30 April 2015 #Commercial Real Estate
What is a rent deposit?
A rent deposit is money provided by a tenant to its landlord as security for payment of the rent and performance of the tenant’s covenants contained in the lease. A rent deposit deed will specify the circumstances in which the landlord can draw on this money and the conditions that must be satisfied for the deposit to be repaid to the tenant.
Landlords like rent deposits because they are easily accessible sources of money that came be drawn upon as soon as the tenant is in breach of a relevant covenant in the lease. Court action is not required to recover the debt or enforce performance of the obligation. Tenants are not generally too keen on rent deposits as they lock up capital, often for a lengthy period.
When will a rent deposit be taken?
A rent deposit will be put in place on the grant of a lease or on assignment of an existing lease. If the landlord does require a rent deposit it will usually be for one of the following reasons;-
As many tenants will not want to lock up the capital required to fund a rent deposit, the possible alternatives include;-
All of these alternatives have potential disadvantages, for example both the bank guarantee or bond and a letter of credit will require a payment to the bank from the tenant to secure the payment and the value of a guarantee will depend upon the strength of the party providing the guarantee.
Points to be considered when negotiating a rent deposit deed
There is no prescribed level for the rent deposit and no statutory constraints on the size of the sum. However, the amount put down usually reflects the rent payable under the lease, the likely period that it would take for the landlord to re-let the property and the landlord’s perception of the risk that the tenant poses.
Rent deposits are generally equivalent to between 6 & 12 months’ rent due under the lease. The amount is usually related to the yearly rent payable but may also include insurance rent and service charges.
The question of a deposit in respect of the sum representing the amount of VAT that will be payable is often a contentious point. The parties may not consider VAT when negotiating the amount of the rent deposit. VAT is not payable on the sum deposited with the landlord as a supply is not being made at that time, but once the landlord draws on the rent deposit as a result of tenant’s default and if the landlord has exercised the option to tax, VAT will be payable on the amount drawn down. Accordingly, where the landlord has exercised the option to tax or is likely to do so, the negotiated rent deposit should be an amount that includes a sum equivalent to the VAT that will be payable if the tenant is in default.
When will the rent deposit be returned to the tenant?
The rent deposit will generally be returnable in the following circumstances;-
The landlord may also agree to return the rent deposit if the tenant demonstrates that its financial position has sufficiently improved to render the rent deposit unnecessary to reassure the landlord that it will meet its financial obligations under the lease. Examples of this trigger are the “net profit” test where the net profits of the tenant are shown to equal or exceed a multiple (usually 3 times) of the rents reserved by the lease for up to 3 years and the “net assets” test where the net assets of the tenant are equal to a multiple (often 5 times) of the rents reserved by the lease.
Tax on rent deposits
In the past, rent deposits did not form part of the “consideration” on the grant or assignment of a lease so no SDLT was charged on. However, the Finance (No.2) Act 2005 contains provisions to enable SDLT to be charged on premiums that are disguised as rent deposits. Under these statutory provisions, rent deposits are held to be “consideration” for the purpose of the grant or assignment of a lease (and therefore potentially liable for SDLT) unless the rent deposit is less than twice the highest amount of annual rent payable in any 12 month period in the first 5 years of the term or, in the case of an assignment, in the first 5 years of the term remaining outstanding at the date of the assignment.
It is argued by some advisors that these provisions only apply to the type of the rent deposit structure where the tenant actually transfers ownership of the deposit monies to the landlord. However, most rent deposits are drafted to provide that the money is held by the landlord but owned by the tenant.
Where a landlord has opted to pay TAX, VAT is payable on the annual rent. As mentioned above, it is therefore usual where the option has been exercised, for the landlord to ask that the money deposited incorporates a figure equivalent to the VAT on the rent deposit to ensure that the landlord will be able to claim the full amount due if the tenant fails to pay rent.
VAT is not actually payable when the money is put on deposit, since the landlord is making no supply at that date. It is only if and when the Landlord makes a deduction from the deposit monies that a taxable supply is made that is liable to VAT.
No VAT invoice is required when a rent deposit deed is entered into if a sum equivalent to VAT is paid.
This note contains some initial points to be considered in relation to rent deposit deeds. These documents are often drafted in a complex way and questions will arise on each form of rent deposit deed used for example whether a landlord can draw against a rent deposit if a corporate tenant becomes insolvent, and what happens when the landlord sells its interest in the property.
If you have any queries on any of these points or the point referred in this note or any other matters relating to rent deposit deeds please contact Rachel Krol, firstname.lastname@example.org or any member of the Commercial Property team.