May 302013
 

When a landlord grants a lease, the tenant may be required to pay a premium in addition to regular rental payments. How is this premium taxed?

In this article we shall find that the answer is by no means a simple one. If the lease is a long lease, the premium is taxed as a capital receipt, but if the lease is a short one, part of this sum is taxed as income.

The meaning of what is long and short, and how much of the premium is taxed, will become clear in the following discourse.

(This article can be downloaded in pdf format at Academia.edu.)

Granting a lease is a CGT event

When a landlord grants a lease, he is treated as making a part disposal of his interest in the property1.

This fact is not always appreciated. In a normal buy to let business, where the tenant just pays the rent, no capital gains tax (“CGT”) is charged2. The reason is simple – no capital sum has been paid. But if a premium were to be paid, this sum would be taxed in addition to the rental payments.

However, unlike the rentals, the premium is taxed as a capital receipt. This means that the landlord is able to deduct part of the CGT base cost of the property, together with any professional fees incurred in negotiating the lease3.

The amount that the landlord can deduct is calculated by adjusting the original base cost by the following factor:

P/(P+R)

where P is value of the premium and R is the value of the landlord’s reversionary interest, together with the capitalised value of the rentals under the lease4.

Let us stop to look at this fraction for a minute and consider what this means. Suppose the landlord grants a long lease of 999 years. The reversionary interest is of very little value, and so the above fraction is nearly equal to unity. In other words, the base cost adjustment is minimal – which is what we would expect. Granting a 999 year lease is as good as selling the freehold – the tenant is getting a “home for life.” We should therefore expect that nearly all of the original base cost is allowable in this situation.

On the other hand, a short lease means a larger value for R – the landlord’s reversionary interest is more valuable, as he will soon be in possession again. The above fraction is therefore very small, so that there is very little to deduct in calculating the tax charge on the premium.

Note that this deduction isn’t possible against the rent. As noted in our first article on Starting a Property Business, rent constitutes an income receipt – it is not possible to deduct capital sums such as the cost of the property.

So is the solution for the tenant to pay a larger premium in return for a lower rent? This is ideal if capital treatment is more favourable than income – for example an individual property investor paying tax at higher rates, will pay only 28% on the premium as opposed to 40-50% on the rentals. There is also the advantage of obtaining an immediate tax deduction for the property.

Unfortunately, this is not as simple as it seems. There are two obstacles, both of them connected with the length of the lease:

  • First note that the lease needs to be long enough, so that the fractional adjustment to the base cost yields a substantial figure;
  • If the lease is a short lease – for 50 years or less – part of the premium is actually taxed as income, not capital. This is the effect of the lease premium rules, which we shall now look at in more detail.

What are the lease premium rules?

If a lease is granted for a term of 50 years or less, part of the premium is taxed as an income receipt. The amount chargeable is given by the formula:

P – [(P x Y)/50]

where P is the premium, and Y is the number of complete years that the lease is to run, less the first year5.

This looks like a frightening number, especially for those who aren’t too fond of maths. But if one takes a closer look, this formula helps to explain what is happening.

Essentially, the premium is being split into income and capital components. The above expression is the amount that is taxed as income – and if we subtract this figure from our original premium P, we get:

[(P x Y)/50]

This is the remainder – it is this figure that is taxed as capital6. Instead of adjusting the base cost by the factor:

P/(P+R)

the “P” part in this equation is replaced by [(P x Y)/50]. In other words, the CGT computation proceeds on the assumption that the lease was granted for this latter figure, rather than the amount that was actually paid.

The reasoning behind the lease premium rules is apparent from what we’ve said earlier about setting off capital costs against income. If we have a short lease, and a very large premium is paid, this begs the question – is it really a premium or is it just rent paid in advance? If it is an advance rental payment, there shouldn’t be a deduction at all. This is what HMRC have to say about it7:

“A premium paid for a very long lease is clearly a capital sum. If it is paid for a shorter lease it has a character more like rent paid in a lump sum rather than periodically. It is more akin to income, and the shorter the lease, the more like income it is.”

What exactly is a premium?

