ATO ID 2010/30: Capital allowances: business related costs - limitation of deduction - in relation to a lease or other legal or equitable right
Date of decision: 14 January 2010
Year of income: Year ended 30 June 2006 Year ended 30 June 2007 Year ended 30 June 2008
Business line: Public Groups and International

Issue
Does paragraph 40-880(5)(d) of the Income Tax Assessment Act 1997 (ITAA 1997) apply to limit the taxpayer's deduction under section 40-880 of the ITAA 1997 for a Capital Appreciation Payment that it makes to the lessee upon termination of a lease?

Decision
Yes. Paragraph 40-880(5)(d) of the ITAA 1997 applies so that the taxpayer has no deduction under section 40-880 of the ITAA 1997 for the Capital Appreciation Payment that it makes to the lessee upon termination of a lease.

Facts
The taxpayer carries on a business of operating a retirement village on land that it owns. The retirement village contains a number of residential units and facilities in respect of which the taxpayer provides general services for which they charge a fee. As part of their business of operating the village, they lease the residential units to residents for a term of 99 years. Pursuant to the lease agreement, the resident agrees to pay to the taxpayer on the date the lease agreement is entered into an ingoing contribution to secure a right to reside in the retirement village. The ingoing contribution includes an interest-free loan to the taxpayer, which makes up the majority of the contribution, and a smaller amount for the purchase of fixtures, fittings and furnishings. The amount of the loan is based on an estimate of the market value of the right to reside at the time the lease is entered into. Pursuant to the lease agreement, the taxpayer must repay the loan to the resident on termination of the lease. Also on termination of the lease, the resident is entitled to receive an amount referred to as the Capital Appreciation Payment. The Capital Appreciation Payment is capital expenditure incurred by the taxpayer, calculated by reference to the amount by which the ingoing contribution paid by the new incoming resident exceeds the ingoing contribution earlier paid by the outgoing resident. The taxpayer's capital expenditure was incurred 'in relation to your business' for the purpose of paragraph 40-880(2)(a) of the ITAA 1997 and the taxpayer's deduction for that expenditure under section 40-880 of the ITAA 1997 is not limited by subsection 40-880(3) of the ITAA 1997.

