It is increasingly common for businesses in search of office space to pay preleasing rates of a year or more. But given Russia's hyperinflationary environment and the instability of the ruble, it would be wise to consider the potential taxation treatment of such lump-sum fees and the surprising consequences that can result.


Before setting pen to paper, landlords and tenants alike should consider the prepayment issue carefully, especially when both are Russian tax-registered and at least one of the parties is a foreign legal entity.


Most Russian-based taxpayers rely on "cash-basis" accounting as a way of negotiating the country's high inflation. This allows income or expenses to be recognized on a company's books at the time of cash receipt in rubles or, if in hard currency, using the ruble equivalent at the Central Bank exchange rate on that date.


But for prepayments -- rent or otherwise -- Russian accounting rules require a cash-basis landlord or tenant to recognize the advance rental fees on a pro rata, or "accruals" basis, factoring in the income or expenses over the life of the lease.


Ordinarily this deferred recognition of income or expenses can prove favorable to both the landlord and the tenant. This can be particularly important for commercial representative offices, as there is no provision in Russian law allowing for the carrying forward of losses.


On the currency devaluation front, prepaying rent in rubles or hard currency is economically important as well. In a declining ruble environment where the advance rent is paid in hard currency, a landlord may benefit. This is because the hard-currency prepayment will be booked as deferred revenue in the landlord's accounts and valued in rubles at the date of prepayment.


These advance rentals will then be recognized for tax purposes as they accrue over the period of a lease, when the value of the ruble-denominated prepayment is less in hard-currency terms. Thus, the deferred hard-currency payments are not indexed to their current ruble value when recognized for tax purposes, and the landlord recognizes less rental income for taxation purposes than if the income were fully recognized on actual receipt.


For the tenant, however, prepayments are generally not good.Not only can the money not be put to other uses, but also rents prepaid in hard currency at a time when the ruble is declining must be booked at the historic rate on actual payment. Similarly, a tenant cannot revalue the deferred hard-currency rents into rubles using the higher ruble exchange rate, which is likely to be in effect at the time of future payments.


Additionally, since rent payments are not indexed against ruble devaluation, the tenant effectively receives devalued taxation benefits on the lease payment in hard-currency terms.


Tenants should keep in mind that the devalued tax benefit of the deferred rentals is the same whether prepayments are made in hard currency or rubles. Therefore, although the currency of payment is less of an issue, it is in the tenant's interest to keep the term of rental prepayments as short as possible.


One further consideration for tenants is that prepayments are treated as assets included in the property tax base and will be subject to a property tax of up to 2 percent in most of Russia, 1.5 percent in Moscow. Where the prepaid rent is substantial, this cost also can be substantial.


Effectively, the Russian real estate rental market is a seller's market. With the benefit of advance receipt and the use of the funds, as well as the ability to recognize less taxable income than if taxed on receipt, the cards are at least for the present time clearly stacked in the landlord's favor.





Scott Antel and Vladimir Abramov work in Arthur Andersen's tax and legal department.