By definition, a lease is a contract whereby one of the parties (lessor) binds himself to give to another (lessee) the enjoyment or use of a thing for a certain price, and for a period that may be definite or indefinite. The lessor retains ownership of the asset during the term of the lease. For taxation purposes, a lease could be classified as an operating lease or a finance lease.
In business nowadays, commercial leases constitute a major area of consideration. Some businesses enter lease transactions to take advantage of not spending too much in capital outlay to operate, especially startups, as well as the opportunity to use a facility or amenities at low cost. For some, the right physical location could provide them with an advantage for marketing, targeting customers, logistics, or an efficient value chain.
Lease transactions between related parties are common. How should related parties ensure that their lease transactions are arm’s length in nature?
Arm’s length principle in lease
Lease transactions between related parties must adhere to the arm’s length principle. This means that the material and relevant terms and conditions of the lease, such as lease rate, payment terms, and escalation clause, among others, with a related party are comparable with those of an independent party.
Application of arm’s length principle in lease
Comparable Uncontrolled Price (CUP) method
One way of applying the arm’s length principle to leases is by using the CUP method. This method evaluates whether the lease rate charged by the lessor to its related party-lessee, as well as the terms and conditions of the lease, are at arm’s length by reference to the lease rate charged in a comparable uncontrolled transaction in comparable circumstances. This is the most direct way of ascertaining an arm’s length lease rate but requires the highest degree of comparability of the terms and conditions of the lease with those of a related party-lessee and an independent party-lessee. In case of differences, reliable adjustments should be made to eliminate the material effects of such differences.
The CUP method is further classified as an internal and external CUP method.
The internal CUP compares the lease rate charged by the lessor to its related party-lessee with that of the lease rate charged by the same lessor to its independent party-lessee. For example, Lessor A charges P1,000 per square meter lease rates to its independent party-lessee for office space. If Lessor A leases office space comparable to its related party-lessee, the lease rate should ideally be comparable to the P1,000 per square meter.
Please note that in using internal CUP, it must be demonstrated that internal comparable is not transactions that were performed/entered solely to justify that the related party transactions are at arm's length or to artificially create a comparable uncontrolled transaction that serves as a benchmark.
On the other hand, external CUP compares the lease rate with related party-lessee with that of the lease rates between two independent parties. For example, Lessor A has no lease transaction with an independent party. Assuming Lessor B charges P1,500 per square meter to Lessee C (both are independent parties). Then, the lease rate of Lessor A to its related party-lessee should ideally be comparable to the P1,500 per square meter.
Again, the CUP method requires the highest degree of comparability of lease terms and conditions. With that said, a comparability analysis must be performed first between the related and independent transactions. In performing this analysis, it is crucial to know the characteristics of the lease transaction. This is because differences in the terms and conditions might have a material influence on the lease rate.
Factors affecting the comparability could be qualitative and quantitative. For example, the classification of the property, whether residential, commercial, industrial, or agricultural would affect the lease rate. Likewise, location matters most. Properties in prime locations would normally command higher lease rates than those in rural and undeveloped areas. The same is true in a commercial building depending on what floor you are located. Moreso, the lease term (i.e., short-term, or long-term) would have an impact on the lease rate. Payment terms also play a factor, such that the longer the payment term, the higher the lease rate.
Other relevant factors are the party who pays for the taxes, insurance and maintenance, escalation clause, improvement and modifications, and purchase options, among others.
To reiterate, the CUP method is acceptable provided that reliable adjustments can be made to eliminate the several factors enumerated above that affect the lease rate.
Transactions Net Margin Method (TNMM)
Instead of comparing the lease rate, TNMM uses the profit level indicator (PLI) to evaluate whether the lease transactions with related parties pass the arm’s length test. This method compares the net profit margins relative to an appropriate base such as costs, sales or assets attained by the lessor from a related party transaction to those attained by the comparable independent lessors engaged in similar transactions.
The TNMM is based on the economic concept that similar firms operating in the same industry would tend to yield similar returns over time.
In our earlier example, instead of comparing the lease rate charged by Lessor A to its related party-lessee, TNMM will compare the net profit ratio using an appropriate base earned by Lessor A with that of the net profit ratio generated by independent comparable lessors, such that if Lessor A’s net profit ratio is comparable, then the lease transaction of Lessor A passes the arm’s length principle.
The BIR has laid down the criteria in searching for comparable companies. The challenge in using TNMM is the capability and resources of the taxpayer to find reliable, comparable independent lessors.
When applying the TNMM, differences in the characteristics of lease transactions between related party transactions and comparable companies generally do not have a material influence on the operating profit. A greater emphasis is placed on functional comparability than on the characteristics of lease transactions. In this regard, the factors affecting the lease rates discussed in CUP method generally have no bearing on TNMM.
As such, the application of TNMM allows the use of broader comparable companies, as operating profits are less likely to be affected by differences in the terms and conditions of the lease and certain functions.
Takeaway
Taxpayers seek the services of a professional real estate broker that would help them locate the best property and location and negotiate the best economic deal possible. But taxpayers should not forget that the best economic deal possible is one that complies with the arm’s length principle.
Let's Talk TP is an offshoot of Let’s Talk Tax, a weekly newspaper column of P&A Grant Thornton that aims to keep the public informed of various developments in taxation. This article is not intended to be a substitute for competent professional advice.
As published in BusinessWorld, dated 25 July 2023