Reasons for decision
Summary: (All legislative references are to the ITAA 1997 unless otherwise stated) Section 40-880 provides a deduction over five income years for certain business related capital expenditure. Paragraph 40-880(5)(d) provides that you cannot deduct anything under section 40-880 for an amount of expenditure you incur to the extent that it is in relation to a lease or other legal or equitable right. A 'lease or other legal or equitable right' is not defined in the legislation. However, in respect of paragraph 40-880(5)(d), paragraph 2.68 of the Explanatory Memorandum to Tax Laws Amendment (2006 Measures No. 1) Bill 2006 states: This exclusion replicates that found in the repealed section 40-880, having been added in 2002 in the context of the Government's review of the treatment of expenditure incurred on leases or other legal or equitable rights. The 2005-6 Budget announced that the Government would take a case-by-case approach in relation to the taxation of rights. Since that paragraph states that the exclusion contained in paragraph 40-880(5)(d) replicates that found in the repealed section 40-880, it is relevant to consider the former paragraph 40-880(3)(d). In discussing the former paragraph 40-880(3)(d), paragraph 3.67 of the Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 5) 2002 states: The Government is reviewing the treatment of expenditure incurred in relation to leases or other legal or equitable rights as part of the consideration of the recommendations of the Review of Business Taxation. The appropriate income tax treatment of capital expenditure incurred in relation to these leases and rights will be determined as part of that review. Consequently, capital expenditure on leases or other legal or equitable rights will be excluded from deduction under section 40-880. For example expenditure representing lease surrender payments incurred in closing down your business will not be deductible under section 40-880. It is therefore relevant to consider what 'leases and rights' were considered in the recommendations of the Review of Business Taxation in order to determine the intended scope of the expression 'in relation to a lease or other legal or equitable right' in paragraph 40-880(5)(d) and the former paragraph 40-880(3)(d). Section 10 of the Review of Business Taxation, A Tax System Redesigned, Report, July 1999 , made recommendations in relation to the taxation of leases and rights. While that report did not explain what was encompassed by the expression 'leases and rights', it can reasonably be inferred that it was referring to the sorts of 'leases and rights' outlined in the Review of Business Taxation, A Platform for Consultation, Discussion Paper 2 Volume 1, February 1999 , which included 'leases and similar contracts which provide rights over physical assets'. On the facts, the lease arrangements between the taxpayer and the residents are of the type considered by the Review of Business Taxation (in the context of its review of the taxation of leases and rights) to be leases that would be covered by paragraph 40-880(5)(d). However, for paragraph 40-880(5)(d) to apply in this case, the capital expenditure, being the Capital Appreciation Payment, incurred by the taxpayer must be 'in relation to' the lease. The phrase 'in relation to' was considered by the High Court in PMT Partners Pty Ltd (In Liquidation) v. Australian National Parks & Wildlife Service (1995) 184 CLR 301. Brennan CJ, Gaudron and McHugh JJ observed, in considering the application of the Commercial Arbitration Act 1985 (NT), at 313: Inevitably, the closeness of the relation required by the expression 'in or in relation to' in s 48 of the Act, indeed, in any instrument - must be ascertained by reference to the nature and purpose of the provision in question and the context in which it appears. In that case, Toohey and Gummow JJ also observed: It is apparent that the words 'in or in relation to' are particularly wide. ... Cases concerning the interpretation of this phrase in other statutory contexts are of limited assistance. However, the cases do show that the words are prima facie broad and designed to catch things which have sufficient nexus to the subject. The question of sufficiency of nexus is, of course, dependent on the statutory context. (at 330) ... The connection which is required by the phrase 'in relation to' is a question of degree. There must be some 'association' which is 'relevant' or 'appropriate'. The question of the relevance or appropriateness of the connection is a question which cannot be divorced from the particular statutory context. (at 331) In First Provincial Building Society Limited v. Federal Commissioner of Taxation (1995) 56 FCR 320; 95 ATC 4145; (1995) 30 ATR 207, Hill J considered the phrase 'in relation to' within the context of paragraph 26(g) of the Income Tax Assessment Act 1936 . He considered the words 'in relation to' in that context included a relationship that may either be direct or indirect, provided that the relationship consisted of a real connection, but that a merely remote relationship is insufficient. Thus, whether capital expenditure is incurred to any extent 'in relation to' a lease or other legal or equitable right will depend on whether there is a sufficient and relevant connection between the incurrence of the expenditure and in this case, the lease. In this case, the Capital Appreciation Payment is calculated by reference to the amount by which the ingoing contribution paid by the new incoming resident exceeds the ingoing contribution earlier paid by the outgoing resident. Although the Capital Appreciation Payment is dependent upon an increase in value of the right to reside over the term of the lease, the payment is required to be made by the taxpayer to discharge their contractual liability to the outgoing resident under the terms of the lease between the taxpayer and the outgoing resident. As such, the Capital Appreciation Payment will be 'in relation to' the lease as a sufficient and relevant connection exists. Subsection 40-880(6) provides that the exception in paragraph 40-880(5)(d) does not apply to expenditure that is incurred to preserve (but not enhance) the value of goodwill if the expenditure is incurred in relation to a legal or equitable right and the value to the taxpayer of the right in question is solely attributable to the effect that the right has on goodwill. The taxpayer is in the business of operating a retirement village, which includes leasing the units that it owns to residents. The Capital Appreciation Payment, was incurred by the taxpayer to pay an obligation arising from the termination of a lease as part of the normal trading operations of the business and therefore, the Capital Appreciation Payment has value to the taxpayer that is not solely attributable to goodwill. As such, the operation of paragraph 40-880(5)(d) is not impacted by subsection 40-880(6). Accordingly, paragraph 40-880(5)(d) applies to prevent a deduction that might otherwise be available under section 40-880 in respect of the Capital Appreciation Payment incurred by the taxpayer.

Legislative references: Income Tax Assessment Act 1936 paragraph 26(g)
Case references: PMT Partners Pty Ltd (In Liquidation) v Australian National Parks & Wildlife Service (1995) 184 CLR 301
Other references: Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 5) 2002 Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 Review of Business Taxation, A Tax System Redesigned, Report, July 1999 Review of Business Taxation, A Platform for Consulation, Discussion Paper 2 Volume 1, February 1999
Subject references: Blackhole expenditure Capital Allowances CoE Leasing Retirement villages Uniform capital allowances system