Journal of Australian Taxation
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WHEN WILL LEASE INCENTIVES BE OF AN INCOME NATURE?
By Neil Bellamy and Associate Professor Stephen Barkoczy
Despite being a fundamental issue in taxation law, the question of what constitutes “ordinary income” is by no means settled and continues to frequently arise before the courts. In particular, a series of recent cases dealing with lease incentive payments have considered this issue in some detail. This article examines these cases with a view to developing a set of principles relating to when such paymets will constitute ordinary income.
It has been eight years since the Full Federal Court handed down its controversial decision in FC of T v Cooling[1] in which it held that a lease incen-tive payment received by a firm of solicitors constituted income according to ordinary concepts. Since then, the Commissioner has sought to apply Cooling to other cases involving lease incentives. In addition, he has also sought to apply the principles on which that case is founded to cases involving “lease surrender payments”. While the Commis-sioner succeeded before the Administrative Appeals Tribunal (“AAT”) in Case 57/94[2] and Case 22/95[3] and before the Full Federal Court in Rother-wood v FC of T[4], he failed in his three most recent attempts before the Courts in Lees & Leech Pty Ltd v FC of T,[5] Selleck v FC of T,[6] and Montgomery v FC of T.[7] In each of these cases, the Court was able to distinguish Cooling.
The purpose of this article is to examine the con-cept of “ordinary income” in the light of the cases dealing with lease incentives relating to business premises.[8] The article analyses and contrasts the judgments in the various cases. It also considers the Commissioner’s ruling on lease incentives con-tained in Income Taxation Ruling IT 2631 and indicates where this ruling is flawed given the deci-sions in the cases. The article concludes by providing clear propositions which establish the cir-cumstances in which lease incentive payments will and will not constitute income. It also concludes by making some important observations on the future scope of what the writers have termed the “ordinary incident of the business activity” principle devel-oped in Cooling.
Lease incentives are inducements offered by landlords to entice tenants to enter into leases of their premises. They are common in a “tenants’ market” where there is an oversupply of commer-cial premises available for rent. As pointed out by the Commissioner in Income Taxation Ruling IT
2631, the incentives can take various forms, includ-ing cash payments, non-cash items such as motor vehicles, holiday packages, rent-free periods, free fit-outs and payments for the surrender of an existing lease.
The lease incentive cases have concerned the principles established in Californian Copper Syn-dicate Ltd v Harris[9] and FC of T v The Myer Emporium Ltd.[10]
Californian Copper is authority for the well-entrenched canon of taxation law that a gain arising out of an act done in carrying on a business is of an income nature.[11] Californian Copper concerned a one-off profitable sale of land. The Scottish Court of Exchequer found that notwithstanding that there was only an isolated transaction involved, the tax-payer had been trading in the land and therefore should be assessed on the profit.[12] In the course of delivering his judgment, Lord Justice Clerk exam-ined the position where an owner of an investment (such as a security) realises it at a profit and stated “enhanced values obtained from realisation or con-version of securities may be so assessable, where what is done is not merely a realisation or change of investment, but an act done in what is truly the car-rying on, or carrying out of a business”.(emphasis added)[13]
The High Court in Myer relied on Californian Copper for the proposition that where a gain is made from an isolated business operation or com-mercial transaction entered into otherwise than in the ordinary course of a taxpayer’s business, the gain may nevertheless still be of an income nature provided the taxpayer had the requisite profit-mak-ing purpose at the time the transaction was entered into. In a famous joint judgment, Mason ACJ, Wil-son, Brennan, Deane and Dawson JJ stated in what is known as the “first strand” of the decision that:
Although it is well settled that a profit or gain made in the ordinary course of carrying on a business constitutes income, it does not fol-low that a profit or gain made in a transaction entered into otherwise than in the ordinary course of carrying on the taxpayer’s business is not income. Because a business is carried on with a view to profit, a gain made in the ordinary course of carrying on the business is invested with the profit-making purpose, thereby stamping the profit with the charac-ter of income. But a gain made otherwise than in the ordinary course of carrying on the business which nevertheless arises from a transaction entered into by the taxpayer with the intention or purpose of making a profit or gain may well constitute income. Whether it does depends very much on the circum-stances of the case. Generally speaking, however, it may be said that if the circum-stances are such as to give rise to the inference that the taxpayer’s intention or pur-pose in entering into the transaction was to make a profit or gain, the profit or gain will be income, notwithstanding that the transaction was extraordinary judged by reference to the ordinary course of the taxpayer’s busi-ness. Nor does the fact that a profit or gain is made as the result of an isolated venture or a ‘one-off’ transaction preclude it from being properly characterized as income ... The authorities establish that a profit or gain so made will constitute income if the property generating the profit or gain was acquired in a business operation or commercial transact-tion for the purpose of profit-making by the means giving rise to the profit.[14]
The Court went on to say in Myer that:
a receipt may constitute income, if it arises from an isolated business operation or com-mercial transaction entered into otherwise than in the ordinary course of the carrying on of the taxpayer’s business, so long as the tax-payer entered into the transaction with the intention or purpose of making a relevant profit or gain from the transaction.[15]
When Californian Copper and Myer are read together, it is apparent that they stand for two sep-arate principles both of which give rise to income:
The first principle is the “ordinary business income” principle which applies to gains made in the ordinary course of carrying on a business.
The second principle is the “first strand of Myer” which relates to extraordinary gains.
There is, however, a common thread underlying the two principles - both principles rely on the exis-tence of a profit-making intention. In this respect, it has been noted that:
it is the existence of a profit-making intention on the part of a taxpayer which deter-mines whether a profit realised by the taxpayer is income. Where the profit arises from the ordinary business activities of the taxpayer, that intention is inferred. However, where the profit arises outside the taxpayer’s ordinary business activities it is necessary to separately establish that profit-making inten-tion by examining the taxpayer’s subjective intention at the time of entering into the rel-evant transaction.[16]
The taxpayer in FC of T v Cooling[17] was a part-ner in a Brisbane firm of solicitors operating out of premises leased by its service company. Since its establishment in 1939, the firm had occupied premises in four different buildings. In 1985, agents for “AMP” sought to attract the firm as tenants to AMP’s new premises in Comalco House. The prospect of moving premises was not unattractive to the firm due to the fact that the configuration of space in the existing premises was regarded as “pretty unworkable” and there was no emergency power. It was eventually agreed that in return for the partners of the firm procuring their service compa-ny to accept a lease in Comalco House, AMP would make cash payments to the individual partners totalling $162,000. The payments were initially used by the partners to fund the move and fitting out of the premises. The fit-out was then sold to a financier and leased back to the partners. The evi-dence established that at the time in Queensland it was an ordinary incident of leasing premises to receive such incentives.
