Income tax: lease surrender receipts and payments

This Ruling explains the circumstances where it is considered that: (a) a lease surrender receipt is assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997); and (b) a lease surrender payment is deductible under section 8-1 of the ITAA 1997.

This Ruling also addresses the application of the provisions of the ITAA 1997 covering capital gains and capital losses (CGT).

The table at paragraph 89 of this Ruling cross references the provisions of the ITAA 1997 referred to in this Ruling to the corresponding provisions of the Income Tax Assessment Act 1936 (ITAA 1936). References to provisions of the ITAA 1997 should be read as also including, unless a contrary intention appears, references to corresponding provisions of the ITAA 1936. Cases relied upon in this Ruling that deal with issues in terms of provisions of the ITAA 1936 are considered to have equal application to the corresponding provisions of the ITAA 1997. Legislative references, unless otherwise stated, are to the ITAA 1997.

A lease surrender amount refers to the consideration given or received for surrendering a lease. A lease surrender constitutes a disposal of a CGT asset (that is, the lease) and the ending of contractual rights under the lease. A lease surrender is to be contrasted with a mere variation or waiver of a term of a continuing lease. For CGT purposes expenditure incurred in obtaining a variation or waiver of a term of a lease falls for consideration under Subdivision 104-F of the ITAA 1997 (about leases).

This Ruling does not consider variations or waivers of a term of a lease, however, it is noted that similar commercial outcomes may be achieved through a surrender and a variation or waiver of a term of a lease, but with different tax outcomes. For example, CGT event F3 crystallises an immediate capital loss for a lessor who pays to obtain a lessee's agreement to vary or waive a term of a lease, whereas under this Ruling, a lessor who pays for the lessee to surrender the lease, has the expenditure included in the cost base of the property. The general anti-avoidance provisions in Part IVA of the ITAA 1936 may apply where a technical variation or waiver of a term of a lease is used to effect a substantive surrender, predominantly for the purpose of gaining a tax benefit.

This Ruling applies only to the surrender of leases of land and buildings and does not apply to the surrenders of leases that still come within the operation of Division 4 of Part III of the ITAA 1936.

This Ruling applies to years of income commencing both before and after its date of issue. However, there are two exceptions. The first exception is that the Ruling does not apply to taxpayers to the extent that it conflicts with the terms of settlement of a dispute agreed to before the date of issue of the Ruling (see paragraphs 21 and 22 of Taxation Ruling TR 92/20). The second exception is if the surrender arrangement was entered into before 23 March 2003 (the date Taxation Ruling TR 1999/18 was withdrawn) and the outcome provided by this Ruling is less favourable than that provided by the withdrawn Taxation Ruling TR 1999/18. In that case, this Ruling does not apply (and Taxation Ruling TR 1999/18 does). An example of a less favourable outcome under this Ruling is if a lessor accepts the surrender of a valuable lease but does not receive any actual consideration, then there would be no capital proceeds under CGT event H2 (as ruled in Taxation Ruling TR 1999/18) but there would be deemed capital proceeds under CGT event C2. A taxpayer in this situation can continue to apply Taxation Ruling TR 1999/18.

Taxation Ruling TR 1999/18 (withdrawn 23 March 2003).

A lease surrender receipt of a lessee would be of a capital nature when received for the surrender of a lease that formed part of the profit-yielding structure of the business of the lessee. However, a lease surrender receipt of a lessee would constitute assessable income under section 6-5 if received: (a) in the ordinary course of carrying on a business of trading in leases; (b) as an ordinary incident of business activity (even though it was unusual or extraordinary compared to the usual transactions of the business); or (c) as a profit or gain from an isolated business operation or commercial transaction entered into by the lessee (otherwise than in the ordinary course of carrying on a business), with the intention or purpose of making the relevant profit or gain.

A lessee makes a capital gain from surrendering a lease acquired after 19 September 1985 (CGT event A1, section 104-10, about the disposal of a CGT asset) to the extent that the surrender receipt exceeds the cost base of the lease (including any non-deductible premium paid by the lessee for the grant of the lease). Note that in limited circumstances the market value substitution rule (section 116-30) may determine the capital proceeds for the event.

A lessee makes a capital loss upon surrendering a lease acquired after 19 September 1985, to the extent that the reduced cost base of the lease exceeds the surrender receipt, provided the lease was used solely or mainly for the purpose of producing assessable income (section 118-40). In limited circumstances the market value substitution rule (section 116-30) may determine the capital proceeds for the event, however it is unlikely that the market value would be other than a negligible amount.

Where a lessee makes a lease surrender payment to dispose of an onerous lease that is part of the profit-making structure of the lessee's business or income producing activity, the payment is of a capital nature and is not deductible under section 8-1.

