Lease inducement and lease surrender payments

Clauses 4B, 17B, 25B, 32B and 57(19B)

Issue: Policy considerations

Submission

(New Zealand Law Society)

Tax asymmetry is inherent and inevitable in a tax system that distinguishes between capital and revenue items. If the proposed amendments do proceed, it is important that the intended symmetry relied on to justify the proposed amendments is in fact achieved, and that the proposed amendments, once enacted, have a logical and reasonably certain application.

Comment

The current tax treatment of generally deductible but non-taxable lease inducement payments poses a risk to the tax base because it creates an opportunity for taxpayers to substitute tax-deductible rent payments with non-taxable cash lease inducement payments. Also, compared with other forms of lease inducements such as a rent-free holiday or a contribution for fit-out costs, these payments provide a tax advantage which distorts business decisions on leases.

To remove this distortion, it is necessary to modify the capital-revenue boundary for lease inducement payments to make them taxable to the recipient. This is in line with several measures in tax legislation where the judicially delineated capital/revenue boundary has been modified to counter arrangements based on converting revenue receipts into capital receipts. Past examples include redundancy payments, payments received for restrictive covenants and exit inducements.

The reforms included in this bill are limited to lease inducement and lease surrender payments, and are the result of the lease inducement payments review undertaken in July 2012. The proposed changes address the revenue risk associated with lease inducement payments and the “black hole” expenditure problem associated with lease surrender payments. They provide a consistent tax treatment of lease inducement and lease surrender payments by treating them as taxable to the recipient and deductible to the payer.

As announced by the Minister of Revenue on 11 December 2012, a wider review of the tax treatment of land-related lease payments is currently underway to rationalise the rules into a coherent regime. It is expected that an officials’ issues paper will be released for public consultation this year seeking feedback on the review.

Recommendation

That the submission be noted.

Submission

(KPMG, Corporate Taxpayers Group, Deloitte)

The submitters generally support the reforms.

Recommendation

That the submission be noted.

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Issue: Application date

Submission

(PricewaterhouseCoopers, Deloitte, Ernst & Young, Corporate Taxpayers Group)

The application date should reflect the Minister of Revenue’s media statement. (PricewaterhouseCoopers)

The application date should be made clearer, in particular the words “an amount that is…not derived as consideration for the agreement, before 1 April 2013, to a lease of land or a licence to use land”. (PricewaterhouseCoopers, Deloitte, Corporate Taxpayers Group)

The term “agreement” should be clarified as to what level of completion is necessary for the relevant lease agreement to be considered in existence before 1 April 2013. (Ernst & Young, Deloitte, Corporate Taxpayers Group)

Comment

The proposed wording of the application date is intended to reflect the Minister of Revenue’s media statement of 27 September 2012. It stated that the reforms will apply to lease inducement payments on commercial leases entered into on or after 1 April 2013.

This is a form of “savings” provision for taxpayers. It is intended to provide more business certainty for those who have entered into a lease (i.e. completed a binding lease agreement) before 1 April 2013, but who derive or incur lease inducement payments on or after 1 April 2013.

An alternative wording for the application date including the term “agreement” will be considered to better reflect the policy intent. Additional guidance on the application date will also be provided in a Tax Information Bulletin article following enactment of the bill.

Recommendation

That the submission be accepted, subject to officials’ comments.

Submission

(Ernst & Young)

That the application date for an amount derived or incurred for an agreement to a lease or licence to use land seems redundant for the lease surrender payments amendments in proposed sections CC 1C and DB 20C.

Comment

Officials recommend that the application date for lease inducement payment and lease surrender payment amendments be separated.

Recommendation

That the submission be accepted.

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Issue: Deductions for lease inducement payments

Submission

(KPMG)

Consideration should be given to allowing an immediate deduction for lease inducement payments.

Comment

The proposed timing rules spread income and deductions over the term of a lease. This approach, which is consistent with the method used for accounting purposes, recognises that lease inducement payments are all part of the price paid for the lease. Moreover, these payments relate to the securing of an asset – the lease with the tenant – and, in principle, the expenditure on an asset should be spread over its income-producing life. For these reasons, allowing an immediate deduction of these payments is not supported.

Recommendation

That the submission be declined.

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Issue: Timing of income and deductions for lease inducement payments

Submission

(PricewaterhouseCoopers, Deloitte, Chapman Tripp, Ernst & Young)

The term “spreading period” in proposed section EI 4B(1) should clarify the beginning and end of the spreading period. (Ernst & Young, PricewaterhouseCoopers, Chapman Tripp, Deloitte)

Express definition should be included as to the relevant period over which income and deductions should be allocated for situations such as those when there is an initial fixed term but the land right contains rights to renew or extend which may, or may not, be exercised in due course. (Ernst & Young)

Comment

The timing rule spreads income or deductions for lease inducement payments evenly over the term of a land right (for example, a lease). The “spreading period” in the rule determines the term of the relevant land right over which income or deductions are allocated.

