Depreciation of inseparable improvements: in tax accounting and accounting

General concept of inseparable improvements

Inseparable improvements can be considered those changes or transformations of an object that directly improve its capabilities, both functional and technical, but are at the same time inseparable from this object. For example, let’s take rented premises for a company office. Often the company has to invest additional funds in it. For reconstruction, modernization and other improvements. At the same time, when changing office premises, we can take these improvements with us without causing harm to the object.

However, the main question remains: what is the difference between these improvements and ordinary routine repairs? The legislation provides clarification on this matter. Current repairs, as a rule, are necessary to maintain the facility in working condition, and work on modernization, technical re-equipment, and completion of the facility are considered inseparable.

Tax consequences of inseparable improvements to leased property: a decision is overdue

don't go for an interview at Taxology if you don't know anything about integral improvements

(from the people's applicant)

Many in the tax community know that every fall my colleagues and I from the Tax.Live project hold a student competition on Russian taxation in the moot court (game model court) format. Traditionally, teams from dozens of universities across the country participate; the judges are well-known and respected professionals representing both tax consulting and the legal profession, as well as real business and, of course, tax authorities and academic science. And every year the organizing committee is faced with the difficult task of deciding which issue to build a case study for the contestants around this time.

The plot of our very first competition in the fall of 2016 included as a central topic the then-maturing problem of the tax consequences of returning real estate from lease, in respect of which the tenant managed to make inseparable improvements, but did not have time to fully depreciate them in tax accounting. According to the terms of the plot, as most often happens in real life, the property owner agreed to the tenant’s capital investments in the form of improvements, but refused to compensate for them. During the competition, the tax authority had to defend the position that when the leased property is returned before the expiration of the useful life of inseparable improvements, the latter are sold free of charge, which, by virtue of paragraph 16 of Article 270 of the Tax Code of the Russian Federation, does not allow the lessee to take into account expenses in the form of residual value, but itself gratuitous sale entails the obligation of the lessee to calculate value added tax on it. The taxpayer, as part of the competition task, had to refute this approach and justify the legality of accounting for the under-depreciated part of inseparable improvements in expenses.

The judges of each game sought to decide the case on its merits (“by right”) in parallel with the selection of the winning team, which showed itself better in terms of professional skills, regardless of the procedural role that the lot assigned to it. The panel of judges for the final competition was represented by a dozen excellent lawyers. And when resolving the “legal” issue of the plot in the deliberation room (I will reveal this terrible secret), not one of them had any doubts that when returning the improved property from the lease, there could be no sale, and the tenant has the unconditional right to take into account economically justified and confirmed expenses. The student teams were able to convincingly analyze this and justify it in such a way that the last skeptics had no questions about this part.

However, unfortunately, our gaming board did not include any of the current judges or at least representatives of the Department of Tax and Customs Policy of the Russian Ministry of Finance. Because both before 2016 and after it, the regulatory body’s explanations and judicial practice (thank God, not uniform), repeating like a mantra the idea of “free implementation of inseparable improvements,” have not gone away, seriously affecting the conditions for doing business in the country.

1. Case of “PG “Metran”

In 2022, the issue with the tax fate of inseparable improvements has probably finally come to a head, and the next suitable dispute of Metran Production Group JSC was submitted to the SKES of the Armed Forces of the Russian Federation for consideration. The fact of the case was strikingly reminiscent of our game case four years ago: the taxpayer in 2005-2007 leased a number of non-residential premises from the Federal State Unitary Enterprise "Plant Pribor" to house its production, in 2007-2013. made a number of capital improvements in them, and in 2015-2016 abandoned the unnecessary lease, since he completed the construction of his own production building. The court decisions emphasized that the improvements were agreed upon by the landlord, but were not compensated by him. The under-depreciated part of the cost of inseparable improvements was recognized at a time by PG Metran in non-operating expenses.

The Inspectorate did not agree with this accounting procedure and, in line with the clarifications of the Ministry of Finance of Russia, proposed the following qualification:

the tax authority considered the return of the leased real estate to be the sale of inseparable improvements made to this property during the lease period;
since the tax audit established that improvements were carried out with the consent of the landlord, but without compensation for their cost to the tenant, the tax authority considered such implementation free of charge;
to the operation of the gratuitous sale of property to a state enterprise, the inspectorate applied the provisions of paragraph 16 of Article 270 of the Tax Code of the Russian Federation, prohibiting the accounting for profit tax purposes of expenses associated with the gratuitous transfer;
Likewise, such an operation for VAT purposes was qualified as not forming an object of taxation by virtue of subparagraph 5 of paragraph 2 of Article 146 of the Tax Code of the Russian Federation, and therefore entailing the obligation to restore VAT from the residual value of inseparable improvements on the basis of paragraph 3 of Article 170 of the Tax Code of the Russian Federation.

The courts of the two first instances fully supported these arguments. However, the Arbitration Court of the Ural District took the position of the taxpayer. At the same time, in fact, the only motive for this decision was the argument that the transfer of inseparable improvements was not gratuitous, since the lessor, as a “consideration,” allowed the tenant to use the property, and therefore the provisions of part two of the Code with the mention of “gratuitousness” cannot be applied. In my opinion, despite the correctness of the final decision of the cassation court, its motivation does not seem obvious and explainable, raising additional questions. Perhaps that is why the judge of the SKES of the Supreme Court of the Russian Federation became interested in this case, transferring it to the Collegium for consideration. In any case, we don’t have long to wait for a decision, daring to hope that the bacchanalia that has been going on for about ten years in multidirectional judicial practice on this issue will find its unambiguous and correct solution.

