Prepaid rent found to be not deductible

In brief - Full Federal Court finds that payments made by a franchisee in connection with the acquisition of McDonald's restaurants and described as prepayment of rent were not deductible in Mussalli v Commissioner of Taxation [2021] FCAFC 71

The Full Federal Court agreed with the decision of the primary judge that the payments were not deductible because they were on capital account. In essence, the Court found that the payments were disguised as "prepayment of rent" for the premises when in reality they were payments to acquire the right to operate the restaurants.

Mussalli was the State Manager of New South Wales for McDonald's Australia Limited (MAL). He decided that he wanted the opportunity to take over some restaurants that were being operated by MAL.

MAL offered Mussalli a lease and licence to operate four restaurants, which were accepted by the trustee of the Mussalli Family Trust. The offers required the payment of a base rent amount and a turnover rent amount based on monthly gross sales of the restaurant. The trustee could elect to reduce the turnover rent amount by making a payment to MAL called a prepayment of rent on the day it began to operate the restaurant.

Later MAL made further offers to Mussalli to operate three more restaurants, which were materially on the same terms as the initial four restaurants. These offers were also accepted by the trustee.

For each restaurant the trustee decided to prepay rent to reduce the turnover rent. The documents signed by the parties reflected this option and did not mention the original higher rate of turnover rent based on monthly gross sales of the restaurant. This meant that the trustee was never required to pay the higher rent.

Apart from one restaurant, the prepayments of rent were not refundable. For that restaurant, there was a part refund if MAL could not obtain a further head lease for the premises.

Although the lease and licence were for limited terms, Mussalli was confident that the lease and licence would be renewed by MAL based on his knowledge of MAL's procedures and policies.

MAL valued the restaurants by reference to a multiple of their adjusted yearly profits. The rent prepayment was the residual value of the restaurant after the value of equipment was subtracted. The lease term did not have any impact on the amount of rent prepayment.

Court finds that purpose of prepaid rent was to obtain a more profitable business structure

The Court found that the purpose of each prepayment of rent was to obtain a better version of the lease, and therefore a more profitable business structure, at least for the duration of the lease and probably longer. The payments were not connected with the obligation to pay rent since: 

• the payments were calculated as the residual value of the restaurant after the value of equipment was subtracted

• the method of calculation was the same even though the duration of the leases were different 

• the payments were lump sum amounts made when the restaurants were acquired

• no payment was required on renewal or extension of a lease

• the payments actually extinguished any obligation to pay the original higher rent

• the payments were generally not refundable

• the payments did not necessarily cause a reduction in turnover rent due to the way that the turnover rent was calculated

• similar calculations were undertaken when a franchisee transferred a restaurant back to MAL or to another franchisee.

What factors might you consider when determining difference between payments on revenue or capital account?

While the decision in Mussalli v Commissioner of Taxation is particularly relevant for other McDonald's franchisees, it is also relevant to other parties that prepay rent in connection with the acquisition of a business.

The Court made the following statements that may be useful when considering the distinction between payments on revenue or capital account in other cases:

• the character of the advantage sought (or what the payment is for) is generally the chief, if not critical, factor

• the character of the advantage sought is to be determined objectively from the perspective of the entity making the payment

• identification of the advantage sought normally involves consideration of how the thing acquired is to be used

• the focus is on identifying an enduring advantage rather than an asset, a payment may be on capital account even though no asset is acquired

• the terms on which an asset is acquired can affect how advantageous or disadvantageous, or valuable, that asset is

• to work out whether a payment was made to secure a preferable business structure involves a comparison of the expected structure of the business after making the payment with the expected structure if the payment had not been made

• there is no general principle that a payment that reduces or eliminates future revenue outgoings is of itself a revenue payment

• the use of the label rent is not determinative

• the way in which the payments are calculated may be relevant in determining what the payments were for, even if the calculation is determined unilaterally by the entity receiving the payment

• the accounting treatment of the payment may also be relevant.