The HMRC Manual provides a useful explanation8. A premium is a sum paid on the creation of an interest in property. A distinction is made between:

  • A premium paid for the grant of a lease; and
  • Rent due under the lease.

In the language of the law of contract, the premium is the consideration paid by the tenant in return for the landlord letting out the property. However, as HMRC notes, there are cases where it is sometimes hard to distinguish whether a payment really is a premium, or simply rent paid in advance.

A premium is not limited to a cash payment. The landlord is also treated as receiving a premium if the terms of the lease require the tenant to carry out works on the premises. In these circumstances, the amount is calculated as the growth in value of the landlord’s reversionary interest9.

Note that this figure is not necessarily equal to the cost of the works. The landlord is taxed on the benefit received – so if the landlord holds his interest in the form of a headlease which has a short tem to run, there is very little benefit, no matter how much the works cost. The headlease will soon come to an end, and if there is no guarantee of renewal, the landlord is unlikely to profit by letting the property out again at a higher rental.

How long is a piece of string? Long leases and short leases

The length of a lease for tax purposes is not necessarily the same as the length for which it is actually granted. For example10:

  • A lease for 99 years but with an option to terminate after 7 years can be treated as a 7 year lease, if circumstances make it likely that the lease will be terminated. It is necessary that the premium paid by the tenant is similar to the premium one would expect for the shorter lease;
  • A lease for 35 years with an option to extend for another 60 years, can be treated as a 95 year lease, if circumstances make it likely that the lease will be extended;
  • At the end of the lease the tenant is entitled to be granted a further lease of the same premises, or even part of the premises. This can be considered as an extension of the original lease. This includes the case where it is a connected party rather than the tenant who moves into the property.

The reasoning is apparent when we consider the first example. Suppose the parties really want to grant a 7 year lease. The landlord isn’t too happy about part of the premium being charged to income, so instead a 99 year lease is granted, containing two important clauses:

  • An option to terminate the lease after year 7;
  • A ten-fold increase in the rent after year 7.

It is not very likely that the tenant will continue after 7 years. This is therefore regarded as a 7 year lease, provided that the premium paid is similar to one that would be expected for such a lease. The amount of the premium is important – it cements the argument that the parties are entering a short lease. If the premium is substantially higher than one would normally expect, this begs the question – why is the tenant paying so much money if it is likely that he’ll be moving out in a few years time?

Is there any way round the lease premium rules?

No. Or, rather, ways have been attempted, but they have been stopped!

For example, one cannot pay the premium to a party other than the landlord. The tax is payable by the person who is in receipt of the premium – whoever they may be11. This means that it isn’t possible for a landlord to direct the payment to a connected person, such as a fellow group member (assuming a corporate landlord). However, the third party need not be connected to the landlord at all.

Lease premium rules - third party payment
Lease granted at an undervalue

Another method is to grant the lease at an undervalue, and the tenant then assigns the lease to a third party12.

Lease premium rule - undervalue

Suppose in the above diagram, L and T are connected – they are in the same “family”, whether as fellow group members or an individual and his personal company. One can see that the arrangement is equivalent to granting a lease to the assignee A with a substantial premium.

But under the original rules only the amount paid to the landlord L is taxed as a premium and subject partly to income treatment. So instead of paying a market premium P, the tenant T pays a much smaller amount, (P – x). When T assigns the lease to A, the profit element y, is taxed as capital – this is not caught by the original rules as the latter applies only when a lease is granted.

Not any more.

In this situation, T is also treated as having received a premium. This is split into income and capital components in the same way as if a lease had been granted. The amount of the premium is either:

  • y, the profit element that T gains on the assignment; or
  • x, the amount foregone by L in granting the lease to T

whichever is the smaller. Note that if this second premium is deemed to be x, then the total amount treated as a premium is equal to:

  • (P – x) taxed as a premium for L; and
  • x – taxed as a premium for T

which adds up to P, the amount that L would have received had the lease been granted at market value.

Note that L and T don’t actually have to be connected for this rule to apply.

Sale and reconveyance

 What about the following?