For my part, without prejudging the conclusions of the Board, I would like to share my thoughts on how the controversial situation could be resolved based on the meaning and content of domestic legislation.

2. Legal qualification of inseparable improvements and return of leased property

The legal regime for improvements to leased property that cannot be separated without harm to such property is established by paragraph 2 of Article 623 of the Civil Code of the Russian Federation. Taking into account paragraph 1 of the same article, such improvements are not the property of the tenant, but belong to the owner of the leased property from the moment of their creation. Moreover, in accordance with paragraph 1 of Article 133 of the Civil Code of the Russian Federation, a thing, the division of which in kind is impossible without destroying, damaging the thing or changing its purpose, is recognized as an indivisible thing.

Consequently, inseparable improvements from the moment of creation are part of the indivisible rental property and belong to the owner of this property. Article 623 of the Civil Code of the Russian Federation provides only the obligatory right of the tenant to compensation for expenses incurred if the parties to the rental relationship come to an appropriate agreement.

Thus, taking into account Articles 133, 623 of the Civil Code of the Russian Federation, inseparable improvements are not an independent thing, property that acts as such in civil circulation.

In turn, paragraph 2 of Article 38 of the Tax Code of the Russian Federation establishes that property for tax purposes is determined in the same way as in civil law. Property sold or intended for sale, in paragraph 3 of Article 38 of the Tax Code of the Russian Federation, is called a product, the sale of which, in accordance with paragraph 1 of the same article, forms an object of taxation. Consequently, since for tax purposes inseparable improvements cannot be recognized as property, by virtue of paragraphs 1 and 3 of Article 38 of the Tax Code of the Russian Federation they are not goods and do not form an object of taxation in connection with the sale of goods.

Likewise, paragraph 1 of Article 39 of the Tax Code of the Russian Federation, which directly defines the concept of the sale of goods (work, services), also establishes that the sale of goods occurs only in the event of a transfer of ownership of them. By virtue of this definition, for example, the operation of transferring an object for rent or returning from it is not a sale - in this case, there is no transfer of ownership.

Since inseparable improvements are part of the leased property and the property of the lessor from the moment of their creation, the tenant, by definition, can never have a proprietary right in relation to the improvements, and therefore the transfer of ownership of such improvements separately from the leased property is impossible. Moreover, taking into account the above-mentioned paragraph 1 of Article 133 of the Civil Code of the Russian Federation, even the very use of the term “ownership right to inseparable improvements” is incorrect, since the right of ownership by virtue of Article 218 of the Civil Code of the Russian Federation arises in a thing, and inseparable improvements in themselves are not a thing - they are only part of a larger indivisible thing (rental object).

At the same time, to complete the legal analysis of the nature of inseparable improvements, it is necessary to determine whether the implementation of inseparable improvements to the leased property can be classified as work carried out to the owner of the leased property.

Taking into account paragraph 4 of Article 38 and paragraph 1 of Article 39 of the Tax Code of the Russian Federation, the implementation of the results of work performed arises from the results of activities that have a material result, “one person for another person.” In other words, the implementation of the results of work can only occur when such work is performed for another person and in his interests. As follows from paragraph 4 of paragraph 26 of the Resolution of the Plenum of the Supreme Arbitration Court of the Russian Federation dated May 30, 2014 No. 33 “On some issues that arise in arbitration courts when considering cases related to the collection of value added tax,” the owner of the property can indeed act as a customer for the improvements made, but only subject to compensation for their cost to the tenant, which would confirm his interest in such improvements.

By the way, in the court decisions in the case of PG Metran JSC there is not even a hint of such interest on the part of the owner, and the controversial improvements were made with the consent of the lessor, but without compensation for the corresponding expenses (see page 8 of the decision of the court of first instance).

Thus, since inseparable improvements are not property and an independent thing different from the leased object, their transfer (sale) as property (goods) is impossible by virtue of the law and their legal nature. And in the case when they are performed by the tenant at his own expense, without compensation from the owner of the leased object, they cannot be the result of work that can be sold to the lessor.

3. Economic interest of the parties in inseparable improvements

As a general rule, inseparable improvements to the leased property are carried out by the tenant in his own interest, being necessary for him to conduct his business. As stated in the Resolution of the Presidium of the Supreme Arbitration Court of the Russian Federation dated October 8, 2013 No. 3589/13 in case No. A40-75971/10-112-388 IKEA MOS LLC (Trade and Real Estate), the implementation of improvements “is not determined by the desire to provide gratuitously for the benefit of society [lessor]”, but the tenant’s interest in bringing the leased objects to the condition he requires. The implementation of improvements in itself “cannot indicate that said work was performed solely in the interests of society [the lessor], or that society received the result of these works free of charge.”

Likewise, according to the Presidium of the Supreme Arbitration Court of the Russian Federation, approval by the property owner of the work being carried out “does not turn the lessor into a customer and is explained by the need to take into account his interests as the owner of the property, interested in preserving his property from structural and other damage.”

Consequently, the mere implementation of inseparable improvements to the leased property does not automatically mean the actions of the tenant in the interests of the property owner and in an effort to improve the situation of the latter.