In these circumstances, the lessee disposes of the whole of the lease including the right to possession of the leased premises. While the lessee also obtains a release from the obligation to pay rentals that would have been deductible under section 8-1, the lease surrender payment is still of a capital nature because there is a surrender of the whole of the lessee's interest under the lease.

However, where a lessee carries on a business of entering into and surrendering leases, lease surrender payments would be revenue rather than capital in nature.

A lease surrender payment made by a lessee cannot be included in the cost base or reduced cost base of the lease disposed of because it is not a cost of acquiring the lease (subsection 110-25(1)), it is not an incidental cost that relates to the CGT event (section 110-35), and nor does it qualify under any other element of cost base (section 110-25). The lessee receives no actual capital proceeds from the disposal of the lease. In limited circumstances the market value substitution rule (section 116-30) may determine the capital proceeds for the event, however it is unlikely that the market value would be other than a negligible amount.

A lease surrender receipt of a lessor would constitute assessable income under section 6-5 if received: (a) in the ordinary course of carrying on a business of granting and surrendering leases; (b) as an ordinary incident of business activity (even though it was unusual or extraordinary compared to the usual transactions of the business); or (c) as a profit or gain from an isolated business operation or commercial transaction entered into by the lessor (otherwise than in the ordinary course of carrying on a business), with the intention or purpose of making the relevant profit or gain. Otherwise the lease surrender receipt is of a capital nature.

The entry into a lease by a lessor and lessee constitutes the acquisition of an asset by the lessor. The asset comprises the contractual rights vested in the lessor under the lease agreement, including the right to receive the nominated rent, but subject to the provision of possession.

Upon the surrender of the lease by the lessee, CGT event C2 under section 104-25 of the ITAA 1997 happens to the lessor in relation to the discharge of its rights (as a single asset) under the lease agreement. The lease surrender receipt usually constitutes the capital proceeds for the event happening to the asset. Note that if the market value of the rights asset is different from the actual capital proceeds, then the market value amount is the capital proceeds (section 116-30(3A)). In practise, it is considered unlikely that there will be a difference between the receipt and the market value of the rights.

A lessor makes a capital gain if the capital proceeds from the surrender of its rights are more than the asset's cost base (including, for example, any non-deductible lease incentive paid to the lessee on the grant of the lease).

The lessor makes a capital loss if those capital proceeds are less than the asset's reduced cost base.

Where a lessor who does not carry on a business of granting and surrendering leases makes a 'once and for all' payment to obtain a permanent advantage, namely the surrender of the lease, the payment is of a capital nature and is not deductible under section 8-1.

Although a lessor may make a lease surrender payment in order to re-let the property at a higher rental and so derive more assessable income, the payment is still of a capital nature because of this permanent advantage.

However, where a lessor carries on a business that involves granting and surrendering leases as a normal incident of it, or that involves incurring recurrent outlays to obtain lease surrenders as part of the constant demand of its business which have to be met out of circulating capital, then the lease surrender payments would be a revenue rather than a capital outgoing.

A lessor who makes a lease surrender payment obtains a conveyance or transfer of a lease and can include the payment in the cost base of that CGT asset (being the lease) under paragraph 110-25(2)(a). The lease surrender payment is the money paid in respect of acquiring that asset from the lessee. Generally, when a lease is transferred to a lessor who owns the reversionary interest in the land, the term of the lease merges into the land. The cost base of the merged asset is calculated in accordance with subsection 112-25(4) and includes the cost bases of the land and the lease acquired from the lessee.

CGT event C2 in section 104-25 of the ITAA 1997 also happens to the lessor in relation to the discharge of its contractual rights under the lease agreement. As no capital proceeds are received for the discharge, the lessor may make a capital loss to the extent to which the reduced cost base of the rights asset (which could include incidental costs and any non-deductible incentive paid to the lessee on the grant of the lease) exceeds its market value, if any (section 116-30), however it is unlikely that the market value would be other than a negligible amount.

The amount of any capital gain accruing to a lessee or lessor that arises from the surrender of a lease is reduced in accordance with section 118-20, to the extent that the lease surrender receipt is assessable under section 6-5. Deductible amounts (for example lease document expenses deductible under section 25-20 of the ITAA 1997) may also be excluded from the cost base or reduced cost base of relevant assets.

A lease surrender receipt of a lessee would be of a capital nature when the lease formed part of the profit-yielding-structure of the lessee's business. In Westfair Foods Limited v. The Queen [F1] the Federal Court of Canada held that two lease termination amounts received by a large food retailer with numerous distribution outlets were of a capital nature as the amounts were received for the realisation of capital assets. The leases had originally been for terms of 25 years with rights to renew for further 10-year periods and the taxpayer as lessee had used the premises as food stores for many years before surrendering the leases at the initiative of separate lessors.

