Is the cost of improvements subject to VAT?

Is VAT charged on the transfer of improvements

Zaporizhzhia tax authorities reminded us of the SFS position regarding VAT taxation of operations involving the transfer of improvements to a leased asset, which was previously expressed, in particular, in Individual Tax Ruling dated 08.11.2017 No. 2559/IPK/15-32-12-01-14.

In their consultations, tax authorities conclude that:

“...If the costs for improving a leased asset are incurred with the lessor's consent and are not compensated to the lessee, then upon return of the leased asset, the value of the improvement is considered a gratuitously provided service. As a result, such improvement value is subject to VAT taxation at a rate of 20%, based on the purchase price of goods/services used for such improvement.”

We do not entirely agree with this opinion and will explain why.

Let's consider the situation:

Company A leased a production facility for a period of 10 years. A year later, it made inseparable improvements to the leased premises amounting to UAH 500 thousand (for example, a shed was added, which was used for storing production materials). Before making the improvements, the company obtained consent from the lessor, as required by paragraph 1 of Article 778 of the Civil Code of Ukraine (hereinafter – CCU). After the lease term expired, the property and improvements were returned to the lessor.

How operations for the return of inseparable improvements will be reflected in accounting

In Company A's accounting, the cost of improvements will form a separate asset in the "Other non-current assets" group. The depreciation period for such an asset should not exceed the remaining lease term. In our case – 9 years. When applying the straight-line method (the production method is also allowed, according to paragraph 27 of P(S)BO 7), the enterprise will annually allocate a portion of the improvement costs – UAH 55.6 thousand (UAH 500 thousand / 9 years) – to the production cost of goods sold. These expenses will form the cost of sales of finished products and will be included in the VAT tax base upon the sale of such products (assuming the selling price is not lower than the ordinary price).

In tax accounting, the cost of improvements will be accounted for within group 9 "Other fixed assets," with a minimum allowable useful life of 12 years (para. 138.3.3 of the TCU).

Thus, on the date of return of the leased premises and the improvement in the form of a shed after the expiration of the lease term:

• the book value of the separate asset "Shed" in the "Other non-current assets" group in accounting will be zero. (here and further in the text, for calculation simplification, we deliberately did not consider the specifics of determining the start and end periods for depreciation accrual, as defined in paragraph 29 of P(S)BO 7)
• the entire amount of improvement costs was included in the VAT tax base as part of the product sales price
• the value of this asset in tax accounting will be UAH 125 thousand, which will reduce the financial result in the income tax declaration based on the requirements of paragraph 138.2 of the TCU.

Is it really necessary to reflect VAT tax liabilities for the entire amount of improvements made

On the one hand, if the enterprise received permission to make improvements from the lessor, then according to part 3 of Article 778 of the CCU, it has the right to receive reimbursement for such expenses. If Company A does not demand reimbursement, this can be considered a gratuitous transfer of such improvements to the lessor.

On the other hand, the improvements (additions) were used by the company for 9 years and, naturally, they do not have the same value on the date of return as at the time the improvements were made, due to physical and other wear and tear.

Furthermore, we are inclined to consider the transfer of inseparable improvements upon the return of leased property as a supply of non-current assets, rather than a gratuitous provision of services, as stated by the tax authorities. Therefore, when determining the VAT tax base, one should be guided precisely by the norms of paragraph 188.1 of the Tax Code, which pertain to the supply of non-current assets, namely:

“...the tax base for operations involving the supply of non-current assets cannot be lower than the book (residual) value according to accounting data, as of the beginning of the reporting (tax) period during which such operations are carried out.”

Our advice to the accountant

• upon transfer of improvements, Company A must reflect VAT tax liabilities for the gratuitous transfer of improvements
• the tax base should be determined based on their contractual value (which is zero in the situation under consideration), but cannot be lower than the residual value of the asset according to Company A's accounting data at the beginning of the month in which the return occurred (in our example = UAH 4.6 thousand ((UAH 500 thousand * 1 month) / (9 years x 12 months)))
• if the residual value is zero or to reduce tax risks, the value of gratuitously transferred improvements can be determined by independent appraisal or by an appraisal agreed upon between Company A and the lessor and specified in the acceptance and transfer (return) act of the leased property.

Of course, we have considered only one of many possible situations. And in each specific case, there may be various arguments both in support of the tax authorities' conclusions and against them.

Therefore, considering the position of the controlling authorities, as well as the possibility of different interpretations of the TCU norms, we still recommend signing a separate agreement with the lessor for the compensation of the lessee's expenses for improving the leased asset, in an amount to be agreed upon by the parties (for example, on the date of transfer of such improvements), taking into account their physical and moral wear and tear and other parameters. In this case, in our opinion, this contractual value will be the VAT tax base (provided, of course, that such value corresponds to the level of ordinary prices).

You might also be interested in our other articles: Acquisition of NGO services with VAT and VAT accrual on re-export operations.