Consider the following scenario, where we have a tenant occupying business premises which it wishes to vacate. The reasons could be various. For example, it has surplus office space, or perhaps the tenant is a big retailer who has discovered its mistake of opening a branch in a dead end part of town and now wants to make a “strategic withdrawal”.
In these circumstances, the tenant may be willing to pay the landlord a sum of money in order to free itself from its obligations under what has become an onerous lease. What are the tax implications of this transaction? In particular, is the tenant’s exit payment tax deductible?
In the following discourse we shall use the term income tax to denote the tax paid on income, and CGT – short for capital gains tax – for the tax paid on capital gains. Strictly, UK resident companies pay corporation tax, but we shall use these terms for the sake of convenience.
Furthermore, we shall concentrate only on the direct tax implications in this article. It is important to bear in mind that there are also SDLT and VAT issues to consider.
Tenant’s position – payment to surrender the lease is capital
The basic premise is that the tenant is paying the landlord to rid himself of an onerous capital asset, so the payment is capital1. Accordingly, no deduction against revenue profits is possible2. There is a limited exception in the case of a short lease, which has an effective duration of 50 years or less. We shall look at this exception in more detail below, as it is closely tied with the landlord’s position.
The surrender of the lease constitutes a disposal of an asset, but since the tenant isn’t being paid, there is no CGT charge. But can the tenant claim a capital loss which can be set against present or future gains? And more importantly, can the surrender payment be included in this loss?
The short answer to the second question is always “No.” The surrender payment can never be included in the CGT calculation for the following reasons:
- It is not enhancement expenditure, since it doesn’t reflect the state or nature of the asset at the time of disposal3. How can this be the case when the payment is consideration for surrendering the lease?
- It doesn’t fall within any of the listed categories as an incidental cost of making the disposal. These categories include fees on various professional services, such as surveyors, valuers, accountants and legal advisers4.
The best that the tenant can hope to achieve is a capital loss which will arise if a premium was paid on entering the lease. This will be the base cost of the asset5 – so if the consideration for surrendering the lease is nil, there is a loss at least equal to the value of the premium, together with any incidental costs incurred when the lease was granted. If no premium was paid, the base cost is nil and no capital loss arises at all.
In summary, the general position is that the surrender payment cannot be deducted from the tenant’s revenue receipts; neither does it contribute to any capital loss arising on the lease. Not a very satisfactory state of affairs.
What is the landlord’s position?
For the landlord, the payment is also capital, subject to the rules on short leases. However, the position is not straightforward. There is a distinction between the two following scenarios:
- The case where the terms of the lease provide for a payment on surrender; and
- The case where the lease makes no such provision.
We shall look at these two scenarios in turn.
What does the lease say? Lease provides for a surrender payment
The position isn’t great for the landlord. The surrender payment is also taxed as a capital gain, but he cannot utilise his CGT base cost to offset the liability. This sounds bizarre, but this is what the legislation actually stipulates.
If the terms of the lease require a payment upon surrender, this payment is regarded as a premium6. However, the landlord is treated as having disposed of his interest in the lease, and not the freehold, or the superior interest out of which the lease was granted7. No part of the landlord’s acquisition costs can be deducted from the payment, since the wrong asset is being disposed of.
If the lease is a short lease, the lease premium rules come into play. Part of the surrender payment is treated as revenue for both landlord and tenant8. While this doesn’t help the landlord either, the tenant will at least be able to deduct the appropriate amount from his business profits.
These issues are not so important for a tax exempt landlord such as a pension fund, or an offshore commercial landlord, who isn’t subject to CGT. However, the latter does bear the risk of income treatment where the tenant is surrendering a short lease.
What if the landlord and tenant make a separate agreement?
The landlord is much better off terminating the lease under a separate agreement.
The entire surrender payment is treated as a capital sum derived from an asset9. In this case, the asset is the superior property interest out of which the lease was granted. The landlord is treated as having made a part disposal and is now able to use an appropriate part of the acquisition cost to set against the capital gain10.
This is the position even for a short lease. The lease premium rules don’t apply to surrenders made outside the terms of the lease. So the landlord is safe – no part of the capital payment can be converted into income. But this also means that the tenant can’t claim an appropriate tax deduction. Is there another way to structure the transaction?
We shall look at the following three possibilities:
- Can part of the payment be regarded as a prepayment of rent?
- Can part of the payment be allocated towards dilapidations?
- Can the parties still use the lease premium rules by varying the lease in a suitable way?
