Source: Private Binding Ruling BPR 401 of 14 December 2023
This ruling determines the tax consequences for a lessor in respect of improvements effected by a lessee.
In this ruling references to sections are to sections of the Act applicable as at 11 September 2023. This is a ruling on the interpretation and application of section 11(h).
Parties to the proposed transaction
The Lessor: A resident company
The Lessee: A resident company, which is independent of the Lessor
Description of the proposed transaction
The Lessor, a company that is a member of an international group, wishes to upgrade its current warehouse to a facility that can accommodate its required capacity and maximize its distribution efficiencies. To achieve this, the Lessor considered various options, bearing in mind its business strategy, operational needs, and the transactional implications of each option. The Lessor’s corporate philosophy is driven by the group’s global strategy and approach to capital expenditure, being to focus its capital expenditure on its main business, by spending its allocated capital budget on machinery and equipment to manufacture its product and not to build or acquire buildings. The reason for choosing the proposed structure is, therefore, driven by global guidance, business and capital investment strategy.
The proposed transaction entails the Lessor leasing the lease area to the Lessee under a ground lease and the Lessee subletting the lease area back to the Lessor under a sub-lease. The intention of the parties is that the Lessee should act as landlord of the lease area.
In terms of the provisions in the ground lease read with the sub-lease the Lessee will have the obligation to erect a warehouse on the lease area.
The following are the salient terms of both lease agreements:
- The lease area is to be leased by the Lessor to the Lessee in terms of the ground lease, for a period of 50 years for a nominal rental amount.
- One of the conditions precedent to the ground lease, is that the sub-lease is concluded simultaneously between the Lessor and Lessee.
- When read together, the ground lease and the sub-lease provide that the Lessee will erect, at its own cost, certain improvements upon the lease area,
being a warehouse. As such the Lessee will procure the construction, installation, and completion of a warehouse. - The lease area, along with the warehouse, are to be sublet by the Lessee to the Lessor in terms of the sub-lease for an initial period, which may be extended on three occasions for 5-year periods each, at the option of the Lessor.
- The sub-lease is subject to the suspensive condition that the ground lease becomes unconditional and that the site development plan of the warehouse is approved by the relevant authorities.
- The Lessor is entitled to terminate the ground lease prior to the end of the 50-year period, either at the end of the initial period of the sub-lease or at the end of an applicable renewal period.
- Should the ground lease be so terminated, the Lessor will be obliged to pay the Lessee an amount equal to the market value of the lease area and warehouse.
- Should the Lessor not exercise its early termination right but elect not to renew the sub-lease, the ground lease will continue to operate for the balance of the 50-year lease period and the Lessee will be entitled to sublet the lease area to third parties.
- Should the ground lease be terminated for any reason the sub-lease will also be terminated.
- Should the ground lease be terminated prior to the expiry of the initial period of the sub-lease resulting from a material breach:
➢ by the Lessee, then the Lessee will be entitled to claim an amount equal to the balance of the monthly rental payable in terms of the sub-lease which would have been payable up to the expiry of the initial period of the sub-lease, from the Lessor; or
➢ by the Lessor, then the Lessee will be entitled to claim an amount equal to the market value of the lease area and the warehouse erected thereon from the Lessor, plus an amount equal to the net present value of the monthly rental payable in terms of the sub-lease, which would have been payable up to the expiry of the initial period of the sub-lease.
- Should the ground lease terminate prior to the expiry of the relevant renewal period but after the initial period of the sub-lease as a result of a material breach by either party, then the Lessee will be entitled to claim an amount equal to the balance of the monthly rental payable in terms of the sub-lease, which would have been payable up to the expiry of the relevant renewal period of the sub-lease, from the Lessor.
Conditions and assumptions
This binding private ruling is subject to the following additional conditions and assumptions:
a) The Lessee will be granted a deduction under the provisions of section 11(g) over 25 years; and
b) The value of the improvements will be included in the Lessor’s “gross income” (Inclusion Amount) under paragraph (g) or paragraph (h) of the definition of “gross income” in section 1(1).
Ruling
The ruling made in connection with the proposed transaction is as follows:
a) In respect of the Inclusion Amount, the Lessor may deduct from its income an allowance under section 11(h), equal to the difference between the Inclusion Amount and the present value of the Inclusion Amount, which present value is determined by discounting the Inclusion Amount at 6% over the number of years taken into account in the determination of the relevant allowance granted to the Lessee under the provisions of section 11(g).
