September 2017

Lease incentives - things to watch out for

It is common for landlords to provide tenants incentives to enter into commercial leases.  Incentives can be provided in a number of ways, but the most common are:

  • a fitout contribution,

  • a rent free period,

  • a rent reduction, either by equal reductions in monthly rent instalments over the term of the lease, or with larger reductions at the beginning of the term and smaller reductions for the balance of the term, or

  • a combination of the above.

These arrangements are normally provided for in a separate incentive deed which gives rise to some of the issues addressed below.

Tax matters

There are usually no tax implications were the incentive is provided as a rent free period or by rent abatement.

However, where the landlord provides a fitout allowance there may be tax consequences to both parties.  Normally, if the landlord retains ownership of the relevant fitout, the tenant is not liable for tax on the incentive, but will not be entitled to claim capital allowance or depreciation benefits.  If the tenant owns the relevant fitout, it may be liable to pay tax on the value of the fitout, but should be able to claim capital allowance deductions or depreciation.

Where the landlord retains ownership of the fitout, the landlord will normally be entitled to any capital allowance deductions or depreciation.

Whenever any significant incentive is involved, both parties should understand the tax consequences.  It may be possible to adjust the arrangements to achieve a better tax outcome.

Assignment of lease

Incentive deeds sometimes provide that the incentive will only be available while the original tenant remains the tenant in occupation of the premises.  From the tenant’s perspective, this is unfair as it substantially limits the tenant’s freedom to assign the lease.

It is recommended that the incentive deed provide that if the tenant assigns the lease in accordance with its terms, then the landlord, tenant and assignee of the lease should enter into a further deed transferring the rights and obligations of the tenant under the fitout deed to the assignee so that the assignee enjoys the benefit of the incentive from the assignment date.

Sale of premises

The tenant should ensure that the incentive deed contains a provision to the effect that if the leased premises are sold, the landlord must ensure that the purchaser enters into a deed with the landlord and the tenant providing for the rights and obligations of the original landlord under the incentive deed to pass to the purchaser of the premises from completion of the sale.

This will ensure that the new owner of the premises is bound to give effect to incentive arrangements arising after completion of the sale.  Without such a provision, the purchaser will not be bound to provide the incentive and the original landlord may not be in a position to provide the incentive after completion of the sale.

Bear in mind that the property could be sold by a mortgagee.  In theory, the tenant could insist that any mortgagee be a party to the incentive deed but in practice few mortgagees would agree to this.  The tenant should at least insist that the relevant provision in the incentive deed provide that if the premises are sold, whether by the landlord or by a mortgagee, the landlord must ensure that the purchaser enters into the deed with the landlord and tenant and that if the purchaser does not enter into such a deed, the landlord must indemnify the tenant for any incentive that the tenant misses out on.

Default provisions

The incentive deed will often provide that if the tenant is in default under the lease, the landlord can terminate the lease and/or suspend or terminate the incentive arrangements, and the tenant must refund part or all of the incentive received by it to the landlord.  Care should be taken to ensure that such provisions operate fairly for both parties.  The following points should be considered:

  • Provisions which simply require the tenant to refund the whole of any incentive may be unenforceable as penalties.

  • In the case of fitout allowances, it is reasonable to provide that if the lease is terminated as a result of the tenant’s default, the tenant should refund a proportion of the fitout allowance previously received by it equal to the proportion that the unexpired period of the lease term at the time of termination bears to the total lease term.

  • Where the incentive is provided as a rent abatement by equal reductions in monthly rent instalments over the term of the lease, there should be no provision for refund on termination of the lease.

  • Where the incentive is provided as rent abatement, but with monthly rent reductions at the start of the term being greater than the rent reductions for the balance of the term, it may be appropriate that the tenant should pay a refund in respect of the excess part of the initial monthly rent reductions. The tenant would refund a proportion of the excess being the proportion that the unexpired part of the term bears to the whole term of the lease at the time of termination.

  • Where the incentive is provided as a rent free period, it is reasonable to provide that if the lease is terminated for the tenant’s default, the tenant should pay an amount equal to the proportion of the rent abatement enjoyed by the tenant to the time of termination equal to the proportion which the unexpired part of the term at the time of termination bears to the whole of the term.

  • The incentive deed may provide that if the tenant is in default under the lease, the landlord can suspend the incentive for the period of the default or cancel the incentive. The landlord should be required to give the tenant an opportunity to rectify the default before applying the suspension or cancellation.

  • The incentive deed should spell out clearly what is to happen in the case of default after assignment of the lease or sale of the leased premises. Normally, the tenant under the lease at the time of termination should be the party liable to pay any refund, and the refund should be paid to the landlord under the lease at the time of termination. (See above under Assignment of lease and Sale of premises)

Author: Jack Gordon