Leases
1005. Alterations to suit tenant's requirements: Tax Consequences
June 2002

 

 

Introduction

In the event that a tenant effects repairs to a building, occupied under a lease agreement, such repairs will, so long as they are indeed repairs, as envisaged in section 11(d) of the Income Tax Act, Act 58 of 1962, as amended (the Act), be allowable as a deduction insofar as the tenant is concerned. It is appropriate to consider the distinction between improvements and repairs and maintenance insofar as immovable property is concerned. It is also necessary to consider the tax and VAT consequences relating to a settling in allowance made available by a landlord in order to secure that a tenant concludes a lease agreement with the landlord or alternatively the landlord may undertake to effect refurbishments to the property occupied by the tenant. Both the income tax and value added tax (VAT) consequences thereof are often overlooked and the purpose of this article is to consider the fiscal consequences relating to the different scenarios sketched above.

 

Repairs and Maintenance

Section 11(d) of the Act allows as a deduction:

"Expenditure actually incurred during the year of assessment on repairs of property occupied for the purpose of trade or in respect of which income is receivable, including any expenditure so incurred on the treatment against attack by beetles of any timber forming part of such property and sums expended for the repair of machinery, implements, utensils and other articles employed by the taxpayer for the purposes of his trade;"

 

Where the tenant occupies immovable property for the purposes of trade in accordance with the lease agreement and effects repairs thereto such repairs will generally be deductible for the purposes of income tax.

 

What is critical though is that the expenditure incurred by the taxpayer constitutes repairs and maintenance and not improvements to the property.

 

A large number of court cases have been required to decide upon what constitutes a repair for the purposes of determining whether an item of expenditure should be allowed for income tax purposes or not. In ITC 617 14 SATC 474 the following principles were laid down by C J Ingram, President of the Special Court for Hearing Income Tax Appeals:

  1. Repair is restoration by renewal or replacement of subsidiary parts of the whole. Renewal as distinguished from repairs is reconstruction of the entirety, meaning by the entirety not necessarily the whole but substantially the whole subject matter under discussion.

  2. In the case of repairs effected by renewal it is not necessary that the materials used should be identical with the materials replaced.

  3. Repairs are to be distinguished from improvements. The test for this purpose is, has a new asset been created resulting in an increase in the income-earning capacity or does the work undertaken merely represent the cost of restoring the asset to a state in which it will continue to earn income as before?

 

Where the tenant undertakes, for example, to paint a building and to repair broken windows, clearly the expenditure relating thereto will be allowed as a deduction on the grounds that the expenditure constitutes repairs for the purposes of the Act. Where, however, the tenant chooses to effect changes to the leased property for aesthetic reasons only, without the building being in a state of disrepair, the cost will not, in my view, be regarded as deductible for tax purposes in that the expenditure cannot be said to have been incurred as required under the provisions of section 11(d) of the Act.

 

What is necessary is that the taxpayer is merely seeking to place the building in a state of repair and to repair those items of the building that have fallen into a state of disrepair. It is important that the expenditure does not in any way enhance the structure of the building thereby increasing the area available for occupation.

 

In some cases it may be difficult to determine whether a building has been repaired or improved, particularly where the building undergoes a major face lift and the expenditure incurred runs into tens or hundreds of thousands of Rands.

 

In the event that a large scale project is undertaken to repair parts of the building that have become dilapidated and also to improve parts of the building, it is important to retain proper and adequate records so as to prove those items that clearly constitute repairs thereby enabling the Commissioner: SARS to determine what portion of the expenditure incurred can indeed be said to constitute repairs for the purposes of section 11(d) of the Act. In the event that building changes are effected to the building those generally will be regarded as improvements to the structure and thus not deductible for income tax purposes. It is important though that the taxpayer obtains adequate breakdowns of accounts from the various contractors so as to be able to discharge the onus of proof that those items that are indeed repairs can be clearly identified from the invoices and records made available to the Commissioner: SARS in the event that the repairs claimed are queried for income tax purposes.

