Lease Premiums: Why Part of That Lump Sum Is Taxed as Income, Not Capital

A premium for granting a lease looks like a straightforward capital sum — a lump sum paid up front, in return for handing over the right to occupy for a fixed term. Landlords and developers often price a lease premium the way they'd price a sale: as one number, taxed once, at capital gains rates. For a short lease, that assumption is wrong, and it's wrong in a way that shows up as an unplanned income tax or corporation tax bill in the same year the money lands.

Why a "capital" payment ends up taxed as income

The starting point in tax law is that a lease premium is capital — it's the price of a proprietary interest, not rent for the use of the property. If that were the whole story, granting a 99-year lease for £500,000 and granting a 5-year lease for £500,000 would be taxed identically. HMRC has never accepted that a short lease and a long lease are economically the same thing dressed up differently, and ITTOIA 2005 section 277 exists specifically to stop a landlord using a short lease premium to convert what is, in substance, rent paid up front into a capital receipt taxed at lower rates or sheltered by reliefs that don't apply to rental income.

The rule only bites on leases of 50 years or less. Grant a lease for a term longer than that and the premium is pure capital, dealt with entirely under Capital Gains Tax. It's the shorter leases — the ones actually common in commercial lettings, ground rent structures, and sale-and-leaseback arrangements — where the split applies, and where the numbers matter.

The formula that splits the premium

Where the rule applies, the amount treated as property income (or, for a corporate landlord, brought into the Corporation Tax Act 2009 equivalent) is calculated as:

P × (50 − Y) / 50

where P is the premium and Y is the number of complete years in the lease term, other than the first. A 25-year lease has a Y of 24, so a £40,000 premium produces £40,000 × (50−24)/50 = £20,800 taxed as property income in the year of receipt, with the remaining £19,200 treated as capital. Shorten the term and the income-taxed slice grows fast: a 10-year lease on the same £40,000 premium brings £32,800 into income, leaving only £7,200 as capital. The shorter the lease, the closer the whole premium comes to being taxed exactly as if it were rent.

The critical point for cash flow planning is timing. This isn't tax deferred over the life of the lease — the income-taxed portion is assessable in full in the tax year (or accounting period) the premium is received, on top of whatever rent is also charged. A landlord who's budgeted the premium as a single capital sum, timed a disposal around it, or used it to fund a development elsewhere can find a meaningful chunk of it already owed to HMRC before the next rent payment is even due.

Section 278: the trap for work instead of cash

Not every premium is paid in cash, and the legislation anticipates that. ITTOIA 2005 section 278 treats a lease as if it required payment of a premium where the lease instead obliges the tenant to carry out work on the property — a refurbishment, a fit-out, a change of use conversion — and that work increases the value of the landlord's interest. The deemed premium is taxed under exactly the same income/capital split as a cash premium would be.

This catches landlords who structure a deal so the tenant funds improvement works in place of an upfront payment, on the assumption that no money changing hands means no premium and no tax point. It doesn't work that way. If the arrangement increases the value of what the landlord holds, HMRC treats it as a premium regardless of the form it takes, and the tax charge arrives whether or not there's cash on the other side of the transaction to pay it with.

Relief for a trading tenant who pays the premium

The rules aren't entirely one-sided. A tenant who occupies the property for the purposes of a trade, rather than sub-letting it on or holding it as an investment, can generally deduct the income-taxed element of the premium they've paid as if it were additional rent, spread evenly across the term of the lease, under ITTOIA 2005 section 61 (or the corporation tax equivalent). This relief exists precisely because the landlord has been taxed on that slice as income, so a trading tenant paying it gets symmetrical treatment as a trading expense over time rather than a one-off capital cost that never reduces their taxable profit.

That symmetry only holds for a genuinely trading occupier. An investor taking a lease to sub-let, or an intermediate landlord in a chain, doesn't get the same relief — which is worth knowing before assuming a group structure with an intermediate leasehold entity will automatically pass the tax cost down cleanly.

What happens to the rest for Capital Gains Tax

The part of the premium already brought into income isn't taxed twice. TCGA 1992 apportions the premium so that the amount already charged to income tax or corporation tax is excluded from the consideration used to calculate any capital gain, and the grant of the lease is treated as a part disposal of the landlord's freehold or superior leasehold interest for the remainder. This means the base cost of the interest has to be apportioned between the part disposed of and the part retained — not simply carried forward in full — which is easy to get wrong if the premium is treated as a single, undivided capital receipt in the accounts.

Reverse premiums run the other way

Not every premium flows from tenant to landlord. A reverse premium — a payment or inducement a landlord makes to a tenant to secure a letting, common where a landlord needs to fill a difficult unit or lock in an anchor tenant — is generally treated as taxable income in the tenant's hands where it's revenue in nature, rather than a tax-free capital receipt. Landlords occasionally assume the reverse case mirrors the forward one and expect some relief for making the payment; in practice, the landlord's payment is usually a capital cost of securing the lease with no equivalent income deduction, while the tenant receiving it faces an income tax charge on money they may already be treating as a contribution towards fit-out costs.

What this means in practice

• Check the lease term before pricing the premium — anything at or under 50 years brings section 277 into play; over 50 years, it's pure capital.
• Run the formula before you agree the figure — P × (50−Y)/50 tells you how much of the headline number is really taxed as income this year, not spread over the term.
• Budget the income tax or corporation tax hit as immediate — it falls due in the year the premium is received, alongside rental income, not deferred over the lease.
• Don't assume works-in-lieu-of-cash escapes the charge — section 278 brings a deemed premium into the same rules if the tenant's works increase the value of your interest.
• If you're the paying tenant and you trade from the property, check whether section 61 relief applies before writing the premium off as a dead capital cost.
• Apportion the base cost, don't just apportion the premium — the CGT part disposal rules require the underlying interest's cost to be split too.

Common questions

Is a lease premium taxed as income or capital?

It depends on the lease term. Over 50 years, the premium is pure capital. At 50 years or less, ITTOIA 2005 section 277 taxes part of it as property income in the year received, with the balance treated as capital.

What is the formula for splitting a lease premium?

P × (50−Y)/50, where P is the premium and Y is the number of complete years in the term other than the first. A 25-year lease on a £40,000 premium brings £20,800 into income.

Can a tenant claim relief for the income-taxed part of a premium?

A tenant trading from the property can usually deduct the income-taxed element as additional rent, spread over the lease term, under ITTOIA 2005 section 61. Investors and intermediate landlords generally can't.

What is a section 278 premium?

Where a lease obliges the tenant to carry out work that increases the value of the landlord's interest instead of paying cash, section 278 treats that as a deemed premium taxed under the same rules as a cash payment.

This article is general information, not personal tax advice, and tax rules change. Your own position depends on facts we cannot see from here — please take advice before acting on anything above.

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