This is also the basis of the Plenum of the Supreme Arbitration Court of the Russian Federation in paragraph 26 of the above-mentioned Resolution No. 33 dated May 30, 2014. According to paragraph 3 of this paragraph, a tenant who does not receive compensation from the owner for expenses for improvements “should be considered as a person purchasing goods (work, services ) for the needs of its economic activities."

In addition, the impossibility of qualifying the implementation of improvements as work in the interests of the lessor is evidenced by the fact that the tax authority, as a rule (and in the commented case too), does not challenge the legality of depreciation calculation according to the rules of Chapter 25 of the Tax Code of the Russian Federation for such improvements. When performing work, such an accrual would be unlawful, and expenses would be subject to recognition according to the rules of paragraph 2 of Article 272 and Article 254 of the Tax Code of the Russian Federation at the time of transfer of the result of the work performed to the customer. If inseparable improvements are classified as work carried out in the interests of the lessor and their transfer is free of charge, as the tax authority insists, in accordance with paragraph 16 of Article 270 of the Tax Code of the Russian Federation, the depreciation expenses of the tenant would also be subject to exclusion, but the inspectorate still does not dispute their legality.

Thus, as a general rule, until the contrary is proven, inseparable improvements to the leased property are carried out in the interests not of the lessor, but of the lessee for the purpose of conducting his own business activities. At the same time, after the leased object is returned to him, the lessor gets the opportunity to use the “improved” property not because he ordered such “improvements” in his own interest. The “transfer” of improvements as part of the leased property upon return of the latter from the lease does not depend on the will of the parties, and it can only be avoided by incurring additional costs for dismantling the improvements, which will inevitably cause damage to the leased property. Requiring such economically unreasonable behavior from the parties solely to avoid negative tax consequences when conducting normal business activities, when it is not of fundamental importance for the lessor to bring the leased object to its original condition, obviously cannot be considered legal and justified in any way.

With today's prevailing approach to solving the commented problem, on the contrary, there is rather a clear economic injustice and double loss: tenants are forced to bear part of the costs of improvements objectively necessary for their work at the expense of net profit, often without the right to full accounting of expenses. And besides, in addition, they are required to pay VAT at their own expense, which no counterparty is allowed to deduct, but this breaks the chain of step-by-step calculation of this tax, contrary to the well-known principle of neutrality.

4. Suppression of possible abuses

Arguing from the position of achieving a balance of private and public interests, it should be recognized that under certain circumstances, tax control measures can identify situations where taxpayers, under the guise of inseparable improvements, make improvements to someone else’s (leased) property precisely in the interests of the lessor, and not their own. In this case, it is likely that the production of improvements should be qualified as the performance of work in someone else's interest, and the taxation procedure should also be based on this qualification.

This kind of abuse may be evidenced, for example, by the following circumstances that cannot be explained by reasonable reasons, especially when the parties to the lease agreement are interdependent:

absence of activities of the taxpayer using the leased property, except for the actual production of its improvements;
return of leased property after a short lease immediately or a short time after the improvements have been completed;
obvious discrepancy between the improvements being made and the nature of the tenant’s activities;
returning the property a short time after the improvements have been made and getting it back for rent at a higher cost.

Obviously, circumstances of this kind may indicate unfair use of the tax regime for inseparable improvements and a different economic content of the analyzed transactions. Using the concepts of “business purpose” and “substance over form,” such situations can be easily reclassified, for example, as gratuitous work for someone else’s benefit, and the tax consequences are determined based on such qualification.

By the way, returning to the case of PG Metran, based on the facts described by the courts, set out, for example, in the decision of the Arbitration Court of the Chelyabinsk Region (pp. 5, 10), such circumstances are most likely not seen. The leases were entered into with an independent party, lasted for 8-10 years, most of the improvements were made at the beginning of the lease period, but even the most recent of them were completed several years before the leased property was returned. The use of leased property for production purposes and in the interests of the taxpayer itself is not clearly disputed by the inspectorate, if only because it agrees with the calculation of depreciation on improvements during the period of validity of the lease agreements.

5. Inapplicability of the norm of paragraph 16 of Article 270 of the Tax Code of the Russian Federation

From the above it follows that the return of leased property in respect of which inseparable improvements have been made cannot be qualified as an operation for the sale of goods (works, services). Moreover, the operation of “transferring” inseparable improvements is impossible for the same reasons: inseparable improvements are not property, as a general rule they are not recognized as results of work for tax purposes, and are obviously not a service.

As a result, the key condition for the application of paragraph 16 of Article 270 of the Tax Code of the Russian Federation, indicated in such situations, which refers to the value of “freely transferred property (work, services, property rights),” is not met. In the absence of the object of transfer (goods, work, services), such transfer itself cannot be carried out. Simply put, when returning the leased object, the tenant physically cannot transfer anything other than this object, which already belongs to the lessor, to the latter, and “transfer of inseparable improvements” is an initially legally incorrect formulation, however, it is very popular in practice.

In this case, the argument described above about the absence of an economic interest on the part of the owner of the leased property in receiving inseparable improvements, and on the part of the tenant, to improve the well-being of the lessor through the gratuitous transfer of the improved leased property to him, works quite well. The provisions of paragraph 16 of Article 270 of the Tax Code of the Russian Federation are aimed at regulating precisely such situations and are obviously inapplicable in the present case. Thus, the refusal to account for expenses solely on the basis of paragraph 16 of Article 270 of the Tax Code of the Russian Federation is unlawful; this norm was given incorrectly by the inspectorate and the courts of the first two instances.

