As businesses work their way through the current economic malaise they are assessing their long term future and addressing issues that are likely to present trading difficulties. One such difficulty can often be an onerous lease entered into at a time when rents were high and commercial space at a premium. The solution for a business in such circumstance can often be the surrender of the lease to the landlord; however, this can result in a surrender payment being made to the landlord. The tax consequences of the surrender of a lease are worth considering.
A surrender of a lease is a mutual acceptance by landlord and tenant of the end of the lease i.e. both the landlord and tenant agree the terms on which the lease will be given back to the landlord.
For the purposes of this article it is assumed that the payment on surrender of the lease is made by the tenant solely for the surrender rather than to discharge a different liability such as unpaid rent or dilapidations.
INCOME TAX AND CGT
The taxation of the surrender payment is dependent on a number of different factors such as the terms of the lease and the remaining duration of the lease. Where a surrender payment is made under the terms of the lease the payment will be treated as if it were a premium received by the lessor for the disposal of their interest in the lease. Section 98 Taxes Consolidation Act 1997 provides that a premium will be partly subject to income tax and partly to CGT. The split of the premium proceeds between income tax and CGT is determined by a formula:
Premium * (n -1)/50
This is best illustrated by way of example.
A landlord grants 25 years lease to a tenant, the lease provides for a surrender of the lease after 10 years for a payment of €10,000. After 10 years the tenant surrenders the lease. The computation is as follows:
Subject to income tax
Payment on surrender €10,000
€10,000 * (10-1)/50 €1,800
Subject to income tax €8,200
Subject to CGT €1,800
Schedule 14 Taxes Consolidation Act 1997 provides that the amount of the premium subject to CGT is deemed to arise from a separate transaction (i.e. not from the surrender) and is to be regarded as proceeds received for the disposal of
the lessors interest in the lease. As the landlord is unlikely to have any base cost in his interest in the lease no deduction from the consideration is likely to be available.
The taxation of a surrender payment that is not within the terms of the lease is a different matter. It would appear that such a surrender payment is not within the ambit of either section 98 Taxes Consolidation Act 1997 or schedule 14 Taxes Consolidation Act 1997. The legislation under section 98 reads “where under the terms subject to which a lease is granted”; while schedule 14 contains similar wording. The key point is that the surrender payment is not within the terms of the lease and thus outside of the scope of these sections. The taxation of the surrender payment must therefore be reviewed under normal CGT principles.
On surrender the landlord will have derived a capital sum from an asset and the provisions of section 535 Taxes Consolidation Act 1997 will apply. The key point is to determine from which asset the capital sum is derived; is the capital sum derived from the right to rent under the lease or is it derived from the landlords interest in the land? This is not an easy question to answer. Absent the landlords interest in the land no lease would exist however, without the lease there would be no surrender payment.
If it can be maintained that the surrender payment is derived from the landlord’s interest in the land then it will amount to a part disposal of the land and it may be possible to utilise some of the base cost of the land against the surrender proceeds thereby reducing the gain. HMRC in their guidance note CG71280 put forward the proposition that a surrender payment made outside the terms of the lease should be regarded as a capital sum derived from the landlord’s interest in the property rather than the lease itself. This is the more favourable view for the taxpayer of how a surrender payment should be treated for CGT purposes.
Revenue have published extensive guidance notes dealing with a number of different scenarios involving the taxation of leases; the reference to surrender payments outside of the terms of the lease reads as follows “Where a payment, which is not made under the terms subject to which the lease is granted, is received by a lessor for the surrender of a lease, the amount received should be treated as a part disposal of the lessor’s interest.” The reference to the lessor’s interest is vague. It would seem that by making reference to a part disposal occurring, the reference to the lessor’s interest is the interest the lessor has in the land rather than the interest in the lease; this is because following the surrender the lease no longer exists and therefore there can be no part disposal of the lease.
The alternative view is that the surrender payment is a capital sum derived from the right of the landlord to receive rent under the lease rather than from the landlord’s interest in the property. If this is the case it may not then be possible to offset a portion of the base cost of the landlord’s interest in the property against the capital sum received for the surrender.
The surrender of a lease, if it is in writing, is a form of conveyance. If the landlord pays the lessee to give up the lease there may be a conveyance on sale with stamp duty payable by the lessor. It may be possible to surrender a lease without documenting it; the tenant could hand over the keys and cease occupation. If there is a written record of the oral surrender, it is subject to stamp duty as a conveyance on sale. Where the lessee pays the lessor to surrender the lease there is no conveyance on sale and no liability to stamp duty should arise.
The VAT treatment of the surrender of a lease is a complex area. It is assumed in this article that the lessee is surrendering a long lease entered into before 1 July 2008 and that the lessee has full VAT recovery; as this is likely to be the most common case encountered in practice. Under the present VAT rules such a lease is regarded as a “legacy lease”. The surrender of a legacy lease is regarded as a supply of goods if the surrender occurs within 20 years of the creation of the lease. The landlord is obliged to account for VAT on the surrender on the reverse charge basis; the amount of VAT is calculated by reference to the VAT which originally arose on the creation of the lease as adjusted for the remaining Capital Good Scheme life of the property. There is a formula to calculate the tax payable:
T x N/Y
T = total tax incurred on the acquisition of the lease.
N = the number of full intervals, plus one, that remain in the adjustment period for the person making the assignment or
surrender at the time of making the assignment or surrender, and
Y = the total number of intervals in the adjustment period for the person making the assignment or surrender (cannot exceed 20).
The taxable amount is the tax payable amount re-grossed @ 13.5%. Any reverse premium payable by a tenant to a landlord in respect of the surrender of a legacy lease is considered outside the scope of VAT. The VAT chargeable on such an assignment or surrender is restricted to the amount calculated using the formula as outlined above.
DEDUCTIBILITY OF SURRENDER PAYMENT FOR LESSEE
It would seem that a payment to surrender a lease may not be deductible for tax purposes in computing the profits of a trade. Where the taxpayer’s trade is not a trade of buying and selling leases, a lease is a capital asset. The costs of acquiring or disposing of a lease may therefore be on capital account. Some consideration should be given to the deductibility of the lease payment and in this regard case law can be a useful aid. The case of Bullrun v CIR is relevant. Bullrun (a U.S. partnership) leased premises in London for a period of 10 years. The annual rent was £550,000 for five years following which it could be reviewed upwards. After four years the rent payable under the lease exceeded the market rent for similar premises and Bullrun wished to surrender the lease. Bullrun had claimed to deduct the amount paid by them to surrender the lease for tax purposes on the basis that the lump sum payment made to extinguish recurring revenue payments was prime facie a revenue payment. HMRC successfully argued that a surrender payment was not available as a trading deduction for tax purposes.
The taxation consequences of the surrender of a commercial lease can be quite complex; a full review of the terms of the lease is required before determining the tax position
This article first appeared in the March issue of taxpoint magazine