BIM35610 - Capital/revenue divide: intangible assets: inducements to enter a lease

Reverse premiums

The case described in the guidance that follows is relevant to periods before 9 March 1999. For reverse premiums received under agreements entered into on or after Budget Day, 9 March 1999, provisions in FA99/S54 and Schedule 6 ensure that they are treated as revenue receipts (see BIM41050 onwards).

The Judicial Committee of the Privy Council decided the case of Commissioner of Inland Revenue v Wattie and Lawrence [1998] 72TC639. Privy Council decisions are of ‘persuasive’ authority only in the UK; this means that courts and tribunals such as the Commissioners should treat them with respect but are not bound in law to follow them. Nevertheless, in this case the Privy Council, four out of five of whom were UK Law Lords, went out of their way to mention UK tax law at various points and also cited UK decisions such as Atherton v British Insulated & Helsby Cables Ltd [1926] 10TC155 (see BIM35010) and Strick v Regent Oil Co Ltd [1965] 43TC1 (see BIM35560). Furthermore UK courts have frequently cited the ‘Hallstrom’s’ test of ‘practical and business point of view’ as the correct test to apply. There is therefore no reason to suppose that the Law Lords’ decision would have been different if they had been hearing a UK tax appeal as the House of Lords. In other words you can assume that the decision expresses UK tax law as well as New Zealand tax law.

The New Zealand firm of Coopers & Lybrand received a sum of NZ$5 million as part of an arrangement whereby the firm entered into a lease of premises for the purposes of its business. This was done at a time when it was common practice for New Zealand property developers to draw up lease agreements, which recorded apparent rents in excess of the real cost of the right to possession. The apparent rent would inflate the apparent capital value of the building and in turn promote its financing and ultimate sale. Since tenants were not prepared to pay any more than actual market rates the parties would also sign a collateral agreement, containing enough in the way of ‘inducements’ to return the effective rental to actual market rates. The existence and content of the collateral agreement would be confidential to the parties.

The firm commenced negotiations with property developers, knowing that there was a strong tenant’s market, especially for an anchor tenant. It eventually came to an agreement with the owners of one building. The ‘incentives’ were a lump sum ‘inducement’ of $5 million, contributions to fit-out costs of up to $4.7 million and a monthly rent subsidy of $94,008. The ‘inducement’ receipt was paid into a suspense account and, after allowance for losses and costs of the move, was paid out to the partners. In its partnership tax return the firm included the monthly rent subsidy as assessable income but showed the $5 million ‘inducement’ as a capital receipt. The New Zealand Revenue assessed it as income.

It was common ground that for the purpose of determining the true character of the $5 million receipt the lease agreement and the collateral deed should be read as one. It was also common ground that the receipt did not arise from the firm’s ordinary business operations of the practice of an accountancy profession. The Revenue did not seek to challenge the deductibility for tax purposes of the above-market level of the rent payable under the lease. However, the Revenue contended that the $5 million was indistinguishable in principle from the monthly rent subsidy, which was agreed by the firm to form part of the revenue receipts of their business. The firm, on the other hand, contended that the $5 million was of the same nature as a normal premium under a lease and was thus a capital receipt in their hands. The Privy Council held that the $5 million was a capital receipt and was not assessable income.

The Privy Council asked what the $5 million was calculated to effect from a practical and business point of view. The Revenue contended that the commercial reality was that Coopers & Lybrand paid the rent in the lease only because of the $5 million and the other inducements. In essence the $5 million constituted reimbursement of revenue expenses. The Privy Council rejected this argument. It was true that the $5 million was ‘commercially, financially and mathematically’ linked to the rental payments. However, the same would normally be true of an ordinary premium paid by a lessee to a lessor upon the grant of a lease. Nevertheless (in the absence of special legislation to the contrary) such a premium had always been recognised, in the law of both New Zealand and the UK, as capital rather than revenue.

Similarly a lump sum payment made by a lessee to a lessor to secure the termination of an onerous lease was of a capital nature. In the case of Coopers & Lybrand the lessor paid the $5 million to the lessee for undertaking an onerous lease for a substantial period. It was the mirror image of a payment made to secure the termination of an onerous lease. There was no conflict between the legal nature of the payment and the practical and business effects it was intended to secure.

The effect of Wattie is that a reverse premium received under an agreement entered into before 9 March 1999 will be a capital receipt even if it is ‘commercially, financially and mathematically’ linked to an increased rent.

On the other hand it is still possible that a receipt described as a ‘reverse premium’ may be in substance a contribution to:

• revenue expenditure such as relocation costs, or
• capital expenditure with capital allowance or CG consequences (see BIM41080), CA14100 - CA14300 and CG70830 onwards.

But you should not argue for either of these possibilities unless there is clear evidence that the reverse premium is such a contribution, which will normally be in the document under which the reverse premium is payable. A reference in negotiations is unlikely to be enough.

There was no issue in Wattie regarding the deductibility of any part of the rent. However, given the attitude of the Privy Council it is most unlikely that they would have accepted the re- characterisation of any part of the rent as the repayment of a capital sum. You should not argue for this. It is possible that in some circumstances there might be a non-business purpose for the increased rent (for example, in Wattie itself where the reverse premium was credited to the partners’ accounts rather than to the profit and loss account) but such cases are likely to be rare. You should not argue for a non-business purpose just because the effect of the agreement is the receipt of a tax-free lump sum.