6. Erroneous application of subparagraph 5 of paragraph 2 of Article 146 and paragraph 3 of Article 170 of the Tax Code of the Russian Federation

In accordance with subparagraph 5 of paragraph 2 of Article 146 of the Tax Code of the Russian Federation, the “transfer on a gratuitous basis, the provision of services for the transfer for gratuitous use of fixed assets to state authorities and management bodies and local self-government bodies, as well as state and municipal institutions, state and local governments” is not recognized as an object of taxation. municipal unitary enterprises".

As follows from this definition, the application of this rule is possible if two conditions are met: the transfer of fixed assets, carried out on a free basis.

Arguments about the absence of gratuitous transfer are given several paragraphs above. Already due to this circumstance, the application of this norm is erroneous. Likewise, for this reason, in the absence of sale within the meaning of Article 39 of the Tax Code of the Russian Federation, when returning improved leased property, the object of VAT taxation under Article 146 of the Tax Code of the Russian Federation does not arise with the subsequent obligation to calculate tax on the sale (and such qualification is also popular in practice).

Additionally, one could argue here that inseparable improvements cannot be recognized as the main means for tax purposes, since, for example, in Chapter 25 of the Tax Code of the Russian Federation they are only very close to them in terms of their regime, but are directly excluded from the scope of the concept “main means”, which in paragraph 1 of Article 257 of the Tax Code of the Russian Federation means property used as means of labor. However, even without this argument, the inapplicability of subclause 5 of clause 2 of Article 146 of the Tax Code of the Russian Federation in the situation under consideration is obvious.

As a result, the inspection had no grounds for applying the provisions of subparagraph 2 of paragraph 3 of Article 170 of the Tax Code of the Russian Federation, since the taxpayer did not carry out the operations provided for in paragraph 2 of Article 146 of the Tax Code of the Russian Federation (subparagraph 4 of paragraph 2 of Article 170 of the Tax Code of the Russian Federation). Returning property from rental is generally a tax-neutral operation. However, as well as termination of use of property due to objective circumstances. And even more so, it is not a transaction that is the basis for tax restoration. In relation to the nature of VAT from the point of view of the principle of neutrality of this tax, the EU Court of Justice came to a similar conclusion when considering the relevant issue (paragraphs 19-20, ECJ, 09 July 2020, Case C 374/19, Request for a preliminary ruling under Article 267 TFEU from the Bundesfinanzhof (Federal Finance Court, Germany). Here in the margins it should be noted that the obligation to restore the tax should not arise depending on the figure of the owner of the leased property in the absence of an economic difference in the lease itself from private individuals and government agencies, a different approach would be contrary to the principle equality of participants in economic relations.

7. The taxpayer’s right to account for expenses

From the direct indication of paragraph 6 of paragraph 1 of Article 258 of the Tax Code of the Russian Federation, it follows that inseparable improvements are a special accounting object that is not property or fixed assets, the costs of which are taken into account in a special manner by calculating depreciation. The direction of expenses in the form of inseparable improvements to generate income is determined by the tenant’s own entrepreneurial activity (see Determination of the SKES RF Armed Forces of December 13, 2019 No. 301-ES19-14748 in case No. A43-5424/2018 LLC “Sweet Life N.N.”), and not the subsequent disposal of the leased property.

The right to account for documented and economically justified expenses is established by paragraph 1 of Article 252 of the Tax Code of the Russian Federation, guaranteeing the taxpayer the opportunity to fully account for the relevant expenses, unless otherwise directly follows from the special provisions of Chapter 25 of the Code. Likewise, special provisions of tax legislation may provide for a special procedure for accounting for certain expenses (without violating the principle of completeness of expense accounting). However, such provisions are not provided for the residual value of inseparable improvements in the event of the return of the leased asset before the expiration of the useful life of the improvements and their full depreciation.

In the absence of special provisions, in this case, by analogy, the norm of subparagraph 8 of paragraph 1 of Article 265 of the Tax Code of the Russian Federation can be applied, allowing the taxpayer to take into account the residual value of fixed assets decommissioned as part of non-operating expenses. In terms of its economic content, the termination of the possibility of using inseparable improvements as a result of the return of the leased object to the owner is equivalent to the liquidation of a fixed asset that can no longer be used in activities aimed at generating income.

In this context, the argument proposed by the tax authority (as presented by the courts) looks surprising that for the purpose of taxing profits, the principle of “mirroring” should supposedly apply, and the accounting of the tenant’s expenses must necessarily correspond to the income of the lessor, therefore, in the absence of such income, by virtue of subparagraph 32 Paragraph 1 of Article 251 of the Tax Code of the Russian Federation does not have the right to expenses for the tenant in principle. Probably, in this logic, the tenant, in principle, should not have the right to account for depreciation expenses for inseparable improvements, however, this directly contradicts the provisions of the same Article 256 of the Tax Code of the Russian Federation, and the tax authority, as far as can be seen from the judicial acts in the commented case, depreciation expenses are not disputed.