Prepayment of rent
A prepayment should be distinguished from a payment made to commute future rental obligations in return for a lump sum:
- A prepayment is simply an early payment of rent due under the lease, and is deductible from income receipts;
- A rent commutation payment is capital, for which no deduction is allowed.
The line between the two is fine, but provided that one can argue that the payment is genuinely an early payment of rent, a deduction should be available.
As an example, suppose that the lease contains a break clause, exercisable at a future date. Surrendering the lease constitutes an early exercise of this clause, and the surrender payment represents the rent that the landlord would have been entitled to had the tenant made his exit in accordance with the terms of the lease.
If the tenant was obliged to make good any dilapidations during the term of the lease, it would have obtained a revenue deduction on the basis that the work constituted a “repair”. A lump sum payment to the landlord in lieu of dilapidations is therefore treated as an income expense and is tax deductible.
The tax treatment of the landlord is not as straightforward. The following is a summary setting out HMRC’s view11:
- If the landlord subsequently disposes of the property, or takes occupation, he is treated as having received a capital receipt. The payment is compensation for the landlord being required to take back his property in a dilapidated condition;
- If the landlord lets the property out again, the payment is “likely to have the effect of filling a hole in the landlord’s profits” and reflects the lower rent that will have to be charged. In short, it is compensation for lost profits and is taxed as income;
- However, if the landlord himself carries out the repairs and the tenant’s payment is a contribution towards those costs, the landlord can obtain a revenue deduction, on the net cost.
Lease variation method
Under a lease variation, the tenant pays the landlord a capital sum to vary the terms of the lease for a period of 2-3 years. The tenant is also granted the option to terminate the lease which it exercises shortly after this period expires.
Under the lease premium rules, the payment is treated just like a premium paid for the grant of a lease for a term equal to the variation period12. Since this period is less than 50 years, part of the payment is taxed as an income receipt in the hands of the landlord13. The tenant is able to deduct this same amount when calculating his own business profits, the deduction being spread over the variation period14.
The obligations being varied should be substantive and not be limited to simply reducing the rent. This is because these rules only apply if the payment is made “otherwise than by way of rent”.
This treatment applies irrespective of whether or not the lease itself provides for a payment to be made on the variation – unlike the case where the tenant pays the landlord to surrender the lease.
Note the downside for the landlord is that part of a capital sum is converted to revenue. However, at least the part taxed as capital is treated as a part disposal of the freehold or superior interest out of which the lease was granted15. This will enable the landlord to deduct the appropriate part of his acquisition costs.
This concludes the direct tax treatment of a tenant paying his landlord to surrender the lease. In a later article we shall consider what happens when it is the landlord who pays the tenant to move out.
HMRC Business Income Manual BIM35625 for the tax treatment of onerous leases.
HMRC Capital Gains Manual – CG71281 has an example of the tax position when the lease provides for a payment to be made on surrender. Compare the position at CG71282 where the parties make a separate agreement outside of the lease.
HMRC Property Income Manual PIM2020 on repairs and renewals.
- See the HMRC Manual BIM35625 for a comprehensive discussion of the authorities, including Mallett v The Staveley Coal and Iron Company Ltd (1928) 13 TC 772 and Bullrun v CIR (2000) SPC 248. ↩
- ITTOIA 2005 ss 33, 272; CTA 2009 ss 53, 210. ↩
- TCGA 1992 s 38(1)(b). ↩
- TCGA 1992 ss 38(1)(c), 38(2). ↩
- TCGA 1992 s 38(1)(a). ↩
- TCGA 1992 Schedule 8, paragraph 3(2). ↩
- TCGA 1992 Schedule 8, paragraph 3(4)(a). ↩
- ITTOIA 2005 s 280 and CTA 2009 s 220 for the landlord; ITTOIA 2005 ss 61, 292 and CTA 2009 ss 63, 232 for the tenant. ↩
- TCGA 1992 s 22. ↩
- See the example at HMRC Manual CG71282 and compare it to the example in CG71281, where the payment is made under the terms of the lease. ↩
- HMRC Manual PIM2020 has a section on dilapidations. ↩
- TCGA 1992 Schedule 8, paragraph 3(3). ↩
- ITTOIA 2005 s 281; CTA 2009 s 221. ↩
- ITTOIA 2005 ss 61, 292 and CTA 2009 ss 63, 232. ↩
- TCGA 1992 Schedule 8, paragraph 3(4)(b). ↩
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