Ask an expert: Reverse premiums: capital or revenue?

Question

My client is a company which holds a 40 year lease over a shop unit. The company decided not to occupy the premises for its own business, and granted a 35 year sub-lease of the property to another company. Both the sub-lease and the superior lease have 30 years left to run. The freeholder has decided that he wants to develop the premises as residential flats for resale and offered my client a payment of £1m for the termination of the 40 year lease. My client will offer a somewhat smaller sum to the tenant under the sub-lease in order to secure the surrender of the sub-lease. I believe these receipts and payments will be capital receipts. Is this correct?

Answer

Definition

HMRC’s Business Income Manual defines a reverse premium (at BIM41050) as a payment or other benefit received as an inducement to take on a lease or other interest in land. A reverse premium is treated for income tax and corporation tax purposes as a receipt of a revenue nature. If the transaction is entered into for the purposes of a trade, the reverse premium is treated as a receipt of that trade; otherwise, it is treated as a receipt of a property business.

In general, only benefits procured by actually laying out money are within the meaning of the term ‘reverse premium’ for tax purposes. Inducements that represent amounts foregone or deferred by the operator, such as rent-free periods, are not reverse premiums. The smaller deduction for rent payable will reflect such inducements in the tenant’s taxable profits. Also, the replacement by agreement of an existing lease at an onerous rent, or with onerous conditions, with a new lease at a lower rent or without the onerous conditions is not a reverse premium.

Inducements which are taxable as reverse premiums, apart from cash payments, include:

• a contribution towards a tenant’s costs of fitting out the premises;
• the assumption by the landlord of the tenant’s liabilities under an existing lease;
• other sums paid to third parties to satisfy some obligation of the tenant; and
• payment of cash by indirect means, for example, writing off a loan which is the liability of the tenant.

The above are contained in the HMRC’s Business Income Manual at BIM41075.

Other reverse payments

The term ‘reverse premium’ is often used commercially to describe various other payments that are not within the statutory rules; for example, as in the query, a sum paid by a landlord to an existing tenant for the surrender of a lease, to secure vacant possession. In this instance, the tenant may be chargeable under the general provisions for capital sums derived from assets under TCGA 1992 s 22(1). This may not be the case however when the payment is made as compensation for disturbance, when the payment may be revenue in nature. The landlord may ordinarily deduct the sum paid as enhancement expenditure, provided it is reflected in the state or nature of his interest at the date of disposal, as required by TCGA 1992 s 38(1)(b).

Another form of reverse premium is when an existing tenant makes a payment to a landlord for the surrender of an onerous lease. When the payment is not made in accordance with the terms of the lease, HMRC takes the view that the sum is chargeable at the time the sum is received as a part disposal of the landlord’s interest in the land, under the normal provisions for capital sums derived from assets. A sum payable under the terms of a short lease is taxed as income of the recipient as income of a property business, computed by a formula similar to that used for a premium. HMRC considers that such a sum paid by the tenant is not allowable in calculating a loss on the tenant’s disposal of the lease. This applies irrespective of whether the sum was paid in accordance with the terms of the lease.

The query

Company 1 (C1) has agreed to accept a payment of £1m from the freeholder (F) in exchange for C1 surrendering its lease. C1 has simultaneously agreed to pay Company 2 (C2) a smaller sum for the surrender of its sub-lease.

C1 will be making a payment to C2 to secure the surrender of the lease. Therefore, C2 is making a disposal of its lease interest and C1 is making a corresponding acquisition. As far as C1 is concerned, the payment will be capital and will fall within TCGA 1992 s 38, provided it is reflected in the state and nature of the asset at the time of a disposal by C1. This should be the case, as an unencumbered lease is more valuable than a lease which is subject to a sub-lease.

C2 is making a disposal of its lease in exchange for a capital payment. As the lease is a short lease, it is a wasting asset and C2’s base cost is wasted in accordance with TCGA 1992 Sch 8 para 1.

C1’s transaction with F similarly involves the disposal of the newly merged lease. The payment from F to C1 is a capital expense for F and a capital receipt for C1. C1 will include its expenditure on securing the surrender of the sub-lease to C2 in its own calculation of gain arising on the disposal to F.

The reverse premium rules in CTA 2009 ss 96–100 do not apply in this case as s 96(3) is failed: the recipient in each case (firstly C2, then C1) does not become entitled to an estate, interest or right over land under the transaction.

To the extent that what is being received relates to compensation for disturbance, rather than the value of the leasehold interest being acquired, it may be arguable that part of the receipt is revenue rather than capital.

It is assumed that neither C1 nor C2 in the query carry on a property dealing trade, as this would mean that the receipts would be revenue rather than capital for tax purposes.