Private ruling: Surrender of lease and 'make good' payment
Date of advice: 25 May 2018
Published: August 2018
Ruling period: 30 June 201X
Date scheme commenced: 1 July 201X

Ruling: Q1: Is the receipt for 'making good obligations' assessable under section 15-25 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes | Q2: 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? | A2: Yes

Relevant facts and circumstances: The property is a functional office/warehouse. On #, company A entered into a lease agreement for building of the property with company B, the tenant. Company C acts as trustee for the trust which was established on # when it acquired the property from company A. Since its acquisition, the Trust has held the Property as a commercial lease property (passive investment). This is the entity’s primary source of income. The Trust does not carry on a business of granting and surrendering leases. The Trust became the landlord under the existing lease agreement when it purchased the Property from company A in #. Company B subsequently requested that the Trust allow company B to surrender its interest under the lease (i.e. wanted to vacate early). The Trust agreed and Deed of Surrender of Lease agreement was signed by the Trust and company B on #. Company B vacated the premises on # in accordance with the Deed of Surrender of Lease. In addition, company B paid the Trust a Surrender Fee of $ plus GST of $ on #. The Surrender Fee was negotiated to include three components, comprising: a) Payment upon account of the agreed estimate of the cost to the Trust of assuming company B make good of the premises, with the Trust carrying out these works and releasing the tenant from this obligation under the lease- $; b) The payment of an agreed capital sum to compensate the Trust for releasing company B from the lease prior to its expiry date including its obligation to continue to pay rent and outgoings in accordance with the lease - $; and c) GST on the above amounts - $

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 receipt for 'making good obligations' assessable under section 15-25 of the Income Tax Assessment Act 1997 (ITAA 1997)? 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: Company B paid the following amount to the unit trust: $X described as 'make good' obligations under the lease and negotiated surrender of lease agreement. 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 trust 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. Nor does the section require a lease to have terminated before it can be said that obligations under it were failed. 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 unit trust was compensation for the breach. Section 15-25(c) of the ITAA 1997 is satisfied as company B used the premises to conduct business. Therefore, the premises were used for the purposes of producing assessable income. | Detailed Reasoning - Question 2: 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? 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 receipt described as being for the termination of the lease being $, is on revenue account. The unit trust is foregoing future assessable income in the form of rental income. The receipt is 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 - Conclusion:: The amount paid by the lessee for the Trust 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.