In the following circumstances, a lease surrender receipt of a lessee would constitute assessable income under section 6-5 of the ITAA 1997.

A lease surrender receipt of a lessee may be income according to ordinary concepts, such as when the taxpayer carries on a business of trading in leases or the receipt occurs as an ordinary incident of business activity. The fact that a taxpayer's business encompasses leasing premises from which to operate a business is not enough to make a lease surrender receipt income under ordinary concepts. Whether a lease surrender receipt is received in the ordinary course of business is a question of fact and degree to be determined in the circumstances of each case.

In FC of T v. Montgomery [F2] ( Montgomery's case) the High Court of Australia held that a lease incentive receipt was assessable income. The receipt was a profit or gain severed from the capital invested in the business of the firm that had come in to the recipient for his separate use, benefit and disposal. Also, the firm had used or exploited its capital in the course of carrying on its business to obtain the incentive receipt (albeit in a transaction properly regarded as singular or extraordinary).

In FC of T v. Myer Emporium Ltd [F3] the High Court confirmed that a receipt may constitute income where it arises from an isolated business operation or commercial transaction entered into otherwise than in the ordinary course of business provided that the taxpayer entered into the transaction with the intention or purpose of making the relevant profit or gain.

The receipt of a lease surrender amount by a taxpayer who operates a business from leased premises would also constitute assessable income where: (a) the receipt arises in the course of business activity (albeit from a relatively unusual or extraordinary transaction); and/or (b) the lessee enters into an isolated business operation or commercial transaction (other than in the ordinary course of business) with a significant purpose of making a profit or gain from the surrender of the lease.

A lease surrender receipt of a lessee for the surrender of a lease which occurs as a singular transaction (other than one that occurs as an ordinary incident of business activity) would not constitute assessable income unless the transaction involved a business operation, commercial operation or adventure in the nature of trade. [F4]

For the lease surrender receipt to constitute assessable income as a gain from a profit-making undertaking or scheme, the lessee must also have entered into the transaction with the intention or purpose of making the relevant profit or gain. In Case 57/94 ; AAT Case 9787 [F5] a taxpayer exercised an option to renew a lease of premises from which he carried on his business with the intention of making a profit from vacating the premises before the expiry of the lease term. The Administrative Appeals Tribunal held that the taxpayer derived income according to ordinary concepts from a profit-making venture when he received an amount for varying the duration of the lease term.

In Rotherwood Pty Ltd v. FC of T [F6] the Full Federal Court held that a lease surrender amount of $6 million received by a lessee who carried on a business that included subleasing premises to a firm of solicitors constituted income according to ordinary concepts. The amount was received as part of a profit-making transaction under which the lessee surrendered the lease so that the premises could be let to an associate at an increased rental for a ten-year period. The lease surrender receipt was not received as a consequence of an independent transaction to dispose of a capital asset. The surrender was one step in a business operation to carry out a profit-making scheme. In these circumstances, the fact that the lease was a capital asset not acquired for a profit-making purpose did not prevent the receipt being characterised as of a revenue nature.

A CGT event happens when a lessee surrenders a lease (CGT event A1 (section 104-10) about the disposal of a CGT asset).

A lessee makes a capital gain from surrendering a lease acquired after 19 September 1985, to the extent that the surrender receipt exceeds the cost base of the lease. Note that in limited circumstances a market value substitution rule may determine the capital proceeds for the event.

The cost base of the lease is typically constituted by incidental costs paid by the lessee on the grant and surrender of the lease, but will also include any non-deductible premium paid to the lessor to acquire the lease. Rent payable under the lease is not considered to be money paid or required to be paid in respect of acquiring the lease.

The lessee makes a capital loss if the reduced cost base of the lease exceeds the surrender receipt, provided that the lease was used solely or mainly for the purpose of producing assessable income (section 118-40). Note that in limited circumstances a market value substitution rule may determine the capital proceeds for the event.

A lease surrender payment made by a lessee qualifies as a deduction under section 8-1 of the ITAA 1997 only if it is incurred in gaining or producing the lessee's assessable income or it is necessarily incurred in carrying on a business for that purpose, and it is not an outgoing of capital, or of a capital nature.

A lease of business premises is generally an affair of capital. In Montgomery's case, [F7] a case concerning the assessability of a lease incentive payment received by partners in a large firm of solicitors, Gaudron, Gummow, Kirby and Hayne JJ made the following statement about the characterisation of a lease on the facts of the case: That the lease of the premises was part of the profit-yielding structure is beyond question.

