by Tracy E. Reichmuth, Esq., Crowell & Moring LLP [email protected]
When it comes to pass-throughs under retail leases, a tenant’s first line of the defense is a thoughtfully-drafted lease provision. The language of the lease controls what a landlord can and cannot pass on to the tenant, including under tax provisions. However, even careful drafting may not preempt disputes, or prevent landlords from creatively inflating your tax pass-throughs. Smart tenants pay close attention to exactly what “taxes” landlords are passing through under their leases. Tenants should read and understand the language of their leases, and be vigilant in monitoring what landlords are passing on under the guise of taxes.
When tenants pay close attention, they may find that landlords are charging them for “taxes” that are not traditional property or real estate taxes. Rather than taxes on the property itself, these taxes may be assessed based on a landlord’s business operations (for example, margin or franchise taxes). Or, the charges may not even look like a tax at all. For example, some landlords may pass on as “taxes” charges from a municipality that appear more like rent, use fees, or even costs associated with construction.
In one recent example, at Sawgrass Mills in Sunrise, Florida, and Ontario Mills in Ontario, California, Simon Malls sold adjoining land to the municipality. The municipality, in turn, built a parking structure solely for the use of the center, and has been charging the cost back to Simon over time. Simon then passed on these “tax assessments” to tenants as part of the tenants’ tax bills. The result is that tenants are paying for the capital costs of constructing a parking garage at each center.
These types of charges are not the types of real estate taxes tenants typically anticipate contributing towards. The first step in determining whether these pass-throughs are permitted is to review the language of the lease.
The basics of tax provisions and common questions of interpretation
Typically, a tax provision in a retail lease has certain features. In most cases, it will set forth a formula for determining a tenant’s share of taxes in a format such as:
[A measure of the total “taxes” paid by landlord] multiplied by [a measure of the square footage leased by tenant] divided by [a measure of total square footage of the shopping center (or some subset of the shopping center)]. That means there are three key questions in reviewing the language of a tax provision:
First, what types of “taxes” are encompassed by the provision?
Second, what parcel(s) can be included in the pass-through? Is the landlord limited to the parcel on which the tenant’s store is located? Can the landlord include its tax obligations for other tax parcels at the center?
Third, once the amount of taxes is determined, how is the tenant’s share calculated? Generally a tenant’s share is calculated by taking the square footage of the tenant’s space (the numerator) and dividing it by some measure of total square footage of the center (the denominator). While the numerator is typically undisputed, the denominator is often an issue for dispute.
Here, we are focusing on the first question–what taxes are included, and may be passed on to the tenant? Charges from the government can come in any number of forms, and determining what types of taxes are the responsibility of a tenant typically depends on how “taxes” are defined or characterized in the lease.
How landlords push the boundaries of permissible “tax” pass-throughs
Not surprisingly, a landlord will push an interpretation that would classify as many government fees as possible as taxes, so that it can impose the burden of these charges on tenants. For example, a landlord might pay a fee to the government in lieu of a tax and then attempt to charge its tenants for a portion of the fee.
Frequently, landlords attempt to pass through what are more properly characterized as business taxes rather than real estate taxes. These might include “business license” taxes, “gross receipts” taxes, “franchise” taxes, or “margin” taxes. Rather than taxes on the value of a landlord’s real property, these taxes may be imposed on landlords by the state or local government based on revenues or profits, or for the privilege of doing business in a particular location.
Not only may these taxes be specifically excluded under a tenant lease, such taxes can essentially impose a double tax on a retail tenant. Retailers are required to pay their own business taxes, and then required to pay taxes on the landlord’s revenues–which are generated by charging rent to retailers.
Likewise, our Simon Malls garage example tests the question of what are “taxes” that may be passed on under the lease. Are such charges even taxes? Or are they really the cost of capital improvements? Notably, tenants are typically not otherwise responsible for the costs of capital improvements, and the costs of capital improvements are often explicitly excluded from common area maintenance costs that can be passed on the tenant. Pushing these charges from the CAM column to the tax column seems like a creative attempt to overcome this bar on passing through the cost of capital improvements.
A legal perspective: how courts approach disputes over tax pass-throughs
In crafting a tax provision or in navigating a dispute with a landlord, it can help to approach the issue like a judge or jury. Courts will not simply rely on what might be “fair,” or what the landlord charges other tenants at the shopping center. Instead, the question of what types of taxes can be included in calculating the tenant’s charge for taxes is determined by examining the parties’ intent as expressed by the plain language of the lease. See e.g., Sheplers, Inc. v. Kabuto Int’l (Nevada) Corp., 63 F. Supp. 2d 1306 (D.C. Kansas 1999) (interpreting retail lease dispute based on the plain language of the lease).
Ideally, a retailer can limit its obligations for taxes by negotiating to narrowly define what taxes can be included. For example, a tenant can seek to include only “real estate” taxes, or alternatively specifically exclude from the definition of “taxes” any business license, gross receipt, income, or franchise taxes, or any charge paid to a governmental authority in lieu of taxes.
It may be that when a dispute arises, the language of your tax provision is not as clear as you would like. That does not mean you cannot build a strong argument. For example, a tenant can look to other provisions of the lease to prove what a tax provision means. In litigation, a court would typically look at other provisions of the lease for context. See Sheplers, 63 F. Supp. 2d at 1313. Similarly, in “building a case” with the landlord, a tenant can look for language in the lease demonstrating that the parties did not intend to include fees in lieu of taxes or business license or gross receipt taxes as part of a tenant’s obligation for taxes. If the tax pass-through looks like the cost of capital improvements, a tenant can cite language in a CAM provision excluding capital improvements to show that the tenant was not meant to bear such costs.
Finally, correspondence, drafts or other documents relating to the negotiations of the lease may support the tenant’s position that the parties intended a narrow definition of “taxes.” For example, language providing for a broad definition of “taxes” that is struck from a draft lease can be strong evidence the intended definition was narrow.
As with CAM and other pass-throughs, retail tenants should carefully review the scope of what taxes may be passed through under a lease. During the lease term, a retail tenant should regularly audit what taxes are being charged to the tenant, and should never assume that it is required to pay all taxes asserted by the landlord as a non-negotiable pass-through. A retail tenant’s obligations for taxes are governed by the lease and are subject to negotiation and interpretation just like any other provisions in the lease. The key is in carefully drafting, reading, and understanding the language of your lease.
Tracy E. Reichmuth is a counsel in Crowell & Moring’s San Francisco office and is a member of the Litigation Group.