The taxpayer was assessed on his share of the lease incentive payment received by the firm. The Full Federal Court (Lockhart, Gummow and Hill JJ) held that the payment constituted income according to ordinary concepts assessable under former s 25(1) of the Income Tax Assessment Act 1936 (Cth) (“ITAA36”). In delivering the leading judgment, Hill J was influenced by the decision in Lister Blackstone Pty Ltd v FC of T[18] in which the High Court held that the cost of moving stock and plant from one set of leased premises to another was deductible under former s 51(1) of the ITAA36 to a distributor of imported agricultural equipment. According to his Honour, this showed that a “firm does not cease business when it moves from one set of leased premises to another”.[19] In a subsequent passage that has borne much examination in later cases, Hill J stated:
Where a taxpayer operates from leased premises, the move from one premises to another and the leasing of the premises occu-pied are acts of the taxpayer in the course of its business activity just as much as the trad-ing activities that give rise more directly to the taxpayer’s assessable income. Once this is accepted, the evidence established that in Queensland in 1985 it was an ordinary inci-dent of leasing premises in a new city building, at least where the premises occu-pied were of substantial size, to receive incentive payments of the kind in question. Why then should a profit received during the course of business where the making of such a profit was an ordinary incident of part of the business activity of the firm not be seen to be income in ordinary concepts?[20]
The Court also held that the first strand of Myer applied to the arrangements. According to Hill J, “the transaction entered into by the firm was a com-mercial transaction; it formed part of the business activity of the firm and a not insignificant purpose of it was the obtaining of a commercial profit by way of the incentive payment”.[21] On this view an incentive payment can fall within the first strand of Myer, notwithstanding that it was not necessarily the sole or dominant purpose of a firm moving premises, so long as it was a “significant” purpose behind the move.[22]
Hill J observed that the result reached in the case accorded with common sense. This was because the firm had the choice between a rental holiday (which would have resulted in a smaller tax deduction for its rental payments, assuming the rental holiday was passed on by the firm’s service company), or taking the lease incentive payment and not having a rental holiday (which would have resulted in a larger tax deduction for its rental payments and the receipt of an amount in the form of assessable income).
The conclusion that the lease incentive in Cool-ing fell within the first strand of Myer is, in the writers’ opinions, not controversial and is a correct application of the principles enunciated by the High Court in that case. However, the conclusion that the payment constituted assessable income on the basis of the reasoning in the above quoted passage of Hill J warrants closer examination.
The relevant passage indicates that a gain from a transaction which is an “ordinary incident of the business activity of the taxpayer” will be of an income nature. The question which arises is whether this establishes a new principle of taxation law or whether it merely represents a broad view of the “ordinary business income” principle.
Put in another way, there are two ways of look-ing at the above quoted passage:
On one view, the passage can be seen as stating that while the lease incentive did not arise from a transaction which formed part of the ordinary course of the firm’s business (which was to pro-vide legal services), it nevertheless represented a gain from a transaction which was an ordinary incident of the business activity of the firm (which included moving from one set of premis-es to another) and therefore should be treated as assessable. On this view, Hill J was stating that a gain may be of an income nature if it arises outside the ordinary course of carrying on a tax payer’s business, so long as it is an ordinary incident of the business activity of the taxpayer. It thus establishes a distinct jurisprudential prin-ciple which we shall refer to as the “ordinary incident of the business activity” principle in this article.
Alternatively, the passage can be seen as stating that the firm’s business not only involved pro-viding legal services but also leasing premises and that since the receipt of the lease incentive was an ordinary incident of one of these activi-ties, it should be treated as assessable. On this view, Hill J was merely adopting a broad factu-al view of what fell within the ordinary course of carrying on the firm’s business and was there fore simply applying (albeit widely) the “busi-ness income principle”.
Comments made by a number of Federal Court Justices in several cases following Cooling appear to sanction the “ordinary incident of the business activity” principle as a separate jurisprudential test. It was again explained by Hill J (with whom Lock-hart and Gummow JJ concurred) in the Full Federal Court decision in Westfield v FC of T[23] when his Honour stated:
When in Myer the High Court spoke of prof-its made in the ordinary course of business, their Honours were not speaking in a tempo-ral sense. Rather ... it is necessary that the purpose of profit-making must exist in rela-tion to the particular operation. In a case where the transaction, which gives rise to the profit, is itself a part of the ordinary business (eg a profit on the sale of shares made by a share trader), the identification of the busi-ness activity itself will stamp the transaction as one having a profit-making purpose. Sim-ilarly, where the transaction is an ordinary incident of the business activity of the tax-payer, albeit not directly its main business activity, the same can be said. The profit-making purpose can be inferred from the association of the transaction of purchase and sale with that business activity. The cases on profits and losses of insurance companies and banks are examples. (emphasis added)[24]
Hill J’s approach was also adopted by Drum-mond J in the Federal Court decision in Selleck v FC of T,[25] by Black CJ, Lockhart and Beaumont JJ at the Full Federal Court level in Selleck[26] and by Lockhart J in the Full Federal Court decision in Montgomery v FC of T.[27]
However, support for the “ordinary incident of the business activity” principle is not universal - Heerey J in Montgomery declined to follow the decision in Cooling for the same reasons that per-suaded the majority of the New Zealand Court of Appeal in Wattie and Anor v Commissioner of Inland Revenue[28] not to follow the decision. In that case, the facts of which mirrored those in Cooling, a majority of the Court of Appeal (Richardson P, Gault, Henry and Blanchard JJ) stated:
With due respect to the contrary view taken in Cooling, the business of a professional firm, conducted along normal lines, does not include its dealings with its lessor which are necessary if the firm is to be suitably housed. The business of a firm of accountants is accountancy and perhaps the provision of management consultancy and other services, but it cannot sensibly be said to be in the business of dealing with leaseholds because it is obliged to have rental accommodation.[29]
The issue of the assessability of what was described as a “lease surrender” payment but what, in substance, could be regarded as a “lease incen-tive” payment arose in Rotherwood v FC of T.[30] The case concerned a taxpayer which was the cor-porate beneficiary of a discretionary trust established for the benefit of the family of a partner in a firm of solicitors (“Freehills”). The trustee of the family trust held units in the Freehills’ service trust (“CHUT”) that had as its trustee “Chancery Services”, which provided secretarial and other ser-vices to Freehills and also sub-leased office premises.