It seems that the legality of accounting for such costs is made by the legislator dependent solely on the general requirements of Article 252 of the Tax Code of the Russian Federation and their connection with the main activity: inseparable improvements must be made by the tenant primarily “for himself”. This approach is fully consistent with the above-mentioned principle of completeness of accounting for economically justified expenses incurred. Depriving a taxpayer of the corresponding right entails economically unjustified excessive taxation and discrimination in comparison with those taxpayers who make similar capital investments in their own fixed assets - the latter have the right to write off identical costs incurred as depreciation, or include them in non-operating expenses upon disposal of the fixed asset before the expiration of its useful life. This kind of discrimination depending on the type of right on which the taxpayer owns the fixed asset - rent or ownership - violates the constitutionally significant principle of equality of taxation and the economic basis of the tax (clause 3 of Article 3 of the Tax Code of the Russian Federation).

***

Of course, the thoughts set out above may raise some objections or questions from a thoughtful reader, but until today I have not seen a reasoned refutation of them there and then, when individual courts did not accept the formal patchwork approach of the Ministry of Finance, but were still immersed in the legal and economic nature rental relations. I think it’s not for nothing that this kind of immersion gave a unanimous result among professionals at a student competition four years ago.

Therefore, the intention of the SKES of the Armed Forces of the Russian Federation to also delve into this issue, paying due attention to it, cannot but be encouraging - especially since the incredibly interesting tax issues of inseparable improvements are not at all limited to one commented issue, despite all its practical painfulness - but you have to start somewhere ...

Tax accounting of inseparable improvements

In cases where all improvements are carried out after agreement with the lessor, and all costs incurred for their creation are not reimbursed, the lessee can charge depreciation. To correctly determine depreciation rates, you can be guided by both the useful life of the leased property and the useful life of improvements. If even at the end of the lease period there remains an unamortized portion of the capital investment, it in any case cannot be taken into account in calculating income tax. This follows from the Tax Code of the Russian Federation, paragraph 16, article 270.

In the case where inseparable improvements are carried out with the consent of the lessor, but with reimbursement of costs, when the property is returned back, the tenant receives income. The tenant can reduce the amount of this income by the amount of expenses that were made for these improvements.

All costs of capital investments, namely inseparable improvements that are made by the tenant to the leased property, are included in the tax base when calculating income tax. Clause 1 of Article 374 of the Tax Code of the Russian Federation states that these costs are included on a general basis. On the date of return of the asset and inseparable improvements to the lessor, the lessee becomes obligated to charge VAT. This obligation arises on the basis that the gratuitous transfer of goods (works or services) is recognized as a sale.

VAT and expenses for inseparable improvements: reflections on the Metran case

The Supreme Court reached VAT on inseparable improvements to rental property[1]. It’s a pity that the case was won by the taxpayer.

It is possible to hope that the cassation ruling, which is positive for the taxpayer, will remain in force. But it's not worth it. The case was transferred shortly after the Uralbroiler case with a different “texture”, but a very similar fate. Both cases were resolved in favor of the inspection in the courts of first and appellate instances. In both cases, the court decisions were overturned by cassation, resolving the dispute in favor of the taxpayer. The presiding judge in both cases was the same judge. Such are the coincidences. In which the probability of a coincidence based on the results of the review in the second cassation is considerable.

It's a pity. An objective examination of the issues raised in this case would not hurt.

Spoiler: I think in this case the taxpayer has enough reasons to lose. The only question is how he will lose:

on arguments that should lead to loss, or
on arguments that should not lead to it.

I'm betting on the first one.

Arguments of the inspection

The Determination states that the inspector's arguments deserve attention. These arguments are based on the fact that inseparable improvements are transferred free of charge if, under the terms of the contract, they are not subject to compensation. Here are the arguments given by the inspectorate in support of this:

inseparable improvements were created by the company after the conclusion of lease agreements and were not the object of the lease;
inseparable improvements were made by the tenant with the consent of the landlord, but the corresponding expenses were not compensated for,
the parties did not discuss the landlord's counter-obligations;
the parties did not conclude any additional agreements to reduce the amount of rent or to offset against the rent the costs of inseparable improvements made by the tenant;
Based on the principles of tax accounting, the expenses of one party to the contract must correspond to the income of the other party. Since the cost of capital investments in the form of inseparable improvements, by virtue of subparagraph 32 of paragraph 1 of Article 251 of the Tax Code, is not taken into account by the lessor as part of income, the corresponding right of the tenant to account as expenses for the costs incurred in the form of the residual value of inseparable improvements is also absent.

These specific arguments are not suitable to justify the gratuitous nature of the transaction. Neither together nor separately.

Hostile fragmentation

I call this set of arguments from the inspectorate “hostile fragmentation.” Its essence is the division of a single set of interrelated operations into separate functions to determine the adverse consequences of the selected function. In this case, neither the final goal nor the final result of a set of interrelated operations are taken into account.

Now, let’s imagine a purchase and sale agreement for something, for example, a car from a manufacturer to a dealer.

In order to fulfill it, the manufacturer instructed the workers to produce it, transported the parts from the warehouse to the assembly shop, turned on the conveyor, checked the quality of the assembly, moved the product from the workshop to the warehouse, notified the buyer about its readiness, organized delivery of the car to the dealer's store and handed it over there. to his dealer. At this point, title transferred to the dealer and the sale occurred. And now we take and give tax qualification to each operation: separately, without taking into account other operations and the end of the entire cycle of contract execution. Then the VAT object arises only upon transfer. There is a counter-representation (payment) for the transfer. There is no doubt: the costs of transferring the car to the dealer are deductible when calculating income tax. VAT on them is also deductible.

