Satwaki Chanda outlines the rules for landlords to calculate taxable income on the grant of a short lease, and highlights some pitfalls and practical issues.
When a landlord grants a short lease for a premium, part of the sum is taxed as income and the remainder is taxed as capital. This article takes a closer look at some of the key issues involved.
Starting point: Capital costs cannot be deducted against rental profits
This is the key to understanding why we have the lease premium rules. Probably the biggest cost that a landlord incurs is the acquisition cost of the rental property. However, because this cost is capital, no part of it can be deducted from the rent in calculating his income profits.
But suppose that instead of charging rent, the landlord required a premium to be paid upfront at the start of the lease. In these circumstances, the landlord is treated for capital gains tax (CGT) purposes as making a part disposal of his interest in the property, with the premium taxed as a capital receipt (TCGA 1992, Sch 8, para 2(1)). As a consequence, the landlord is able to deduct part of the CGT base cost of the property, together with any professional fees incurred in negotiating the lease (TCGA 1992, s 38(1)).
The amount that the landlord can deduct is calculated by multiplying the original base cost by the following factor:
P/(P+R)
where P is the 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 lease (TCGA 1992, Sch 8, para 2(1)).
Let us stop to look at this fraction for a minute and consider what it 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.
So should the landlord simply charge a premium instead of rent?
This would seem an ideal solution, since this way, he guarantees at least some tax relief for his acquisition costs – though as we have seen, the amount gets progressively smaller as the lease gets shorter.
Unfortunately, there is an additional hurdle when the lease is a short lease, being of a term of 50 years or less. In these circumstances, the premium is split into two parts – one part is taxed as capital, the remainder as an income receipt (ITTOIA 2005, s 277; CTA 2009, s 217; TCGA 1992, Sch 8, para 5).
The amount taxed as capital is given by the figure:
[(P x Y)/50]
where Y is the number of complete years that the lease is to run, less the first year. The amount of the property’s base cost is also reduced by adjusting the original formula mentioned above.
The amount taxed as income is simply the remainder:
P – [(P x Y)/50]
What do these figures mean?
Broadly, when the term of the lease gets shorter – equating to smaller values of Y – the result is that the amount that is taxed as capital decreases, with a correspondingly larger amount taxed as income. In short, a greater amount of the premium is taxed as rent, reducing the landlord’s ability to utilise the property’s base cost to shelter his tax liability.
This makes sense if one considers the question: ‘What would the tenant be prepared to pay for a lease that carried no obligation to pay any rent?’
If the lease is a long lease, this is a particularly valuable asset and one would expect a high premium to be paid. On the other hand, a shorter lease means a shorter rent-free period, and so one would expect a lower premium. If a short lease is granted for an unduly high premium, it begs the question: Is it really a premium, or is it really rent in disguise? To the extent that is the latter, the payment is taxed as rental income.
Possible trap for landlords: The lease premium rules can also apply to a long lease
Just because the term of the lease is more than 50 years doesn’t mean that a premium cannot be caught. This is because there are special rules to determine the length of a lease, which for tax purposes is not necessarily the same as it is in real life (ITTOIA 2005, s 303; CTA 2009, s 243). Without these rules, one could easily circumvent the lease premium rules, as the following example shows.
Example: Short lease in disguise
A landlord wishes to grant a seven-year lease for a premium, but isn’t too happy about the charge to income. The parties decide to enter a 99-year lease, containing two important clauses:
- the tenant has an option to terminate the lease after year seven; and
- the landlord has an option to increase the rent tenfold after year seven.
How likely is it that the tenant will continue to occupy the property after year seven? In substance, this is really a seven-year lease, and it is treated this way for tax purposes. If the tenant is also paying an abnormally high premium, it is more than likely that this is really rent in disguise – why is the tenant paying so much money if it is likely that he’ll be moving out in a few years’ time?
There are other rules whereby a lease is effectively extended for tax purposes. For example:
- 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; and
- if 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.
Is there any way round the lease premium rules?
No. Or rather, ways have been attempted, but they have been stopped!
We have seen how it is not possible to structure the term of the lease so that it looks like a 50-year lease in disguise. Neither is it possible for the landlord to direct the payment to a third party, who would normally be a connected party. There are also complex rules which prohibit the lease transaction being structured differently from a lease, but with the same economic effect.
Practical Tip:
A landlord who grants a lease at a premium should be wary of falling within the lease premium rules. Consideration needs to be given to whether the amount of the premium is realistic (is it really rent in disguise)? Furthermore, the rules can even apply if the lease is for more than 50 years, and special care needs to be taken in drafting the conditions to ensure that it is not a short lease for tax purposes.