The spreading period is intended to recognise a fixed period set either at the grant, renewal or extension of the land right. This approach is taken to avoid complexities around modifying the spreading period (and relevant income and deduction allocations) when the initial fixed period is later renewed or extended. Under the proposed rule, if there is a payment for a renewal or extension of the land right, the fixed period of the renewal or extension would be regarded as a separate spreading period.

Officials will consider an alternative wording for the timing rule, in particular, the term “spreading period” to better reflect the policy intent. Additional guidance on the timing rule will also be provided in a Tax Information Bulletin article following enactment of the bill.

Recommendation

That the submission be accepted, subject to officials’ comments.

Submission

(Ernst & Young)

A straight-line allocation method (similar to the approach applied for depreciation purposes for fixed life intangible property) for spreading income or deductions seems more straightforward and appropriate compared with the proposed spreading rule, which allocates income or deductions in equal portions to each income year.

Comment

Under the current approach, the amount of income or deductions may not be allocated consistently for taxpayers with the same duration of lease. This is because the allocation of income or deductions depends on the number of income years in the spreading period for a lease. For example, a lesser amount of income or deductions would be spread in each income year for a lease that begins half-way through an income year compared with a lease that begins at the start of the income year.

Officials accept that allocating income or deductions in equal portions to each income year may not allocate income or deductions proportionately to the actual number of months or days of the spreading period in an income year.

To better allocate income or deductions without requiring a complex set of rules, officials prefer the amount to be allocated proportionately to the number of months rather than the number of days. Officials consider this is a balanced approach of providing a simple, yet reasonably accurate allocation rule. This approach is also consistent with the suggested straight-line method in the depreciation rules.

Recommendation

That the submission be accepted, subject to officials’ comments.

Submission

(Corporate Taxpayers Group)

Transfers to associated persons should be treated consistently for income and deductions purposes to ensure that related entities are able to restructure their holdings of land rights or estates in land without adverse income tax consequences.

Comment

Under the proposed timing rule, a “wash-up” calculation of income or deductions is generally required in certain situations – for example, when a landlord transfers the reversion (i.e. the estate in land from which the land right is granted) or a tenant transfers their lease to a third party before the lease expires.

However, the “wash-up” calculation for deductions is not allowed if the landlord transfers the reversion to an associated person. In this case, the remaining deductions would continue to be spread over the remaining term of the lease. This is intended as a specific anti-avoidance measure to target situations when a lease inducement payment is made by a landlord who subsequently transfers the reversion to an associated person (a new landlord) to accelerate their deductions.

Officials do not agree that the tenant should continue to spread income over the remaining term of the lease if the transfer is between associates. Officials do not consider there is a need to treat transfers between associates differently from transfers between non-associates in relation to the timing of income.

Recommendation

That the submission be declined.

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Issue: Timing mismatch

Submissions

(New Zealand Law Society, Corporate Taxpayers Group)

There is a possible mismatch with the timing of capital contribution income (10 years) and deductions (spread over the term of a land right under the proposed timing rule). (New Zealand Law Society)

Income from lease premiums that is subject to section EI 7 (which spreads income over six years) should be subject to the proposed timing rule to ensure symmetry. (New Zealand Law Society)

Spreading of income and deductions for lease premiums should be consistent. (Corporate Taxpayers Group)

Comment

Officials accept there are some inconsistencies between the existing timing rule for lease premiums and capital contributions, and the proposed timing rule for lease inducement payments. These inconsistencies can be partly explained by the fact that the timing rules have been developed separately for particular payments over a long period of time.

As announced by the Minister of Revenue on 11 December 2012, the tax treatment of land-related lease payments is currently being looked at, with a view to providing a coherent and consistent tax treatment of these payments. The timing rules for these payments will be part of the review. It is expected that an officials’ issues paper will be released for public consultation this year seeking feedback on the review.

Recommendation

That the submissions be declined.

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Issue: Lease surrender payments

Submission

(New Zealand Law Society)

Drafting proposed income and deduction provisions for lease surrender payments (sections CC 1C and DB 20C) in the same way seems desirable.

Comment

Officials do not consider the same drafting format for income and deductions provisions for lease surrender payments is necessary or desirable. There is no general requirement that income and deductions provisions be structured in the same way. The current drafting achieves the policy intent of treating lease surrender payments as income to the recipient and deductible to the payer whether they are a landlord or tenant.

The income provision is drafted differently from the deductions provision – for example, the income provision specifies the recipient only, whereas the deductions provision specifies both the recipient and the payer. This is intended to sufficiently protect the tax base.

Recommendation

That the submission be declined.

Submission

(KPMG)

Proposed section DB 20C needs to be corrected because for lease surrender payments, the payer is the tenant, not the owner of a lease.

Comment

Lease surrender payments are generally made by a tenant to a landlord to surrender an existing lease before its expiry date. However, these payments can also be made by a landlord to a tenant. Hence, provisions relating to lease surrender payments are intended to cover both situations: proposed section DB 20C confirms deductibility of lease surrender payments for both landlords and tenants.

Recommendation

That the submission be declined.