 

Refurbishment of premises by landlord for a tenant

It has become common practice for a landlord to undertake to refurbish the leased premises in order to retain a prominent tenant in a particular building. It is important that the income tax and indeed the VAT consequences of such refurbishments are not overlooked in the event that the refurbishment is undertaken by the landlord.

 

In the event that the landlord chooses to refurbish the leased premises so as to retain a tenant it is necessary to determine what items of expenditure incurred can be claimed for tax purposes and those that will be regarded as improvements and thus not deductible for income tax purposes. With the introduction of Capital Gains Tax those items that constitute improvements will go to increase the base cost for the purposes of determining the capital gain in the event that the building is ever disposed of and a capital gain is realized thereon.

 

Clearly though, the landlord would seek to apportion the greater portion of the costs incurred to repairs in that 100% of the cost will be deductible for income tax purposes, if indeed it can be shown that the expenses qualify as repairs envisaged in section 11(d) of the Act. Where the items constitute improvements to the building, the expenditure will only be partially allowed in that 50% of the gain attributable to the disposal of the building will ultimately be taxed. There is thus a clear incentive to motivate that the expenditure incurred constitutes a repair, in that the full deduction is allowed for income tax purposes which is more attractive than treating the amount as constituting part of the base cost for CGT purposes.

 

Where the landlord contracts with the various contractors to refurbish the building the invoices will generally be issued to the landlord and to the extent that the contractors are registered for VAT purposes the landlord will, so long as it is a commercial building and the landlord is registered for VAT purposes, be entitled to recover the VAT incurred thereon.

 

In the event that the building comprises both commercial and residential property only that portion relating to the commercial property will be recoverable for VAT purposes in that the rentals derived from residential property is specifically exempt from VAT.

 

This problem arises particularly in those buildings which have mixed tenants namely, those occupying the premises for business purposes and those occupying the premises for residential purposes.

 

In the event that the landlord seeks to refurbish a building owned by it in order to secure the long tenancy of a desirable tenant the cost may be regarded as being capital in nature. This is particularly true where the lease is a relatively long one and the expenditure is regarded as equipping the income earning structure and in order to secure an enduring benefit of the landlord's trade as opposed to being regarded as recurrent expenditure.

 

Reference must be made to the case of Heron Investments (Pty) Ltd vs Secretary for Inland Revenue 33 SATC 181. In that case the company owned fixed property and income was derived mainly in the form of rental from the letting out of the property owned by the company. One property comprised a building consisting of a basement and nine other floors. The landlord had, in the particular case, let out three floors as well as certain other space to one company for a period of nine years and eleven months. When the lease in question still had some two years to run the tenant advised the landlord that it had been offered other premises and requested to be released from the remaining period of the lease agreement. The landlord chose to make an offer such that it would alter the premises to suit the tenant's requirements as well as secure the occupation of additional accommodation. A new lease was entered into for a period of nine years and eleven months and the landlord undertook to make the alterations required by the tenant. The lease in question provided that in the event that the tenant vacated the premises before the expiry of fifteen years from the commencement of the new lease it would be obliged to pay the landlord a sum equal to one third of the cost of alterations made.

 

The landlord undertook the alterations required by the tenant and sought to claim the expenditure as a deduction for income tax purposes. At 182 Ogilvie Thompson CJ held as follows, as summarised in the headnote:

"Dismissing the appeal, that expenditure of this amount incurred by the appellant could not be regarded as current expenditure performing part of the performance of the appellant's income earning operations, but constituted expenditure incurred in order to equip its income earning structure and so enable it to obtain the advantage of a long tenancy of a desirable tenant; as such the advantage sought and obtained by the appellant was one for the enduring benefits of its trade and expenditure incurred in obtaining it was of a capital nature."

 

In the instant case it was accepted that the value of the building as a result of the alterations was not enhanced save for the installation of certain air conditioning units. The court emphasised the length of the lease and was of the opinion that the substantial period resulted in the landlord securing an advantage for the enduring benefit of its trade. The court therefore held that the expenses incurred by the landlord were of a capital nature and thus not deductible for tax purposes.