Of course, as observed by their honours immediately after the quoted passage, this does not mean that every outgoing associated with a lease will be on capital account, [F8] and rent paid under a lease is a prime example of an outgoing associated with a lease which is typically on revenue account.

But a lease surrender payment made by a lessee is not like rent. It takes its character from the character of the lease, and this is so even if an advantage sought to be gained by the lessee is a reduction in future rental outgoings. Thus it was held by the House of Lords in Tucker v. Granada Motorway Services Ltd [F9] (a case that was cited with approval by the High Court of Australia in Mount Isa Mines Ltd v. FCT ) [F10] that a payment made by a lessee to have the rent payable under a lease reduced was nevertheless capital in nature as the lease was an asset of the taxpayer and the payment was made to modify the conditions of the lease. The House of Lords held that even though the payment might be made as a commutation of part of the liability for rent, it was still stamped with the character of capital, as the lease was a capital asset of the business. Given that a lease surrender payment involves the termination of the lease, as opposed to a mere variation of it, this line of argument seems even stronger in that context.

The characterisation of a lease surrender payment was considered in New Zealand in Commissioner of Inland Revenue v. McKenzies New Zealand Limited [F11] ( McKenzies case). Judgment of the Court was delivered by Richardson J who stated in response to a submission that the payment was on revenue account, being for the commutation of future lease payments: The surrender of a lease is a surrender of the whole interest of the lessee under the lease and it is fallacious to focus narrowly on the extinguishment of the rental obligation without recognising that at the same time the right of possession has been relinquished. [F12]

This conclusion applies in the context of Australian income tax law even though (in the case of the lessor) the CGT event structure focuses on the discharge of the lessor's contractual rights under the lease agreement, being inter alia the right to receive rent subject to the provision of possession (see paragraphs 61 to 65).

It has been suggested that our acceptance of deductibility for certain expenses considered comparable to lease surrender payments is inconsistent with this approach. In Taxation Ruling TR 93/7 and Taxation Ruling TR 2004/4 we acknowledged that a borrower who pays penalty interest under a loan agreement in consideration for a lender agreeing to accept an early repayment of a loan may be allowed a deduction under subsection 51(1) of the ITAA 1936 and section 8-1 of the ITAA 1997 respectively. In our view, the particular nature of a leasehold estate requires a different approach for lessees' surrender payments, and the cases mentioned above support the different approach.

It has also been put to us that the deductibility of interest incurred after the cessation of a business (see Taxation Ruling TR 2004/4) suggests that other expenses associated with the ending of a business, such as a lease surrender payment, must also be deductible. We do not agree with this suggestion, because the Taxation Ruling merely confirms that some outgoings that would have been deductible had a business not ceased, remain deductible notwithstanding the cessation. It says nothing about deductibility of outgoings that would have been capital in nature during the currency of the business.

It has been suggested that the decision in National Australia Bank Ltd v. FCT [F13] (NAB) indicates a trend in judicial thinking away from the identification of assets that might form part of a business's profit-making structure, with greater emphasis being given to the commercial outcomes of expenditure. Whether or not that is true, we do not agree that the decision in NAB alters any of the judicial analysis relied on in this Ruling. The full court of the Federal Court held that the character of the advantage sought by the payment (under which the bank acquired an exclusive right for 15 years to offer loans to defence force personnel) was to obtain income from the loans then provided and was incurred as part of the 'process' by which the bank operated to obtain regular returns by means of regular outlays. The surrender of a lease of premises from which a business is conducted is most unlikely to be part of a process by which a taxpayer operates to obtain regular returns.

A significant (though perhaps relatively rare) exception to the capital characterisation of surrender payments made by lessees is where the lessee carries on a business of dealing in leases. Whether a lessee carries on such a business is a question of fact. In London Australia Investment Co Ltd v. FCT [F14] Jacobs J held that the relevant question to be answered in determining whether a business of acquisition and disposal exists is whether acquisitions are made with a purpose or intention or expectation of resale with consequent profit .

Most lessees use leased premises as offices, warehouses, factories or shops as part of the profit-making structure of their businesses and do not enter into their leases with such a purpose or intention or expectation. The surrender of a lease that has been used as part of the profit-making structure of a business is not characterised as a revenue transaction merely because the lessee carries on business from many leased premises and, therefore, surrenders leases on a regular or frequent basis. [F15] As Richardson J stated in McKenzie's case: [F16] A lease will be held on revenue account if the taxpayer trades in leases so that the leases form part of its trading stock or are otherwise regarded as circulating capital. Here [a lease surrender payment by a retail company] as in the case of most taxpayers, the lease was part of the profit making structure of the business.

CGT event A1 in section 104-10 of the ITAA 1997 happens when a lessee surrenders a lease.

