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If a lessee incurs expenditure of a capital nature on making improvements to leased property, the CGT consequences depend on whether the lessee or the lessor is the owner of the improvements.

If the lessee owns the improvements (see Taxation Determination TD 46), the cost base of the improvements includes the amount of capital expenditure incurred in making the improvements. On a CGT event happening to the improvements, the amount of any capital proceeds received will determine whether a capital gain or loss is made. If the improvements remain affixed to the land on the expiry or termination of the lease, CGT event A1 (disposal of a CGT asset - section 104-10 of the Income Tax Assessment Act 1997) happens to the improvements. The improvements are disposed of by the lessee to the lessor.

If the parties are not dealing with each other at arm's length or no capital proceeds are received, sections 116-30 and 112-20 apply and the lessee is taken to have received, and the lessor to have paid, the market value of the improvements.

If the lessee does not own (and has never owned) the improvements, but the capital expenditure is incurred by the lessee to increase the value of the lease and is reflected in the state or nature of the lease at the time of a CGT event happening to it, subsection 110-25(5) allows for the expenditure incurred to be included in the cost base of the lease to the lessee. If any part of the lessee's expenditure is recouped, and the amount of the recoupment received is not included in the lessee's assessable income, subsection 110-25(8) precludes the amount from forming part of the cost base of the lease.

On expiry or termination of the lease, CGT event C2 in section 104-25 - about cancellations, surrenders and similar endings of intangible assets - happens 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, section 116-75).

This Taxation Determination rewrites and replaces Taxation Determination TD 56, which is now withdrawn. TD 56 is being rewritten under a project to review and rewrite Taxation Rulings and Taxation Determinations as necessary to reflect changes made to the income tax law by the Taxation Law Improvement Project. There is no material change in the views expressed in TD 56. However, we have included a reference, in paragraph 4, to the cost base recoupment provision (subsection 110-25(8)) which now includes a change made to clarify that a recoupment of expenditure cannot both reduce the cost base and be included in assessable income. The change adopts the Commissioner's interpretation of the old law.