The purpose of the article is to describe legal and tax issues of renting and modifying premises on the part of tenants. Leasing of business properties comprises a part of most business projects in the area of relocating operations to the Czech Republic from other countries. This particularly involves non-residential spaces in office buildings, industrial facilities or shopping centres.
Unlike in many Western European countries, the rules governing lease contracts related to properties such as those described above in the Czech Republic are very liberal. Czech law allows the contracting parties a wide berth to formulate their own agreement, and mandatory provisions from which the parties may not deviate are kept to a bare minimum. The parties can freely agree on the duration of the lease agreement or an extension option, length of the cancellation notice period, reasons for unilateral termination of the lease, etc.
Until recently this state of affairs, together with strong economic growth and related demand for rental properties practically throughout the entire Czech Republic, led to a very strong position of lessors in negotiating the conditions of lease agreements. This trend has been diminished somewhat by the recent economic development, resulting in much more favourable conditions for lessees. It can be recommended to those interested in rental spaces that they should dedicate due care and time to negotiating the terms and conditions of the lease agreement, because the resulting savings and improved legal standing may be very significant. Really very significant.
The basic aspect of a lease contract is its paper. That sounds banal, but it is necessary to remember that any lease agreement not concluded in writing between the parties in the contract or other document will be invalid. It is necessary to draw attention particularly to the fine print (e.g. detailed technical or financial conditions), when in practice one party proposes to the other that the contractual conditions be modified without any linkage to the signed contract. The other party does not confirm this new agreement in writing, but either in the intentions of the proposal begins to act alone (e.g. undertakes the proposed payment) or does not object to the subsequent actions of the first party undertaken in accordance with its proposal.
The contracting parties, most commonly their employees, can get the impression that the agreement is concluded and the rental relationship will henceforth be governed only by these new terms and conditions. However, the reality is usually the exact opposite. If one of the parties subsequently calls into question the validity of such changes, it is very probable that in the case of a dispute it will be decided that the addendum was not part of the contract because it was not executed in a written form. The parties then would not be bound by such an agreement and it would be necessary to fulfil the terms and conditions of the lease contract in its original wording or, as the case may be, return to fulfilment pursuant to such an agreement already in force.
Modification of spaces
Where modifications of spaces are concerned, this is fully a basic question of their tax deductibility. From the legal perspective, it is necessary to emphasise that nearly every significant intervention or change in the manner of using any business property requires a construction permit. It is worth mentioning that it is not unusual for a decision on building approval to stipulate in detail the activities that are permitted in a particular space or building. Even if the new tenant does not undertake any modifications of the space but conducts an activity other than that stipulated in the building-approval decision, it is highly probable that a new permit will have to be obtained.
In the case of completed structures, obtaining new permits is not difficult if the tenant uses the services of an experienced engineering consultant. However, it is necessary to take into account that the issuance of a new permit takes a certain time during which the given space cannot be legally used for the new purpose.
With regard to legal certainty, it is necessary to consider that rental contracts always clearly stipulate who is responsible for obtaining the relevant structural–modification permit, specific conditions for structural modification imposed by the lessor beyond the framework of the relevant legal regulations, and the time period in which the tenant has the responsibility to render modifications. It is always good to negotiate a sufficiently lengthy liberation period, during which the tenant can perform modifications without paying the rent.
When renting business properties, it can be a problem to ensure that there is a sufficient number of parking places if the original tenant needed a smaller number of parking places than the new tenant. It is always necessary to explicitly stipulate in the contract the number of parking places reserved for the tenant and it is completely unreasonable to rely on the lessor’s oral assurance or on the current state, when parking places in the complex are apparently unused and can thus be used without limitation.
The lessor can rent most of these places to new tenants in the building or the complex, or to any other third party any time. If the contract does not ensure a specific number of parking places for the tenant, the tenant does not have any automatic claim toward the lessor for a sufficient number of parking places.
Tenants usually modify non–residential premises in order to make them suitable for the intended business activity. In most cases, this involves extensive construction work that, from the perspective of the Income Tax Act, is considered to be technical improvement of the leased property. It can be stated simply that technical improvement consists in structural modification, renovation and/or modernisation of property if the cost of such work exceeds CZK 40,000 (EUR 1,600) in the given tax period.
