Laura Oliver and Christopher Hyde urge landlords and tenants to ensure that the tax consequences are understood before entering into a lease re-gear
Aside effect of the economic recovery is the increasing number of leases being “re-geared”. Legally a re-gear means that the terms of an existing lease are restructured or varied by mutual agreement. The current commercial impetus for lease re-gearing is unsurprising: leases negotiated and put in place in less certain economic times may need to be adapted to better fit a healthier business or a change in occupational needs.
For example, a tenant may have no intention of exercising a break option that it negotiated when business was less robust. An astute tenant can capitalise on this by agreeing to relinquish its break option in return for some concession on the landlord’s part – typically a rent suspension. From a landlord’s perspective, this may be an opportunity to secure its rental income and increase the capital value of its investment. The re-gear therefore represents a “win-win” outcome for both parties.
Some variations – for example, to increase the duration of the lease or the extent of the demise – will result in a deemed surrender and re-grant of the lease, which may not be an intended consequence of the variation. Other variations – for example, removing a break option – will be less legally significant. However, in all cases the reach of the taxman is long and it may result in unexpected consequences for unwary landlords and tenants.
SDLT
Most landlords and tenants will be aware of the SDLT implications that may arise from some common variations:
- A variation to increase the rent in the first five years of the term is treated as if it were the grant of a new lease in consideration of the additional rent. SDLT is payable by reference to the increase in rent.
- A variation that will result in a deemed surrender and re-grant of the lease (such as an extension to the length of the tenancy or an increase in the demised area) will also be treated for SDLT purposes as if it were the grant of a new lease. As with any other lease, SDLT will be payable in respect of the deemed new lease subject to the availability of “overlap” relief. This is one reason why tenants may want to take steps to mitigate the SDLT implications, for example, by taking a reversionary lease rather than extending the term of the lease or by taking a supplementary lease rather than increasing the demise, particularly if the original lease was subject to stamp duty. The landlord should not suffer SDLT in respect of the surrender itself, which is in effect disregarded for SDLT purposes on a surrender and re-grant provided that the parties remain the same (and that the landlord gives no consideration other than the re-grant).
- Where the tenant gives money or money’s worth for a variation (other than an increase in the rent or a variation to the term), the variation is treated as an acquisition of a chargeable interest by the tenant and SDLT must be paid on the consideration. Consideration given by the tenant for a reduction in rent is also chargeable to SDLT, although HMRC states that it ignores a party relinquishing a right under a lease (such as a tenant’s break option) for these purposes.
The relevant notification and charging thresholds, and the rules for linked transactions, should be taken into account in each case.
VAT
The VAT consequences of a lease variation are also worth considering.
If either party has opted to tax the property for VAT purposes then VAT will need to be charged on any supplies treated as made by that party. Often, however, the parties do not appreciate that there has in fact been a supply.
In our example where a tenant’s break option is being removed in consideration of an additional rent-free period, a landlord who has opted to tax the property should charge VAT on the value to the landlord of the consideration given by the tenant (ie, the value of the tenant’s break option). If the variation is commercially neutral, then the value of the tenant’s variations will be the same as the value of the landlord’s variations. So, in this example, the value of the tenant’s break option will be the same as the rent the landlord is forgoing and the landlord would raise an invoice for VAT on that amount.
If the tenant has opted to tax the property, it would also have to charge VAT on the variation. In that case, the parties can agree to swap VAT invoices on completion marked “paid”, rather than paying an equal amount of cash to each other: the net effect on their VAT accounts should be neutral, assuming both can recover the input VAT in full. This will clearly have a cash flow advantage and for this reason a tenant may want to opt to tax the property ahead of the variation.
The position is more complex where a variation causes a deemed surrender and re-grant. HMRC issued a statement of practice on this topic in the 1990s suggesting that the deemed surrender and re-grant will sometimes be accepted as a non-event for VAT purposes, probably reflecting the fact that they often represent the functioning of property law rather than transfers of commercial value.
However, the treatment of the deemed surrender and re-grant needs to be considered in the context of the transaction as a whole and VAT may well be chargeable on other elements of the transaction. The statement of practice envisages that VAT will be charged on the surrender if a landlord pays cash, or if the demise or term is reduced (subject to an option to tax). Likewise, if the tenant pays cash for the variation, VAT is usually charged on the deemed re-grant, or alternatively the landlord may be seen as making a taxable supply of accepting the surrender of the old lease if, for example, it is onerous. Advice should be taken on a case-by-case basis.
Direct tax
The direct tax treatment of re-gears can vary dramatically depending on the nature of the lease, the nature of the variation and the characteristics of the taxpayer. The applicable tax treatment may be affected by a number of overlapping rules.
Payments made for a lease variation can be subject to a wide range of tax outcomes. Non-monetary aspects of the transaction (such as a surrender and re-grant) may also give rise to taxable gains. The deductibility of any payments and associated transaction costs such as professional fees and SDLT will similarly be affected by the specific facts of the transaction.
Many institutional investors will be subject to advantageous regimes that may eliminate or reduce the amount of tax payable on re-gears. In the case of a registered pension scheme, for example, no tax should arise provided the land is held as an investment asset rather than on a trading basis.
Other landlords may be subject to a combined charge, partly income and partly capital, in respect of any payments received on a re-gear of a lease lasting no more than 50 years. The interplay between the income and capital charges – and the relevant computational rules – is notoriously complex.
HMRC policy can also make an important difference. For example, a tenant’s costs will normally be capital in nature and therefore non-deductible for income purposes, but HMRC states that it usually allows “small” professional fees for renewal of a lease of no more than 50 years. Equally, concessionary treatment can prevent a tenant being taxed on the surrender element of a deemed surrender and re-grant, provided certain conditions are met.
In considering the direct tax treatment of a re-gear, a number of key questions – set out in the box above – should be considered.
Although the application of the rules will be straightforward in many situations, a wary eye will help to ensure that variations do not give rise to unexpected tax consequences.
Planning ahead
The concept of re-gearing is a very flexible one: lease variations can be negotiated at any time and many terms of the existing lease may be up for grabs. Re-gearing can therefore be a genuine opportunity for both landlords and tenants to better their position. However, to evaluate fully the financial advantages of a re-gear, the tax consequences must be understood and factored into the economic equation.
Questions to ask when considering the direct tax treatment of a re-gear
- What is the tax status of the landlord? Does it have the benefit of any exemptions? Is the land held as an investment asset?
- Does the lease reserve a full commercial rent or does it possess capital value?
- Is a payment being made? Is the payment made under an existing term of the lease? Is the tenant obliged to carry out building works?
- Are there more than 50 years of the lease term left?
- Does the variation relate to the rest of the lease term or a shorter period?
Laura Oliver and Christopher Hyde, Hogan Lovells International LLP