Due to concerns about the level of Chancery Services’ indebtedness, a new service trust (“FHP”) was created, the trustee of which was “FHP Ser-vices”. Shortly afterwards, the head lessor agreed to pay Chancery Services $6 million for the surrender
of the lease and licence (which had no marketable value at that time) and to thereupon enter into a new 10 year lease of the office premises and licence of the parking bays with FHP Services at an increased rental. At the time, supply of office space exceeded demand and it was common for landlords to offer inducements to prospective tenants to encourage them to take leases.[31] Upon entering the new lease, Chancery Services ceased to operate as Freehills’ service company and the services it had previously provided to the firm were thereafter provided by FHP Services.
Most of the $6 million payment was distributed between the unit-holders in CHUT including Chancery Services which in turn distributed a por-tion of the amount it received to the taxpayer. The Commissioner treated the $6 million received by Chancery Services as being of an income nature and thus assessed the taxpayer on its share of the distribution received through the family trust pur-suant to s 97 of the ITAA36.
The Full Federal Court held that the $6 million payment was received in the ordinary course of Chancery Services’ business of providing various services to Freehills and thus constituted income under the “ordinary business income” principle. According to Lee J (with whom Spender and O’Loughlin JJ concurred):
Given ... that it was part of the business of Chancery Services to dispose of property according to its utility as determined by Free-hills, it should have followed that the circumstances described above were inci-dents in the ordinary course of the business of Chancery Services stamping the sum received for the surrender with the character of revenue within the meaning of sub-sec 25(1). It was the business of Chancery Ser-vices to serve the practice conducted by the Freehills partnership including negotiating terms of occupancy under which Freehills could be a sub-lessee, and if surrender of the lease under which Chancery Services was Freehills’ sub-lessor was necessary to advance the interests of Freehills, it was part of the business of Chancery Services to carry out that step. The fact that the surrender of the lease for that purpose was coincident with the termination of Chancery Services’ services to the partnership meant that the sur-render could not be isolated and identified as a mere act of disposal of an asset in the wind-ing-up of the business.[32]
The Court rejected the taxpayer’s argument that the lease and licence had been realised in order to put an end to Chancery Services’ business. Thus, the fact that the payment was described as a “sur-render payment” rather than a “lease incentive” did not benefit the taxpayer. Lee J went on to state:
The surrender was not unrelated to, and inde-pendent of, the other elements of the arrangement involving FHP and Freehills. Chancery Services would not have offered the surrender unless those other elements of the arrangement were in place. The surrender was one step in a set of integrated steps designed by Chancery Services, FHP and Freehills to take advantage of extraordinary market conditions and provide to Chancery a sum described as a fee payable for the sur-render of the lease. The sum so generated and received represented a gain to Chancery Services produced by the arrangement not a sum produced by mere realization of a capi-tal asset.[33]
The Court also held that the $6 million was assessable under the first strand of Myer on the basis that it arose from a business operation or com-mercial transaction entered into by Chancery Services for the purpose of making a profit.
Two AAT cases handed down prior to Rother-wood had demonstrated the willingness of the Tribunal to apply the first strand of Myer to not only a lease incentive payment but also a lease surrender payment where the intention of the taxpayer in obtaining the payment was a significant object of the relevant transaction.
Case 22/95[34] concerned a partner in a firm of accountants which operated from premises leased by the firm’s service company. Shortly before the lease was due to expire, the partners inquired as to the rent likely to be payable if the firm renewed their current lease. The amount was found to be far in excess of the current rent and the firm sought alternative premises. Shortly afterwards, the part-ners agreed to procure the firm’s service company to take a lease of premises in a new building in the city in consideration of the payment of $2,416,134 to the partners by the landlord. Purvis J (sitting as Presidential member of the Tribunal) held that the taxpayer should be assessed on his share of the incentive payment on the ground that the first strand of Myer applied:
the arrangement entered into by the partners, the trustee company and the trust formed a part of the business activity of the partners and ‘a not insignificant purpose of it was the obtaining of a commercial profit by way of the incentive payment’.[35]
A year earlier, Purvis J had come to a similar conclusion in Case 57/94[36] which involved differ-ent facts. In that case, the taxpayer solicitor was informed by his landlord that it wished to have vacant possession of the premises he was leasing by 30 September 1990 in order to refurbish and upgrade the entire building. However, the taxpayer exercised an option to renew the lease for a further three years from 1 July 1990. The taxpayer was subsequently paid $275,000 by the landlord in con-sideration of agreeing to surrender the new lease. Purvis J held that the first strand of Myer applied since:
the intent of the taxpayer and his purpose in exercising the option to continue the lease for a period of three years, he knowing that the lessor was at that time seeking vacant pos-session, was to make a profit or gain. The exercise of the option was done with the intent that on his vacating the premises at the request of the lessor and to enable it to carry out renovations, he would receive a mone-tary consideration. The Tribunal is satisfied that the taxpayer did not intend at the time of exercising the option to remain in possession for the term of the renewed lease, but rather to vacate on the amount of a monetary con-sideration being agreed between landlord and tenant.[37]
The taxpayer in Selleck v FC of T[38] was a part-ner in a firm of solicitors (“AR&H”) which had been formed out of a merger of two firms in 1984 located at two different premises. The partners of the new firm wanted to operate from the one build-ing and, after extensive negotiations with prospective lessors, the firm leased offices in the “AMP Tower” owned by AMP. As part of the leas-ing arrangement, AMP paid AR&H $1.066m by instalments subject to the proviso that the money would be used to contribute to the $2.5m cost of fitting out the new premises (the fit-out was to be owned by AR&H). The balance of the cost of the fit-out (approximately $1.5m) was paid for by AR&H and funded by way of a temporary overdraft facility it had with the Westpac bank. After entering into the leasing agreement, AR&H sold the fit-out to the Westpac bank for approximately $1.5m and then leased it back. The proceeds of sale were then used to discharge the overdraft.
