts commercial decision-making. It is this asymmetry they wish to remove by the following:
- taxing any amount derived by a person, or an associate, as an inducement to enter into a lease, sub-lease, licence, easement or the like (but excluding a sale or sale and leaseback); and
- taxing both lump sum cash LIPs and also any non-cash inducements such as contributions to a tenant's start up or relocation costs, forgiveness of a tenant's liabilities, or the provision of interest free loans.
The Issues Paper states that a LIP is deductible by the payer under general principles, on the basis that it is an expense incurred in carrying on a business for the purpose of deriving assessable income. This ignores the possibility that a LIP may not be deductible if it is viewed by IRD as a capital expenditure (as would arguably be the case if, for instance, the payer owns just one building and is paying an LIP to the sole tenant). If the officials are genuinely concerned about tax asymmetry, they should recommend to Parliament that all LIPs be automatically deductible.
The officials suggest allocating the LIP for both income and deduction purposes on a straight-line basis, either over the period of the lease, or the period when the first rent review is due, whichever comes first.
To prevent deferral of LIP income recognition (through long-term arrangements between associates or up-front payments ahead of the lease commencing), a specific anti-avoidance provision is proposed that requires such LIPs to be recognised in the year of receipt.
What does the LIP proposal mean?
LIPs have proven to be useful tools for landlords in attracting and inducing prospective tenants to enter into commercial leases during economic downturns. Landlords can use LIPs to secure major tenants in large buildings for longer periods, making them flexible and effective bargaining tools. They may also have been used as a way of influencing property values, by increasing the apparent rental yield of a property.
If the proposal goes ahead, it will counter the primary tax advantage associated with LIPs for the recipient. This renders LIPs no more tax-advantageous than other forms of inducement, such as fit-out contributions, which are either taxable to the recipient or reduce their depreciation cost base.
However, it will do so only by overriding the intrinsically capital nature of a lease inducement payment in the hands of the lessee. This was confirmed by the Privy Council in CIR v Wattie in 1999. In that case, Coopers & Lybrand (now PwC) had entered into a commercial lease in tandem with an inducement agreement that called for payment of a LIP. IRD argued that the LIP was taxable. This was rejected by the Privy Council which (agreeing with the Court of Appeal) held that it was paid for the lessee undertaking an onerous lease for a substantial period, and so was capital in nature.
What's really going on?
This proposal is the latest example of officials targeting specific instruments and arrangements that produce an asymmetric tax outcome, but notably only where it is the taxpayer, not the tax base, that benefits from the asymmetry. Many asymmetries go the other way. For example, interest on money borrowed by a taxpayer (other than a company) to fund the acquisition of a capital asset is non-deductible, but assessable to the lender. Such asymmetries are bound to arise within a tax system ostensibly faithful to the capital/revenue distinction.
It is more than 12 years since the Wattie decision, so the need for haste (as evidenced by the controversial announcement as to the implementation date, mentioned above) is also questionable.
In reality, the proposal is a symptom of the IRD being put under pressure to raise more revenue within the current tax rate structure. They are stamping down on smaller, specific areas in which perceived tax advantages legitimately arise under current rules. Other recent examples include the proposal to tax "salary trade-offs", which will have the effect of significantly constraining salary packaging options available to charities (see our earlier FYI on this topic), and the proposed reversal of the GST exempt treatment of late payment fees on utility charges and other goods and services.