All other operations listed above, taken in isolation from the general context that unites them into one indivisible whole, are not accompanied by payment for this particular (separate) operation. Therefore, they must be qualified as gratuitous (according to the logic of the concept based on “hostile fragmentation”).

In a rental situation, the transfer of inseparable improvements without compensation for their cost by the lessor cannot be taken out of the general context of the contract. Otherwise it will be the same “hostile fragmentation”. The property was leased under the conditions established by the lease agreement. The price of such transfer, incl. for tax purposes, takes into account the distribution of functions, assets and risks between the parties to the transaction (subclause 2, clause 4, article 105.5 of the Tax Code of the Russian Federation).

The condition of the agreement that the cost of inseparable improvements is not subject to compensation is an element of the legal relations that this lease agreement gives rise to. Within the framework of these relations, the parties are allowed to agree on the absence of compensation (clause 2 of Article 623 of the Civil Code of the Russian Federation).

Since the scope of the lease covers this condition, the contract is not mixed. Therefore, it does not need to be divided into a lease transaction and a transaction for the use or disposal of the results of work on inseparable improvements. Neither these nor other terms of the lease agreement should be assessed for consideration or gratuitousness in isolation from the other terms of the lease agreement.

It is no coincidence Art. 423 of the Civil Code of the Russian Federation gives definitions to a paid and gratuitous “contract”, i.e. such a distinction is appropriate for the contract as a whole, and not for some of its separate (from other) conditions.

The definition of gratuitousness given in paragraph 2 of Art. 248 of the Tax Code of the Russian Federation, also does not lead to a different result: “For the purposes of this chapter, property (work, services) or property rights are considered received free of charge if the receipt of this property (work, services) or property rights is not associated with the occurrence of an obligation on the recipient to transfer the property ( property rights ) to the transferor (perform work for the transferor, provide services to the transferor).” The rights to improvements in the property arose with the lessor as a result of the lease agreement. Under this agreement, the lessor transferred the right to use the property. Consequently, the receipt of improved property without compensation of costs to the tenant is conditioned by the transfer of this property earlier for use and (or) ownership to the tenant.

All the above arguments are based on the impossibility of “hostile fragmentation”. On the illegality of separating from a set of economically inextricably linked transactions one or more for their separate (independent) tax qualification, in isolation from other operations from the same set, as well as in isolation from the final result and their final purpose that unites all these operations. But where is this directly said?

I will refer to the authority of the judiciary. Let's use a precedent.

Thus, the Presidium indicated that the zero rate applies to services for the transportation of petroleum products for export, provided from the beginning of the transportation route to the end[2], and not just those provided on the last section of this route.

In Resolution No. 2196/10 of June 22, 2010, the Presidium of the Supreme Arbitration Court of the Russian Federation considered a dispute where property was transferred to a joint activity for its subsequent use in carrying out VAT-taxable transactions. The inspectorate insisted on restoring VAT at the stage of transferring property to joint activities, because such transfer is not subject to VAT. At the same time sub. 2 clause 3, sub. 4 clause 2 and sub. 4 p. 3 art. 39 of the Tax Code of the Russian Federation directly provide for the restoration of VAT on property transferred to joint activities.

The Presidium considered it impossible to break up the operations united by a single goal of transferring property into joint activities and its subsequent use. The transfer of property into joint activities is not the final purpose of the operation subject to qualification. It only mediates joint activities. And if the latter consists of carrying out operations recognized as a VAT object, then this imposes a marker of connection with the VAT object on all operations that mediate joint activities, incl. for the transfer of contributions by participants. And it doesn’t matter that in the chain of interconnected operations leading to a taxable goal, there are elements that are not recognized as subject to VAT.

In Resolution No. 9202/10 dated November 23, 2010, the Presidium of the Supreme Arbitration Court of the Russian Federation considered additional charges based on arguments about the gratuitous nature of operations for the free transfer of coal to preferential categories of the population. The Presidium responded to these arguments as follows: “... the main activity of the company is the continuous process of mining and selling coal, that is, carrying out operations recognized as objects... VAT. As a condition for carrying out this activity, the company is required by law to provide rationed coal to certain categories of persons, including those who were not and are not in labor relations with it and are not directly involved in the production process.” Once again, we see how the Presidium does not allow an operation to be taken out of the general context for its qualification without taking into account the main goal and the inseparability of the operations through which it is achieved.

In Resolution No. 14630/09 dated June 22, 2010, the Presidium considered such a case. The organization provided car repair and maintenance services. For this activity I applied UTII. When providing these services, the taxpayer replaced defective parts. At the same time, there were even 2 agreements concluded: an agreement to replace the part and an agreement for its purchase and sale to the client.

The inspectorate took advantage of this, pointing out that purchase and sale does not fall under UTII. The Presidium did not agree with her, saying: “ mere fact of using spare parts and additional equipment belonging to the company in the repair and maintenance of motor vehicles cannot serve as an unconditional basis for qualifying such activities as trading... the company carried out the sale of spare parts and additional equipment for automobiles as part of the provision of repair and maintenance services for motor vehicles.”

