Sale of lease rights and lease premium

The matter arose again in the recent case of XYZ (Pty) Ltd v The Commissioner for the South African Revenue Service (Case No 14189) (as yet unreported) in the Johannesburg Tax Court.

The facts of the case are not entirely clear, but the following summary should suffice. In 2009, the taxpayer concluded a lease (DF Lease) with DF (Pty) Ltd (DF) in respect of certain immovable property. The initial lease period was 12 years, with two renewal periods. Under the DF Lease, the taxpayer undertook to erect a facility on the property. DF ran into financial difficulties.

In 2010, the taxpayer concluded a lease agreement with MN Properties (Pty) Ltd (MN) in terms of which the taxpayer let the same immovable property to MN for a period of 50 years, subject to DF’s tenancy under the DF Lease. The taxpayer then assigned the DF Lease to MN, and MN stepped into the shoes of the taxpayer as landlord under the DF Lease. Under the lease agreement with MN, MN agreed to pay the taxpayer a nominal amount per month and a percentage of its turnover. In consideration for the assignment, MN agreed to pay the taxpayer an amount of R125 million. The amount was referred as a “lease premium” by the parties and in the documents.

The taxpayer did not include the amount of R125 million in its “gross income” for purposes of income tax. SARS sought to levy income tax on the amount as revenue in the hands of the taxpayer.

The taxpayer argued that the payment was of a capital nature: it was proceeds on the disposal of an asset, namely, the rights of the taxpayer under the DF Lease.

The Court found that the payment was not of a capital nature and should have been included in the taxpayer’s “gross income” and subject to income tax. The Court also imposed penalties.

Unfortunately, it is not readily apparent from the judgment what the grounds were for that finding. Two of the taxpayer’s employees gave evidence. Essentially, they testified that the concept “lease premium” was used loosely, and that they viewed the assignment of the DF Lease as a disposal of rights. However, the Court disallowed the evidence on the basis of the parol evidence rule, that is, the rule that, if a document was intended to provide a complete memorial of a legal act, extrinsic evidence as to the import of the document is not allowed. On the other hand, later in the judgment the Court, in fact, does keep referring to the evidence of the employees when interpreting the agreement.

The Court also referred to other facts. It appears as if there were facts which the taxpayer and SARS agreed on beforehand, but it is not apparent from the judgment that this was the case.

On the face of things, it appears as if the entire matter actually hinged on the question of whether the assignment agreement between the taxpayer and MN was a sale agreement, in form, but a lease agreement, in substance. The taxpayer argued that, despite the fact that the agreement referred to the consideration as constituting a “lease premium”, the payment was in fact the price for the disposal of the taxpayer’s rights under the DF Lease.

The Court, however, was of the view that the agreement constituted a lease, in form and substance, and, as such, the payment was a lease premium. The definition of “gross income” in s1 of the Income Tax Act, No 58 of 1962 specifically includes “an amount received or accrued from another person, as a premium or consideration in the nature of a premium…for the use or occupation or the right of use or occupation of land and buildings”.

However, generally, when a landlord disposes of its rights under a lease to another person, any consideration for the acquisition of that right is not a lease premium as it is not paid for the right to use or occupy land.

It is trite that, when determining whether the proceeds on disposal of an asset is of a capital nature or a revenue nature, one should have regard to the intention of the taxpayer. One should determine whether the intention of the taxpayer was to dispose of the asset in a scheme of profit-making or whether the intention of the taxpayer was to hold and dispose of the asset as a long-term investment. The receipt would, in the latter case, be of a capital nature, and in the former, of a revenue nature. Although the judgment is not clear on this point, it does appear as if the Court found that, irrespective of the substance and form of the agreement, the payment of R125 million was of a revenue nature.

Unfortunately, it is very difficult to distil any general principles from the judgment in relation to lease premiums and the sale of rights under a lease. One thing is clear, however: when entering into any form of lease, or any agreement in terms of which lease rights are assigned, taxpayers should exercise great caution from a legal perspective, generally, and from a tax law perspective, particularly.