Your Taxes: Active versus passive rental income

The Supreme Court decided that by law, rental income will be considered active business income in two cases.

One of the tougher tax questions in many countries is: When is rental income active business income rather than passive income? For example, say you own and operate a shopping mall and ensure that the ambiance and tenant mix are always appropriate, the building is properly maintained and the mall is fun for people of all ages - is the resulting rental income active or passive? The tax rates and rules may be very different in each case. The Supreme Court recently issued a judgement that goes a long way to clarifying the issue of how to classify rental income - active or passive (Barshaf Eilat Ltd. vs Eilat Assessing Officer) issued December 19, 2007, Civil Appeal 10251/05. Barshaf was a company owned by a father and son who operated a gas station in Eilat. After being in business for about 30 years, they entered into a rental agreement with a gas company, whereby exclusive possession of the gas station property and related rights were handed over in consideration for a fixed monthly amount. From then on, the father and son did not have any function in the gas station; in practice, they cut off all business connection with it. The Supreme Court was asked to rule whether the rental income from the gas station was business income, as claimed by the taxpayer, or passive income, as claimed by the assessing officer. This was important, because business income in Eilat is eligible for special tax breaks under the Eilat Free Trade Area Law, but not passive income. The Supreme Court decided that by law, rental income will be considered active business income in two cases. The first case of active rental income concerns a leasing business, where the rented assets constitute business inventory (stock in trade), and rental operations are continuous and systematic with a clear purpose. In this case, income is accompanied by activity related to leasing or services supplied to the lessee (tenant), which show a business character involving personal effort of the taxpayer. For example, income will generally be considered to be from a business if the taxpayer rents out assets and manages an organizational network and a system for managing leasing activities including: raising finance, marketing and publicity, maintaining an office, accounting, building planning and development, repairs, etc. Additional factors indicating a business character include: wide range of assets, supply of services to the lessor, external finance, incurring deductible expenses, etc. However, the court found there was no such leasing business in this instance. The second case of active rental income concerns the renting out of a going concern, where a taxpayer who has a business continues to derive income from it by renting it out temporarily for a fixed period to another party that operates it. In this case, the rental payments to the lessor are not a return on the rented asset; instead they depend on the profitability of the business. The resulting income is not rental in nature, it is ordinary business income that looks like rental income. Such rent will be treated as business income if the taxpayer can prove that a business, as opposed to an asset, is the subject of the rental transaction. The lessor must therefore prove he rented out a going concern (active business) that is not liquidated but continues to be operated by the lessee. The key test in a going concern scenario is whether the income of the business is separate from the income of the lessor when renting out the asset in which the business is operated. If there is such a separation, the income is not business income. The Supreme Court ruled that the issue of separation is not determined according to hard-fixed parameters, and each case must be weighed on its merits. Nevertheless, there are a number of considerations to take into account, including the following: • The rental period: This can signify a link or the absence of a link. The longer the rental period, the more likely the lessor may be viewed as separated from the business he owns, and hence the more likely the income will be viewed as passive. • The method of fixing the rent: This may sometimes indicate the nature of the income. If the lessee remits all the business profits less his fee to the lessor, this is likely to be considered business income. This also applies where the rent varies according to the profitability of the business, even if the lessor-taxpayer does not play an active part in the conduct of the business. But it is not enough to claim the rent is determined by reference to profitability of the business. The question of risk matters; does the rent reflect the business risk? • To what extent is the lessor a partner in the business: There may be cases where rental income is characterized as business income even if the lessor does not incur an element of risk. Such a case would be if it can be proved that the lessor is active in managing the business. If so, the tendency would be to view the lessor as an active partner in the management of the business if he puts in real active effort. After reviewing the purpose of the above-mentioned law, the Supreme Court ruled that it should be interpreted liberally so that its benefits are given to those whose efforts and toil generate income for Eilat. Nevertheless, in this case, the taxpayer's appeal was rejected by the Supreme Court. It ruled that the rental income was not business income and the taxpayer was not entitled to the tax breaks in the law. To sum up, in this case, the Supreme Court has given us useful benchmarks for classifying income as active or passive - not only rental income, but also financial income, royalties and so forth. As always, consult experienced tax advisors in each country at an early stage in specific cases. [email protected] Leon Harris is an international tax partner at Ernst & Young Israel.