The gain arising from the transfer of the use of immovable property for consideration is counted, for the purposes of the Income Tax Act, among the elements of income subject to tax. The financial side of a lease relationship is therefore not complete once the rent has been paid on time; the tax duties attaching to the gain must also be performed in due form.
In residential leases the person on whom that duty falls is, as a rule, the person letting the property. In leases of commercial premises the picture changes, and the task of withholding an amount from the rent and transferring it to the tax authority is placed on the tenant. Following that distinction, a series of questions arises in practice: does the fact that a withholding has been made remove the property owner’s duty to file a return altogether, may the tax burden be transferred to the other party by agreement, and what do clauses in an agreement that conflict with the fiscal legislation mean as regards the tax authority?
In this briefing note we consider the differences between the tax regimes governing residential and commercial leases, the question of who bears the duty to withhold and the duty to declare, the conditions governing the exemption, and the typical situations that give rise to disputes, within the framework of the legislation in force and of settled practice.
Tax Liability in Residential Leases
Rental income derived from a residence is one of the items of income subjected to income tax. Where the thresholds set by law are exceeded, the person letting his or her residence is faced with the obligation to declare the income obtained and to pay the tax assessed. The point of departure from leases of commercial premises becomes clear here: in residential leases the liability rests on the property owner without any intermediary.
Most of the uncertainties in this field are gathered around three points. Once it has been correctly established whether any withholding is to be made from the rent, beyond which threshold the filing of a return becomes compulsory, and which amounts are left outside the scope of tax, a significant part of the problems encountered in practice will have been resolved from the outset.
Who Pays the Tax on Income from a Residence?
The person on whom the tax on residential rent falls is, as a rule, the person who makes the property available for use. Put another way, in residential leases no tax duty is placed on the tenant; the tenant is not expected to withhold anything from the rent.
Accordingly, where the receipts obtained over the calendar year exceed the statutory limit, the person letting his or her residence must bring that amount within the scope of the annual return and pay the tax calculated. The moment at which the liability arises is the moment the income is obtained.
Is Withholding Applied at Source in Residential Leases?
The rule in residential leases is that no withholding is made. The tenant is not given the task of deducting tax from the sum it pays. Residential rent is therefore paid directly to the property owner without any amount being deducted.
Withholding at source is in essence a practice confined to leases of commercial premises; in a residential relationship no such step on the tenant’s part arises. Where premises let as a residence are in fact used as a bureau, an office or a consulting room, however, the tax characterisation may change and a duty to withhold may arise.
The Threshold at Which the Duty to File a Return Arises
Under the Income Tax Act, where residential rental income exceeds the exemption figure redetermined each year, a duty arises on the part of the property owner to file an annual income tax return. That duty is performed by way of the return to be filed in March of the year following the calendar year to which the income relates.
Whether a return is required is assessed separately by reference to the limit updated each year. While a return may not be required for receipts falling below the limit, filing becomes compulsory where the threshold is exceeded.
Conditions for Benefiting from the Residential Exemption
The Income Tax Act provides for an advantage in respect of residential rental income known as the “residential exemption”. By virtue of that provision, residential receipts up to the figure determined each year are left outside the scope of tax. Benefiting from the exemption, however, depends on the conditions required by the law being satisfied together.
- The absence of liability assessed on an actual basis: persons who are income tax payers assessed on an actual basis by reason of a commercial, agricultural or professional activity fall outside this advantage. Members of the liberal professions, business owners and holders of commercial income assessed on an actual basis are the typical examples of that group.
- The property must have been made available for use as a residence: the exemption operates only in respect of premises let as a residence. It cannot be relied upon in the case of property let as commercial premises, whatever the size of the receipts.
- The person’s other income must not exceed the threshold: the total of salary, interest, dividends, income from movable capital and other gains and revenues must remain below the limit set out in the law. In that calculation no regard is had to whether the income in question is subject to declaration or falls within the scope of some other exemption; gross figures are taken into account. As a result, while persons whose income consists solely of rent for the most part benefit from the exemption, the advantage may not operate for those with high salary or interest income.
It should also not be overlooked that the exemption attaches to the person. For a person deriving receipts from more than one residence, the exemption is applied only once, on the total rental income obtained, and not separately for each property.
Withholding and Tax Liability in Leases of Commercial Premises
Taxation in leases of commercial premises departs from the residential regime and is founded on the principle of withholding at source. Under that method an amount at the rate indicated in the legislation is deducted from the rent and paid directly to the tax authority. In a commercial relationship, therefore, the tax duty has not been left to the property owner alone; a concrete responsibility has been placed on the tenant as well.
The question marks in practice generally cluster around the following headings: what is the nature of the withholding, whose is the task of making it and declaring it, how is the rate determined, and does a withholding that has been made remove the property owner’s separate duty to file a return? Withholding and the income tax return must therefore be addressed together rather than in isolation from one another.
The Concept of Withholding and How It Operates
Withholding denotes the tax deduction made from the rent for commercial premises. In practice the tenant, when making payment, retains an amount at the rate determined and transfers that amount to the tax office. The tax on the rental gain is thereby collected at source at the moment the income arises.
The purpose of the method is to ensure that the tax due passes to the treasury regularly and securely. By reason of that function, withholding in leases of commercial premises is regarded as one of the building blocks of the tax system.
Whose Duty Is It to Withhold and to Declare?
In leases of commercial premises the task of calculating the withholding, transferring it to the authority and filing the corresponding declaration rests, as a rule, with the tenant. The tenant must deduct the amount found on the sum it is to pay, remit it to the tax office and perform its duty of declaration.
