"Prepaid rent" - capital or revenue?
Tax Bar Association member Joel Phillips discusses the Full Federal Court's recent decision in Mussalli v Commissioner of Taxation regarding the prepayment of rent and whether it is expenditure on revenue or capital account. A PDF copy of this article is available to download below.
While the legal principles concerning whether expenditure is on revenue or capital account are well established, they remain productive of disputes. A recent example is Mussalli v Commissioner of Taxation  FCAFC 71, where the Full Court held that amounts described as a “prepayment of rent” were capital or capital in nature and thus non-deductible.
McDonald’s Australia Limited (MAL) operates a franchise model. On seven occasions, it offered Mr Mussalli, MAL’s former State Manager for NSW, a “Full Lease and Licence” (FLL) to operate a new or existing McDonald’s restaurant. Each offer required the payment of an amount for plant and equipment, a base rent amount, and a percentage rent amount calculated by reference to monthly gross sales.
On each occasion, Mr Mussalli was given an option to reduce the percentage rent amount by making a “prepayment of rent”. For the new restaurants, the option was in the offer letter, with the lease subsequently referring only to the applicable percentage rent. For the existing restaurants, the option was a provision of the lease. With one exception, the upfront payments were not refundable.
The Mussalli Family Trust (MFT), a discretionary trust controlled by Mr Mussalli, accepted each offer and opted to make each upfront payment.
By the first instance hearing date, some of the FLLs had been extended or held over, with the existing lower percentage rent being applied, and without any further upfront payment being made. There was evidence that Mr Mussalli was “well aware” of MAL’s policies and procedures concerning when FLLs would be renewed and that he was “confident” of obtaining renewals.
MAL treated the upfront payments as assessable rent. The taxpayers (Mr Mussalli and other beneficiaries in receipt of trust distributions) contended that the upfront payments were on revenue account and deductible over 10 years in accordance with s 82KZMD of the Income Tax Assessment Act 1936 (Cth); the Commissioner contended that the upfront payments were on capital account and thus non-deductible.
The Federal Court’s decision
At first instance, the taxpayers contended that the advantage which Mr Mussalli (as the controlling mind of MFT) sought in making the upfront payments was the use and enjoyment of the relevant store.
Jagot J rejected that submission. Her Honour noted that, irrespective of the label attached to them, the upfront payments were not a prepayment of rent: “The payments negated or extinguished any obligation to pay the higher percentage rent and did not thereby relate to any future obligation to pay rent.” Her Honour concluded that each upfront payment was an outgoing of capital or of a capital nature, being “a one off, lump sum, non-refundable payment made to secure an enduring advantage (the right to pay the lesser percentage rent) for the term of the FLL and most likely the term of any renewal of the FLL”.
Her Honour stated that the same conclusion was reached even if one disregarded Mr Mussalli’s awareness that the lesser percentage rent would likely endure beyond the initial term, and even if one also disregarded the basis on which MAL had calculated the upfront payments (namely, by deducting the value of equipment from the agreed value of the business, rather than by calculating the present value of the difference between the higher and lower percentage rent).
The Full Federal Court’s decision
Characterisation, and deductibility of payments in substitution of revenue outgoings
On appeal, the taxpayers relied on the primary judge’s finding that the upfront payments “negated or extinguished any obligation to pay the higher percentage rent”. The taxpayers submitted that this meant the payments were made to secure a reduction in a revenue outgoing (ie, rent) and that such a payment is on revenue account. The taxpayers emphasised that the payments did not change the leasehold interest. They asserted that the payments therefore did not change MFT’s business structure but instead changed only the outgoings incurred in carrying on the business.
The plurality, McKerracher and Stewart JJ, rejected that submission. Their Honours held that the payments were made for “an enduring advantage in the form of a right to pay the lesser rent for the term of the FLL, and most likely longer”. The advantage was a “better version of the lease”.
Their Honours stated that “the payments were not made to secure… the ongoing use and enjoyment, or occupancy, of each store over the term of its lease because that advantage was otherwise secured”. Their Honours observed that, while the payments did not change the leasehold interest, they secured the right to pay the lesser rent and thereby changed MFT’s profit-making structure for the term of the FLLs.
Their Honours held that the conclusion that the upfront payments were capital or capital in nature “necessarily followed” from the correct identification of the advantage. In particular, because the upfront payments were not made to secure the right to occupy the premises, it followed that they were not a substitute for future rental expenses.
Their Honours also held that the authorities “do not establish…. any general principle that payments made to secure a reduction in revenue outgoings will always be on revenue account”. Their Honours observed, for example, that the payment in W Nevill (made to procure a managing director’s resignation and thereby save his salary) did not give rise to any capital asset or enduring benefit, and that the payment in Anglo-Persian (made to terminate an existing agency arrangement under which commissions were payable) also did not relate to an identifiable capital asset.
The taxpayers contended that the character of the advantage sought should have been determined solely from MFT’s perspective, and that the primary judge erred in having regard to the basis on which MAL had calculated the upfront payments.
McKerracher and Stewart JJ rejected that submission. They held that the way in which the upfront payments had been calculated an objective fact which formed part of the wider commercial context and could properly be taken into account into determining their character.
Thawley J's concurring judgment
Thawley J agreed with "the substance" of the plurality's reasons but held that the outgoings could be characterised by an objective comparison of the two options provided by MAL to the purchaser. He observed that, in the case of one restaurant, MAL had valued the business at $940,000 but the associated equipment at only $465,000 – with the purchaser having the option to pay the difference of $475,000 by means of an upfront payment. He concluded that "[o]bjectively assessed, the purpose of the purchaser in incurring an obligation to pay $475,000 would be to acquire the business and associated structure, not to prepay rent". This analysis raises the question whether, if MFT had opted not to make any upfront payment, the increase in the percentage rent amount would itself have been capital or capital in nature.
Mussalli provides another useful example of how to identify a taxpayer’s profit-making structure and the advantage sought by a payment. It also illustrates how easily an asymmetric outcome can arise for payer (non-deductible) and recipient (assessable).
The taxpayer has sought special leave to appeal.
By Joel Phillips, Barrister at the Victorian Bar
Liability limited by a scheme approved under Professional Standards Legislation
 Examples since Federal Commissioner of Taxation v Sharpcan Pty Ltd  HCA 36 include Watson atf Murrindindi Bushfire Class Action Settlement Fund v Commissioner of Taxation (2020) 277 FCR 253 (concerning costs incurred in administering the Murrindindi Bushfire Class Action Settlement Scheme); Clough Limited v Commissioner of Taxation  FCA 108 (concerning amounts paid in consideration for the cancellation of employee entitlements); and Federal Commissioner of Taxation v Healius Ltd  FCAFC 173 (concerning lump sum amounts paid to medical practitioners under arrangements to conduct practice from the respondent’s medical centres).  Mussalli v Federal Commissioner of Taxation  FCA 544.  W Nevill & Co Ltd v Commissioner of Taxation (1937) 56 CLR 290.  Anglo-Persian Oil Co Ltd v Dale (1932) 1 KB 124.