Some Practical Tax Issues Arising on the Conclusion and Implementation of Lease Agreements

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During the process of concluding and implementing a lease agreement, the parties often find it necessary to resolve many different issues -- reimbursement of the utility costs to the lessor, prolongation of the lease agreement, reimbursement of inseparable improvements, repair and maintenance of the leased premises, etc.

Settling all these issues is very important for the lessee, not just for commercial reasons but also from a tax point of view, as unresolved issues may result in tax risks for the lessee.

What are the risk areas we are talking about?

Tax authorities may refuse to accept the deduction of some expenses incurred by the lessee from profit tax (currently the profit tax rate in Russia is 20%). Although Russian tax legislation does not formally connect deductibility of expenses for profit tax purposes and recovery of the respective amount of VAT (value added tax) paid by the lessee, the tax authorities will in practice make all efforts to connect these. They tend to reject any in recovery of VAT claims from the lessees, if they believe that the respective costs should not be deducted from the taxable profit of the lessee.

Below we have briefly outlined some aspects of the lease relations between the parties, which may, potentially, result in tax consequences for the lessee:

1. Reimbursement of utility costs which are not included in the lease payment and which the lessee pays to the lessor in addition. Recently, for many years the tax authorities claimed that the lessor cannot "re-invoice" the utility costs to the lessee, as the lessor is not authorized to provide, say, electricity or heating or similar services. As a result, they claim that the lessee cannot recover VAT paid to the lessor on a "reimbursement of utility costs" basis. On the 25th of February 2009, the Presidium of the Supreme Arbitration Court of the Russian Federation finally ruled this issue in favor of the lessees. It was decided that VAT that the lessor charges on top of "reimbursement of the utility costs" invoiced to the lessee may be recovered by the latter.

2. Expenses incurred by the future lessee under the preliminary lease agreement. In practice a substantial period of time may elapse from the date when the office is physically ready for use and the date of the registration of ownership to the lessor. The parties cannot sign a lease agreement before the ownership is registered, however the future Lessee will often not want to wait for the registration, but rather to start occupying the office, start the fit-out works, etc. So the parties often sign a preliminary lease agreement. Under this agreement the future lessee may incur the expenses connected with (i) payments to the future lessor for access to the premises during the period of fit-out works, and (ii) fit-out works paid to some third party contractors. The tax authorities tend to dispute the deductibility of the aforementioned expenses for the future lessee, claiming that in the absence of duly registered ownership of the office, lease relations cannot arise, so the lessee does not have the right to deduct the costs incurred during the period of the "preliminary lease." However, there is already a set precedent for such a situation. The courts rule that for the profit tax deduction the "substance over form" principle should apply, which means that the actual relations of the parties should be considered irrespective of the formal registration issues.

3. Monthly Acts of Acceptance, which the parties to the lease agreement have to sign, is general practice in Russia. Now the Finance Ministry has changed its conservative position (they used to require a monthly acts from the lessees) and now they confirm that the monthly acts of acceptance are not needed to confirm deduction of the lease payments for the lessee. However, we are aware that in practice the companies still prefer to be on the safe side and sign monthly acts of acceptance of the lease services.