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. Last Updated: 07/27/2016

Legal Changes Should Give Developers a Push

A number of tax and currency changes introduced during the past two years have made real estate development significantly more attractive, real estate lawyers say.

"It's good for everybody," said Hermann Schmitt, partner with law firm Clifford Chance Puender.

"The tax effect is the same for everybody -- foreign and local developers -- and the same is true for the changes to hard currency regulations as we read them. Real estate can now be sold for foreign currency to a foreigner by foreign as well as local developers."

The tax change of most importance to developers is the deductibility of interest payments for real estate investments from the taxable base for profit tax, Schmitt said in an interview.

"The tax inspections have not traditionally accepted that all expenses a company has are deductible," he said. "Sometimes, if you make a loss, you have to pay taxes."

Interest is often one of developers' main expenses, he said, and not being able to deduct it made it difficult to make ends meet.

"If you earned $1,000 in rent and paid $500 in interest on the loan you took out to pay for the building, the taxman still used to say you have to pay tax on the full $1,000, even though you had only $500."

It became possible to exempt interest expenses on Jan. 1, 2001, but on Jan. 1, 2002, the profit tax itself was reduced from 35 percent to 24 percent, making a "big, big difference" to developers' finances, he said.

Value-added tax rules also changed at the beginning of this year.

Previously, property developers or investors could not recover VAT spent on materials and subcontractors when a building was built. Now, if they are able to show tax officials receipts for that VAT, they can offset it against VAT on rents until the amount is fully recovered, Schmitt said.

"You don't pay VAT until you have recovered all the VAT that was in the building when you built it," he said. "For a number of years, there is effectively no VAT; that means 20 percent more in your pocket."

Another change that came into force this year concerns depreciation, which had been a mere 1 percent per year. It has now been raised to 3.2 percent, or three times what it was before.

Daniel Marti, of law firm Denton Wilde Sapte, said it was still unclear how the depreciation rate will be calculated and could vary according to the official assessment. Nevertheless, he said, the rate is likely to be higher and that this will make property investment more attractive.

The new, larger depreciation rate also helps to reduce the negative consequences of high property tax rates by reducing the book value of the property, Schmitt said.

Property tax is levied on the full value of a building and not, as in the West, only on the part a landlord really owns after deducting financing on the building, Schmitt said.

"Say your building is worth $100 million, you might have financed $90 million and so you really have only $10 million of it, but in Russia you pay the property tax on the full amount, or $2 million," Schmitt said. "This can serve as a big disincentive to own."

In addition, Russian property is traditionally valued very highly for accounting purposes.

"During the high-inflation years companies recalculated the value of their buildings so that they would not have negative capital and face bankruptcy proceedings, and in order to enable themselves to take out loans," he said.

Changes in October to hard currency regulations mean that you can now sell to a foreign firm in hard currency and you can rent to foreign firms in hard currency.

Technically this was possible previously through Central Bank permits, but in practice the Central Bank never issued any permits, Schmitt said.

"Of course, if you were a foreign investor and landlord you could, provided you had the right structure in place, always rent for rubles and then change them into dollars. This course was not available to Russian investors," he said.

However, foreign banks were not inclined to lend to companies on that basis.

"The foreign bank would say: 'You have the right to convert to hard currency so that you can repay us in hard currency, but what if Russia runs out of hard currency in a new crisis?'' Schmitt said.

"The potential country risk still exists after the change, but the currency risks are reduced by the new law," he said. "If a developer can get a foreign tenant who agrees to pay, for example $2 million a year, then hard currency loans can be paid directly from hard currency sources without conversion. Now the circle is closed and that should make financing easier."

Denton Wilde Sapte's Marti said last year's reduction from 75 percent to 50 percent in the Central Bank's requirement for selling hard currency earnings was also of great benefit to developers.

Another positive change for real estate financing, he added, are moves to change the rights of creditors who have lent money against security.

Currently, they are only the third in line when it comes to bankruptcy proceedings, and they are satisfied collectively, he said.

This is now being addressed by both an agreement on banking reform between the Central Bank and the government at the end of last year and by a new insolvency law that had its first reading in the State Duma on March 6.

Under the agreement, secured creditors will be satisfied out of the assets they have secured and that they will be satisfied individually and come before any other claims, Marti said. The new insolvency law will give secured creditors priority, with only creditors who have damage to their health and employees that have claims that existed before the pledge was created ahead of them, he said.

Schmitt said urgent change is still needed to the law on ownership that says you cannot legally sign a lease contract before the building has been completed and registered because you don't have ownership.

"The inability to sign a lease means that developers have to finance projects out of their own pockets. It requires a change to the Civil Code," he said.

Marti agreed, saying the ownership law is out of step with international practice.

Andrei Starovoitov, head of the legal department at the State Construction Committee, or Gosstroi, said another problem is that contracts are not enforceable before a developer's ownership is registered. This is particularly bad when it concerns private citizens buying apartments, he said.

The citizens' stake is accepted as a partnership rather than a contract and they risk losing the apartment, he said.