New rules for documenting relationships in the area of investment and construction: tax implications
Pepeliaev Group advises that, on 28 July 2011, a Resolution of the Plenum of the Russian Supreme Arbitration Court [1] (the “SAC”) with direct implications for construction and investment activity was published on the SAC’s website. The Resolution creates substantial tax risks for all those involved in that sector: builders, investors and developers.
Main provisions of the document adopted and their impact on taxation
The resolution adopted by the Plenum of the SAC (the “Resolution”) governs issues concerning the classification under civil law of relationships arising when investments are made in facilities under construction (offices, shopping malls and entertainment complexes, etc), as well as how ownership title to the investment item arises, and how transactions are documented when they involve future real estate being acquired, including transactions of an investment nature.
The conclusions set out in the Resolution contain a fundamentally different classification of the relationships between investors and developers. As a result, the implications of those relationships in terms of the tax law have changed substantially.
In particular, in clause 4 of the Resolution, the Court indicated that investment activity in the area of financing the construction or reconstruction of real estate facilities may be classed as a relationship under a sale and purchase agreement, a contractor agreement or a simple partnership agreement. The Court also noted that other types of agreement may be used. However, unless it is stipulated otherwise, contracts associated with investment activity in the area of financing the construction or reconstruction of real estate facilities are classed as sale and purchase agreements for future real estate.
Before the Resolution was adopted, parties making joint investments to finance the construction of real estate objects put together an investment agreement using an agency model to govern the proprietary relationship to the investments set out in the agreement which have been constructed as a result of investment activity. Thus, ownership title to newly constructed property passed direct to the investor. In this context, the developer was purely an intermediary. This legal classification of the relationship is based on the provisions of article 4(3) of Federal Law No. 39-FZ dated 15 February 1999 On investment activity in the Russian Federation carried out in the form of capital investments, fr om which it follows that the developer, not being the investor, assumes the rights to possess, use and dispose of the capital investments for the duration of and within the limits that the agreement authorises. The above provision of the law does not result in the developer assuming ownership title to the investment monies transferred to it by the investor.
In accordance with such a legal nature of an investment agreement (an agency type of agreement), the tax implications were also defined: making an investment in the form of money or other property had no link with the subsequent sale of the real estate facility and was therefore not subject to VAT, while the transfer of the facility to the investor was also not treated as a sale.
Tax risks arising
In accordance with the civil law classification of the investment relationship as defined by the Resolution, the relations that arise between the investor and the developer are those under an agreement for the sale and purchase of future real estate (clauses 4 and 6 of the Resolution), but only the owner of the land plot may acquire ownership title to a completed real estate facility.
Despite the Court in clause 4 of the Resolution leaving open which agreements may be used to document an investment relationship, agreements on the agency model in many cases may no longer be used in construction. This is because the Court indicated that only the owner of the land plot may acquire ownership title to the real estate facility.
Taking this into account, we surmise that the tax authorities may regard the investment relationship as having the nature of a relationship involving the sale of real property.
The main tax implication of this is that the investment should be classed as a prepayment under a sale and purchase agreement for future real estate, meaning that it is subject to value added tax under article 154(1) of the Russian Tax Code.
Should the owner of the land plot be a constituent entity of the Russian Federation, a municipal body or a state enterprise, the ‘investor’ (the purchaser of the future real estate) has an obligation to calculate VAT, to withhold it and to pay it to the state budget as a tax agent.
Moreover, if the relationship is not governed by a contractor agreement (clause 6 of the Resolution) or by a simple partnership agreement (clause 7 of the Resolution), then VAT at a rate of 18% will be payable on the value of the property transferred by the ‘investor’ (purchaser of the future real estate) for construction purposes.
The legal reclassification of the relationship (taking into account that the developer, which owns the land plot, will become the owner of the new real estate) may also result in a change to the procedure for developers (the sellers of the future real estate) to account for expenditure and the taxation of profit. In particular, funds received from an investor may be classified by the tax authority and the court as income of the developer, which may be reduced by its expenses as confirmed by documents.
The Resolution allows the investment relationship also to be classified as a relationship arising under a simple partnership agreement (clause 7 of the Resolution). However, various factors outlined by the Plenum of the SAC will prevent this classification from being applied widely.
As stated in clause 7 of the Resolution, there is a particular procedure for ownership title to arise to an investment item: it is the owner of a land plot which directly acquires ownership title to a facility built on that land plot. For all partners to acquire ownership title to the land plot, shared ownership title to the land plot must be registered.
Since in practice the amount of the partners’ property investments is only determined once construction is completed, practical considerations mean that shared ownership title may only be registered once the proportions of the partners’ ownership shares have been determined.
Conclusions and recommendations
Taking account of the conclusions reached by the Plenum of the SAC in the Resolution, organisations involved in investment relationships entailing the construction of real estate facilities need urgently to assess whether they should review their tax obligations for VAT and profit tax. Because of the three-year time lim it for tax audits to be held, they should assess not only planned transactions but also current and already completed transactions in terms of the legal reclassification of relationships set out in the Resolution.
[1] Resolution No. 54 of the Plenum of the Russian Supreme Arbitration Court On several issues in resolving disputes arising from obligations to transfer real estate which will be built or acquired in future dated 11 July 2011.
For further information, please contact:
in Moscow – Sergey Savseris, Partner, at: (495) 967-0007 or by s.savseris@pgplaw.ru; Mikhail Zausalin, Senior associate, at: (495) 967-0007 or by m.zausalin@pgplaw.ru
in St Petersburg - Sergey Sosnovsky, Head of Tax Practice (St. Petersburg), at (812) 640-60-10 or by e-mail