 

In the event that the expenditure relates to items of plant, machinery and equipment such as stand alone air conditioning units, such amounts cannot be regarded as deductible immediately for tax purposes. In such circumstances the landlord will be entitled to claim wear and tear thereon in accordance with the provisions contained in section 11(e) of the Act. This is true also in respect of items of fixtures and fittings that can be regarded as separate to the building and not affixed to the building itself.

 

In the current rental market it is more usual for the lease to be for a shorter period and not as long as was the case at the time of the Heron's decision. Leases currently will generally range for a period of three to five years with further renewal options made available to the tenant. It is submitted that where the lease period is of a relatively short duration and the landlord undertakes to effect alterations to suit the tenant’s requirements such alterations may be deductible by the landlord so long as it cannot be said that the expenditure in question relates to the enhancement of the building or structure itself. Where, for example, the building has become dilapidated and the landlord chooses to repair such building in order to secure the tenancy of an attractive tenant the cost so incurred should in my view be deductible for income tax purposes. It is submitted also that the rental market has changed dramatically since the time that the Heron decision was handed down. That case was decided upon in 1971 relating to expenditure incurred during 1965 and 1966. The case is important in that it was a decision of the erstwhile Appellate Division but the changes in the rental market must in my view be taken into account in that leases are often negotiated for periods ranging from three to five years as opposed to eleven or fifteen years as was the case at the time in question.

 

Where the landlord embarks upon a refurbishment programme it is important that a detailed analysis of expenditure incurred is maintained thereby enabling the landlord to distinguish between those items that constitute repairs and those items that enhance the value of the building and indeed constitute items of a capital nature.

 

Where the landlord is in the habit of changing the layout of offices for a tenant, because of demands placed upon it by the tenant such expenditure should in my view be deductible for tax purposes in that there is no enhancement in value to the building and that the expenditure cannot be said to have conferred a benefit of an enduring nature on the landlord. When one has regard to the current needs of business the layout of offices is in a continual state of flux and it will thus, in my view, be very difficult for a court to disallow all of the expenditure claimed by a landlord to alter the premises for tenants in such circumstances.

 

Many buildings are today constructed such that the offices are constructed with partitions that are demountable allowing for regular alterations in the size and layout of offices. In many other cases tenants choose open plan offices which allows for greater flexibility in the determination of the location of workstations for their employees. It must be remembered that expenditure incurred on demountable partitions can be depreciated at a rate of 16% per annum in accordance with the provisions of section 11(e) of the Act and the practice note issued by the Commissioner: SARS on rates of wear and tear available on various assets used by taxpayers in the carrying on of their trade.

 

Settling in allowance

Landlords will in certain instances agree to pay an amount to a tenant with the condition that the funds made available be used by the tenant in furnishing the leased premises to meet the tenant's requirements.

 

In the event that the tenant is registered for VAT purposes it will be necessary to add VAT to the consideration paid by the landlord to the tenant. The landlord will, to the extent that the property is indeed used for rendering taxable supplies, be entitled to recover the VAT paid to the tenant as an input credit under the VAT system. The tenant receiving the settling in allowance will have to pay over the VAT received to the Commissioner: SARS.

 

What is important to consider also is the treatment of the allowance received by the tenant insofar as income tax is concerned.

 

It may happen that the landlord will agree to pay a lump sum to the tenant such that the amount must be used for carpeting, lighting and finishes etc required in the leased premises.

 

The income tax consequences, will to some degree, depend on the nature of the agreement concluded by the landlord with its tenant. In certain instances the landlord may undertake to reimburse the tenant the expenditure as and when it is incurred up to an agreed consideration. In such cases the tenant will generally be allowed to appoint the contractors subject to approval by the landlord and will then present invoices to the landlord for reimbursement.

