Tax consequences of capital improvements of leased property: new approaches
The new approach to assessing the tax consequences of such improvements is set out in the Ruling of the Russian Supreme Court dated 1 February 2021 in case No. A76-8895/2019 (JSC Metran Industrial Group).
The essence of the problemFifteen years ago Chapter 25 of the Russian Tax Code (the “Tax Code”) was supplemented with a rule that integral improvements to leased property that are not refunded by the landlord are not included in the landlord’s income. Simultaneously, a provision was added to the Code whereby the tenant depreciates such improvements if they have been made with the landlord’s consent.
The provisions on depreciation:
- provided that the useful life established for the leased property should be used for improvement depreciation purposes, on the one hand, and
- limited the depreciation accrual period to the lease period, on the other hand.
The Metran case addresses the possibility for this part to be booked as expenses.
The main idea the inspectorate was pushing in this dispute was that the net book value of the improvements was not included in the tenant’s expenses and was subject to VAT payable by the tenant as a sale for no consideration. The landlord in this case was a unitary enterprise. A free-of-charge transfer of improvements to it is not subject to VAT under article 146(2)(5) of the Tax Code. Therefore, the VAT claim in this case was based on the reinstatement of tax that was deducted when the capital investments were made, rather than on extending the tax base.
The main conclusions of the Russian Supreme Court and comments on them
1. Non-refundable improvements to leased property are subject to capitalisation on the part of the tenant if such improvements may be defined as further construction, procuring additional equipment, reconstruction, modernisation or technical re-equipment.
According to the general rule, a part of the expenses that has not been depreciated during the lease term does not meet the criteria for being economically justified and cannot be booked for tax purposes.
According to the logic of the court, the economic grounds of the legal regulation for which article 257(2) of the Tax Code provides are as follows:
- the operational life of an improvement equals the operational life of the leased property;
- if the operational life exceeds the lease term, only part of what has been spent corresponds to the tenant’s benefit;
- this part is determined as the share of the lease term in the operational life of the leased property;
- the part exceeding this share is not economically justified.
2. At the same time, the Russian Supreme Court has not ruled out the tenant’s right to book as expenses the part that has not been depreciated. For this purpose, the presumption of not being economically justified that follows from article 257(2) of the Tax Code should be denied.The Ruling singles out two groups of “denial criteria”.
The first group is associated with the tenant. The tenant should prove that there is a relationship between the capital investments and the specifics of its activity.The Ruling contains examples.
In such a case, it is clear why the presumption does not work. Property that has been improved to meet the tenant’s needs cannot be used by the landlord or anyone other than the tenant. This denies the presumption that part of the useful life of the improvements refers to the period outside of the lease term.
Example 2: utility facilities are set up that are necessary primarily for the tenant to operate equipment.
In this case the presumption is denied in a similar way. If the tenant removes the specific equipment, this entirely devalues the utilities connected to it. Therefore, the useful (operational) life of the “improvements” is economically dependent on the lease period.
Example 3: at the time when an agreement is concluded there is an intention on the part of the tenant as well as a possibility for the tenant to recoup the cost of the capital investments by using the leased property during the proposed lease term.
In this case the economic justification of the presumption is not that the investments cannot “work as improvements” after the lease term expires. In such a case, the presumption of not being justified is denied by the tenant’s business strategy:
- the tenant intended to recoup the improvement costs within a shorter period (as compared with the operational life of the improvements). This means that, despite the presumption, the tenant’s activity was actually aimed at generating income;
- these plans were grounded in opportunities that actually existed, i.e. the plans were genuine.
This example appears to be connected with the previous one. If the costs were unreasonable (were not associated with genuine plans to recover them), the input data from this example will not work. If in this case the agreement is terminated on reasonable grounds and the facility is returned, reasonable grounds for the return will not be sufficient for the presumption to be denied. In other words, in the event of early termination, evidence must be provided for the input date from example 3 as well as from example 4.
The criteria from example 4 are grounded in the fact that the evidence of the costs being economically justified is to be based on the intention and purpose, rather than on the result. When the intention to recover the costs from example 3 is justified, but has not actually been implemented owing to the termination of the agreement, evidence must be provided of the termination being justified.