Although in principle the owner of a property is entitled to amortise the value of such work, pursuant to Section 28(3) of the Income Tax Act, a tenant (but not a sub-lessee) can write off the costs of the technical improvement of a property on the basis a written agreement (most commonly contained directly in the lease contract), even though in terms of private law this does not involve a separate asset.
A condition for this is that the tenant must pay the costs of the technical improvement and the owner may not raise the acquisition price of the property by the amount of such costs. The tenant can write off technical improvements performed by him in the same amortisation group in which the rented tangible asset is classified pursuant to the Income Tax Act.
Where real estate or non-residential premises are concerned, the property can be classified in the sixth amortisation group containing hotels and similar accommodation facilities, administration buildings, retail outlets and underground shopping centres. Property classified in this group can be amortised over fifty years. Other properties and non-residential spaces are classified in the fifth amortisation group and are amortised over thirty years. Technical improvement of properties in such buildings can be amortised over either 30 or 50 years if the lease relationship does not terminate earlier than that.
In such a case, it is necessary to deal with termination of the lease and with the technical improvements undertaken in the context thereof. The easiest way to proceed is to anticipate, when concluding the lease contract, how the technical improvements of the subject of the lease will be disposed of.
Termination of an agreement
From the lessee’s perspective, the most advantageous approach to a settlement between the lessee and lessor upon the termination of the lease is for the lessor to pay to the lessee the net tax value of the technical improvement, which at the time of termination of the lease contract should be stated in the lessee’s records pursuant to the Income Tax Act. The net tax value of the technical improvement can then be considered a tax-deductible cost in the full amount pursuant to the provisions of Section 24(2)(t) of the Income Tax Act. If the net tax value of the technical improvement is paid by the lessor only in part, the difference is not a tax-deductible cost for the lessee.
However, the termination of a lease relationship as described above is not very often accepted by lessors. Lessors, for whom modifications of the subject of a lease according to the need’s of a specific lessee’s business usually do not have any added value, often allow lessees to leave technical improvement in the leased property without payment, or they undertake to enter the subject of lease into their own costs in the original state prior to modifications.
In the first case, the total net tax value will not be a tax-deductible cost for the lessee. In the second case, it is necessary to divide the tax treatment between the values of the liquidated technical improvement and the costs of the removal of such technical improvement.
Regarding the net tax value, pursuant to Section 24(2)(b) of the Income Tax Act this could be considered as a deductible cost. There are differing opinions as to whether tax-deductibility is conditioned by the payment of compensation. Where costs associated with liquidation of the technical improvement are concerned, the law does not explicitly govern such costs; therefore, in the event of a tax control it will always be necessary for the lessee to demonstrate to the tax authority that it involved expenditures required to achieve, ensure and maintain taxable income.
Transfer of technical improvements directly to the new tenant
It is necessary to reiterate that a technical improvement is not in itself a separate asset even though for the purpose of the Income Tax Act it can, under certain conditions, be amortised for the period of duration of the lease as a separate tangible asset. In terms of the private law, a technical improvement remains together with the improved property under the ownership of the lessor.
It is thus not possible to transfer it between the lessee terminating the lease relationship and the new tenant. A possible solution is to completely change the lessee without terminating the original lease agreement with the lessor. This involves a succession of tenants on the basis of a three-party agreement between the lessor, the lessee that is leaving the rented premises, and the new lessee that will take over the lease and use the property. Although this situation is not explicitly governed by the Income Tax Act, in practice it is often used and, in our experience, recognised by the tax authorities.
The lessee terminating the lease relationship will obtain from the new tenant a financial settlement in whose amount the net tax value will be considered as a tax-deductible cost on the part of the original lessee.
On the part of the new lessee, the amount of this settlement will be considered as a new technical improvement that the new lessee can write off pursuant to Section 28(3) of the Income Tax Act. This solution is also favourable for the lessor because it will not be necessary to resolve the problem of taxation possibly arising from non-monetary fulfilment in the form of a free-of-charge acquisition of the technical improvement.
However, it is clear that for the new lessee it will perhaps not always be acceptable to take over the rights and responsibilities of the original lessee without any changes thereto. Here lies the only opportunity for an agreement between the new lessee and the lessor within the framework of the aforementioned three-party agreement. It is highly improbable that the lessor will be willing to accept any further changes to the terms and conditions at a later time.