Liquidated damages or remuneration?

The conditions prevailing on the market are forcing landlords to make their lease offers more and more competitive. Some of their options pose real difficulties in terms of compliance with existing taxation law. Buying out tenants is a good example of these, and one which has been spreading

A typical method of searching for tenants is to outsource the task to real estate agents. Tax offices do not challenge the deductions of real estate agent commissions for income tax purposes, even if a given agent was not successful in executing a lease with a potential tenant. This is because such expenses are incurred by a landlord in a reasonable and justifiable manner, i.e. to generate revenue.
Winning tenants by buying out tenants (i.e. purchasing their lease agreements) from the present landlords is common practice in international business. In Poland however, this option has not been very popular.

Money for a tenant
A lease is usually bought out when a tenant needs larger office space or higher standard premises. In this case the owner of the building, to which the tenant will "move", is expected to pay compensation to the previous landlord.
The fee paid to the previous landlord should be treated as remuneration for his consent to terminate the lease and relinquish all and any rights to the tenant. For this reason this fee does not qualify as an indemnification (liquidated damages) for terminating or defaulting on the lease but as a peculiar type of fee. The new landlord should in turn include the total amount of the related expenses in his tax deductible costs, which are however not recognised until the "purchased" tenant pays the first rent.

Inconsistency of tax authorities
The factors outlined above allow the new landlord to deduct expenses from the purchase of a lease, for income tax purposes. A different approach would imply that one of the above methods of searching for tenants (i.e. relying on real estate agents) is clearly a method favoured by taxation law. This would also imply the unjustifiable interference of tax law in entrepreneurs' expenses arising from their business operations.
Although the analysis above is commercially justified, we know of cases in which landlords were denied the right to deduct the expenses in question for tax purposes. The tax authorities argue that these expenses are in fact liquidated damages, which are not related to revenue in any way whatsoever. However, we also know of a special case in which the taxpayer did succeed in persuading the authorities that capitalisation of the said expenses in the value of the project (building) was justified. Therefore we expect that in future, the tax authorities will follow a more consistent approach, which will also prove more favourable to entrepreneurs.

Trouble with VAT
The payment of fees for "purchased" tenants may raise doubts as to the applicability of VAT. Under the existing law, such fees do not attract VAT but this status will change after 1 May 2004, when Polish legislation is scheduled for harmonisation with EU directives. Once Poland becomes a full member of the Community, remuneration of that type will probably be subject to VAT; this will then raise questions about the deductibility of input tax, as it is not certain whether the total amount of such remuneration will be deductible for income tax purposes.
It again turns out that taxation law has not caught up with the changing market environment and that every tax aspect of a lease should be judged on an individual basis. However, the most important thing is to make sure that leases are not created and amended until after all the financial issues involved have been thoroughly analysed. z

Piotr Wieliński and Łukasz Ziółek
Tax advisers of the Real Estate Services Group, Ernst &Young