Income tax and VAT aspects of technical improvements to leased assets
The termination of a lease of premises to which the lessee carried out technical improvement may have significant tax implications for both the lessee and the lessor. If, with the lessor's consent, the lessee makes technical improvement to the leased property at their own expense and has the lessor's written consent to its tax depreciation, several options arise upon the termination of this lease. Each carries different tax consequences for both parties. What are the options and what to look for?
Disposal of technical improvement
One option is to put the leased premises into their original condition. According to GFD Instruction D-59, if the lessee puts the leased premises into their original condition at the end of the lease, the net book value of the technical improvement carried out by the lessee can be considered a tax deductible expense in the taxable period in which the premises are put into their original condition. In this case, there are no tax consequences for the lessor.
We often encounter lessees who underestimate the need for proper documentation of the disposal of technical improvements. The disposal can be carried out by a contractor (even by the lessor themselves), but the burden of proof is always on the lessee. If the disposal is carried out by a third party, or even by the lessor, the lessee should still have not only any relevant invoices but also other detailed documentation including, e.g., disposal reports and photographs of the premises before and after the disposal of the technical improvement.
To avoid any disputes, it is also crucial that the technical improvement will have already been removed on the day the premises are handed back to the lessor. Should the lessor instead keep the technical improvement, it would be a gratuitous transfer from the lessee's point of view and the tax consequences would be entirely different.
Gratuitous transfer of technical improvement
In practice, it is very common that a lease is terminated with the lessee neither putting the leased premises into their original condition nor receiving any reimbursement for the expenses incurred for the technical improvement from the lessor. This is evidently not an optimal tax solution.
In such a case, the net book value cannot be considered a tax deductible expense on the lessee's part. Moreover, the lessor generates non-monetary income and is therefore obliged to increase their tax base by the net book value of the technical improvement acquired free of charge. At the same time, the lessor may increase the cost of the leased premises by this amount and subsequently reflect it in their tax base through tax depreciation.
The gratuitous transfer of technical improvements to the lessor also has VAT implications. If the lessee claimed a VAT deduction upon their acquisition, their gratuitous transfer to the lessor constitutes a taxable supply and the lessee is obliged to pay output VAT.