Given the above information, an explanation of Section 11(h) is necessary.
Section 11(h) provides for the deduction of an allowance in respect of amounts included in the taxpayer’s gross income under paragraph (g) or paragraph (h) as the Commissioner may deem reasonable having regard to any special circumstances of the case.
For sake of completeness, the wording from Section 11(h) of the Income Tax Act is given below.
Section 11(h) reads as follows:
“(h) such allowance in respect of amounts included in the taxpayer’s gross income under paragraph (g) or paragraph (h) of the definition of “gross income” in section 1 as the Commissioner may deem reasonable having regard to any special circumstances of the case and, in the case of an amount so included under the said paragraph (h), to the original period for which the right of use or occupation was granted or, in the case of any amount so included under the said paragraph (h) in consequence of an agreement concluded on or after 1 July 1983, to the number of years taken into account in the determination of the relevant allowance granted to any other person under the provisions of paragraph (g) of this section: Provided that where there has on or after the twenty-ninth day of March, 1972, accrued to the taxpayer the right to have improvements effected on land or to buildings by any other person and an amount is required to be included in the taxpayer’s gross income under the said paragraph (h) with respect to such improvements, no allowance shall be made to the taxpayer under this paragraph in respect of such amount, if:
(i) the taxpayer or such other person is a company and such other person or the taxpayer, as the case may be, is interested in more than 50 per cent of any class of shares issued by such company, whether directly as a holder of shares in that company or indirectly as a holder of shares in any other company; or
(ii) both the taxpayer and such other person are companies and any third person is interested in more than 50 per cent of any class of shares issued by one of those companies and in more than 50 per cent of any class of shares issued by the other company, whether directly as a holder of shares in the company by which the shares in question were issued or indirectly as a holder of shares in any other company.
Paragraph (h) and section 11(g) are complementary to each other. Section 11(g) provides for the deduction of an allowance for the expenditure actually incurred by the lessee in meeting an obligation under an agreement, which grants the right of use or occupation of the land or buildings, to effect improvements on such land or to such buildings used or occupied for the production of income or from which income is derived.
Section 11(g) reads as follows:
“(g) an allowance in respect of any expenditure actually incurred by the taxpayer, in pursuance of an obligation to effect improvements on land or to buildings, incurred under an agreement whereby the right of use or occupation of the land or buildings is granted by any other person, where the land or buildings are used or occupied for the production of income or income is derived there from:
Provided that:
(i) the aggregate of the allowances under this paragraph shall not exceed the amount stipulated in the agreement as the value of the improvements or as the amount to be expended on the improvements or, if no amount is so stipulated, an amount representing the fair and reasonable value of the improvements.
(ii) any such allowance shall not exceed for any one year such portion of the aggregate of the allowances under this paragraph as is equal to the said aggregate divided by the number of years (calculated from the date on which the improvements are completed, but not more than 25 years) for which the taxpayer is entitled to the use or occupation;
(iii) if:
(aa) the taxpayer is entitled to such use or occupation for an indefinite period; or
(bb) the taxpayer or the person by whom such right of use or occupation was granted holds a right or option to extend or renew the original period of such use or occupation, the taxpayer shall for the purposes of this paragraph be deemed to be entitled to such use or occupation for such period as represents the probable duration of such use or occupation;
(iv) the aggregate of the allowances under this paragraph in respect of any building or improvements referred to in section 13(1) or 27(2)(b) shall not exceed the cost (after the deduction of any amount which has been set off against the cost of such building or improvements under section 13 (3) or section 27 (4)) to the taxpayer of such building or improvements less the aggregate of the allowances in respect of such building or improvements made to the taxpayer under the said section 13(1) or 27(2)(b) or the corresponding provisions of any previous Income Tax Act;
(vi) the provisions of this paragraph shall not apply in relation to any such expenditure incurred if the value of such improvements or the amount to be expended on such improvements, as contemplated in paragraph (h) of the definition of “gross income” in section 1, does not for the purposes of this Act constitute income of the person to whom the right to have such improvements effected has accrued;
(vii) if during any year of assessment the agreement whereby the right of use or occupation of the land or buildings is granted is terminated before expiry of the period to which that taxpayer was entitled to the use or occupation, as contemplated in paragraph (ii) or (iii), so much of the allowance which may be allowed under this paragraph, which has not yet been allowed in that year or any previous year of assessment, shall be allowable as a deduction in that year of assessment.