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Allocations of land and buildings: a risky issue

21 DECEMBER 2016

Allocations of land & buildings: a risky issue

As the year end approaches, now is a good moment to reconsider the above question, which was the subject of two important rulings in 2016 (Conseil d’Etat rulings nos. 367467 SARL Daves and 380400 LG Services of 15 February 2016) followed by a recent report issued by AFREXIM (the French Association of Property Valuation Firms).  

In tax terms this issue is highly important as the amount appropriated to depreciation, which is deductible from the taxable result, depends on this allocation. This is all the more pertinent as, in the event of an inspection, the French Tax Authorities, FTA, may challenge the taxpayer’s allocation, with no time limit. The usual three-year deadline will not apply in such cases and the FTA may increase the value of the land with respect to the first business year falling outside the statutory limitation period, irrespective of the date on which the building was acquired (subject to certain exceptions).

The allocation of the total price of a building between land (non-depreciable) and buildings (depreciable) is not set out in any accounting or tax provisions and purchasers must proceed under their own responsibility.

The number of criteria to be considered (transaction date, location, building quality and state, town planning authorisations, goodwill, etc.) make the task especially complex and this question regularly involves discussions with the FTA.

◊ Cases of 15 February 2016:

In these two cases the FTA had disputed the division of costs between land and buildings used by two companies on the basis of the values of the land and buildings recorded on the balance sheets of companies in possession of “comparable” assets. The appeal court upheld the position of the FTA.

Moreover, in one of the two cases (no. 367467), the Administrative Court of Appeal of Paris also confirmed the position of the FTA which, for the purpose of the division to be applied to the taxpayer, had taken the total price of the asset on the date of its recording as a fixed asset (in the case in point, following works) rather than on the date of acquisition. This result of this approach was that the costs of works that had increased the cost price of the building subsequent to its acquisition were now included in the basis used for the division. 

The French Conseil d'Etat has now overruled the above decisions, stating in particular that:

  • the Court of Appeal of Paris had not verified whether the tax authorities were correct to make use of an analysis of accounting data taken from the accounts of other taxpayers;

  • the division of the cost between land and buildings should be determined on the date that the asset is recorded on the taxpayer’s balance sheet, including the acquisition of an existing building for the purpose of demolition and rebuilding or of conversion.

The French Conseil d'Etat therefore set out three, hierarchical, methods of division:

  • 1st method: the value of the land is to be determined with regard to transactions carried out on dates similar to the date on which the building was recorded on the company’s balance sheet in reference to vacant land located in the same geographical area;

  • 2nd method: failing this, the value of the building is to be determined on the basis of the cost of its rebuilding on the date on which the building was recorded on the company’s balance sheet, taking account of its dilapidation and state of repair;

  • 3rd method: if it is not possible to use one of the two above methods, the division of the cost between land and buildings is to be determined on the basis of data taken from the accounts of other companies that have, on similar dates, acquired buildings of a comparable location and type of construction. 

These three methods are applicable to both the FTA and the taxpayer, who was vindicated (i) in demonstrating that the FTA had used them incorrectly and (ii) in introducing other data than that applied by the FTA in its case.

◊ Remarks:

To our knowledge, this is the first time that the French Conseil d'Etat has ruled on the criteria for dividing the acquisition price of real estate between land and buildings. However, the principles set out by the judges appear to produce significant risks:

  • In the absence of any comparable asset, application of the first method is in practice very limited for assets located in major urban areas.

  • The second method will thus be the one most often selected. However, it masks one of the determining factors in the valuation of investment properties, namely the rental conditions, which will inevitably result in an increase in the value of land to the detriment of buildings. Indeed, the value of investment properties (and especially of assets used for business purposes) depends on the existence and “quality” of the leases concluded, which will result in a goodwill value compared to a vacant property.

This method results in all of the goodwill being apportioned to the cost price of the land and thus significantly reduces the depreciation deductible for buildings.

  • The French Conseil d'Etat proposes seeking comparable data in the accounts of other companies only in cases where the rebuilding cost method cannot be used. While undoubtedly more favourable to enterprises, this solution is complex to apply in the absence of sufficient information, whereas the FTA have a very large database from which to choose comparative data in support of their position.

For their part, the European Valuation Standards recommend several methods for distributing such goodwill:

  1. Determining the value of the land, which is assumed not to be developed, for its use on the date of valuation, then deducting this value from the value or the price of the asset in order to obtain the value of the buildings; or 

  2. Determining the net replacement cost of the buildings and developed facilities on the land on the date of valuation, and deducting the amount obtained from the value or the price of the asset in order to obtain the value of the land; or

  3. Determining the value of the land, which is assumed not to be developed, in order to determine the net replacement cost of the buildings, adding the two amounts thus obtained, then adjusting each in proportion such that the sum of the value of the two elements is equal to the value or price to be divided. 

AFREXIM for its part considers that the role of the expert in valuing buildings is to establish the goodwill value, but that its appropriation in the accounts must be on the basis of the accounting advice received by investors.

Ultimately, it is highly advisable to make use of both valuation experts and accounting practitioners, taking into account the recent criteria handed down by the French Conseil d'Etat, in order to have solid evidence in the event of an inspection and to avoid the punitive use of the “rebuilding method”.

Note that, should the FTA challenge the method of division selected, all of the depreciation on buildings appropriated since the acquisition of the building may be reassessed, up to the proportion deemed as excessive by the FTA, through an increase in the value of the land.

→The outcome may thus be a considerable issue!  

By Pierre Appremont & Yacine Bousraf