 

In such a case the tenant should be neutral from an income tax point of view in that the expenditure would have been incurred which is wholly reimbursed by the landlord. The tenant will not be out of pocket and all expenses incurred by it on the refurbishment will be recovered from the landlord and the tenant will thus be in a neutral position insofar as income tax is concerned. From a VAT point of view the tenant will, so long as it is acting as principal insofar as the contractors are concerned, seek to recover the VAT borne on the various contractor's invoices. The amounts recovered from the landlord will have to be subjected to VAT with the landlord recovering the VAT paid as an input credit and the tenant accounting to SARS for the VAT received on the reimbursement received from the landlord. In determining whether or not the amounts paid by the landlord to its tenant are deductible for income tax purposes one will have to have regard to the nature of the expenditure incurred. Where the amounts comprise structural alterations to the premises enhancing the value of the building any expenditure incurred in relation thereto will constitute an item of a capital nature and thus not be deductible for tax purposes. In such a case the expenditure would form part of the base cost for the purposes of CGT. Where, however, the landlord reimburses the tenant for the cost of repairing those items that have become dilapidated or worn out the expenditure so incurred will be deductible for income tax purposes.

 

Where, however, the landlord agrees to pay a lump sum to the tenant to use as it pleases in order to secure a lease with an attractive tenant, such amount should, in my view, be deductible for tax purposes on the grounds that it is an incentive to conclude the lease. The payment of a settling in allowance in such circumstances is no different, in my view, to a commission paid in order to secure the conclusion of a lease with an attractive tenant. The court has held that such a commission is deductible insofar as the landlord is concerned. In the event that the landlord pays, for example, R1 million to the tenant and it can be shown that the lease is not for a substantial period, say, not in excess of five years, the amount should be capable of being claimed by the landlord on the grounds that it is no different to a commission paid to secure an attractive tenant. Clearly, VAT would have to be accounted for thereon by the landlord and the tenant. What must also be considered is the income tax consequences facing the tenant.

 

Where the tenant incurs R800 000 of refurbishment costs and has recovered R1 million from the landlord, the R800 000, in my view, would not be deductible for tax purposes in that it has been recovered from the landlord. The tenant cannot be in a better position such that it is entitled to claim the refurbishment costs as a deduction for tax purposes and treat the settling in allowance of R1 million as a receipt of a capital nature not liable to income tax. When one has regard to the provisions contained in section 8(4)(a) of the Act there is a nexus between the allowance received and the refurbishment costs incurred by the tenant. The question that must be considered thus is the excess allowance received by the tenant and not expended on the property.

 

The tenant may, in my view, be able to show that the excess allowance received is a receipt of a capital nature and thus not liable to income tax but subject to CGT. The tenant may be able to secure a greater settling in allowance from the landlord than what is in fact required in order to achieve the desired refurbishments. Such excess, will in my view, so long as the tenant is not in the habit of regularly relocating be regarded as a receipt of a capital nature and thus liable to CGT as opposed to income tax.

 

Conclusion

Any agreement concluded by a landlord with a tenant in order to effect alterations to the leased premises to meet the requirements of the tenant must be drafted carefully particularly insofar as VAT and income tax are concerned. It is most important that the agreement specifically refers to the manner in which VAT is to be dealt with insofar as the refurbishment costs are concerned and especially in the case of a settling in allowance being made available by the landlord to its tenant. In the event that the lease is of a relatively short duration such as a period of three to five years and the costs do not enhance the value of the building or indeed the structure thereof such costs should, in my view, be deductible for tax purposes on the basis that the property market has changed substantially since the time of Heron's decision and furthermore that case dealt with a set of particular circumstances where the lease period approximated ten years. Business is far more mobile today than was the case in 1964 and this in my view does impact upon the tax consequences facing the landlord and tenant in the event that alterations are effected by a landlord to suit the tenant's requirements.

 

Beric Croome

Edward Nathan Friedland (Pty) Ltd

 

IT Act: S 8(4),

IT Act: S 11(d), 11(e)