Surface rights: how to generate property income with tax efficiency

Many family business groups need to plan a balanced investment strategy, typically carried out using the surplus generated by their operating companies through dividend distributions to the group’s parent holding company. This holding company, or other entities to which the treasury is reallocated, then implements the investment plan.

It is already well established how important it is for both the holding company and its subsidiaries, in which a stake of more than 5% is held, to invest in assets used for an economic activity, so as not to jeopardise exemptions for Wealth Tax or reductions applicable to family businesses under Inheritance and Gift Tax.

Accordingly, it is important to invest in assets used for an economic activity, such as the acquisition of property for rental purposes, with at least one full-time employee engaged in managing this activity.

Characteristics of the surface rights assignment agreement

In this regard, it is common for operators in the retail, distribution and restaurant sectors, typical of large commercial areas, to offer landowners a type of agreement different from the traditional model of leasing a complete property (land and building).

These operators require properties with very specific characteristics, so the arrangement proposed is for the landowner to grant a long-term surface right (around 25–30 years), allowing the operator to construct the building, which it owns for the duration of the agreement. In return, the landowner receives a monthly payment throughout the term of the contract (a periodic ground rent).

Naturally, the income received is lower, but the investment is limited to the land, no construction risk is assumed, and the property reverts to the landowner at the end of the term of the agreement.

From a financial perspective, it is a highly efficient transaction for the investing owner, who also manages to incorporate an asset used for an economic activity into its balance sheet (provided the remaining requirements are met), securing a recurring long-term cash inflow and the future addition of a building to its property at the end of the assignment period.

Although these agreements sometimes provide for a minimum commitment period of only five or ten years, the operator usually remains for the long term, given the substantial investment made in construction. If it were to leave before the end of the agreed term, the reversion of the property to the owner at that point is always provided for.

As this is a complex agreement, it is advisable to analyse all the tax aspects, considering a transaction of this nature within a business context between corporate entities. The main issues are set out below.

VAT treatment of the assignment of surface rights

For VAT purposes, this transaction is regarded as akin to a lease and is therefore a continuous supply of services. Accordingly, the tax becomes chargeable on a pro rata annual basis where payments have been agreed at intervals exceeding one calendar year.

For VAT purposes, the taxable base of the surface right, in terms of the VAT to be charged by the granting landowner, will be the sum of:

• The monetary payments made to the landowner, which will accrue with each monthly ground rent payment for their amount, with the corresponding invoice to be issued.
• The market value attributed to the building that will revert at the end of the agreed term; in this case, the owner must issue an invoice on each 31 December for the proportion of the construction’s value corresponding to each year.

Upon reversion of the building, the assignee company will transfer the construction, which will, for VAT purposes, constitute a second supply of the property and will therefore be exempt from VAT. Consequently, the landowner would, in principle, be liable for Transfer Tax (ITP) (Article 20.One.22 of the VAT Act).

However, if the company intends to use the building for an activity subject to VAT, a waiver of the VAT exemption provided for in Article 20.Two of the VAT Act may be agreed when the surface right is formalised (thereby excluding Transfer Tax). In that case, the assignee must invoice the reversion each year without VAT (Article 75.2 of the VAT Act, concerning advance payments), and the landowner will be the taxable person under the reverse charge mechanism (Article 84.One.2(e) of the VAT Act).

In the latter case, as the surface right is a real right that must be executed in a public deed, has an economically assessable value and is registrable at the Land Registry, it gives rise to Stamp Duty (AJD) for the assignee under the graduated scale (generally 1.5%, depending on the Autonomous Community, calculated on the capitalised rent).

Similarly, upon termination, if the reversion is formalised in a public deed, Stamp Duty (AJD) may also become payable under the graduated scale, based on the value of the building at that time.

Practical example

A company grants a surface right over a plot of land it owns for a period of 25 years, receiving a monthly ground rent of €5,000 and, at the end of the term of the agreement, it will receive a building valued at €1 million.

• The landowner will issue a monthly invoice for €5,000 plus VAT (21%) in respect of the ground rent and, in addition, must issue a further invoice each 31 December for €40,000 plus VAT (21%), corresponding to the annual proportion of the construction’s value.
• If the VAT exemption is waived, the assignee will issue an invoice each 31 December for €40,000, without VAT, and the landowner will be required to account for VAT (21%) under the reverse charge mechanism.

Impact on Corporation Tax of these transactions

The granting company will recognise, for accounting purposes, the agreed monthly ground rent as income, while the portion relating to the reversion of the building it will receive at the end of the agreed contractual period will be treated as follows:

• An estimate must be made of the value of the building at the time the reversion is expected to occur, based on a financial criterion (it should be similar to the net book value of the construction for the assignee at that point, if an economic depreciation method has been applied).
• Once this value has been determined, an amount equivalent to the annual proportion of that value will be recognised each year as an asset, recorded as a receivable under “non-current trade debtors”, with the corresponding entry recognised in “income from surface rights”.
• At the end of the agreed contractual period, when the building reverts, all the related income will already have been recognised year by year, and the accumulated balance in trade receivables will be transferred to the “Buildings” account, thereby recognising the building as an asset for the landowner.

Practical example

Based on the above figures, if the estimated value of the building is €1 million at the end of the term of the agreement:

Each year:

• €40,000 → (acct. 430) × (acct. 75x)

At the end of the agreement (reversion):

• €1,000,000 → (acct. 211) × (acct. 430)

With regard to the superficiary, it will recognise the monthly payment of the periodic ground rent as an expense, and in respect of the treatment of the building:

• It will recognise the construction as an asset at cost, depreciating it each year over the term of the agreement, unless the duration of the agreement exceeds the useful life of the building, in which case it will be depreciated over its useful life.

For Corporation Tax purposes, the expenses and income recognised in accordance with these accounting criteria will form the taxable base. However, if the superficiary depreciates the building over a period exceeding the maximum tax depreciation rate, this may give rise to a temporary difference to be taken into account each year.

Key considerations for effective planning in surface rights transactions

As can be seen, surface rights assignment agreements are complex transactions in which careful review and planning are essential to ensure the correct tax treatment and to properly assess all costs and taxes before making a decision.

Do you need advice? Access our area related to surface rights:

Tax Advice

Real Estate Law