High Court confirms a lease surrender payment is a revenue receipt in the hands of the landlord
2017 case note - High Court confirms a lease surrender payment is a revenue receipt in the hands of the landlord – capital, unacceptable tax position.
The taxpayer is a commercial landlord and received a lump sum payment from one of its tenants for early termination of a lease. The Court held that where the taxpayer is in the business of leasing property the lease surrender payment was received by the taxpayer in the ordinary course of the taxpayer’s business and was therefore a revenue receipt subject to tax. However, as the case was not clear cut, a shortfall penalty was not appropriate.
The judgment provides assistance in distinguishing between capital and revenue receipts. However, in the case of lease surrender payments, the impact is limited as the Income Tax Act 2007 (“ITA”) has been amended to make it clear that lease surrender payments are income in the hands of the recipient (see s CC 1C of the ITA effective from 1 April 2013).
Easy Park Limited (“the taxpayer”) purchased the four storey Whitcoulls building at 312 Lambton Quay on 28 June 2003. At the time of purchase the building was subject to a 12 year lease by the anchor tenant Whitcoulls Group Limited of levels 1, 1A and 2 of the building. Levels 3 and 4 of the building were later leased to Lifestyle Gym.
When the building was purchased there were no identified earthquake concerns. However, a new earthquake building code was introduced in 2004. In 2007 the Wellington City Council advised the taxpayer that its initial evaluation had placed the building at 11% of the new building standards. The taxpayer commissioned a report which provided that the Whitcoulls building met 16% of the new building standard. Consequently, in 2010 the Wellington City Council issued a notice requiring the taxpayer to strengthen or demolish the Whitcoulls building by 2025.
Whitcoulls Group Limited went into voluntary administration in February 2011. The business was sold to Whitcoulls 2011 Limited (“W2011 Ltd”) in May 2011 and the lease was assigned to the new owners. W2011 Ltd announced publicly that it intended to move to the nearby premises at 226 Lambton Quay.
In June 2011, W2011 Ltd and the taxpayer agreed to surrender the lease and a deed of surrender of lease was signed in February 2012. W2011 Ltd agreed to pay the taxpayer $1.1 million for the early termination of the lease (about a third of the rent remaining).
Bayleys’ commercial leasing team advised the taxpayer that it would need to undertake the required strengthening work in order to attract a quality tenant. While the extent of the remedial work was assessed, the taxpayer agreed in principle to lease levels 1, 1A and 2 to Hallenstein Glassons Limited. An agreement to lease was signed on 5 December 2012 with an annual rent of $1.1 million. As part of the agreement the taxpayer was required to undertake the strengthening work to at least 85% of the new build standard, and was to use its best endeavours to obtain at least 95%.
In February 2013, a deed of surrender of lease was signed with Lifestyle Gym in order to obtain vacant possession and complete the strengthening work. Once the strengthening work was completed Glassons opened its new flagship store on levels 1, 1A and 2 of the building in October 2013. Level 4 was eventually leased to Harrison Grierson in 2014. Level 3 remained vacant.
When the taxpayer filed its tax return for the 2012 income year, it treated the lease surrender payment as a capital receipt (and therefore not subject to income tax) and provided a covering letter drawing the Commissioner of Inland Revenue’s (“the Commissioner”) attention to the treatment of the payment. The Commissioner assessed the payment as income and applied a shortfall penalty for taking an unacceptable tax position.
The Court canvassed the general principles relating to the distinction between capital and revenue payments and receipts. The Court noted that there is no New Zealand decision in which it has been held that a lease surrender payment received by a landlord is a capital receipt but did look at the relevant cases touching on lease surrender payments. However, the Court noted that these were primarily from the perspective of the payer/lessee rather than the recipient/landlord. Further, the Court considered it clear from the authorities that a payment made to induce a lessee to enter into a lease of premises from which to conduct their business will, in the hands of the lessee, be capital as the payments are made with a view to bringing into existence an asset for an enduring benefit.
The Court rejected the five key points advanced by the taxpayer supporting an argument that the principles relating to the lessee should also apply to the landlord. The Court also rejected the argument that the Court of Appeal decision of Commissioner of Inland Revenue v McKenzies (NZ) Ltd 2 NZLR 736 (CA), supported the proposition that the “identifiable asset” approach means leases must generally be regarded as fixed capital in the hands of both the lessee and lessor.
The Court held that it was not correct to say that the “identifiable asset” test will always be regarded for income tax purposes as capital, regardless of the nature of the taxpayer’s business. What is required is an examination of what the relevant transaction and the receipt was calculated to effect from a practical and business point of view in the specific case at hand. That requires examination of the nature of the asset viewed in the context of the taxpayer’s particular business.
In this case the Court accepted that the asset was the lease and that in the hands of W2011 Ltd, it was a capital asset. However, the Court was unable to accept that the lease was a capital asset in the hands of the taxpayer. The lease did not form part of the taxpayer’s underlying business structure and it was not only indirectly connected with producing revenue. Rather, the lease was the very mechanism which generated profit for the taxpayer and was the taxpayer’s core business.
The Court did not consider that the lease was so fundamental and permanent to the taxpayer’s business that its surrender affected the structure of the taxpayer’s business. The revenue producing asset was the leasehold which could be, and was, made the subject of another lease. Further, the nature of the lease surrender payment in the hands of the taxpayer was not affected by the need to undertake earthquake strengthening work, or the fact that the subsequent lease was on less favourable terms.
The test for determining whether the tax position taken by the taxpayer is an unacceptable tax position for the purposes of s 141B of the Tax Administration Act 1994 is an objective one. The Court held that there was no authority which squarely determined the position against that taken by the taxpayer. Further, public rulings are not binding on taxpayers and in any event the fact that there was a public ruling on the matter arguably suggests that its subject matter may be difficult or controversial. The Court held that the capital/revenue divide is notoriously oblique and it is conceivable that circumstances could yet arise where a lease surrender payment might properly be regarded as capital in the hands of the lessor. Accordingly, on balance no shortfall penalty should be imposed.
Section CB(1) Income Tax Act 2007, Section 141B Tax Administration Act 1994