Private ruling: Surrender of Lease and "Make Good" Payments
Date of advice: 7 December 2016
Published: October 2017
Ruling period: 1 July 2015 to 30 June 2016
Date scheme commenced: 1 July 2015

Ruling: Q1: Is the lease termination receipt assessable under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) in the year ended 30 June 2016? | A1: Yes | Q2: Is the receipt for “making good obligations” assessable under section 15-25 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A2: Yes

Relevant facts and circumstances: An entity entered into leases in in its capacity as trustee for various properties. The leases contained clauses imposing obligations on the lessee to return the premises to a particular state of repair. These were essential terms of the lease and entitled the lessor to damages. The buildings were no longer required due to a change in location of part of the industry. The entity sought releases/variations from the lease agreements it had in place. The trustee entered into a deed of variation and extension of lease of some properties and a Deed of Termination of Lease for others.

Relevant legislative provisions: Section 6-5 of Income Tax Assessment Act 1997 | Section 15-25 of Income Tax Assessment Act 1997

Reasons for decision: Summary: Is the lease termination receipt assessable under s 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) in the year ended 30 June 2016? | Detailed Reasoning - Reasons for decision: Taxation Ruling TR 2005/6 Income tax: lease surrender receipts and payments provides the ATO view on where it is considered a lease surrender is assessable income under section 6-5 of the Income Tax Assessment Act 1997 . Paragraph 17 of TR 2005/6 outlines the 'Tax consequences for a lessor who derives a lease surrender receipt’ and states: | Detailed Reasoning - Section 6-5: 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. Paragraph 17 of TR 2005/6 goes on to state that where the above is not applicable the lease surrender receipt is of a capital nature. In this case paragraph 17(b) of the Ruling applies as renting property is an ordinary incident of business activity and the payment was received as part of a normal business arrangement. Paragraph 17(c) of the Ruling would also apply as objectively the lessor had the intention or purpose of making a gain by renting the property to the lessee; to derive rental income. The receipts described as being for the termination of the lease are on revenue account. The entities are foregoing future assessable income in the form of rental income. The receipts are not compensation for the loss of a capital asset but to compensate the lessor for a reduction in future rental receipts. The amounts must be treated as ordinary income and assessable under section 6-5 of the ITAA 1997. | Detailed Reasoning - Question 2: Is the receipt for “making good obligations” assessable under section 15-25 of the Income Tax Assessment Act 1997 (ITAA 1997)? | Detailed Reasoning - Amounts received for failing to comply with lease obligation to repair: Section 15-25 of the ITAA 1997 specifically states: Your assessable income includes an amount you receive from an entity if: (a) you receive it as a lessor or former lessor of premises; and (b) the entity pays you the amount for failing to comply with a lease obligation to make repairs to the premises; and (c) the entity uses or has used the premises for the * purpose of producing assessable income; and (d) the amount is not assessable as * ordinary income under section 6-5. | Detailed Reasoning - Application of 15-25 of the ITAA 1997: The lessee paid amounts to the unit trusts described as make good obligations under the lease therefore section 15-25(a) of the ITAA 1997 is satisfied. The requirement of section 15-25 (b) of the ITAA 1997 is also satisfied as the relevant amounts paid to the unit trusts were for failing to comply with the covenants in the lease to make repairs. Section 15-25(b) only requires that there is an obligation to make repairs to the leased premises it does not require an earn out. Nor does the section require a lease to have terminated before it can be said that obligations under it were failed. A clause in the lease document required the lessee to: …put maintain repair and keep the demised premises including all machinery and plant equipment fixtures, and things for the time being contained in or affixed to the premises and owned by the Lessor) in good and safe and substantial repair working order and condition… Another clause stated: The Lessee hereby further covenants with the Lessor: (a) That the Lessee will at the expiration or sooner determination of this Lease peaceably surrender and yield up to the Lessor the whole of the demised premises and every part thereof in good and substantial repair order and condition in accordance with the covenants on the part of the Lessee… Section 15-25 of the ITAA 1997 does apply to treat the payment as assessable income as the relevant leases did contain a make good covenant which was breached when the lease was terminated. The nature of the payment received in the hands of the relevant entity was compensation for the breach. Clauses in the relevant leases state certain clauses are essential terms and entitle the lessor to damages. Section 15-25(c) of the ITAA 1997 is satisfied as the lessee used the premises to conduct a business for the purposes of producing assessable income. Section 15-25 specifically states the appropriate tax treatment where all the requirements in the section are met. | Detailed Reasoning - Conclusion:: The amounts paid by the lessee for failure to comply with a lease obligation to make non capital repairs to the premises used for producing assessable income would be deductible to the lessee under s25-15 of the ITAA 1997. Therefore, the amounts received and described as “make good payments” are not capital amounts in their true nature but assessable under s15-25 of the ITAA 1997 in the hands of the lessor.