Investments in third-party asset, especially real estate, often occur in the context of leasing, where the lessee invests funds in improving or adapting the asser they use, which is owned by the lessor. Such investments have specific tax and accounting implications, and special attention is needed in the event of premature termination of the lease agreement.

What are Investments in Third-Party asset?

Investments in third-party asset refers to costs borne by the lessee to improve, maintain, or adapt asset (e.g., real estate) that they do not own. Examples include renovating a business premise, installing new utilities, redesigning the interior, or even significant adaptations such as replacing the roof or facade. Such investments may be agreed upon in the lease contract or arise during the use of the property.

Investments in third-party asset can be classified as:

• Necessary investments: Costs required to preserve the asset (e.g., repairing a leaking roof).
• Beneficial investments: Improvements that increase the value of the asset (e.g., installing air conditioning or modernizing the space).
• Routine maintenance: Minor costs serving the regular use of the asset (e.g., painting walls).

Accounting Treatment of Investments in Third-Party asset

The accounting treatment of investments in third-party asset depends on the nature of the investment, the lease term, and the contractual terms. According to Croatian Financial Reporting Standards (HSFI) and International Financial Reporting Standards (IFRS), particularly IFRS 16 (Leases), investments are accounted for as follows:

Routine Maintenance:

• Routine maintenance costs (e.g., repairs, painting) are recorded as expenses when incurred, typically to operating expense accounts.
• They do not increase the value of the asset on the lessee’s balance sheet because they are regular costs of use.

Beneficial and Necessary Investments:

• If the investments increase the value of the property or extend its useful life (e.g., installing new utilities, replacing a roof), they may be capitalized as part of the right-of-use asset.
• Depreciation: Investment costs in third-party asset can be recognized as tax-deductible expenses through depreciation, but only if the investments are agreed upon with the lessor (written consent) and comply with Article 12 of the Corporate Income Tax Act (ZPD). Depreciation is calculated over the lease term or the useful life of the investment, whichever is shorter.
• Example: If the lessee invests €10,000 in renovating the premise, and the lease agreement lasts 5 years, the investment is depreciated over 5 years (unless the investment has a shorter useful life).

Note – IFRS 16 Requirements:

According to IFRS 16, lessees must recognize a leased asset and a corresponding lease liability for all lease agreements, except for leases contracted for a period up to 12 months or leases for low-value assets. This means the lease is recorded as a right-of-use asset on the statement of financial position, along with a corresponding liability for future lease payments. Investments in third-party asset are often included in this right-of-use asset, increasing its value.

Key Points – Tax Impact

Investments in Third-Party asset as Intangible Assets:

• According to HSFI 5 and IAS 38, investments in third-party asset (e.g., adaptations of a leased business premise) are recorded by the lessee in their books as intangible assets if they meet the conditions (cost > €665, useful life > 1 year).
• According to Article 12 of the Corporate Income Tax Act (ZPD), an expected useful life of 4 years with a regular annual depreciation rate of 25% is prescribed for intangible assets, while from an accounting perspective, it is correct to calculate depreciation based on the estimated useful life of the investment (e.g., the duration of the lease agreement).

Derecognition of Intangible Assets upon Termination of the Contract:

If the asset is fully depreciated:

• Derecognition has no impact on the income statement, as the cost has already been fully recognized through depreciation.
• On the balance sheet, the asset and accumulated depreciation accounts are closed, which does not change the lessee’s total assets.

If the asset is not fully depreciated:

• This is the most common scenario in case of premature termination of the lease contract, leading to the derecognition of the remaining (undepreciated) value as an expense.
• This reduces the lessee’s assets by the undepreciated amount and is recorded as an expense in the income statement.

Tax Treatment of the Remaining Undepreciated Value (Corporate Income Tax)

The portion of the investment that has not been depreciated up to the moment of lease termination (the undepreciated book value) is treated for corporate income tax purposes as follows:

1. ) Scenario – Lessor Pays Compensation: The lessee receives compensation from the lessor for the investments (according to Article 536 of the Obligation Relations Act – ZOO). The undepreciated value is a tax-recognized expense which is offset (compensated) against the income the lessee earns from the compensation received. The recognized difference (profit or loss) is taxable/reduces the tax base.
2. ) Scenario – Lessor Does Not Pay Compensation: The undepreciated value that is written off (due to asset withdrawal) is generally considered a tax-non-recognized expense. The reason is that this expense is not offset by income, and the economic benefits of the investment have passed to the lessor and no longer serve the lessee’s further realization of income.

Therefore, if the lessor takes over the investments without compensation upon premature termination of the lease contract, the expenses from the undepreciated value at the lessee are not tax-recognized expenses.

The lessee is obliged to increase the tax base by the amount of the undepreciated value in the PD Form (corporate income tax return), as the expense is considered not to have been incurred for the purpose of earning profit (Article 7 of the ZPD).

Key Difference:

• Compensation for investments (issuing an invoice): Treated as a taxable supply/service with VAT calculated on the compensation, and the undepreciated value is a tax-recognized expense (in case of a negative sales result).
• No compensation for investments (without issuing an invoice): For VAT purposes, a deductible VAT adjustment is required, and the undepreciated value of the investment is a tax-non-recognized expense.

Premature Termination of the Contract – Impact on VAT

In the event of premature termination of the lease agreement, the investments permanently remain with the lessor, effectively changing the purpose of the asset for which the lessee used the input VAT deduction.

1. ) Scenario: Lessor Pays Compensation for Investments

Issuing an invoice and VAT: If the lessor pays compensation for the value of the investments, the lessee issues an invoice to the lessor. VAT must be calculated on the compensation amount because it constitutes a taxable supply of goods/services (real estate improvement services). The lessor, if a VAT payer, is entitled to deduct this input VAT.

1. ) Scenario: Lessor Does Not Pay Compensation (Lessee does not issue an invoice to compensate for the remaining portion of the investment)

VAT Status for the Lessee: If the lessee does not invoice compensation for the investments and had used the input VAT, they are obliged to perform an INPUT VAT ADJUSTMENT in accordance with Article 64 of the VAT Act. The lessee must return a portion of the previously deducted VAT (input VAT) proportionally to the remaining adjustment period.

Legal Consequences:

• According to the Obligation Relations Act (ZOO, Art. 536), the lessee has the right to compensation for beneficial and necessary investments if they were agreed upon with the lessor. If the contract does not provide for compensation, and the termination occurred due to the lessor’s fault, the lessee may seek compensation through the court.
• If the termination is caused by the lessee’s fault, the right to compensation may be limited or excluded, depending on the contract.

Practical Tips for Risk Management

To avoid adverse consequences of investments in third-party asset and premature contract termination, the following measures are recommended:

• Clear contractual terms: The lease agreement should specify who bears the investment costs, the right to compensation, and the conditions in case of termination.
• Written consent of the lessor: For tax recognition of the investments, written consent from the lessor is required.
• Depreciation planning: Investments should be depreciated in line with the lease term to reduce the risk of large write-offs in case of termination.
• Consultation with an accountant and a lawyer: Before making significant investments, it is necessary to consult experts to ensure compliance with tax and accounting regulations.

Conclusion

Investments in third-party asset are a complex topic that requires careful planning from a tax, accounting, and legal perspective. Proper structuring of the lease agreement is crucial to protect the lessee’s interests, especially in the event of premature termination. While necessary and beneficial investments can be depreciated and tax-recognized, contract termination can lead to financial losses if the investments are not adequately agreed upon or if the contract does not provide for compensation. Therefore, it is key to have a clear contract, follow tax and accounting regulations, and consult experts to minimize risks.

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