Binding Ruling on leasehold improvements

The South African Revenue Service (SARS) released binding private ruling 177 (Ruling) on 31 July 2014. The Ruling concerned a lease and a sublease and SARS was asked to rule on the income tax consequences for, inter alia, the landlord in circumstances where there is an obligation on the sub-lessee to make improvements to the land.

The proposed transaction was briefly as follows:

  • A lessor would lease its land to a lessee;
  • The term of the lease would be 99 years (renewable);
  • The lease agreement would permit the lessee to effect improvements on the land at the lessee’s cost, but placed no obligation on the lessee to do so;
  • The lease would however specify the type of improvements to be effected, and the time periods in which such improvements need to be completed, should the lessee decide to effect improvements;
  • The lessee would pay the lessor a monthly rental based on the development costs of any improvements effected;
  • The lessee would sub-let the land to a sub-lessee concurrently with the main lease;
  • The term of the sublease would be 99 years (renewable);
  • The sub-lease agreement would oblige the sublessee to effect improvements on the land; and
  • The sub-lessee’s rental would be based on the development costs of the improvements effected, which would increase after a period of time.

Applicable principles

Generally, and in terms of paragraph (h) of the definition of ‘gross income’ in s1 of the Income Tax Act, No 58 of 1962 (Act), where a right to have improvements effected on land or buildings accrues to a landlord in terms of a lease in any year or period, the landlord has to include in its gross income either:

  • the amount stipulated in the agreement as the value of the improvements or the amount to be expended on the improvements; or
  • if no amount is stipulated, the fair and reasonable value of the improvements.

Even though such a right would ordinarily constitute a capital accrual for the landlord, the Act specifically provides for bringing it into account as gross income for the landlord so as to prevent parties from disguising or converting rentals (which are usually revenue in nature) as capital accruals in the form of improvements to land or buildings being leased.

Technically, the relevant amounts must be included in the landlord’s gross income in the tax year that the right to the improvements accrues (which is usually when the agreement is entered into), but SARS has previously postponed the inclusion until such time as the improvements have been completed, even though this is not legally correct.

Where a lessee incurs expenditure in respect of effecting improvements on land under a lease, such expenditure would ordinarily not qualify for deduction under s11(a) of the Act because it constitutes capital expenditure. However, s11(g) of the Act provides for an allowance to be claimed by a lessee for expenditure actually incurred in respect of effecting improvements to land or buildings where it is obliged to do so under the lease, subject to various limitations.

Also, because a landlord may be required to include a substantial amount in its gross income under paragraph (h) of the definition of ‘gross income’ at the commencement of the lease, even though the landlord might only benefit (if at all) from the improvements when the lease terminates, relief is provided to the landlord in the form of an allowance in terms of s11(h) of the Act.

Essentially, s11(h) of the Act provides that a lessor may claim as an allowance an amount that “the Commissioner may deem reasonable, having regard to any special circumstances of the case” as well as having regard to the period over which the lessee may claim a deduction under s11(g) of the Act, subject to certain limitations.

SARS usually allows an amount equal to the difference between the value that the lessor has to include in its gross income and the present value of the improvements at that time. If that amount is allowed against the amount included by the lessor in its gross income, then the lessor would effectively only be taxed on the present value of the improvements, which amount reflects more accurately the value of the right that accrues to the lessor at the time of commencement of the lease.

Ruling

With reference to the proposed transaction, SARS ruled that:

  • the lessor should include in its gross income the ‘fair and reasonable value’ of the improvements effected by the sub-lessee (in accordance with paragraph (h) of the definition of ‘gross income’);
  • the lessor may claim an allowance in terms of s11(h) of the Act “…determined by using the present value of the actual development cost arising from the performance of the sub-lessee’s obligations under the sub-lease, discounted at the rate of 6 per cent of the 99-year period…”;
  • The sub-lessee may claim an allowance under s11(g) of the Act in respect of the expenditure that it will incur, over a 25 year period; and
  • If the sub-lease terminates pre-maturely and before the sub-lessee could claim all its allowances of the 25 year period under s11(g), it may claim the entire unredeemed balance in terms of s11(g)(vii).

Comments

The Ruling is significant because it applies paragraph (h) of the definition of ‘gross income’ to a landlord in circumstances where no right to have improvements effected accrues to that landlord in terms of the lease agreement – the right to have improvements effected accrues to the lessee in terms of the sub-lease agreement.

It therefore appears that SARS was willing to impute the terms of the sub-lease agreement on the lessor under the main lease.

The Ruling is not clear as to when the lessor should include the relevant amounts in its gross income ie the year the contract is concluded or the year the improvements are completed. As stated, the correct legal position is that the lessor must include the amounts in the year that the right accrues and not only in the year that the improvements are completed. It may however be very difficult to determine the ‘fair and reasonable value’ of the improvements at the time that the right accrues, depending on how specific the agreements are.

The Ruling also states that the lessor may claim an allowance in terms of s11(h) of the Act determined with reference to the present value of the ‘actual development cost’, as opposed to the ‘fair and reasonable value’ of the improvements that was included in the lessor’s gross income. The ‘actual development cost’ could actually be higher or lower than the ‘fair and reasonable value’ of the improvements and this could have an impact on the net amount that the lessor would effectively be taxed on.

An obvious concern here is also that the ‘actual development cost’ would only be known once the developments have taken place and the improvements have been effected. It is thus not clear whether the Ruling implies that the lessor should claim the allowance at the time of completion of the improvements.

It should also be noted that the Ruling makes it clear that the time period over which a lessee may claim an allowance under s11(g) of the Act (in this case 25 years), is not necessarily the same period over which amounts are discounted for purposes of s11(h) of the Act (in this case 99 years).

Interestingly, the Ruling does not mention any of the Value-added Tax consequences that could arise as a result of the supplies made by the parties.

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