Take note when obtaining or granting leases of immovable properties
Shorter-term leases may become more common due to recent relaxation on tax deductions.
The taxation of immovable property leases, and the expenses surrounding them, is complex. In this article, we try to explain the issues and recent changes that make matters more coherent.
For many years, expenditures such as commission, legal fees, stamp duty, and advertising incurred in obtaining leases of immovable properties are disallowed as tax deduction for the lessees as they are incurred in relation to the premises where the lessees conduct their businesses. As such, the expenditures incurred are regarded as capital in nature and no tax deduction is allowed even though the lessees would typically see such expenditures as normal operating expenses.
On the other hand, for the lessors, such expenditures (i.e., commission, legal fees, stamp duty and advertising expenses) incurred could be deductible if the lessor is in the business of making of investments (e.g., letting the immovable properties to derive trade rental income), or in the business of trading in properties (e.g., developers renting out unsold units in a development). In these circumstances, such expenditures are seen as incurred in relation to the lessors’ trade contracts and regarded as revenue in nature, and therefore tax deductible.
However, the same tax treatment would not apply to a lessor that is merely a landlord earning passive rental income from the letting of its immovable properties and does not carry on an active trade to let out immovable properties. Similar expenditures incurred by such landlords are not incurred in relation to a trade. As such, they are unable to claim tax deduction on such expenditures except where they are incurred in relation to a renewal of a lease.
New tax treatment
Lessee
Under the new tax treatment[i], lessees are now allowed to claim tax deduction on the expenditures in obtaining, renewing or extending a lease of an immovable property that is used by the lessee for the purpose of the lessee’s trade or business.
However, this does not apply to a company or trustee of a property trust in the business of letting immovable properties where the company or trustee has a proprietary interest (other than as a legal owner) and would receive consideration if the proprietary interest is disposed of or transferred. An example would be a master lessee of a food court that leases the food court from its landlord (who is the legal owner of the property) to derive rental income by subletting the food stalls to various tenants in which the lease arrangement between the master lessee and the landlord provides for the master lessee to dispose of or transfer the lease to another party for a consideration. The exclusion for such company or trustee of a property trust that is in the business of letting immovable properties is not unexpected as the immovable properties form part of the capital assets of such business and it is unlikely that tax deduction would be allowed on the cost of acquiring a capital asset.
Lessor
Lessors who derive passive rental income can now claim tax deduction on the expenditures incurred in granting, renewing or extending the lease of the immovable property. The new tax treatment would level the playing field between a passive lessor and one who is in the business of making of investments. This is noteworthy for lessors who do not have the economy of scale to carry on a business of making of investments.
Exclusions
The tax deduction under the new tax treatment does not apply to any lease obtained or granted as a result of any acquisition, sale, transfer or restructuring of any business. In addition, the new tax treatment does not apply to a lease under an arrangement where the immovable property is sold by, and leased back to, the seller of the immovable property. The exclusions are in line with the general tax treatment in not allowing a tax deduction on expenses incurred in relation to any capital transaction.
The new tax treatment also does not apply to any lease for a term that exceeds three years (excluding any option for the renewal or extension of the lease). In other words, leases that are more than three years would not qualify for the tax deduction of their upfront expenses. On the other hand, leases of no longer than three years with the option for renewal or extension after the initial lease term will qualify for the new tax treatment. There is currently no limit placed on the term for the renewal or extension of the lease. As such, it may be possible for a lessor and lessee to enter a three-year lease with an option to renew or extend the lease by a tenure of more than three years.
Final thoughts
The new tax treatment not only provides relaxation and certainty in the tax rules, but could also encourage activities in the rental market. In particular, the limitation of the tax deduction to a lease not exceeding three years is likely to encourage the use of shorter-term leases in the market and boost the activities in the rental market, particularly benefitting the property agency companies.
Some taxpayers, particularly anchor tenants, would not be able to benefit from this new tax treatment as they typically enter into longer-term leases. Lessors and lessees would need to reconsider their lease arrangements and consider the cost and benefits of shorter-term leases as a result of this new tax treatment.
The co-authors of this article are Chee Wei Tan, Partner, International Tax and Transaction Services — Real Estate from Ernst & Young Solutions LLP and Wen Zheng Tay, Associate Director, Tax Services from EY Corporate Advisors Pte. Ltd.
