Landlords and tenants must watch out Income Tax issues of lease improvements

A leasehold improvement is expenditure which adds something new to the leased property and which should ordinarily be treated as capital expenditure. Because the land or building on which they are effected belongs to the landlord, the improvement will become the property of the landlord upon termination of the lease through accession. For this reason they are treated as additional rental income to him and additional rental paid by the tenant. They have income tax and VAT implications to both the landlord and tenant, but discussion in this article is only concerned with income tax implications as fully explained below.

A tenant is permitted in each year of assessment to deduct the value of lease improvement divided by the shorter of the remaining lease period in years (unexpired lease period) and 10 years. The unexpired lease period is calculated from the date improvements are first used or occupied by the tenant for purposes of his trade or in the production of income. However deduction is not granted to a tenant in respect of improvements effected on property not used or occupied by him for purposes of trade or which does not produce income. If the property is used or occupied by him partly for purpose of trade or in the production of income and for some other purposes, the Commissioner is given the discretion to reduce the allowance by such amount as he, in the circumstances, considers fair and reasonable. To the landlord, the lease improvements represent taxable income which should be spread in equal instalment over the shorter of unexpired period of the lease or 10 years commencing the date improvements are completed. If the tenant is entitled to such use or occupation for an indefinite period or the agreement is silent regarding the lease period, a period of 10 years is deemed and where the lease term is renewable or extended for a further period or periods, the extended period is not counted.

The tenant should ensure that there is a lease agreement which obligates him to effect improvements and that the expenditure is incurred by him in pursuance of such obligation in respect of a property used or occupied by him for purposes of trade or in the production of income. Otherwise an allowance cannot be granted to him if these conditions are not satisfied. Although it is possible at law to conclude an enforceable oral lease agreement, a written agreement serves as a burden of proof in the event of a dispute with the ZIMRA. Des Kruger Tax Strategy 4th Edition on page 94 observed that a contract imposing an obligation on a tenant to effect improvements should constitute an agreement granting the right of use or occupation of property. It provides further that the lease agreement should include a clause on the obligation to effect the lease improvements. This obligation must not be left to the discretion of the tenant to effect the improvements rather it must be compulsory for him to do so. If he fails to do so the landlord should be empowered to demand that the improvements are effected and to sue for specific performance.

Having to stipulate the value of improvement to be effected helps as burden of proof for a tenant seeking to claim the expenditure. However, where none has been stipulated, the Commissioner is given the discretion to determine the value. There are times when the parties due to economic factors such as inflation may want to vary the value of the improvements. In order to cater for such variation they must incorporate a clause in the agreement. This enables acceptance of the amended value of improvements provided such variation is agreed upon prior to completion of construction. If the variation is made after completion of construction, only the agreed original figure is recognised and the excess treated as voluntary improvements. If the improvements are required to meet certain specifications, with certain minimum value, the value of improvements shall be the fair and reasonable value and not merely the minimum amount stated. The case of ITC 1036 (1963) 26 SATC 84 noted that, in such cases the landlord is not simply asking for improvements to be erected, he is requesting for specific improvements, and the tenant must meet his requirements even if the cost exceeds the stated minimum value in the lease. If the value is below the minimum stated value, the improvements are disregarded. Meanwhile, any improvements which are meant to brand the tenant’s business or not required for purposes of the business of the lessor are considered not effected under an obligation under lease.  

If a lease agreement is cancelled, ceded or assigned, or the land or buildings on which the improvements were effected is disposed of or sold or the landlord is deceased or declared insolvent, before the improvements are fully taxed to the lessor, the outstanding balance is deemed to have accrued to the landlord immediately. A tenant who acquires the ownership of improvements in respect of which a lease improvement allowance has been granted, shall cease to qualify for deduction of lease improvement from the year of assessment following that in which he acquires such ownership.

In conclusion, when entering into a new lease agreement, both tenants and landlords need to be careful as to who will be paying for the leasehold improvements. If the landlord bears the cost, in which case he would own the improvements and he would be permitted to claim capital allowances on these improvements over the statutorily prescribed life. There would be no tax consequences for the tenant in this scenario unless he also contributes to the cost of improvements. If the improvements are effected in terms of the agreement, the landlord will be taxable on the improvements and the tenant permitted to deduct the expenditure, as outlined above. In a third scenario, where a tenant is permitted to set off the improvements against rent, the improvements will be taxable and deducted in the hands of the landlord and tenant respectively. The taxable or deductible portion of the improvements must be equal to rent that accrues under the agreement at each taxing period. 

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