Private ruling: Capital gains tax - cost base - deductions - rental property expenses
Date of advice: 30 May 2016
Published: July 2016
Ruling period: Year ending 30 June 2016 | Year ending 30 June 2017
Date scheme commenced: 1 July 2015

Ruling: Q1: Is the payment of a strata levy to cover a lease premium, deductible as an expense incurred in earning rental income? | A1: No. | Q2: Can the payment of strata levy to cover a lease premium be included in the cost base of the property for capital gains tax (CGT) purposes? | A2: Yes.

Relevant facts and circumstances: Company A has a leasehold interest over the property via company title. The freeholder of the property is entity A. You own a share in the company A, which gives you exclusive use and occupation of a unit in the property as well as and shared use of common property You lease the unit to an unrelated tenant. You are due to pay a special levy to the lessor to cover the cost of a lease premium. The lease premium is to extend the period of the lease for a further period of 20 years commencing in the 2031-32 financial year If the lessee defaults under the lease agreement, and the lease is terminated the lessor has right to keep or recover the lease premium.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1, | Income Tax Assessment Act 1997 section 108-5 and | Income Tax Assessment Act 1997 section 110-25.

Reasons for decision: Detailed Reasoning - Rent vs lease premium: The terms of lease agreements entered into by a lessor and lessee are important, although not necessarily decisive, in determining the proper characterisation of an amount received by a lessor. The courts will look to the true nature of the transactions between the lessor and the lessee, and are not bound by the label which the lessor and lessee attribute to the transactions (Taxation Ruling TR 96/24). A lease premium is not defined in Australian tax law. It is therefore necessary to consider its meaning from an ordinary or legal perspective. A lease premium is consideration paid to the lessor for the leasehold interest over the asset, that is, the grant of a lease. This is distinguishable from rent which is the remuneration for the use and enjoyment of the leased property. Factors to be considered when determining whether a payment is prepaid rent or a lease premium are: • the provision for a refund - if the lessee is entitled to receive a pro-rata refund of the payment on termination of the lease it may indicate the payment is of the nature of prepaid rent (Taxation Ruling TR 2002/14) • the advantage sought by the lessee - where a payment is made by a lessee to secure an enduring advantage, such as the future use and advantage of an asset, it will be in the nature of a lease premium; and • the calculation of the payment - where a prepayment of rent has been made, it should be a capitalised amount that reflects a periodic outlay for the use of property for periods commensurate with the payment ( FCT v. Creer 86 ATC 4318). In this case, it is considered that the entitlement to a refund of the payment is very limited. This can be contrasted to a retirement village lease (as described in TR 2002/14) which will generally allow for a refund in a wide variety of circumstances. The length of time of the lease agreement is a significant amount of time; in addition the lease agreement gives the lessee the right to receive all benefits accruing to the owner of the land. The lease is a structural solution that effectively transfers 'economic ownership', though not legal ownership, to the lessee. The advantage sought by the lessee is an enduring kind; it will have the advantage of the use and enjoyment of the land for a significant period. You have paid a single lump sum payment in relation to the lease. The lease agreement explains that the payment is calculated by applying a percentage against the freehold value. The percentage will be the same as the number of years nominated to extend the lease. It is not considered to be commercially realistic to receive prepaid rent for such a significant period as the pricing of property would have considerable fluctuation during the period. In a standard lease contract, there will be a rent review clause (a periodic adjustment to reflect the market rate where rent is revised or indexed each year). It is therefore unusual that a lessor would lock themselves into a long term year lease without the chance to re-evaluate the rental as it is in this case. Therefore on the basis of all of the factors identified above it is considered, in substance, that the payment will not be in the nature of rent but will rather be full market value consideration for the granting of the lease for a certain period of time. The true nature of the payment is best described as a lease premium and is capital in nature. | Detailed Reasoning - Question 1: Section 8-1 of the ITAA 1997 allows a deduction for all outgoings to the extent to which they are incurred in gaining or producing assessable income. However, a deduction is not allowable for outgoings that are of a capital, private or domestic nature. Based on the above analysis it was determined that the lease premium amount paid by you has the character of a capital sum paid to obtain the grant of the lease. Therefore it is not deductible under section 8-1 of the ITAA 1997 as the payment is capital in nature. | Detailed Reasoning - Question 2: Section 108-5 of the ITAA 1997 explains that a CGT asset is any kind of property or legal or equitable right that is not property. While section 110-25 of the ITAA 1997 explains that the first element of the cost base includes money paid to acquire the CGT asset. As it was determined that lease premium amount paid by you has the character of a capital sum paid to obtain the grant of the lease, this amount would be included in the first element of the cost base of your CGT asset.