That the withholding is made by the tenant does not, however, mean that the economic burden of the tax remains with the tenant in every case. The parties may agree in the lease agreement which of them is to bear that burden. Even where it is written in the agreement that the burden is left with the tenant, that clause does not remove the tenant’s statutory responsibility before the tax authority; it determines only the internal relationship between the parties, that is to say the arrangements for recourse. As regards the authority, the party addressed continues to be the tenant, on whom the duty to withhold and to declare falls.
Determining the Applicable Rate
The rate of withholding applicable to leases of commercial premises is determined within the framework of the Income Tax Act and the related fiscal legislation. Since the rate may be altered over time, the calculation is always made by reference to the figure fixed under the legislation in force.
The current rate must therefore be monitored both when the agreement is concluded and while the lease relationship continues. Calculations carried out on an incorrect rate may open the door to financial burdens and legal disputes for the tenant and the property owner alike.
The Duty to File a Return Despite Withholding
The fact that the tenant has made a withholding does not in every case remove the property owner’s duty to file an annual return. Where the rental receipts obtained during the year exceed a certain figure, the property owner must bring that income within the scope of the annual income tax return.
Even where withholding has been applied in a lease of commercial premises, therefore, whether a separate duty to declare has arisen must be reassessed each year by reference to the total rental income obtained in that year.
Problems Frequently Encountered in Practice
Although withholding at source is expressly regulated in the fiscal legislation, mistaken steps and misinterpretations in practice can give rise to disputes. The headings that create the greatest uncertainty between the parties are whether the withholding is to be treated as included in the rent, what the property owner’s position is where the tenant fails to make payment, and what consequences follow from amounts paid over short or in excess.
The most effective way of forestalling those uncertainties is to set down in clear language, when the agreement is concluded, the amount on which the calculation is to be made, how the withholding is to be determined and who is to assume the tax duty. That clarity removes at the outset the greater part of the financial and legal contention that may arise later.
Whether the Rent Was Agreed Gross or Net
One of the most widespread problems encountered is whether the sum agreed is inclusive or exclusive of the withholding. Where the parties have not expressly regulated that matter in the agreement, whether the figure is gross or net may give rise to argument.
The settled view is that, unless the contrary is expressly stated in the agreement, the rent is to be treated as a gross amount. As a consequence of that view, the tenant pays the property owner the portion remaining after deducting the withholding from the sum. Where, by contrast, the parties have agreed that the sum is fixed net, the economic burden of the withholding may in fact remain with the tenant.
The Position of the Property Owner Where the Tenant Does Not Pay Over the Withholding
In leases of commercial premises the party on whom the duty to withhold and to pay the tax office falls is the tenant. Where the withholding is not made at all, or is made but not paid over, the authority therefore addresses itself first to the tenant.
That does not mean, however, that the property owner is entirely relieved of all responsibility. The authority may in certain cases also take the rental gain obtained by the property owner under examination; if it concludes that tax has been underpaid, steps directed at the landlord may likewise arise. Faced with that possibility, it is of practical importance for the property owner to monitor whether the withholding is being paid over regularly.
Liability for Withholding That Is Short, Excessive or Not Made at All
Where the withholding is not made at all, is made short or is calculated incorrectly, the tax responsibility belongs essentially to the tenant, on whom the duty to withhold falls. In such a situation the authority may, in addition to the shortfall in tax, apply late-payment interest and a tax penalty.
Where an overpayment has been made, the return of the excess portion may be sought; alternatively, it may be possible for it to be set off against the tax debts of subsequent periods. Consequences of that kind for the most part stem from the application of an incorrect rate or from the rent having been calculated incorrectly.
The Effect Before the Tax Authority of Tax Clauses in the Agreement
Under the Tax Procedure Act, private agreements regulating tax responsibility do not bind the tax office. Even where it has been agreed in the lease that the duty to withhold belongs to the property owner, the party obliged before the authority to withhold, to declare and to pay continues to be the tenant.
Related Topics
For readers wishing to assess as a whole the rights and obligations falling on the parties to a lease relationship, the complementary topics are as follows:
- Termination of a Lease Agreement for Important Reasons and Eviction
- Grounds for Evicting a Tenant and Eviction Actions
- How Is a Lease Agreement Drawn Up?
Independent Legal Assessment
In lease relationships the tax duties are for the most part overshadowed by the negotiation of the agreement, the parties leaving the withholding and declaration side to one side while they settle the rent. Yet a failure to record the distinction between gross and net in writing can turn into a serious contention later on as to the character of the sum paid; and a lapse in the withholding brings with it the risk of penalties and late-payment interest for the tenant and the property owner alike.
That the tax responsibility arises from the law and cannot be transferred as against the authority by agreement is the fundamental principle framing the process. The clauses agreed between the parties regulate only the internal relationship; grasping that distinction at the outset heads off arguments about recourse later.
The headings that should be brought to the fore in structuring a particular lease relationship are as follows:
- Stating in the agreement, so as to leave no room for doubt, whether the rent is gross or net
- Determining the purpose for which the property will in fact be used, and characterising it as residential or commercial accordingly
- Confirming the current rate of withholding in each payment period in leases of commercial premises
- Ensuring that the declarations and payments relating to the withholding are also monitored regularly by the property owner
- Assessing the conditions for benefiting from the residential exemption on a year-by-year basis, taking the person’s other income into account as well
- Bearing in mind that withholding and the annual duty to declare do not take the place of one another
Independent Legal provides advisory services across the whole of the field of real estate law, from the structuring of lease agreements to the conduct of disputes concerning tax duties.