As a result of their changing needs, more and more businesses find themselves with surplus property; many tenants are also locked into leases that were taken out some years ago and are now at above-market rates. It is increasingly common, therefore, for such tenants to negotiate their exit from leases with their landlords.
But when entering into such negotiations, both parties will need to consider the likely tax implications. Not all potential solutions are equal from a tax perspective, so factoring it in at an early stage is important.
Assume, for example, that a tenant wants to exit a lease early. The default approach is likely to be that they offer to make a one-off payment to the landlord to allow for a surrender of the lease. However, this is unlikely to be attractive to the tenant from a tax point of view. From the landlord's perspective, the surrender payment constitutes a capital sum derived from an asset and so they are likely to crystallise a taxable gain. The tenant will not receive any tax relief for the payment either, although relief may be available in respect of payments relating to dilapidations.
Commercially, tenants may be content to pay a tax-inefficient lump sum to the landlord if this means that they make a clean break from their obligations under the lease. They may also consider alternatives such as assigning the existing lease to a new tenant, subletting, or varying the lease – either to insert a break clause or to reduce the rent.
The tax outcome where an existing tenant makes a payment to induce a new one to take an assignment of the lease is unlikely to be any more advantageous than making a surrender payment to the landlord. The existing tenant would receive no tax deduction for such a payment, and where there is any plant and machinery in the property subject to the lease, recent anti-avoidance provisions mean that the new tenant will likely be taxed on the payment – in the same way a landlord would be in respect of a surrender payment.
Instead, by taking on the existing lease, the new tenant benefits from tax deductions for the higher rents it is paying than it would have paid had it taken on a newly granted lease, yet has been commercially compensated for the higher rents by the inducement payment made by the outgoing tenant.
Subletting or varying the lease may prove more advantageous options in terms of tax, and ultimately less costly for the tenant. Where the tenant sublets to a new one at a lower rent than the amount payable under the existing lease with the landlord, it will make a loss of the amount it is paying under the original lease less the rent received from the subtenant. It is likely that this will be a tax-deductible loss.
A payment made by the tenant to vary the lease can also be tax-deductible for them in certain circumstances. The rules here are complex, however, and would require detailed consideration in the specific context.
In all scenarios, both the stamp duty land tax and VAT positions will also need to be considered. So it is clear that there is a lot to think about for landlords and tenants when exiting or varying leases.
While tax should not be allowed to distort commercial decision-making, it does need to be given some thought. Not only will each party need to understand its own position after tax, but it can also help to appreciate the other's to navigate negotiations successfully.
Robert Walker is partner and real-estate tax UK network leader at PwC LLP email@example.com
Related competencies include: Capital taxation, Local taxation/assessment