The pandemic and the resulting drop in the attendance may entail a situation when continuing the lease will not only prevent the improvement costs from being recouped (contrary to the plans), but also cause a loss in addition to the costs that have not been recouped.
The above examples illustrate the following points:
- a normal (economically reasonable) business may reduce the profit tax base by the cost of improvements that have not been depreciated;
- the fact that the business is economically reasonable needs to be proven. This involves keeping and, if needed, additionally documenting evidence of the stages in the business's decision-making process in this sphere that are relevant for taxation purposes.
At this point we deal with a civil law nuance. Integral improvements are actually classified as such because it is impossible to detach them without damaging the leased property (article 623(2) of the Russian Civil Code). In other words, improvements may be of no economic value for the owner, but the owner is unlikely to detach them and cause damage to his/her property.
Example 5: a hall for holding dance performances is leased during the theatre season. In view of the specifics of the performance the tenant needs to change the floor of the stage (for better acoustics and better adhesion to the stage for the dancers, etc.).
It is fairly possible that the owner of the theatre is indifferent to this covering (since the owner usually leases out the hall to tenants who are not as demanding). However, after the lease term expires a reasonable landlord is unlikely to remove the new covering and somehow restore the old one.
This example demonstrates that if the owner does not dismantle the improvements this does not necessarily mean that the improvements that were made have economic value for the landlord.
This group of criteria is outside the tenant’s control and, therefore, creates potential tax risks for the tenant. Fortunately, according to the Ruling, the criteria are of equal significance, i.e. criteria from only one of the two groups will be sufficient for denying the presumption.
3. VAT. According to the general rule, if property is returned to the owner with qualitative improvements for no consideration, VAT should also be refunded.It appears that ultimately the Russian Supreme Court has not supported the tax authority’s point that a return to the landlord of a leased item with improvements is classified as a sale in accordance with article 146(1)(1) of the Russian Tax Code. Such approach is beneficial for tenants who have not deducted VAT on the work purchased. This applies, for example, to banks which, owing to the specific nature of their activity, either do not deduct the input VAT at all, or deduct only a small portion of it. Therefore, such banks will have nothing to reapply. Neither do those who purchased improvement-related work have to reinstate VAT.
4. The Court has also permitted the non-reinstatement of VAT in the event that the above presumption is denied. The criteria for the presumption to be denied are almost the same as for profit tax expenses to be booked.Therefore, the content of evidence for obtaining positive profit tax and VAT consequences is similar.
What to think about and what to doTenants who make capital investments in leased facilities should assess the effect of the approach proposed by the Russian Supreme Court on the tax consequences of such investments that were determined previously. The Supreme Court’s approaches should be taken into account when lease transactions are structured for the future.
According to the approaches set out in the Ruling of the Russian Supreme Court, tenants who make capital investments in leased property should prepare defence files. With regard to each episode the following should be done:
- divide the improvements should into those that may be defined as capitalised costs in accordance with article 257(2) of the Russian Tax Code, and those that cannot be so defined;
- collect evidence (or collect information and document it so that it could be used as evidence) of compliance with the above criteria, including calculations, correspondence, photographs (photo reports), minutes of meetings, etc.
Help from your adviserPepeliaev Group’s lawyers are ready to provide comprehensive legal assistance in view of the new developments and to advise on all tax aspects of capital investments in leased facilities. In particular, we can:
- check whether the capital investment depreciation term may be reduced. The Russian Supreme Court has issued a reminder that with regard to capital investments that have been made starting from 1 January 2010 the depreciation amounts may also be calculated not only taking into account the useful life of the leased facilities, but also taking into account the useful life determined specifically for the capital investments in the leased facilities;
- check or prepare existing defence files as to their compliance with the new approaches proposed by the Russian Supreme Court and assist in eliminating the deficiencies;
- checking whether the improvement costs are correctly distributed between capital and current costs taking into account the relevant administrative and judicial decisions and approaches;
- prepare counter arguments for tax authorities that the improvements made were of economic value for the owner as at the time when the lease was terminated;
- check for and close the gaps in procedural documents, clarifications and objections under existing disputes with the tax authorities, or draft such documents;
- assist in developing internal regulations by which capital investments into leased facilities will be formalised and facts that are significant for tax classification will be documented.