Taxing Tenant Lease Incentives
Updated: Jul 5, 2020
The three most common forms of inducements, excluding contributions, that landlords will commonly offer potential tenants include: –
a rent-free period;
a reduced rent;
a reverse premium (cash payment).
Whatever the incentive, the objective on both sides will be to do the best commercial deal possible but the starting point of each can be different; not least because the parties involved may have a different tax status.
From a tax perspective, a rent-free period is relatively simple and straightforward.
It is commonly used to give a tenant the opportunity to fit out the premises without paying rent and the landlord simply delays collecting rental income. It is not taxable (e.g. as a reverse premium) and should normally give rise to a VAT supply.
Accounting Standards can require such incentives to be spread over the term of the lease or first rent review and this should be considered accordingly.
An ordinary Tenant wishes to take a 20-year lease of a unit in the shopping centre. It negotiates a rent-free period of 18 months and a rent of £120,000 per annum, being reviewed to market rent after ten years. A rent-free period is not treated as a taxable reverse premium for corporation tax purposes. The Tenant prepares IFRS accounts (rather than UK GAAP) so will spread the effective value of the rent-free period (£180,000) in its accounts across the whole 20-year term of the lease, ie each year’s accounts will contain an expense for rent payable of £111,000. This represents an acceleration of the Tenant’s tax relief for the rent. The Landlord should have the opposite position, so he will face the problem of initially paying tax on rent not yet received – though this is probably preferable to paying a reverse premium which is not deductible at all against rental profits.
Reduced rental for a limited period
A midway solution. The tenant pays rental and claims it as a deduction and the landlord secures some income.
A reverse premium
A reverse premium is generally a cash payment made from landlord to tenant at the start of a lease. Common scenarios in which a reverse premium is paid include: –
An out of town retail centre signing up an anchor tenant, one who will inspire others to sign leases of adjacent retail space, to benefit from the anchor’s footfall;
A speculative development in a non-prime location – to attract tenants at a reasonable level of rent a landlord will probably have to pay them an inducement, to get them to commit to leases of the property.
A reverse premium from a landlord (or his nominee, or person acting under the direction of the landlord, or connected to the landlord) is normally taxable on the tenant’s.
Payment of a reverse premium can often make most sense for a developer who intends to sell on the building immediately after completion because he would be able to add it to his costs and deduct the lump sum in calculating his profit.
A landlord, who is a property investor, does not obtain a deduction from rental profits for the payment of a reverse premium. This is because it is regarded as a capital payment – being expenditure on (enhancing the value of) an identifiable asset, namely the landlord’s own interest in the land. On disposal the landlord may be able to obtain a deduction for the reverse premium in its capital gains tax calculation.
A lease inducement can escape being taxed as a reverse premium if it is taken into account in calculating the tenant’s entitlement to capital allowances. To fall within this, the payment must be structured as a contribution by a landlord towards the tenant’s cost of fitting out the property and the qualifying items therein.
The landlord of a large shopping centre would like to secure a key Tenant at a rent of £100,000 per annum. The Tenant requires an inducement of £150,000 before signing up to the lease. The lease is duly signed, with the Landlord being required to make a £150,000 payment on the day of commencement. This is taxable as a reverse premium on the Tenant, however it uses the receipt. In its accounts and tax computations it spreads the £150,000 evenly over the period of the lease up to the first rent review. The Tenant spends £80,000 of the receipt on fitting out the store but this does not change the tax treatment of the receipt.
A payment to an incoming tenant is generally outside the scope of VAT.
But it may be consideration for a supply by the tenant, if the tenant is taking on obligations beyond those normally involved in taking a lease or is providing an additional benefit to the landlord capable of comprising a service in its own right, such as having the status of an anchor tenant.
‘Anchor tenant’ is a term with different meanings in different contexts. The term is commonly understood to mean a company with a strong rental covenant signed up by a landlord wishing to let space in a large property to multiple tenants. Once an anchor tenant is in place, the landlord hopes others will follow. The anchor tenant is often given preferential terms, or is paid a large sum when entering into the lease. The definition for VAT purposes of an anchor tenant is especially relevant. The question is whether the tenant is providing more to a landlord than a firm promise of future rental payments and some good publicity.
Whether anything else is being provided can affect the VAT treatment of a payment made to the ‘anchor tenant’ in question.
The key Tenant will attract other tenants to the centre and it agrees that the Landlord may market the remaining units on this basis. In this case, the Tenant appears to be acting as an ‘anchor tenant’ and the £150,000 inducement payment will be subject to VAT. The Landlord is likely to have opted to tax, so should be able to recover this VAT. If the contract is silent on VAT, the inducement payment will be deemed to be VAT-inclusive, and the Tenant will have to account to HMRC for £25,000 of the receipt, without being able to pass the cost on to the Landlord.
Before embarking on any form of inducement, and specifically, a cash inducement, it is very important to consider the tax implications on the parties involved before contracts are exchanged. Doing so, helps ensure that the best commercial result is achieved.
If you have any question on the above, please do not hesitate to contact us.