by Steven Fogel and Graham Plumbe
Many landlords and tenants have been exploring with their advisers whether the impact of the new VAT rules upon rental values on review may be mitigated artificially by drafting techniques. Parties who are astutely advised and in a strong bargaining position may be able to secure advantages by devising artificial rent review assumptions.
The new VAT rules (see the draft legislation published by Customs & Excise and the Finance Bill 1989) will leave the landlord to decide whether to add tax to the rent. The landlord’s decision will be influenced by several factors. Most important will be whether the landlord himself is bound to pay VAT as a result of the new rules — to the contractor who erected the building which is to be let, for example. If so, the landlord will probably want to pass the tax burden to the tenants of the building. The landlord would hope that these tenants are not at the end of the VAT chain, and can therefore pass the burden to someone else.
But many tenants — notably financial institutions occupying offices — are indeed at the end of the chain. Their status is not favoured for VAT purposes and they have to bear part or all of the burden of any VAT charged to them. This is an important balancing factor which the landlord must take into account when deciding whether or not to tax. The landlord will calculate that if these tenants were asked to choose on tax grounds alone for which building they would pay most rent they would list the following in order of priority:
(1) a building whose lease effectively prevents tax being charged;
(2) a building where the landlord is uncommitted and where there is a reason to believe the landlord will regard it as a matter of self-interest to continue not to charge VAT for so long as the best tenants can thereby be secured; and
(3) a building where the landlord is likely to charge VAT to tenants, or the landlord has already elected to charge VAT to existing tenants of the same building (note that a landlord cannot opt to tax part only of a building).
A commitment not to tax
The landlord ought to consider whether a better rent could be obtained for the premises by offering a lease which will be of special appeal to the tenant with a disadvantaged VAT status. This can be done by adding certain provisions to the lease whose effect is to guarantee that VAT will not be charged. The landlord may be disinclined to volunteer this concession, if lucky enough to be faced with a choice between tenants of both advantaged and disadvantaged VAT status. However, it is conceivable that the tenant with an advantageous tax status will press for the concession; the concern of such a tenant is to ensure that a lease is just as attractive on disposal to the tenant with a disadvantaged status as to the advantaged tenant. The tenant would not want to have to pay a reverse premium to a successor to compensate for the liability to pay irrecoverable VAT.
It will require considerable care to ensure that the terms of the lease are capable of preventing the landlord from exercising the right to charge VAT to the tenant: it is not enough for the landlord to covenant for himself. The covenant needs to bind successors, because the VAT option can be freshly exercised when ownership of the building changes(*). Perhaps the safest approach is for the landlord to covenant additionally to ensure upon assignment that the new landlord enters a direct covenant expressed to benefit the tenant and his successors. In this way the tenant and his successors can be sure that the VAT covenant is enforceable without having to show that it “touches and concerns” the land.
If the landlord is prepared to legislate for the future in this way, then thought should be given to the appropriate length of term of the lease in which a covenant of this nature might be contained, and the fact that the covenant might well be repeated in any “renewal” lease entered pursuant to the Landlord and Tenant Act 1954. It may be acceptable to apply for the lease to be “contracted-out” of the 1954 Act. A remoter issue for the landlord is whether a covenant not to charge tax could rebound in circumstances where the landlord undertakes to carry out “vatable” improvements in response to a tenant’s application to improve the premises pursuant to the Landlord and Tenant Act 1927.
“VAT-neutral” rent review clauses
Most, if not all, rent review clauses are silent about VAT. It is worth examining how these “VAT neutral” clauses will cope with any changes to the state of the property market brought about by the new rules. For the purpose of this simple exercise it will be assumed that the rent review is on the common basis that, at the review date, the premises are to be let on a notional lease to a “willing lessee” and that the notional lease is on the same terms as the actual lease.
The main factor is whether the actual lease itself contains any special VAT provisions. If, for example, the actual lease contains a landlord’s covenant not to exercise the option to tax, then this will be repeated in the notional lease. The notional lease may well, as a result, be attractive to the willing lessee. If, as seems more likely, the actual lease has nothing special to say about VAT, then the rent at review will be as responsive to VAT matters as would a new open market letting.
Rent review clauses with artificial “VAT assumptions”
As mentioned above, there may be circumstances where a strong tenant successfully insists that the landlord covenants not to charge VAT. In these circumstances the tenant may be tempted to go further and require the review clause to be drafted on the basis that the covenant not to charge tax is excluded from the notional lease. The position would then be that the rent at review would more accurately reflect the general position in the market where (a) tenants would adjust their rental bid according to their VAT status so long as market conditions allowed them to do so, and (b) might rarely be offered a VAT-proof lease. The tenant would argue that its own VAT-proof lease represents a “one-off” concession which should not be allowed to distort the level of rent payable at review. But the landlord would resist the introduction of an assumption of this nature on the ground that it shields the tenant against the more immediate reality of having secured favourable lease terms for the particular building. This debate will be familiar to those who have wrestled with the question of how to deal at rent review with the question of rent-free periods.
Turning from the tenant, the most desirable position for the landlord is:
(1) to attract tenants who are prepared to pay the best market rent for the premises, without claiming any special discount on account of tax status;
(2) not to concede any covenant which fetters the landlord’s ability to add tax to the rent or to fetter the options of a purchaser; and
(3) to ensure that, at rent review, rental increases are not depressed by the significant presence in the market at that time of tenants who, despite having a disadvantaged tax status, are able to choose between “VAT-friendly buildings” and those which are not.
The landlord may seek artificially to create the effect of (3) by devising rent review assumptions which contradict reality. One possible assumption of this nature is that the notional lease is deemed to contain a landlord’s covenant not to tax, as described above.
Another possibility is that the willing lessee is assumed to be a person with an advantageous tax status.
The draftsman of assumptions of the type described here must ensure that the person prescribing the artifice does not himself suffer. Take the example of the rent review clause which requires the valuer to assume that the tenant may reclaim the VAT. The clause must take away the ability of the tenant to say “Yes, I see that in my capacity of ‘willing lessee’ I am deemed to be a person who can pass on the VAT, even though in reality I cannot. However, the notional lease which I am deemed to take contains a rent review clause identical to that which is now being operated. That clause contains artificial assumptions about VAT which would deter willing lessees such as me. I am therefore entitled to lower my rental bid to compensate me for having to take such an unusual lease”.
The conundrum can be solved by careful draftsmanship of the rent review assumptions. In a nutshell, one needs to provide that the artificial VAT assumptions in the “actual” rent review clause are deemed to be excluded from the review clause in the notional lease. If you choose to enter the looking glass world you must connive at its own distorted logic!
Conclusion
We think that few landlords and tenants will be prepared to go to the lengths described above to shelter from the real world of the VAT changes. No doubt special cases will require special treatment, but the simple approach — which makes no change to the rent review clause on account of VAT — also seems to represent the fair approach. Once the parties have decided whether the lease should prevent the landlord charging VAT on rent, attempts to escape from the consequences of that decision into rent review artificiality may well be regarded by market sentiment as being unacceptable.