However, the lessee receives no capital proceeds from this CGT event. The lessee makes the lease surrender payment to obtain the lessor's acceptance of the surrender of the leasehold estate and to obtain an extinguishment of the covenants of the lease, such as the obligation to pay rent and to repair and maintain the leased property. While the lessee receives contractual consideration in the form of the consent of the lessor to the surrender, the lessee does not receive money or property for the purposes of the general rules about capital proceeds in section 116-20.

As the lessee receives no capital proceeds from the CGT event, section 116-30 would apply. Under this section the lessee is deemed to have received the market value of the lease that is the subject of the event. The market value is worked out at the time of the event.

However, where the market conditions governing rental properties are such that a lessee who is dealing at arm's length with a lessor has to make a lease surrender payment in order to obtain the consent of the lessor to the disposal of the lease, we would accept that the market value of the lease is likely to be a negligible amount.

The cost base of the lease is determined in accordance with Subdivision 110-A and includes the cost of acquiring the lease (for example a non-deductible premium paid for the grant of the lease), certain incidental costs of acquiring the lease, and incidental costs that relate to the CGT event that happens to the lease. However, a lessee who makes a lease surrender payment cannot include the amount of the payment in the cost base of the lease. The payment is not a cost of acquiring the lease for the purposes of subsection 110-25(1) and it cannot be properly characterised as an incidental cost under section 110-35, which limits incidental costs to, among other things, costs of transfer, stamp duty or other similar duty. Nor does the payment fit into any other element of cost base listed in section 110-25.

A surrender payment which is said to be a commutation of rent payable under the lease, but is not deductible under section 8-1 of the ITAA 1997, does not become part of the cost base of the lease, because rent payable under a lease is not money paid or required to be paid in respect of the acquisition of the lease (rent is paid for the right to occupy the premises and not for the grant of the lease). Nor is such a payment a 'non-capital cost of ownership' of the lease because the commuted amount is for future rent payable, at which time ownership of the lease (the right of possession per McKenzie's case) has been relinquished.

A lease surrender receipt of the lessor received for consenting to the surrender of the lease would be assessable income under section 6-5 if received in the ordinary course of carrying on a business of granting and surrendering leases. This is a question of fact and degree to be determined in the particular circumstances of each case.

A lease surrender receipt of a lessor for consenting to the surrender of a lease would constitute assessable income under section 6-5 where: (a) the lease surrender is an ordinary incident of business activity (even though it is unusual or extraordinary compared to the usual transactions of the business); or (b) the lessor entered into the lease surrender as an isolated business operation or commercial transaction (otherwise than in the ordinary course of carrying on its business) with the intention or purpose of making the relevant profit or gain from the transaction.

If the receipt for consenting to the surrender of a lease does not constitute assessable income within the above concepts it would be a capital receipt.

Paragraphs 104-10(5)(b) and 104-25(5)(b) of the ITAA 1997 indicate that the law recognises a lessor's contractual rights under a lease as an asset for CGT purposes.

A lease is both an executory contract taking the form of promises to be performed in the future and an executed demise by the grant of the lease.

In Progressive Mailing House [F17] it was held that the ordinary principles of contract, including that of termination for repudiation or fundamental breach, apply to leases. Brennan J noted: [F18] In the present case, the lessee's breaches of covenant are said to show an intention to act, and to act only, in a manner substantially inconsistent with his obligations under the lease. For the reasons stated by Mason J, I think that the lessee did show such an intention and that the lessee repudiated the contract embodied in the lease. That conclusion makes it necessary to decide in this case what was assumed but not decided in Shevill v. Builders' Licensing Board (1982) 149 CLR 620 at pp 625-627 namely, whether the general contractual principles relating to recision for anticipatory breach and damages for the loss of benefit of a contract apply when a lessee, by words or conduct, repudiates his obligations under the lease. It is the character of a lease as a demise which may be thought to exclude the operation of those principles. For reasons that I shall state presently I would hold that ordinary contractual principles do apply, but that the character of a lease as a demise distinguishes the consequences of their application to a contract that it is also a demise.

Deane J observed that: [F19] ...except perhaps in the quite exceptional case of a completely unconditional demise for a long term with no rent reserved, ..., the leasehold estate cannot be divorced from its origin and basis in the law of contract ..., the lease should be seen as 'as resting on covenant' (or contractual promise) and it is 'the contract ... not the estate which is the determining factor.' ...(A)s a general matter and subject to one qualification, the ordinary principles of contract law are applicable to contractual leases.

In Kennedy's case [F20] Hill J referred to [F21] what Deane J said in Progressive Mailing House and commented: A lease for a term of years ordinarily possesses a duality of character which can give rise to conceptual difficulties. It is both an executory contract and an executed demise. Its origins lie in contract rather that in real property in that the lessee's remedies were originally restricted to a personal action against the lessor on his covenant to give enjoyment of the land ...