The Commissioner assessed the taxpayer on his share of the lease incentive payments on the basis of the “ordinary business income” principle, the “ordinary incident of the business activity” princi-ple and the first strand of Myer. In doing so, he relied upon the fact that during negotiations between AR&H and AMP, AMP increased its con-tribution offer from $500,000 to $1.066m.
Federal Court Decision
At first instance[39], Drummond J held that the payments were not received by AR&H in the ordi-nary course of its business, but, rather, in respect of the establishment of its first base of operations.[40] His Honour found that even if the move to the new premises could be regarded as part of the business activity of the merged firm (as in Cooling), the receipt of the lease incentive could not be said to be an ordinary incident of that business activity given the limited evidence as to the extent of the practice of landlords offering cash incentives to prospective tenants at the time in Melbourne. This can be con-trasted with Cooling where there was such evidence. Thus, his Honour impliedly accepted Hill J’s “ordinary incident of the business activity” prin-ciple, but found that it did not apply.
Drummond J nevertheless held that the relevant amounts were assessable under the first strand of Myer. He found that the payments were “always intended by AR&H to be the means of enabling a cash distribution to be the first strand of Myer. He found that the payments were “always intended by AR&H to be the means of enabling a cash distribution to be made to the partners”[41] and that while the decision to enter into the lease was not influenced by AMP’s offer to contribute to the fit-out costs, “one of the firm’s purposes in negoti-ating the final form that its agreement with AMP took and one of its purposes in entering into that agreement was to take advantage of the offer of the cash contribution by AMP to enable the firm to dis-tribute to the partners by one means or another an amount equalling that cash contribution”[42]
Full Federal Court Decision
On appeal, the Full Federal Court (Black CJ, Lockhart and Beaumont JJ) reversed Drummond J’s decision. Whilst all members of the Court agreed that the payments did not fall within the “ordinary business income” principle or the “ordi-nary incident of the business activity” principle, they held that Drummond J had erred in finding that the first strand of Myer applied. The members of the Court took different approaches in reaching this conclusion.
Lockhart J (with whom Black CJ concurred) held that Drummond J was not justified in drawing the inference that the contribution payments were always intended by AR&H to be the means of enabling a cash distribution to be made to the part-ners. His Honour found that AR&H did not have any relevant purpose of profit-making when it entered into the lease. After noting Drummond J’s finding that AR&H’s decision to lease offices in the AMP Tower was not influenced by AMP’s offer to contribute to the fit-out costs, Lockhart J held that the fact that during negotiations, AR&H desired AMP’s contributions to the fit-out to be higher than had been first offered did not alter the firm’s pur-pose and did not convert a capital occasion into a revenue one. According to his Honour, the only purpose AR&H entered into the lease was to obtain premises from which the new firm would conduct its legal practice. In this respect, his Honour found that the decision in Cooling was distinguishable on the basis that in “Cooling the promised receipt by the partners individually of the incentive payment was a not insignificant purpose in the firm’s deci-sion to move ... premises”.[43] His Honour also observed that the firm in Cooling “had not decided that it was essential or even important to move” and that “real estate agents acting for AMP in Cooling initiated the attempt to have the firm move premis-es, and recommended to AMP that they offer an inducement to make the move more attractive”.[44]
Beaumont J held that the first strand of Myer did not apply as there was no profit or gain, only a shortfall due to the fact that the fit-out cost exceed-ed the amount of the AMP contribution. His Honour found that “there was a commitment to fit out the premises and this was done at a cost in excess of the contribution received” and it was “not appropriate then ... to speak in terms of either a ‘profit’ or a ‘gain’“.[45] Accordingly, he concluded that Drummond J was not justified in drawing the inference that the contribution payments were always intended by AR&H to be the means of enabling a cash distribution to be made to the part-ners on the basis that there was no surplus available for distribution.
His Honour further held that Cooling and Rotherwood were distinguishable on the basis that each of those cases involved a profit-making trans-action. In particular, Beaumont J found that the different result in Cooling arose from the fact that the partners in that case received individual cash payments which they then used, on their own voli-tion, to fund the fit-out. This was unlike Selleck, where the incentive payment was tied to an obligation to fit out the premises. Both Black CJ and Lockhart J concurred with Beaumont J’s view that there was no profit-making transaction in Selleck.[46]
Beaumont J went on to state that a lease incen-tive payment should, subject to three exceptions (namely where: (1) the transaction is a “sham”; (2) the lease incentive is in truth and substance dis-guised rent;[47] or (3) the lease incentive occurs regularly),[48] be treated, prima facie, as being on capital account “in the nature of a premium”. According to his Honour:
A lease incentive payment should be treated, in principle, as prima facie on capital account ... as a payment made, in the nature of a pre-mium, in consideration of a prospective lessee agreeing to accept the burdens (along with the benefits) of the proposed lease. The payment is an inducement to a prospective tenant to enter into the leasing transaction. As a separate and collateral agreement, the agreement to pay this premium or incentive stands apart from, and necessarily precedes, the operation of the lease itself. In con-veyancing terms, the incentive payment is an incident of the agreement for lease, rather than the lease instrument itself. Although a payment made to a prospective lessor is per-haps more readily identified as a premium, and thus prima facie on capital account, for present purposes there can be no distinction in principle between a payment to a prospective lessee or to a prospective lessor as an inducement to take, or to grant, respectively, a lease. In either case the amount is, I think, paid as a ‘price’ for the grant of the lease; it is a premium in that sense ...[49]
This passage is at odds with the dicta of Hill J in Cooling to the effect that an incentive to take a lease is distinguishable from a receipt of a premium by a lessor on the basis that in the former case there is not a disposition of an estate in land by the prospec-tive lessee.[50] However, it is consistent with the majority of the New Zealand Court of Appeal in Wattie which declined to follow Cooling, pointing out in the process that there was “of course an acquisition of a leasehold estate” whenever an inducement is given to a prospective lessee to take a lease.[51]
In a novel approach, Beaumont J also held that even if the receipt of a lease incentive payment could not be regarded as analogous to the receipt of a premium, the payment should nevertheless still be treated as on capital account since it is analogous to a sum received by a trader in consideration of a trading restriction of the kind considered in Dick-enson v FC of T.[52] His Honour maintained that like the petrol station owner in Dickenson who received a payment to sell a particular brand of petroleum products, the taxpayer had received a payment in consideration of its agreement to deal with a particular landlord. It would appear that Beaumont J had the aforementioned dicta of Hill J in mind when formulating this particular piece of reasoning.
