Alexandria Commercial Leases: Tax & Accounting for Make-Good and Dilapidations

Under corporate reporting frameworks, the accounting treatment of make-good liabilities is governed primarily by AASB 137 Provisions, Contingent Liabilities and Contingent Assets, working alongside AASB 16 Leases. When an entity enters an Alexandria warehouse lease requiring the site to be returned to base-building industrial condition, it must recognize an initial make-good provision if an obligating event exists, an outflow of economic resources is probable, and a reliable estimate can be made. Under AASB 16 (paragraph 24(d)), the estimated cost of dismantling, removing assets, and restoring the site is capitalized into the cost of the Right-of-Use (ROU) asset and depreciated over the lease term, while the provision unwinds over time as a finance cost via effective interest.

From an Australian income tax perspective, this accounting recognition creates a profound timing and characterization mismatch. Under general tax principles established in case law and statutory deduction rules [ATO: TR 97/7], accounting provisions represent future, contingent, or anticipated liabilities rather than losses or outgoings that have been definitively 'incurred' under section 8-1 of the ITAA 1997. The progressive balance sheet accrual or the unwinding finance charge provides zero immediate deductibility on an entity’s tax return.

Tax deductibility arises solely when the liability crystallizes into an actual, unavoidable expenditure—either via physical restoration works commissioned before lease expiration or through an executed cash settlement agreement. This systemic timing divergence generates non-temporary and temporary differences requiring meticulous deferred tax accounting under AASB 112 Income Taxes. Entities that conflate their internal AASB 137 balance sheet accruals with statutory tax deductions expose their operations to immediate compliance rejection during tax reviews.

Given that lump-sum cash settlements fail the immediate deduction criteria under sections 8-1 and 25-10, tenants must evaluate whether relief exists under the capital expenditure regime of section 40-880 of the ITAA 1997 (commonly referred to as 'blackhole expenditure'). Section 40-880 acts as a provision of last resort, allowing business-related capital expenditure to be deducted in equal installments over five income years (20% per year), provided the expenditure is not recognized, deducted, or denied elsewhere under the tax acts.

In Alexandria warehouse tenancies, converted industrial structures frequently house substantial tenant additions, such as partitioned studio suites, structural mezzanines, and dedicated commercial extraction infrastructure. Under subsection 40-880(2), capital expenditure incurred by a taxpayer is deductible over five years if it is incurred in relation to a past, existing, or proposed business carried on for a taxable purpose. When a tenant pays a negotiated cash settlement to extinguish an ongoing lease covenant, this outgoing is directly linked to ending the business operations at that specific site.

However, access to section 40-880 deductions is constrained by the ordering rules set out in subsection 40-880(5). Under these provisions, expenditure is strictly excluded from a five-year write-off if it can be taken into account in calculating a capital gain or capital loss under the Capital Gains Tax (CGT) provisions, forms part of the cost base of an asset, or relates to a lease that is not used solely for income-producing purposes. In commercial lease surrenders, taxpayers must carefully substantiate that the settlement payment does not simply alter the cost base of a continuing capital asset, ensuring it qualifies for five-year blackhole amortisation without falling into non-deductibility traps.

For South Sydney commercial property owners, the receipt of a make-good or dilapidations settlement is not an automatic tax-free windfall. The precise characterization of the funds in the landlord’s hands dictates whether the receipt is treated as ordinary income under section 6-5, a recoupment under section 20-20, or a capital proceeds receipt under the Capital Gains Tax (CGT) rules contained in Part 3-1 of the ITAA 1997.

Under Taxation Ruling TR 2005/4, if a landlord receives a cash sum specifically designated as compensation for lost rental income or unpaid outgoings, the amount forms assessable ordinary income under section 6-5. However, if the deed of release establishes that the cash payment is direct compensation for structural damage or permanent diminution in the value of the building, the receipt is treated as capital proceeds. This receipt triggers CGT Event C2 (cancellation, surrender, or satisfaction of an intangible right under section 104-25) or serves to reduce the landlord’s cost base in the underlying building asset under section 110-45.

Crucially, if the landlord uses the make-good proceeds to carry out capital works or modernization improvements to prepare the warehouse for the next commercial creative tenant, those improvement expenditures cannot be offset immediately against the settlement receipt. The landlord must add the construction costs to the property's capital works base under Division 43, depreciating the expenditure at 2.5% per annum over 40 years. Consequently, if the settlement payment is characterized as ordinary assessable income while the corresponding rehabilitation works are forced into a multi-decade capital works write-off, the landlord incurs severe tax asymmetry and a sudden tax liability.

Whether you are a commercial tenant negotiating a lease exit or a landlord managing a complex warehouse dilapidation claim in Alexandria, precise financial structuring is essential. Speak with our principal to review your make-good covenants, balance sheet provisions under AASB 137, and statutory tax deductions under the CPA Code of Ethics.