The Inland Revenue and Treasury have released an ‘Issues Paper,’ proposing to make lease inducement payments taxable.
The proposed legislative change aims at ‘asymmetric tax treatment of lease inducement payments (which) encourages taxpayers to convert revenue receipts into non-taxable capital receipts.’
In other words, officials do not like the fact that a property owner can get deductible (revenue) treatment while a tenant has non-taxable (capital) treatment.
The following scenarios occur under the proposals.
A lease inducement payment will be taxable. Technically, any amount derived by a person (or an associate) to enter into, or in connection with, an arrangement that grants an estate or interest in, or a right in or over, land would be taxable.
Non-cash benefits, such as contributions to a lessee’s start-up or relocation costs or in satisfaction or forgiveness of a lessee’s obligations under a lease would also be subject to tax.
The deductibility rules for lease inducement payments are unchanged.
Income and deductions will be spread on a straight-line basis over the period of the lease arrangement or until the first rent review is due, whichever is shorter.
The new rules would become effective from July 26, 2012.
From a tax policy, and pragmatic, view point we strongly disagree with the proposals.
The Asymmetry
The reason given for this change is the asymmetry between the non-taxable receipt to the lessee and the (generally) deductible payment by the lessor.
However, there are numerous other examples in the tax system where there is an asymmetry, including in favour of the Crown (i.e. where the receipt is taxable but the payment is not deductible).
For example, a bank that lends to a homeowner is taxed on the interest received, but the homeowner is generally not allowed a deduction.
Similarly, if you sell your car to a car dealer, the dealer can claim a deduction for the cost when they subsequently sell the car (as this will be their trading stock).
However, the sale proceeds are not taxable to you.
These examples are due to the private/business distinction.
There are also business-to-business differences.
For example, a service can generate taxable income for the provider while being treated as non-deductible (black hole) expenditure for the recipient.
No justification
Asymmetry is a feature of our tax system. It does not justify a change particularly when correcting the assumed asymmetry is ‘one way’ only.
The proposals do not seek to confirm deductibility for the lessor.
This means, potentially the reverse asymmetry could arise; the tenant would have a taxable receipt, while the property owner could have a non-deductible payment.
If asymmetry is the problem, then it needs to be dealt with comprehensively.
The proposed changes override a significant and well established body of case law, most notably the Court of Appeal and Privy Council decisions in ‘Wattie,’ which confirmed that a lease inducement was a capital receipt when it was compensation for giving up the right to be able to assign the lease for a considerable period of time.
The concern that rentals subsidies could be ‘dressed up’ as lease inducements have also been considered in the case law, and we believe there is support in those cases to distinguish between the two, on the facts.
We accept that any case can be overridden as a matter of tax policy but the headline policy remains that New Zealand does not and should not have a capital gains tax.
Unjust outcome
A continual, ad hoc and inconsistent attack on the capital/revenue distinction means that headline policy is increasingly untrue and, perhaps worse, will continue to generate unfair and unjustified outcomes.
It is also worth noting that the proposals will require spreading not just of the receipt but also the expense (to the extent this is deductible).
While the rules around the timing of the expense are not clear, and may turn on the facts, we note that most lessors are likely to claim an upfront deduction for lease inducement payments.
The proposals therefore go beyond simply changing the rules for recipients of lease incentives.
The other concern is the attempt to ‘legislate by issues paper.’
The application date of the proposals is the date of the publication of the document, for leases entered into on after that date.
While we can see the rationale, this is a retrospective change.
It will create uncertainty over the treatment of such payments in the interim, until legislation (if any) is passed.
We therefore do not support such an application.
The proposals will have wide application to businesses that lease premises, and building owners, both of whom will need to factor in the tax effects.
We strongly advise clients to make their views known by the August 31, 2012 submission date.
Ross McKinley and John Cantin are Tax Partners at KPMG based respectively in Auckland and Wellington. Darshana Elwela is the firm’s National Tax Director based in Auckland.
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