Leasing incentives and tax – hasten slowly
Rodney Timm, director of Property Beyond, provides some pointers about possible traps when it comes to leasing incentives.
In the current commercial property market, tenant leasing incentives are well-entrenched. Based on the dynamics of the market, with landlords seeking to attract quality tenants to their properties, the capital payments involved can be significant. For tenants contemplating a relocation or consolidation, leasing incentives are often essential as a contribution to fitout costs or rental reduction to support the office relocation business case.
But beware – it is best to ‘hasten slowly’ during negotiations and when structuring the leasing incentives.
Triggering an unexpected tax consequence can reduce the benefit of leasing incentives dramatically. But, by planning ahead, nasty surprises in financial accounts and company performance, can be avoided.
Leasing incentives have evolved for variety of reason. Suffice to comment that the total value of an incentive will depend on a range of factors including: the local market supply and demand conditions, the location of the premises, the amount of space taken, the length of the lease, the negotiating skills of the parties and the covenant of the tenant – that is, the perceived ability to pay the rent.
The leasing incentive can take many forms, including: cash payments direct to the tenant, contributions to fitout, payment for relocation costs, taking over lease-tail liabilities and rent-free periods or rent abatement – being reduced rent. The tax implications of these incentives, if not structured appropriately, can result in the incentive being treated as assessable income, as well as triggering GST and stamp duty consequences.
In structuring incentives, it is important to understand the landlord’s challenges in funding and managing them.
Cash payments and contributions require significant upfront capital and need to be funded. As a result, landlords will expect some form of guarantee from the tenant to secure the incentive amount.
In addition, landlords may be keen to ensure that the leasing incentive paid is invested in the premises via fitout and tenant improvements. Also, landlords may want to have access to the depreciation benefits of the fitout if this can be structured appropriately.
This article does not provide specific legal or tax advice; it gives some pointers about possible traps. In all major leases a tax accountant should review the documentation to ensure the tax consequences are fully understood.
Plus, it should be remembered that whatever the form of the leasing incentive, in terms of accounting standards this benefit needs to be accrued over the entire period during which benefit is calculated – another topic not covered in this article.
RENT-FREE AND ABATEMENTS
Leasing incentives in the form of rent-free periods or reduced rent rates are generally the simplest structure in understanding taxation implications. Generally, there will be no GST consequences for the tenant and the incentive will not be deemed to be assessable income, but obviously with reduced rental rates future rental cost tax deductions will be less. The tenant will thus receive the full cash-flow benefit of the rent-free period or abatement.
This structure may be particularly relevant in premises where the existing workplace layouts suit the incoming tenant needs. However, an ongoing rent abatement structure may not suit a landlord wishing to maintain a high headline face rental to underpin the future valuations of the property.
Although incentives in the form of cash payments to be spent at the tenant’s absolute discretion – legacies of the late ’80s and early ’90s – are seen less frequently in the current market, they may still occur in isolated cases.
In certain circumstances, the tenant with strong negotiating leverage may prefer a cash payment to support other business purposes – useful, but the landlord needs to be agreeable. Similarly, a cash payment incentive can be particularly beneficial to a tenant that is carrying a significant tax loss in their financial statements.
The taxation perspective of a direct cash payment made to a tenant will result in the tenant needing to remit GST for receipt of this. In addition, the payment will be treated as assessable income with the tax consequences bought upfront in the lease term.
This will result in a reduced net financial benefit of the incentive after the tax impost and will likely distort the profit and loss statements covering the first year of the lease. So it is crucial that the’ financial controller understand the impacts on the financial accounts before the lease is concluded. In addition, the landlord will obviously need to be supportive in paying a cash incentive.
CONTRIBUTIONS TO FITOUT
The taxation impacts of leasing incentives that are used as contributions to the tenancy fitout are more complex. Without appropriate structuring the tenant can unwittingly expose themselves to GST, assessable income and stamp duty implications.
One of the key aspects to consider in assessing the implications of incentives used as contributions to a fitout is whether the tenant or the landlord is deemed to be the owner of the fitout at the end of the lease period.
The simple approach to avoid negative tax treatment in the tenant’s financial accounts is for the landlord to provide the fitout and retain the ownership. In this case, there are no GST, stamp duty and assessable income consequences for the tenant, and the landlord will enjoy the depreciation benefits.
However, in these circumstances, the landlord must retain the ownership of the fitout and the tenant must not have a contractual obligation to remove the fitout at the end of the lease period. For this approach the tenant must be comfortable with the landlord managing the fitout installation.
However, usually the tenant prefers to manage their own fitout in the newly leased premises. In this case, the transaction will need to be structured differently.
The tenant should act as the agent for the landlord who will be paying the costs of the works as part of the leasing incentives. However, this structure may cause contractual liability issues between the landlord, the tenant and the fitout contractor, if not documented and managed appropriately.
It is also important to understand the GST implications with the tenant contracting for works on behalf of the landlord and any stamp duty implication where fitout may be transferred between the parties.
Issues related to make-good obligations and stamp duty payments are complex and usually require input from experienced lawyers.
So as not to trigger unexpected tax consequences for incentives used as contributions to fitout, the commercial terms need to cover the key aspects of the payments and the execution of the works including: the tenant acting as an agent for the landlord for the purposes of procuring the fitout, the tenant being reimbursed for the costs of the fitout up to the incentive amount by the landlord after the tenant has incurred the cost, the landlord retaining ownership of that portion of the fitout for which it has reimbursed the tenant and the tenant not having a contractual obligation to remove the fitout at the lease expiry.