In Resolution No. 12987/11 of January 31, 2012, the Presidium allowed VAT deductions for the dismantling of fixed assets. The inspectorate justified the refusal to deduct the same: dismantling is not related to operations recognized as a VAT object and is not recognized as a sale. The Presidium objected as follows: “ The use of a fixed asset in economic activity is complex in nature and includes installation, operation, and, when production needs arise, the liquidation of a fixed asset …. the liquidated objects were related to fixed assets used to carry out activities aimed at obtaining products, the sale of which is recognized as subject to VAT.”

I think enough has been written on hostile fragmentation.

Expenses for income

Let’s move on to another argument, this one: “based on the principles of tax accounting, the expenses of one party to the contract must correspond to the income of the other party. Since the cost of capital investments in the form of inseparable improvements, by virtue of subparagraph 32 of paragraph 1 of Article 251 of the Tax Code, is not taken into account by the lessor as part of income, the corresponding right of the tenant to account as expenses for the costs incurred in the form of the residual value of inseparable improvements is also absent.”

First of all, what kind of principle is this? Where is he from? Unlike VAT, income tax does not condition the deduction of expenses on the fact that the beneficiary would have a tax base for the corresponding benefit. In Art. 270 of the Tax Code of the Russian Federation there is no such principle. Exceptions corresponding to cases of non-inclusion of a payment in income according to the rules of Art. 251 of the Tax Code of the Russian Federation are specifically specified. This means that this is not a principle, but special cases.

Do you remember, by the way, the controversy that private security units’ fees for this security were recognized as non-taxable target financing[3] in accordance with the same Article 251? At the same time, Article 270 directly provided that the costs of targeted financing are not recognized as expenses. But practice did not support this approach. This is due to the fact that the income tax “catches” the real increase in the taxpayer’s solvency. And it does not depend on whether the costs are recognized in the tax base by the beneficiary or not.

Secondly, we are talking about the costs of inseparable improvements, i.e. about the costs incurred to create improvements. These costs correspond to the income not of the tenant, but of contractors and suppliers whose purchases improved the property.

Well, now let’s return to the promised “exposure”. Why, despite what was previously stated, can a taxpayer lose in this particular dispute?

The Court of Appeal in this case indicated that “the lease agreements provide for the offset of expenses for inseparable improvements against the rent.” If this is so, then the first block of our reasoning is not suitable. We found out that it is impossible to separate an operation from the totality of legal relations regulated by a lease agreement in order to qualify it independently. But it turns out that within the framework of these relations the tenant has a right to compensation. Forgiveness of this debt is already outside the scope of the lease agreement, since the lease agreement does not provide for such forgiveness. On the contrary, he says: we need to compensate.

Under such an agreement, the costs to be compensated must go to the lessor. This is how it should be [4]: “In the case of compensation by the lessor for capital investments made, the corresponding inseparable improvements in the leased property should be considered transferred to the lessor who paid for them. In this case, the tax amounts previously accepted by the tenant for deduction are presented to the lessor in relation to the provisions of paragraph 1 of Article 168 of the Code. In turn, the lessor, as the owner of the leased object, who has assumed the burden of capital investments, the tax amounts presented by the tenant in this manner can either be deducted in accordance with Article 171 of the Tax Code of the Russian Federation, or included in expenses when calculating income tax (personal income tax) on the basis of Article 170 of the Code.”

In other words, the tenant had to recover VAT on compensable costs. Submit it as an invoice to the lessor. The latter would compensate him.

Therefore, yes, the inspectorate’s arguments deserve attention. But these arguments can work to the advantage of the inspectorate only in the context of the terms of the contract. But in this case, this context does not give rise to consequences favorable for the taxpayer.

What should a taxpayer do in this matter?

In such a situation, the tenant should apparently refer to the fact that the lack of compensation does not indicate that the transfer was gratuitous, but rather the unjust enrichment of the lessor. Such enrichment must be returned, i.e. transfer of the results of completed work (improvements) to the lessor is associated with the latter’s reciprocal obligation to compensate for them.

In this case, the question can be posed differently. Judging by the contents of the judicial acts, the costs of inseparable improvements should have been included in the rent, but they were not. As a result, it is appropriate to consider the issue of overpaid rent and the obligation to return the excess. This will also exclude gratuitousness.

Incomprehensible

It remains unclear why, in such a situation, the improvements were amortized by the tenant. Clause 1 of Art. 258 of the Tax Code of the Russian Federation allows the latter to depreciate those improvements, “the cost of which is not reimbursed by the lessor.” Since the contract provided for compensation, this provision could not be applied. Then it turns out that the tenant could not expense either depreciation or the residual value of the improvements.

But the inspectorate does not argue with depreciation. Why?

It may be that the condition on the offset of improvements against the rent implied that:

Rent = rental rate + improvements,

but not

Rent = rental rate. This rate must be paid minus the tenant's costs for improvements.

That would explain everything. And it would also acquit the taxpayer at the same time.

Resolution of the Plenum No. 33 states in this regard: “If the tenant makes capital investments in the leased property as a form of rent agreed upon by the parties, the tax amounts presented to him on the goods (work, services) acquired in this regard, property rights, are accepted by the tenant to deduction in the same manner as the tax amounts claimed by lessors as part of the rent.

In this case, the tenant has no improvements. He has only rent, part of which is paid in money, and the other by purchasing improvements. If the rental period covered by these costs has expired, then there are no grounds for reinstating VAT or refusing to recognize the costs. If it has not expired, then the costs and payments not covered by the lease are the landlord’s debt. Advance payment or unjust enrichment subject to refund. It can be written off as expenses only after the expiration of the statute of limitations for presenting relevant claims to the lessor.