In Lees & Leech Pty Ltd v FC of T,[53] the taxpayer, a surfwear retailer, was approached to take up a lease of a shop. After some negotiation, a lease was entered into which provided that the landlord would pay the taxpayer $40,000 in consideration of the taxpayer fitting out the premises. The lease permitted the taxpayer to remove items installed subject to making good any damage caused by their removal at the end of the lease. The taxpayer paid $90,000 to a builder to fit out the shop premises. Of the amount paid, $49,496 related to “removable items” such as shop counters and $40,504 related to “non-removable items” including a wooden floor, a storeroom, change rooms and plumbing. The land-lord refunded $36,689.96 to the taxpayer (representing the $40,000 incentive less certain legal fees) and the Commissioner assessed the taxpayer on the refunded amount.
Hill J held that even if it was assumed that the payment received by the taxpayer constituted a profit or gain, it was not received in the ordinary course of the taxpayer’s business. According to his Honour, the taxpayer was carrying on the business of retailing surfwear and not a business which included shop fitting or making improvements to shop premises.[54] Interestingly, Hill J did not go on to examine (as in Cooling) whether the “ordinary incident of the business activity” principle applied. Given the importance placed on the fact that the incentive payment in Cooling was received as an ordinary incident of the business activity of the tax-payer, it is odd that Hill J did not also examine whether the sum refunded had been received as an ordinary incident of the business activity of the tax-payer in Lees & Leech. In other words, why did Hill J not consider the very principle he had earlier developed?
His Honour further held that it was unclear whether the first stand of Myer applied to the arrangements as it was uncertain whether the taxpayer had made a gain. According to his Honour, taking into account the degree and object of annexation to the land and the decision in Commissioner of Stamps (Western Australia) v L Whiteman Limited,[55]each of the non-removable items and an unspecified number of the “removable items” were fixtures and hence attached to the land and became part of the realty. However, having regard to the terms of the lease which gave the taxpayer the right to remove the items at the end of the lease, the items were “tenants fixtures” with the consequence that they only remained part of the realty until the taxpayer exercised its right of removal. It followed that any gain to the taxpayer was mainly constituted by the value of the relevant fixtures at the end of the lease. His Honour found that the evidence showed that immediately after the installation of the fixtures, the only items of salvageable value were a wash basin and some taps. Hill J accordingly remitted the matter to the AAT to determine “whether there was a gain and, if so, the extent of that gain”. His Honour stated:
The point here is that the taxpayer covenanted to effect improvements which operated to benefit, one may assume, both the landlord and itself on the basis that it was to be reimbursed to the extent of $40,000. The work which the [taxpayer] undertook and for which it was in part reimbursed, produced no direct gain to it other than what appears to be a valueless right at the expiration of the lease to remove a washbasin and taps for scrap. The payment was a part reimbursement of the cost of the work. The payment was not, either in form or in substance, a cash incentive to encourage the applicant to take the lease, although it is clear that without the agreement of [the landlord] to contribute to the fit-out the [taxpayer] would not have entered the lease.[56]
In reaching his conclusions with respect to the first stand of Myer, Hill J distinguished Cooling and Rotherwood on the basis that there was clearly a profit or gain in those cases. His Honour also noted that s 21A of the ITAA36 (which concerns non-cash business benefits) was not applicable to the present case as it did “not operate to create a benefit where none existed or to make income that which was not, except where the conclusion that the amount is not income depends upon non-convertibility”.[57]
The most recent case dealing with lease incen-tive payments is Montgomery. Again, this case concerned a partner in a firm of solicitors. The firm practised from premises in BHP House, Melbourne. The premises were being refurbished by the build-ing’s owner and this involved the removal of materials containing asbestos. Although refurbish-ment of the particular levels occupied by the firm was not due to start until 1991, the firm was con-cerned about the disruption to its business caused by refurbishment on other levels and the presence of asbestos dust which could flow through the air conditioning system and endanger the firm’s staff and clients.
The firm considered several options relating to its accommodation needs. On 14 August 1989, the firm’s service company entered into a lease of new premises to be built at 101 Collins Street which were expected to become available for occupation in 1991. A further agreement was entered into requiring the lessor to pay the service company a substantial lease incentive and the taxpayer was assessed on his share of this amount. At the time, it was an ordinary incident of renting premises in Melbourne to receive such incentive payments.[58]
Federal Court Decision
At first instance, Jenkinson J held that the first strand of Myer applied to the arrangements. His Honour held that while the incentive payment was “not easily expressed as a profit”, it was “rightly described as a gain” which arose in the course of the firm’s business and that “one substantial purpose of [the partners] making the decision to choose 101 Collins Street was to obtain the incentive pay-ment”.[59]
Full Federal Court Decision
The Full Federal Court (Davies, Lockhart and Heerey JJ) reversed the decision at first instance. All members of the Court held that the payments did not constitute ordinary business income. As he had done in Westfield and Selleck, Lockhart J con-sidered the “ordinary incident of the business activity” principle from Cooling as a distinct jurisprudential principle. His Honour stated:
If any profit or gain was made by the Firm in relation to the move to the Collins Street premises it was not made in the ordinary course of carrying on its practice. Of course, if firms of solicitors occupy rented premises they cannot be assured of permanent occu-pancy. Obviously it must be expected by a firm of solicitors that it may have to move premises from time to time consistent with the lessor’s requirements, the expansion or retraction of the solicitors’ practice, the rental charged and matters of this kind. But this was not a move to premises made in the ordinary course of carrying on the practice of a firm of solicitors. Nor can it be said, in my view, to be correct that, if a profit or gain was made, that was itself an ordinary incident of the practice of the Firm.[60]
In other words Lockhart J found, like he did in Selleck, that the move of premises was necessitated by extraordinary circumstances. The extraordinary circumstances were held to flow from the decision of the owner of BHP House that the building be gutted and cleansed of asbestos. His Honour stated:
The firm had no practical alternative, when confronted with the gutting and cleansing from asbestos of BHP House including its own premises of four floors, but to move out of those four floors even on a temporary basis while other floors were reconditioned. By staying at BHP House the Firm would experience all the problems that would be consequent upon refurbishment of a major city office block, including the attendant dis-ruption to its practice and nuisance to its clients and staff.[61]
An interesting question is whether a move from an office building caused by a refurbishment alone involving no harmful substances would amount to extraordinary circumstances. It is submitted that the above dicta supports the case that it would. It is also apparent from the above passages, however, that Lockhart J would not regard a move of premises due to a mere lack of space or high rent (as in Case 22/95) as involving extraordinary circumstances. In this sense, Lockhart J’s judgment is consistent with the decision in Cooling and the result in Case 22/95.