The entry into a lease by the lessor and lessee constitutes the acquisition of an asset by the lessor. The asset comprises the contractual rights vested in the lessor under the lease agreement, including the right to receive the nominated rent, but subject to the provision of possession.

Subdivision 110-A provides that the cost base of the lessor's asset includes money the lessor paid to acquire the asset (for example an inducement paid by the lessor associated with granting the lease, unless that payment is deducted) together with incidental costs incurred on the acquisition or disposal of the asset. Commonly, the cost base will be limited to incidental costs.

Upon the surrender of the lease by the lessee, CGT event C2 in section 104-25 of the ITAA 1997 happens to the lessor in relation to the discharge of its rights under the lease agreement. The surrender receipt constitutes capital proceeds for the event happening. If the market value of the rights asset is different from the surrender receipt, then the market value determines the capital proceeds (subsection 116-30(3A)).

A lessor makes a capital gain if the capital proceeds from the surrender of its rights are more than that asset's cost base. The lessor makes a capital loss if those capital proceeds are less than the asset's reduced cost base.

If a lessor makes a lease surrender payment and accepts the surrender of the lease in the course of gaining or producing assessable income, or in carrying on a business for the purpose of gaining or producing such income, the payment would be an allowable deduction under section 8-1 providing it is not of a capital nature.

Dixon J in Sun Newspapers Limited and Associated Newspapers Limited v. FCT [F22] (Sun Newspapers) outlined the three matters to be considered in determining whether a payment is on capital or revenue account, including the character of the advantage sought by the payment.

Hill J considered the application of these matters in the context of a lease surrender payment made by a lessor in Kennedy's case. His Honour stated that: [F23] By the payment, the applicant secured a permanent advantage, namely the surrender of the lease with its attendant option. It could not be said that that advantage was ephemeral merely because immediately thereafter the applicant and its co-owner were able to enter into a new lease, albeit for a more advantageous rent ... The second and third of the matters referred to by Dixon J in Sun Newspapers similarly support the view that the expenditure was of a capital nature. The payment was a once and for all payment, it was not paid by way of a periodical reward or outlay to cover use and occupation for some period commensurate with the payment, nor could it appropriately be said to have been recurrent in the sense in which that expression is used in the cases. The present is not a case of a company whose business consisted of granting leases and obtaining surrenders of them as part of the normal ebb and flow of the business, in which event a different view of the matter might be taken.

Accordingly, we take the view that when a lessor who does not carry on a business of granting and surrendering leases makes a once and for all payment to obtain a permanent advantage, being the surrender of the lease, the payment is of a capital nature and not deductible under section 8-1.

If a lessor carries on a business that involves entering into and surrendering leases as a normal incident of its business, so that lease surrender payments are a part of the normal ebb and flow of the business, the payment would be on revenue rather than capital account (see Kennedy's case). When a lessor carries on a business that involves incurring recurrent outlays obtaining lease surrenders, those lease surrender payments would be revenue outgoings. Recurrent expenditure in this context refers to expenditure that is part of the constant demand of the business which has to be met out of the returns of trade or circulating capital. In FC of T v. Email Ltd [F24] Hill, Drummond and Sackville JJ stated that: By recurrent expenditure it is not meant expenditure which may be incurred more than once, even if incurred on a number of occasions. Expenditure as we have already stated may still be capital, albeit that it is repeated. Recurrent expenditure is rather expenditure which is part of 'the constant demand which must be answered out of the returns of a trade or its circulating capital': Sun Newspapers at 362. Rates, rent, interest, even premiums of insurance of capital assets ( Australian National Hotels Ltd v. FC of T (1988) 88 ATC 4627), notwithstanding that the proceeds of the insurance would themselves be capital, are examples of recurrent expenditure ordinarily on revenue account if incurred in the course of a taxpayer's business. Whether the expenditure is, in the sense used, recurrent, will depend more upon the nature of the expenditure than the number of times it is repeated.

A shopping centre proprietor owns a large shopping centre complex in which there are 150 shops. The negotiation of leases is part of the normal ebb and flow of such a business. In the ordinary course of business affairs leases will expire and come up for renewal, tenants will want to sell their businesses and request permission to assign leases and other tenants may fail to make a satisfactory profit and want to break their lease. On other occasions it may be the proprietor who wants to terminate particular leases in order to attract high profile tenants or to get rid of poorly performing businesses. In these circumstances the principal asset of the proprietor from a practical and commercial point of view is the shopping centre. The building forms part of the business structure whereas the leases are part of the process by which the proprietor operates to obtain regular rental income. [F25] In this case recurring outgoings on lease surrender payments incurred by the proprietor would form part of the normal ebb and flow of the business so that the outgoings would be on revenue rather than capital account .