It’s not clear, in general. There are not enough details in the motivational part of judicial acts to fully understand.

[1] Determination of December 21, 2022 No. 309-ES20-16872

[2] Resolution of the Presidium of the Supreme Arbitration Court of the Russian Federation dated February 25, 2009 No. 13893/08.

[3] Resolution of the Presidium of the Supreme Arbitration Court of the Russian Federation of October 21, 2003 N 5953/03

[4] Clause 26 of the Resolution of the Plenum of the Supreme Arbitration Court of the Russian Federation of May 30, 2014 No. 33.

Depreciation of permanent improvements

All inseparable improvements that the tenant carries out in agreement with the landlord can be considered depreciable. And in cases where the costs of these improvements are not reimbursable by the lessor, the lessee can independently write off the costs by charging depreciation.

In this case, the tenant determines the useful life of the improvements themselves, and not the property. This period may differ from the one accepted by the lessor; at the same time, it must comply with the OS classifier. Depreciation of inseparable improvements occurs in the general manner, from the 1st day of the month following the month of acceptance of this object for accounting until the last day of the month of full repayment of the cost of this object.

Depreciation of permanent improvements, like any expense, must be documented.

These are standard documents that justify the economic feasibility and calculation of depreciation. The actual receipt of this property and its direct use must also be documented. That is, the following documents must be present:

lease agreement (or sublease);
act of transfer of leased assets;
payment documents that can confirm the fact of payment for the rented property.

So that capital investments in fixed assets (improvements) can be recognized as depreciable property, and depreciation can be taken into account for tax purposes:

these improvements must be made only with the consent of the landlord;
the tenant is not compensated for the cost of improvements.

These two conditions must be stated in the lease agreement. The calculation of depreciation of investments in fixed assets (inseparable improvements) is used in the same way as companies use to calculate the depreciation of their own fixed assets. Straight-line depreciation is calculated using the following formula:

A=C*K/12, where

A – depreciation charges per month;
C – initial cost;
K – annual depreciation rate.

Formula for calculating the annual depreciation rate:

Н=1/n*100%, where

n – useful life of inseparable improvements.

Let us remind you once again that the tenant can set the useful life independently, but taking into account the classifier of fixed assets, which distinguishes several depreciation groups. Calculation of depreciation of improvements in a non-linear way can be done in the same way as if depreciation of fixed assets was calculated, taking into account depreciation groups.

Depreciation

The cost of an asset is repaid by calculating depreciation over its useful life (clause 17 of PBU 6/01).
The useful life of inseparable improvements can be set equal to the remaining lease period of the fixed asset (clause 20 of PBU 6/01).

For example, the cost of the system as an inseparable improvement is 100,000 rubles, and 20 months remain from the moment of its commissioning until the end of the lease agreement. This means that monthly depreciation for such an object will be 5,000 rubles. (RUB 100,000/20 months).

Depreciation is included monthly in expenses for ordinary activities based on accrued amounts (clauses 5, 16 of the Accounting Regulations “Organization's Expenses” PBU 10/99, approved by Order of the Ministry of Finance of Russia dated May 6, 1999 N 33n).

Answers to common questions

Question No. 1. “Our company and the company from which we rent the OS sign certificates for the provision of these services every month. Are they needed to confirm expenses for improvements to the OS object?”

For your organization, of course, it is better for you to draw up and sign such a document. But to confirm expenses, the tax office does not require this (clause 2, letter of the Federal Tax Service of Russia N02-1-07/81).

Question No. 2. “How to calculate inseparable improvements at original cost?”

Just like you would calculate the primary cost of an OS, that is, you must include the costs of purchase, transportation and installation.

Corporate income tax

In tax accounting, the inclusion of capital investments in leased fixed assets in the depreciable property of the tenant is not provided for by the norms of Chapter 25 of the Tax Code of the Russian Federation.
Capital investments in the form of inseparable improvements to a leased fixed asset, made by the tenant with the consent of the lessor, are recognized as depreciable property (Clause 1 of Article 256 of the Tax Code of the Russian Federation).

Since the lessor reimburses the cost of such capital investments, in this case such improvements are depreciated by the lessor (clause 1 of Article 258 of the Tax Code of the Russian Federation).

Therefore, the lessee organization does not have the right to include improvements in the depreciable property.

On the date of transfer of inseparable improvements to the lessor, the organization recognizes income from their sale (excluding VAT) (clause 1, paragraph 5, clause 1, article 248, clause 1, article 249, clause 3, article 271 of the Tax Code of the Russian Federation).

According to a number of experts, this income can be considered as income from the sale of other property.

In this case, the organization has the right to reduce it by the purchase price of inseparable improvements (the amount of capital investments made by the organization in the leased fixed asset) on the basis of paragraphs. 2 p. 1 art. 268 Tax Code of the Russian Federation.

Note that there is an opinion of the Ministry of Finance of Russia (Letter dated December 13, 2012 N 03-03-06/1/651), according to which expenses reimbursed by the lessor can be recognized by the lessee for profit tax purposes as expenses related to the performance of work for the lessor, in accordance with Ch. 25 of the Tax Code of the Russian Federation, subject to their compliance with the requirements of paragraph 1 of Art. 252 of the Tax Code of the Russian Federation.