Heerey J held that the “ordinary incident of the business activity” principle should not be followed for the same reasons that persuaded the majority of the New Zealand Court of Appeal in Wattie (see above). Heerey J agreed with Beaumont J’s view in Selleck that lease premiums should be treated, prima facie, as on capital account and then addressed Cooling in the following passage:
In my respectful opinion, the interests of clarity and predicability - desiderata in all areas of the law and especially revenue law - require one to grapple with the issue whether Cooling should be followed or not. Putting aside any suggestion of trading in professional premises, or disguised rent incentives, it does not seem logical to draw distinctions, for example as was done in Sel-leck, between a move to new premises for an existing firm and a move to new premises for a firm which is the result of a merger and in reality a new practice. It is not clear why a lease incentive should be income in the one case but not in the other. Usually an expen-diture on capital account does not lose that character because it is not made at the com-mencement of a business.
Nor does it seem satisfactory to have the issue turn on the degree of compulsion oper-ating on the particular firm to move. It is not clear why a payment should be capital only if a firm is faced with the alternative of being out on the street tomorrow.[62]
Heerey J’s judgment is significant as it indicates that there is not wholesale support at the Federal Court level for the “ordinary incident of the busi-ness activity” principle.
All members of the Full Federal Court further held that Jenkinson J had erred in finding that the first strand of Myer applied to the arrangements. This was not surprising as, unlike Jenkinson J, the Court had the benefit of reading the Full Federal Court decision in Selleck (which had since been handed down). Once again, the members of the Court took different approaches in reaching this conclusion. Both Lockhart and Davies JJ held that the firm did not have a significant purpose of prof-it-making in entering into the lease. Lockhart J stated:
In my opinion, the evidence establishes that the Firm’s purpose in entering into the lease of the 101 Collins Street premises was to secure prestigious premises in which the Firm could conduct its practice as solicitors at the lowest possible cost. The evidence is not consistent, in my opinion, with a finding that the making of a profit or gain was a sig-nificant element in entering into the transaction. Certainly the Firm intended to obtain the incentive payment; but the Firm was primarily concerned to secure ‘a position for the Firm in a landmark prestige building’ with as little inconvenience and disruption to its practice, clients, members and staff as possible. Naturally the Firm wished the inducement payment to be as large as possible, but it does not follow that the acquisition of an incentive payment was the object of the transaction. The purpose or object of entering into the transaction to lease the Collins Street premises and to receive the inducement payment was to secure premises for the long term future of the Firm, not to obtain a payment by way of inducement to be received as a profit or gain by the members of the Firm.[63]
In this respect, Cooling was distinguished on the basis that in Cooling, the firm had not decided that it was essential or even important to move premis-es. Lockhart J also noted that in Cooling “there were no extraneous factors such as a merger or refurbishment of the building which brought about the need to move”.[64]
It is apparent from Lockhart J’s judgment (and also his judgment in Selleck) that an important fact in Cooling which led the Federal Court in that case to conclude that the first strand of Myer applied was that the firm in Cooling did not initiate the move of premises. Rather, the move was initiated by AMP which attempted to induce the firm to move from its existing offices by offering a lease incentive. This is in contrast to Montgomery, where the move was ini-tiated by the firm due to circumstances unrelated to the receipt of the incentive payment. Viewed in this light, the conclusion of the AAT in Case 22/95 that the first strand of Myer applied seems harsh. This is because it could also be said of that case that the purpose of the partners in procuring their service company to take a lease of offices in the new build-ing “was to secure premises for the long term future of the Firm, not to obtain a payment by way of inducement”, especially given the fact that the firm initiated the move of premises due to the expected increase in rent in respect of their existing premises.
Heerey J held that the first strand of Myer did not apply to the arrangements on the basis that the firm did not make a “gain”. In this respect, his Hon-our agreed with Beaumont J’s analysis in Selleck which required looking at the net result of the whole scheme, including outgoings. His Honour also held that Myer was distinguishable from the present case on the ground that in Myer, the taxpayer “had acquired something (the loan with a right to inter-est) with the intention of profit-making by selling the interest to Citicorp” whereas in “the present case there [was] no equivalent thing which [the firm] acquired and then sold so as to make a profit or gain”. It would appear from this statement that his Honour was of the view that property is needed in order for the first strand of Myer to apply. How-ever, it is submitted that the operation of the first strand is not precluded by the absence of an acqui-sition and disposal of property, as evidenced by the passage from Myer quoted at the beginning of this article.[65]
Davies J also found that the first strand of Myer did not apply to the arrangements on the basis that they did not give rise to a profit or gain to the firm, “having regard to the obligations under the existing lease, the costs of the fit-out and of the transfer and the rental obligations under the new lease”.[66] His Honour also distinguished Myer on the basis that the sum assessed as income in Myer was the reward obtained by the taxpayer from the use of its capital whereas in the present case, “the sum was not a profit and it was not a gain made by [the firm] from the provision of services or the exploitation of its assets”.[67] Again, it would appear that his Honour is of the belief that property is needed for the pur-poses of the first strand.
Shortly after the decision in Cooling, the Com-missioner issued Income Taxation Ruling IT 2631 dealing with lease incentives.[68] While it is not intended to restate the Commissioner’s views expressed in the ruling, it is worthwhile highlight-ing certain comments made which are now doubtful in the light of the cases discussed.