A lessor who makes a payment to obtain the surrender of a lease, obtains a conveyance or transfer of the lease, and can include the payment in the cost base of that CGT asset under paragraph 110-25(2)(a).

A surrender of a lease may be either express or by operation of law. An express surrender must be by deed or in writing. A surrender by operation of law can be effected where a lessee delivers possession of the leased land that is accepted by the lessor. In both cases, the surrender consists of the yielding up of the term to the person who has the immediate estate in reversion. The lease term will then, by mutual agreement, merge in the reversion. [F26]

In Kennedy's case Hill J questioned whether a surrender by operation of law amounted to a conveyance of an interest in land. His Honour made no finding on the issue but made an assumption favourable to the lessor (that is, that no capital asset was acquired) and found that, even on this basis, the lease surrender payment was not an allowable deduction under section 51 of the ITAA 1936 because it was of a capital nature.

Whether a lease surrender by operation of law constitutes a conveyance of the lease term at common law was briefly considered by the High Court of Australia in Bagnall v. White . [F27] Griffiths CJ acknowledged that the exception in the Statute of Frauds for lease surrenders that can take effect without writing (such as surrenders by operation of law) may operate to make the surrender good as a matter of conveyancing, but then went on to find against the appellant on other grounds (see also Phene v. Popplewell ). [F28]

The form and effect of both express lease surrenders and surrenders by operation of law are described in Halsbury's Laws of England [F29] in the following terms: The surrender consists of the yielding up of the term to him who has the immediate estate in reversion in order that the term may, by mutual agreement, merge in the reversion ... The surrender vests the estate immediately in the surrenderee without express acceptance, but is made void by his dissent.

On the basis of these authorities, we accept that a lease surrender operates to convey or transfer the lease from the lessee to the lessor irrespective of whether there is an express surrender or surrender by operation of law. Consequently, for CGT purposes, the lessor acquires a CGT asset being the lease and is able to include the lease surrender payment in the cost base of that asset.

When a lease is surrendered to a lessor who owns the land, the lease merges into the land [F30] . The law of merger of a lease term at law and in equity is described in Halsbury's Laws of England [F31] in the following terms: ... where a term of years becomes vested in the owner for the time being of the reversion immediately expectant on the term, the term is merged in the reversion ... Where the term merges the covenants attached to it are extinguished.

The law on merger was summarised by Cozens-Hardy LJ in Capital and Counties Bank Ltd v. Rhodes : [F32] The rule of the former [Courts of Law] was rigid, that whenever a term of years and a freehold estate, whether for life or in fee, immediately expectant upon the term, vested in the same person in his own right, the term was merged in the freehold, whatever may have been the intention of the parties to the transaction which resulted in the union. The Courts of Equity, on the other hand, in many cases treated the interest which merged at law as being still subsisting in equity. They had regard to the intention of the parties, and, in the absence of any direct evidence of intention, they presumed that merger was not intended, if it was to the interest of the party, or only consistent with the duty of the party, that merger should not take place.

Thus, after the lease vests in the lessor, the leasehold estate merges into the reversion unless this would be contrary to the intention of the parties.

The statutes establishing the Torrens system are primarily concerned with the registration of titles to land and with the evidence by which titles are established, and do not change property law concepts such as the law of mergers. [F33] For example, subsection 69(2) of the Transfer of Land Act 1958 (Vic) confirms that when the Registrar of Titles records the surrender of a lease on a title '... the estate and interest of the lessee shall vest in the lessor or other proprietor of the reversion immediately expectant on the term'. In Shell Co of Australia Ltd v. Zanelli & Ors [F34] the NSW Court of Appeal held that a lease did not merge into the fee simple of Torrens title land until the Registrar-General noted the merger on the title.

The cost base of the merged asset is calculated in accordance with section 112-25 and would include the original cost bases of the lessor in the reversion and leasehold.

If the land was acquired before 20 September 1985 the merger of a lease into the freehold or the extinguishment of a lease created after 19 September 1985, does not affect the pre-CGT status of the land.

CGT event C2 in section 104-25 of the ITAA 1997 also happens to the lessor in relation to the discharge of its contractual rights under the lease agreement. As no capital proceeds are received for the discharge, the lessor may make a capital loss to the extent to which the reduced cost base of the rights asset (which could include incidental costs and any non-deductible incentive paid to the lessee on the grant of the lease) exceeds its market value (if any) (section 116-30(3A)). Whilst, in theory, a capital gain could arise, this is considered unlikely.