Instead of granting a lease, sell the property, but with the right to have it reconveyed in a few years time (by which we mean 50 years or less). Since it is a sale of an existing property interest, rather than a grant of a new one, the lease premium rules don’t apply.

Lease premium rules - sale and reconveyance
They do now! And for good measure, T can’t reconvey the property to a party connected with L, and T can’t lease the property back either13.

In this case, the sale part of the transaction is equivalent to the granting of the lease, and the “reconveyance” equates to the lease coming to an end – the “landlord” is once again in possession of the property.

The term of the “lease” is the period between the sale and reconveyance – and if this is 50 years or less, the lease premium rules come into play.

In this case, the amount treated as a premium is (P – Q) – the excess of the sale price over the re-sale price. Note that this is the amount that eventually goes into L’s pocket, though it is taxed at the beginning of the transaction – there is at least a cashflow advantage here – L receives P, but is taxed on the smaller amount (P – Q).

Further points to note:

  • The property conveyed need not be the freehold – it can be a long leasehold; and
  • The reconveyance can take the form of T granting a lease back.

Additional points

There are a two other situations where the lease premium rules apply. In both cases, the landlord or a third party receives a capital receipt, which is treated as if a premium had been paid under a short lease.

  • ·The tenant pays to surrender a (short) lease14;
  • The tenant pays to waive or vary the terms of the lease, including the commutation of the rent15. The period over which the variation will apply is taken to be the length of the lease – so it is quite possible for a payment to be taxed as income even if the lease is over 50 years. For example, if the rent is commuted for two years, the tenant is treated as having paid a premium for a two year lease.

What about the tenant?

We have neglected the tenant in this discourse. The tax treatment of the tenant mirrors that of the landlord. That part of the premium that is treated as an income receipt for the landlord is normally treated as an income expense for the tenant16.

This is a very important result, as income expenses are deductible from business receipts. This is the key behind the idea that in certain circumstances a property landlord may be able to deduct a substantial part of the acquisition cost of the property. We shall see how this can be achieved in another article.

Links

HMRC Property Income Manual at PIM1200 – how premiums are taxed under a straightforward grant of a lease.

HMRC  Property Income Manual at PIM1210 – situations where a premium is deemed to have been paid, such as on a surrender of a lease, or variation or waiver.


 

  1.  TCGA 1992 Schedule 8 paragraph 2(1).
  2.  We shall use the term CGT to denote the tax payable when a capital sum is paid. Strictly only individuals and trustees pay CGT – companies pay corporation tax on their chargeable gains.
  3.  TCGA 1992 s 38(1).
  4.  TCGA 1992 s 42, Schedule 8 paragraph 2(2).
  5.  ITTOIA 2005 s 277; CTA 2009 s 217.
  6.  TCGA 1992 Schedule 8 paragraph 5(1).
  7. HMRC Property Income Manual PIM 1202
  8.  Ibid.
  9.  ITTOIA 2005 s 278; CTA 2009 s 218. However, no tax charge arises if the landlord would have obtained a deduction had he done the work himself – ITTOIA 2005 s 278(5); CTA 2009 s 218(5).
  10.  ITTOIA 2005 s 303; CTA 2009 s 243
  11. ITTOIA 2005 s 277(2); CTA 2009 s 217(2).
  12. ITTOIA 2005 s 282; CTA 2009 s 222.
  13.  ITTOIA 2005 ss 284, 285; CTA 2009 ss 224, 225.
  14.  ITTOIA 2005 s 280; CTA 2009 s 220.
  15.  ITTOIA 2005 ss 279, 281; CTA 2009 ss 219, 221.
  16.  ITTOIA 2005 ss 62, 292; CTA 2009 ss 63, 232. Note that this symmetry is by virtue of what the tax legislation says. There is no general tax rule that dictates that if a payment is income or capital for one party it is automatically income or capital for the other.
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Satwaki Chanda

Satwaki Chanda

Satwaki Chanda is a tax lawyer with a First Class degree in Mathematics. Called to the Bar in 1992, he is the Editor of Tax Notes.
Satwaki Chanda

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