In IT 2631, the Commissioner states that in “view of the decisions in Myer and Cooling, where a business taxpayer is given a cash incentive to enter into a lease of business premises, the incentive is income of the taxpayer”.[69] It is submitted that the effect of Myer and Cooling is not as wide as the Commissioner suggests. Selleck, Montgomery and Lees & Leech went against the Commissioner, notwithstanding that they all involved business tax-payers which received cash payments.[70]
The Commissioner in IT 2631 also discusses the application of s 21A of the ITAA36 to lease incen-tive payments, stating that if “a business taxpayer receives a non-cash incentive to enter into or vary a lease of business premises, it will have an income character provided that it is convertible to cash, either as a matter of fact or through the operation of section 21A”.[71] It would appear that this comment is at odds with the statement of Hill J in Lees & Leech (noted above) that s 21A “does not operate to create a benefit where none existed or to make income that which was not, except where the con-clusion that the amount is not income depends upon non-convertibility”.[72] Importantly, however, the Commissioner considers that rent-free periods do not give rise to income according to ordinary con-cepts due to the effect of the otherwise deductible rule in s 21A(3).[73]
While the Commissioner does not consider that a free fit-out provided to a tenant but owned by the landlord will give rise to income according to ordi-nary concepts, he considers the situation to be different if ownership of the fit-out has been given to the tenant.[74] According to the Commissioner, if “the lessee has a contractual right to remove the fix-tures, he or she would have a valuable interest in the fixtures akin to ownership” and for “the purposes of section 21A, the value of that interest is considered to be the cost of the fit-out”.[75] This was more or less the basis of the Commissioner’s assessment of the taxpayer in Lees & Leech which was found to be incorrect by the Federal Court in that case. The Commissioner further states that “if the lessee paid for the fit-out after receiving a cash incentive from the lessor, the lessee will be considered to have derived an assessable amount equal to the full cash incentive”.[76] Again, this view is questionable given the decisions in Selleck and Lees & Leech.
It is submitted that the cases demonstrate that there is no general rule that lease incentive pay-ments received by business taxpayers will be of an income nature. The decisions show that each case needs to be considered on its own facts.
From the Commissioner’s perspective, it is cru-cial to establish that the relevant transaction gives rise to a gain. This is illustrated by the comments in the fit-out cases - particularly the comments of Hill J in Lees & Leech and Beaumont J in Selleck.
Furthermore, even if there is a gain, the gain will only be of an income nature where it falls within one of the following three propositions, namely:
1. the gain is received in the ordinary course of car-rying on the taxpayer’s business: Rotherwood;
2. the gain arises from a transaction which is an “ordinary incident of the business activity of the taxpayer” (note, however, the concluding com-ments below): Cooling; or
3. the gain arises otherwise than in the ordinary course of a taxpayer’s business and a significant purpose of the taxpayer in entering into the transaction was to make a profit from the lease incentive payment: Cooling, Rotherwood, Case 22/95 and Case 57/94.
In relation to the above propositions, it is appar-ent from the cases that a gain arising from a lease incentive payment will not be of an income nature where:
(in relation to propositions 1 and 2 above) the lease incentive is received as a result of a move of premises necessitated by “extraordinary cir-cumstances”: Selleck and Montgomery; or
(in relation to proposition 3) the taxpayer’s deci-sion to move premises is not influenced by the lease incentive payment (notwithstanding that the firm may have, during negotiations, attempt ed to maximise the amount of the incentive pay ment): Selleck.
Finally, the cases also demonstrate that whilst the “ordinary incident of the business activity” prin-ciple formulated by Hill J in Cooling has been applied by other Federal Court Justices as a distinct jurisprudential principle, it has yet to be truly test-ed by the Courts. In Cooling, its application was not needed to decide the case in favour of the Com-missioner as the first strand of Myer was held to apply. In Selleck and Montgomery, the principle was held not to apply and in Lees & Leech, it was not considered. In other words, to date, there appears to be no case, the outcome of which has hinged on the ordinary incident of the business activity principle alone. Indeed, the principle is now under attack as evidenced by the judgment of Heerey J in Montgomery and the New Zealand decision in Wattie. In this respect, it remains to be seen whether the principle will pass the scrutiny of the High Court.
It is submitted that the law should remain as stat-ed in Myer and that the High Court should reject, at its earliest opportunity, the “ordinary incident of the business activity” principle as a distinct jurispru-dential test of what constitutes income. The finding that the receipt of a lease incentive payment by a firm of solicitors operating from leased premises is an ordinary incident of the business activity of the firm is a very wide finding and it is not surprising that it has caused much consternation. The trend in the recent lease incentive cases, however, demon-strate the willingness of the courts to limit the potential application of the decision. It is submitted that if the “ordinary incident of the business active-eity” principle is sanctioned by the High Court, it has the potential to make the distinction between income and capital receipts considerably uncertain. There have been many instances where the courts have found it difficult to grapple with the simple question of whether or not a gain falls within the ordinary course of carrying on a taxpayer’s business.[77] To require the courts to also determine whether or not a gain falls within the ordinary inci-dent of the business activity of a taxpayer will only further blur the income/capital distinction and open up a new “can of worms”.
[1] 90 ATC 4472.
[2] 94 ATC 491.
[3] 95 ATC 243.
[4] 96 ATC 4203.
[5] 97 ATC 4407.
[6] 97 ATC 4856.
[7] 98 ATC 4120.
[8] The potential capital gains tax aspects of these payments are not considered in this article.
[10] 87 ATC 4363.
[11] This principle is the subject of the first part of Professor Parson's famous 14th proposition on what is income: R Parsons, Income Taxation in Australia (1985) 26. See further the discussion of this proposition in S Barkoczy, "Income According to Ordi-nary Concepts - Part 1: Mere Realisation or Business Operation" (1997) 3 New Zealand Journal of Taxation Law and Policy 75.
[12] The fact that an isolated transaction could give rise to income was accepted in subsequent United Kingdom cases: see Duck-er (Inspector of Taxes) v Rees Roturbo Development Syndicate Ltd [1928] AC 132 and Edwards (Inspector of Taxes) v Bairstow & Anor [1955] UKHL 3; [1955] 3 All ER 48; but contrast Jones v Leeming [1930] AC 415 which concerned special circumstances as discussed in J Waincymer, "If at First You Don't Succeed ... Reconceptualising the Income Concept in the Tax Arena" [1994] MelbULawRw 23; (1994) 19 Melbourne University Law Review 977, 1005. For an illustration of early Australian acceptance of the Californian Copper principle see: Blockey v FC of T [1923] HCA 2; (1923) 31 CLR 503.
