It is common for tenants to be responsible for fit out costs for leased premises. Common law considers anything that is properly affixed to the land is part of the land and therefore owned by the owner of the land (i.e., the landlord). By installing an item of fit out in such a way that it becomes ‘part of the land’, a tenant may change the status of the object from a chattel to a fixture and convert ownership of that item to the landlord. Nonetheless, tax treatment does not necessarily follow common law, notably the taxpayer (i.e., landlord or tenant) who gets to claim a tax deduction. One that comes to mind is a deduction under Division 43 for construction expenditure incurred on certain capital works (including buildings) that are income producing.
Generally, an entity is entitled to a Division 43 deduction for particular capital works to the extent that it is the owner of the capital works. For a taxpayer who is a tenant, Division 43 has been extended to allow a deduction to the tenant notwithstanding the common law principle. For this to occur, the construction expenditure must have been incurred by the tenant and the building (on which construction work was undertaken) has been continuously leased by the tenant since construction was completed. The landlord is prevented from claiming a deduction for the same construction expenditure until the lease is terminated and there remains an amount of undeducted construction expenditure.
A matter that recently crossed our desk was in relation to a tenant seeking to claim a balancing deduction for an amount of undeducted construction expenditure when the leased premise was restored to its original state. The construction expenditure was incurred by a previous tenant and the balance remaining to be deducted was of substantial value. The previous tenant’s lease had been terminated and the current tenant had entered into a new lease.
Division 43 states:
The amount of the balancing deduction… is the amount (if any) by which the undeducted construction expenditure for the part of your area that was destroyed exceeds the amounts you have received or have a right to receive for the destruction of that part.
For earlier lessees’ expenditure, relevantly Division 43 states:
Your area is the part of the construction expenditure area that you lease… and that is attributable to a pool of construction expenditure incurred by another lessee…, and has been continuously leased or held since the construction was completed by the lessee …, or an assignee of that lessee’s lease…
The phrase “assignee of that lessee’s lease” is undefined in the Act. The Explanatory Memorandum to the Income Tax Assessment Act 1997 clarifies that if you are a lessee who did not incur construction expenditure, your area is the area you acquired by assignment from the lessee who incurred the expenditure (or one of their successors).
An assignment (according to common law principle) is the transfer by agreement of the interest held by one person (the ‘assignor’) to another person (the ‘assignee’) and includes another party taking over the residue of the term of a lease, or where possession is given up for the remainder of the term. It follows an assignment involves the transfer of all of the remaining interest in the original lease to the assignee. Where the earlier lessee’s lease is terminated, the new lessee is not an assignee of that lessee’s lease.
An assignment can be distinguished from a novation. An essential feature of novation is that the parties to the contract mutually agree to discharge that contract and a new contract is formed in substitution for the old contract. In ATOID 2012/4 the Commissioner considered the expression ‘assignee of that lessee’s lease’ means the entity to which the rights under the existing lease are transferred and concluded a novation was not an assignment of the earlier lessee’s lease.
An assignment can also be distinguished from a sub-leasing or sub-subleasing arrangement. In PBR 39465, the Commissioner concluded the sub-sublease granted by Company B (the original sub-lessee under which the construction expenditure was incurred) was not an assignment of the sublease. A deciding factor was the term of the sub-sublease was less than the term of the sublease. This is so notwithstanding the sub-sublease was subsequently assigned to the taxpayer.
It follows, in order to benefit from a Division 43 deduction for construction expenditure incurred by an earlier lessee, it is important to identify the lease under which the construction expenditure was incurred and to transfer that lessee’s lease to the taxpayer by way of assignment. This will be most relevant in the context of a lease transfer under a business sale arrangement where the amount of undeducted construction expenditure incurred by the business owner (the existing tenant) is substantial. A transfer of that lessee’s lease by way of assignment means the new tenant can access the benefit of a Division 43 deduction (including in certain circumstances, a balancing deduction where the tenant is required to restore the leased premise into its original state upon termination of the lease).