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Issue: Definitions of “residential premises” and “tenant”

Submissions

(Ernst & Young, New Zealand Institute of Chartered Accountants)

The policy intent and drafting of the term “residential premises” should be clarified. (Ernst & Young)

The term “residential premises” should be defined. (New Zealand Institute of Chartered Accountants)

The term “tenant” should be defined. (Ernst & Young)

Comment

Under the proposal, lease inducement and lease surrender payments derived by a tenant of residential premises are not income of the tenant. The policy rationale for this exclusion is to provide symmetry of income and deductions for a tenant of residential premises. The tenant would not able to deduct these payments or rent because they do not meet the general permission in section DA 1 and the private limitation in section DA 2(2) would also apply.

Officials accept that some uncertainty may arise over what “residential premises” or “tenant” refer to. Having considered a number of Acts that define these terms, officials are not convinced that providing a specific definition for these terms would be helpful.

Alternative wording will be considered to better reflect the policy intent. It is expected that the exclusion would apply in a very limited circumstance because lease inducement and lease surrender payments are generally incurred or derived in a commercial context (i.e. between landlords and commercial tenants).

Recommendation

That the submissions to clarify the residential tenant exclusion in proposed sections CC 1B(4) and CC 1C(3) be accepted.

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Issue: Deductions for landlords of residential premises

Submission

(New Zealand Institute of Chartered Accountants)

The bill should be amended to allow deductions for lease inducement and lease surrender payments by landlords of residential premises.

Comment

Proposed sections DB 20B and DB 20C already allow deductions to a landlord of residential premises who makes lease inducement and lease surrender payments. The exception for tenants of residential premises is relevant for income purposes only.

Recommendation

That the submission be declined.

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Issue: Lease premiums and lease inducement payments

Submission

(Chapman Tripp)

The definition of “lease inducement payments” should be clarified as provisions relating to lease inducement payments are drafted very broadly and are not clear how these provisions interact with existing provisions.

Comment

Officials do not consider clarifying the term “lease inducement payments” is necessary. The current provisions sufficiently identify the type of lease inducement payments that are currently not taxable under the Income Tax Act 2007.

The income provision (proposed section CC 1B) is broadly drafted so that it includes both lease premiums (such as “key money” paid by incoming tenants to landlords) and lease inducement payments (paid by landlords to incoming tenants). Although lease premiums are already covered under section CC 1, the amount of income would be allocated to a person once because of the existing single income allocation rule in section BD 3(6).

The deduction provision (proposed section DB 20B) allows deductions for landlords who make lease inducement payments to an incoming tenant. The existing depreciation rules allow deductions for tenants who make lease premium payments to landlords.

Officials accept that these similar payments are covered under various regimes. The scheduled review of the tax treatment of land-related lease payments will seek to rationalise the various rules relating to lease payments. An officials’ issues paper is expected to be released for public consultation this year.

Recommendation

That the submission be declined.

Submission

(Corporate Taxpayers Group)

Proposed section DB 20B should be amended to allow deductions for “key money” paid by tenants to landlords. This would ensure that the existing asymmetry does not arise.

Comment

Proposed section DB 20B covers deductions for lease inducement payments only – deductions are allowed to landlords who make lease inducement payments to incoming tenants. Deductions for lease premium payments or “key money” made by incoming tenants to landlords are already covered under the existing depreciation rules.

Having two different deductions mechanisms for lease premiums and lease inducement payments that are similar in substance (i.e. payments to enter into a lease) is undesirable. In practice, it may create some inconsistencies and confusions over which mechanism applies to these payments. The scheduled review of the tax treatment of land-related lease payments will seek to rationalise the various rules relating to lease payments.

Recommendation

That the submission be declined.

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Issue: Rationalisation of provisions relating to lease payments

Submission

(New Zealand Law Society)

When a further review of lease payments is being contemplated, consideration should be given to how all provisions should fit together.

Comment

Officials agree there is a need to rationalise existing provisions and new provisions relating to lease inducement and lease surrender payments. The scheduled review of the tax treatment of land-related lease payments will seek to rationalise the various rules relating to lease payments. An officials’ issues paper is expected to be released for public consultation this year.

Recommendation

That the submission be noted.

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Issue: GST treatment

Submission

(New Zealand Institute of Chartered Accountants)

The GST treatment of lease inducement and lease surrender payments should be clarified.

Comment

The reforms included in this bill are intended to cover the income tax aspects only of lease inducement and lease surrender payments only.

Recommendation

That the submission be declined.

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Issue: Minor technical drafting issues

Submissions

(Deloitte, New Zealand Law Society, New Zealand Institute of Chartered Accountants, Corporate Taxpayers Group)

Submitters have made a number of technical suggestions to improve the provisions that are consistent with the policy intent. Officials agree with these submissions. These are outlined below:

• Certain amendments should be made to exclude capital contribution payments (such as contribution for fit-out costs) being subject to the proposed rules, in line with the policy intent. (Deloitte, New Zealand Law Society, New Zealand Institute of Chartered Accountants, Corporate Taxpayers Group)
• Proposed sections CC 1B(4) and CC 1C(3) should be amended to refer to a tenant or licensee of residential premises because these provisions would apply to both a leasehold estate and a licence to use land. (New Zealand Law Society, Corporate Taxpayers Group)

Recommendation

That the submissions be accepted.