[13] (1904) 5 TC 159, 165.
[14] 87 ATC 4363, 4366-4367.
[15] Ibid 4367.
[16] S Barkoczy and P Cussen, "When are Profits Realised from the Sale of Leased Equipment Income in Nature - The Inconsis-tent Approach of the Full Federal Court" (1994) 23 Australian Tax Review 153, 154. See also S Barkoczy, "Income According to Ordinary Concepts - Part 2: Extraordinary Transactions or Isolated Business Ventures?" (1997) 3 New Zealand Journal of Tax-ation Law and Policy 131, 132-133.
[17] 90 ATC 4472.
[18] 76 ATC 4285.
[19] 90 ATC 4472, 4484.
[20] Ibid.
[21] Ibid.
[22].The question which obviously arises, therefore, is in what circumstances will a purpose be "significant" as opposed to "insignificant"? The cases discussed below provide some insight into the answer to this question.
[23] 91 ATC 4234.
[24] Ibid 4242.
[25] 96 ATC 4903.
[26] Selleck v FC of T 97 ATC 4856.
[27] 98 ATC 4120, 4141.
[28] (1997) 18 NZTC 13297.
[29] Ibid 13308.
[30] 96 ATC 4203.
[31] Compare the situation in Cooling discussed above.
[32] 96 ATC 4203, 4213.
[33] Ibid 4213-4214.
[34] 95 ATC 243.
[35] Ibid 246.
[36] 94 ATC 491.
[37] Ibid 497.
[38] 97 ATC 4856.
[39] 96 ATC 4903.
[40] Drummond J held that AR&H could be regarded as a new business as it resulted from the merger of two firms with different areas of expertise and practice into a firm offering a service significantly different from that offered by the two component firms.
[41] 96 ATC 4903, 4914.
[42] Ibid 4910.
[43] 97 ATC 4856, 4859.
[44] Ibid.
[45] Ibid 4875.
[46] Lockhart J sanctioned Beaumont J's views by agreeing with his analysis of the cases, while Black CJ concurred with the judg-ment of Lockhart J. It is acknowledged that Hill J in Lees & Leech Pty Ltd v FC of T (discussed below) noted that "on any view of the matter, the taxpayer [in Selleck] received a profit or gain of $1M" (97 ATC 4407, 4419). However, this view was predi-cated on the incorrect finding of Drummond J in Selleck at first instance that the incentive payment provided the firm with the means to enable the cash distributions to be made to the partners out of the proceeds of sale from the fit-out. It is submitted that Hill J may well have come to a different conclusion of Selleck on the facts of the case as found by the Full Federal Court.
[47] Compare with Cooling.
[48] His Honour found that none of these exceptions applied in this case.
[49] 97 ATC 4856, 4877.
[50] 90 ATC 4472, 4485.
[51] (1997) 18 NZTC 13297, 13308.
[52] [1958] HCA 62; (1958) 98 CLR 460.
[53] 97 ATC 4407.
[54] In this regard, his Honour distinguished the decision in GP International Pipecoaters Pty Ltd v FC of T 90 ATC 4413 on the basis that in that case the scope of the taxpayer's business was not limited to the coating of the pipes but extended to the con-struction of the plant.
[55] [1940] HCA 30; (1940) 64 CLR 407.
[56] 97 ATC 4407, 4419.
[57] Ibid 4418.
[58] Again, compare the situation in Cooling discussed above.
[59] 97 ATC 4287, 4297. His Honour also held that the "resolution for commitment of the incentive payment to the firm's work-ing capital was in law a direction under the partnership agreement to apply each partner's share of the payment in a particular way" and did not affect the income nature of the incentive payment.
[60] 98 ATC 4120, 4140-4141.
[61] Ibid 4140.
[62] Ibid 4125.
[63] Ibid 4141.
[64] Ibid. Davies J also observed that in Cooling, an intention to make a profitable gain could also be inferred from the fact that the payment went to the individual partners of the firm rather than the lessee and from the fact that the solicitors and the lessee had the option of negotiating for a lesser rent and a lesser incentive.
[65] In fairness to Heerey J, however, Cooling is the only case not involving the disposal of property where the first strand has been found to apply and his Honour declined to follow that case.
[66] 98 ATC 4120, 4128.
[67] Ibid.
[68] There is also a draft ruling on lease surrender payments: see Draft Taxation Ruling TR 97/D19.
[69] Paragraph 8.
[70] In this regard, Hill J in Lees & Leech noted that the proposition in Income Taxation Ruling IT 2631 that "any cash incentive to enter into a lease of a business premise will be income" was stated "badly" (97 ATC 4407, 4412).
[71] Paragraph 9
[72] 97 ATC 4407, 4418.
[73] Paragraph 23.
[74] Paragraphs 25-29.
[75] Paragraph 28.
[76] Paragraph 29.
[77] Ultimately the outcomes in the cases turn on whether the Courts adopt broad or narrow findings of fact. Contrast, for exam-ple, the Full Federal Court decisions in Memorex Pty Ltd v FC of T 87 ATC 5034 and FC of T v GKN Kwikform Services Pty Ltd 91 ATC 4336 with FC of T v Cyclone Scaffolding 87 ATC 5083 and FC of T v Hyteco Hiring 92 ATC 4694.
Neil Bellamy is a Lecturer at Monash University. He holds BEc and LLB degrees and is admitted as a Barrister and Solicitor. He previous-ly worked for Price Waterhouse and KPMG Peat Marwick. Neil has written numerous journal articles and is co-author of the Australian Tax Casebook published by CCH Australia Limited.
Stephen Barkoczy is an Associate Professor at Monash University and co-editor of the Journal of Australian Taxation. He holds BA LLB and M Tax Law degrees. Stephen has been a consultant to the Australian Taxation Office, practised as a solicitor and was formerly Nation-al Tax Director of Panell Kerr Forster. He currently serves as Chairman of the Law Institute of Victoria's Taxation and Revenue Committee. Stephen has published several articles on taxation law and is co-author of the Australian Tax Casebook, Australian Taxation Law and the 1998 Core Tax Legislation and Study Guide published by CCH Australia Limited.
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URL: http://www.austlii.edu.au/au/journals/JlATax/1998/3.html