A Few Other Ways to Save Under VAT Law

The new year has brought a new challenge for real estate investors ?€” coming to grips with the value-added chapter of the Tax Code that came into effect Jan. 1.

Before 2001, the fact that VAT on construction expenses could not be recovered was a barrier to investment in real estate since it significantly increased the cost of development. The ability to recover such VAT starting this year was widely debated in the business community and enjoyed extensive coverage in the media.

As a result, it was easy to overlook the other changes in the VAT law that could significantly influence the costs of doing business in the real estate sector. These changes can affect all stages in the life of a property.

There are three changes to the VAT legislation that could be important at the start of a development, at the stage of putting the building into use and upon selling the building.

Usually one of the first significant costs to be incurred is the cost of land. Generally a 49-year ground lease remains the strongest title currently available in Moscow. In order to obtain it, an investor is usually required to make a significant lump-sum payment to the city of Moscow for "the right to conclude a land lease agreement" and then pay regular fees over the period of the land lease. The previous VAT regulations specifically exempted land lease payments from VAT. The new VAT legislation does not provide for such an exemption. As a result, in 2001 the tax authorities could seek VAT at a rate of 20 percent on these payments. Although the new legislation leaves significant scope to argue that land lease payments to the city authorities should not be subject to VAT, it is not yet clear how the Moscow land committee will interpret the law and whether the developers will need to pay 20 percent more as VAT.

Generally, VAT on regular land lease fees should not be a problem for developers, who in most cases should be able to recover it. It appears, however, that any VAT charged on the lump-sum payment "for the right to conclude the land lease agreement" would be irrecoverable. It is important therefore that developers should be aware about this exposure and provide for it in their cost budgets.

When construction is finished, developers should not automatically assume that under the provisions of the new legislation VAT on construction should be fully recoverable. It should be emphasized that even after Jan. 1 VAT may remain partly or fully irrecoverable. This primarily relates to buildings developed for use by insurance and pharmaceutical companies, banks, investment companies and other businesses whose revenues are exempt from VAT.

However, this exposure also applies to commercial properties: If rentals from part of an office building are exempt from VAT, part of the VAT on construction may be irrecoverable for the landlord. The amount of such irrecoverable VAT is calculated in proportion to revenues subject to VAT and exempt from VAT.

The same limitation of VAT recovery was in the old VAT law. The good news, however, is that new VAT legislation also provides some opportunities for managing this exposure.

VAT can represent a significant cost on the future sale of any building in Russia. The new VAT legislation has provided for a new mechanism for minimizing the VAT cost on the sales of buildings. Without going into too much technical detail, in certain circumstances the new law enables a company to effectively revalue buildings constructed in previous years, which can be used to reduce the VAT charged when selling such buildings.

Steven Snaith is a partner and Dmitry Rudakov a manager at the real estate taxation practice of PricewaterhouseCoopers Russia.