The following table summarises the income and capital gains tax consequences of lease surrender receipts and payments for both lessees and lessors. Lessee derives lease surrender receipt Assessable section 6-5? CGT No, unless: (a) received in ordinary course of business of trading in leases; (b) received as an ordinary incident of business activity; or (c) received from a profit-making business operation or commercial transaction. Otherwise a capital receipt. (Paragraphs 9, 27-35) Capital gain (CGT event A1 for the lease) (if receipt exceeds cost base); or Capital loss (if reduced cost base exceeds receipt) provided lease was used in producing assessable income. (Paragraphs 10-11, 36-39) Lessee makes lease surrender payment Deductible section 8-1? CGT Generally not, as a capital outgoing (cf. on revenue account if taxpayer in business of entering into and surrendering leases). (Paragraphs 12-14, 40-50) Not included in cost base of lease (no capital loss). (Paragraphs 15, 51-56) Lessor derives lease surrender receipt Assessable section 6-5? CGT Yes, if: (a) received in ordinary course of carrying on a business of granting and surrendering leases; (b) as an ordinary incident of business activity; or (c) received from a profit-making business operation or commercial transaction. Otherwise a capital receipt. (Paragraphs 16, 57-59) Possible capital gain or capital loss (CGT event C2 for the contractual rights under the lease). (Paragraphs 17-20, 60-68) Lessor makes lease surrender payment Deductible section 8-1? CGT Generally not, as a capital outgoing (cf. On revenue account if taxpayer in business of entering into and surrendering leases). (Paragraphs 21-23, 69-74) Forms part of cost base of land. (Paragraphs 21, 74-85) Possible capital loss (CGT event C2 for the contractual rights under the lease). (Paragraphs 24-25 and 75-87)

The following table cross references the provisions of the ITAA 1997 referred to in this Ruling to the corresponding provisions of the ITAA 1936. 1997 Act provision referred to Corresponding 1936 Act provision Section 6-5 Subsection 25(1) Section 8-1 Subsection 51(1) Subdivision 104-F Section 160ZT Section 104-10, CGT event A1 Subsection 160M(1) Paragraph 104-10(5)(b) Paragraph 160L(1)(b) Section 104-20(1) CGT event C2 Section 160N Paragraph 104-25(5)(b) Paragraph 160L(1)(b) Subdivision 110-A Section 160ZH Section 110-25 Subsections 160ZH(1) to (3) Section 110-35 Subsection 160ZH(7) Section 112-25 Subsections 160ZH(12) and (13) Section 116-20 Subsection 160ZD(1) Section 116-30 Paragraph 160ZD(2)(a) Subsection 116-30(3A) Subsection 160ZD(2A) Section 118-20 Subsection 160ZA(4) Section 118-40 Paragraph 160Z(9)(d)

We invite you to comment on this draft Taxation Ruling. Please forward your comments to the contact officer by the due date. Due date: 19 November 2004 Contact officer details have been removed following publication of the final ruling.

Below is a detailed contents list for this draft Taxation Ruling: Paragraph What this Ruling is about 1 Class of person/arrangement 1 Date of effect 7 Previous Rulings 8 Ruling 9 Tax consequences for a lessee who derives a lease surrender receipt 9 Section 6-5 9 CGT 10 Tax consequences for a lessee who makes a lease surrender payment 12 Section 8-1 12 CGT 15 Tax consequences for a lessor who derives a lease surrender receipt 16 Section 6-5 16 CGT 17 Tax consequences for a lessor who makes a lease surrender payment 21 Section 8-1 21 CGT 24 Avoidance of double tax and denial of double benefit 26 Explanation 27 Tax consequences for a lessee who derives a lease surrender receipt 27 Surrender of lease as a disposal of a capital asset 27 Lease surrender receipts as ordinary income 29 Is a lease surrender receipt of a lessee assessable under the CGT provisions ? 36 Tax consequences for a lessee who makes a lease surrender payment 40 Is a payment by a lessee to obtain the consent of a lessor to the surrender of a lease deductible under section 8-1 ? 40 What are the CGT consequences for a lessee who makes a lease surrender payment ? 51 Tax consequences for a lessor who derives a lease surrender receipt 57 Is a lease surrender receipt of a lessor assessable income under section 6-5 ? 57 Receipt in the ordinary course of business 57 Gain from profit-making undertaking or scheme 58 Is a lease surrender receipt of a lessor assessable under the CGT provisions ? 60 Tax consequences for a lessor who makes a lease surrender payment 69 Is a payment by a lessor to obtain a lease surrender deductible under section 8-1 ? 69 Example 74 What are the CGT consequences for a lessor who makes a lease surrender payment ? 75 Your comments 90 Detailed contents list 91