Taxes Under a Lease: Not Just a Simple Pass-Through

The One Sentence Summary: While some view a tenant's obligation to pay taxes as a pass-through from the landlord, this characterization is often inaccurate. Landlords frequently collect more in taxes than they in fact pay, and sometimes they collect less. Courts and juries in deciding what amount of taxes the landlord is entitled to charge a tenant, look not to some notion of fairness or a pass-through, but to the language of the lease. Thus, determining a tenant's obligation for taxes is no different from determining a tenant's obligations for other charges under a lease. The first place to look is the written lease.

Typically, a retail lease will provide a formula for calculating taxes in a form similar to the following:



In examining the lease to determine whether a tenant’s obligations for taxes is calculated properly, a tenant should focus on three main issues.

1. What types of taxes fall into “total taxes paid by landlord”? Taxes from the government can come in various forms, and determining what types of taxes are the responsibility of a tenant typically depends on how the term “taxes” is defined in the lease

2. What parcel(s) can be included in “total taxes paid by landlord”? 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?

3. Once it is resolved what types of taxes and what parcels can be included in “total taxes paid by landlord,” the next step is to calculate the portion of the taxes that can be charged to the tenant. This 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.

Issue 1: What types of taxes is the landlord permitted to include in calculating the total taxes subject to allocation to the tenant?

It is in the landlord’s interest to classify as many government fees as possible as taxes, so that its tenants will ultimately be responsible for these charges. For example, a landlord may pay a fee to the government in lieu of a tax and then attempt to charge its tenants for a portion of the fee. And, landlords are increasingly attempting to pass through to retail tenants “business license” or “gross receipts” taxes, which typically are taxes imposed by cities based on revenues received by commercial landlords. Since retailers are required to pay their own taxes to the cities, requiring a tenant to pay for the landlord’s share of business license or gross receipts taxes often results in a double tax to the retailer.

Like any lease dispute, 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). A retail tenant’s first line of defense to limit its obligations for taxes is to negotiate a narrow definition of what types of taxes can be included in this charge. For example, a tenant can seek to 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.
If the lease language does not specifically exclude business license or gross receipt taxes or fees paid in lieu of taxes, a tenant may still have a strong argument that the parties to the lease did not intend a particular tax to be the tenant’s responsibility. Again, the definition of “taxes” in the lease is critical. The term may be defined narrowly, such that by its plain language, it does not include the charge being asserted by the landlord. A narrow definition of “taxes,” such as “those taxes and assessments that will during the term of the lease be assessed as a lien on the land, buildings and improvements comprising the real property tax parcel of which the Premises and the building in which the Premises are located are a part . . . .,” simply would not include business license or gross receipt taxes. This language also likely would not include payments by the landlord to a governmental authority in lieu of taxes.

Further, if the provisions of the lease relating to taxes are not conclusive, the tenant may be able to rely on language in other portions of the lease to challenge the landlord’s attempt to pass through other charges as taxes. See Sheplers, 63 F. Supp. 2d at 1313. The tenant will want to 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.

Finally, if any correspondence or meeting notes relating to the negotiations of the lease support the tenant’s position that the parties intended a narrow definition of “taxes,” this evidence should be identified and used to challenge the landlord’s attempt to use a broader definition.

Issue 2: What parcel(s) are included in calculating the landlord’s total real estate taxes subject to allocation to the tenant?

Since a landlord’s real estate taxes are generally tied to specific real estate, the next question is what parcel(s) can the landlord include when calculating its total taxes that are subject to allocation to the tenant. Centers are sometimes developed on multiple tax parcels. Anchor stores may sit on their own tax parcels or be part of a larger parcel. In addition, tax parcel lines may change over the period of a lease. Portions of a center may be on the same parcel as the tenant’s leased space when the lease is executed but at some point become part of a different parcel. Thus, the question arises: Can the landlord include taxes paid on all parcels in the center in determining a tenant’s tax obligations? Or is the landlord limited to only the parcel on which the tenant’s store is located?

Again, the answer to these questions is governed by the language of the lease. Tenants should be vigilant to confirm that they understand what parcel(s) are being included in the total taxes paid by the landlord, and that the lease provisions support the inclusion of each of those parcels. In some cases, this evaluation is simple – the taxes provision in the lease may specify the parcels that can be included in calculating the tenant’s tax obligations. In other cases, the lease language may not be as clear. For example, it may permit the landlord to include all tax obligations for the “center.” In those cases, the tenant should examine how that term is defined elsewhere in the lease and whether it excludes certain parcels, anchor stores, etc. Further, the tenant should be aware of any changes to the parcel maps in case those changes would result in a reduction of the tenant’s tax obligations.

Issue 3: How are applicable taxes apportioned to the tenant?

Once the parties have agreed to the types of taxes that can be charged to the tenant and the parcel(s) that can be included in the calculation, the next step is to calculate what portion of the applicable taxes will be allocated to the tenant. This is determined by using a fraction in which the numerator is the square footage of the tenant’s leased space and the denominator is some measure of total square footage of the center.

What goes into the denominator is the primary issue of dispute in calculating what portion of the applicable taxes will be allocated to the tenant. It is in the landlord’s interest to keep the denominator as small as possible. In contrast, it is in the tenant’s interest to use the largest denominator possible. Thus, a landlord may want to exclude anchor stores or include only the square footage of the parcel where the tenant’s leased space is located, while a tenant would want to include the total square footage of the entire center, including anchor stores.

Another issue that arises is whether the denominator should include total square footage of all “leased space,” as opposed to total square footage of all “rentable” space. The tenant would prefer to use “rentable space” because it would be a larger number and result in a smaller portion of taxes being charged to the tenant.

Further issues can arise even if the parties agree that the denominator will include total square footage of “rentable space” and they agree to the applicable parcel(s). Suppose a center is experiencing low occupancy and the landlord decides to close an entire wing of the center or convert it to a non-retail use (e.g., a public library), or suppose the landlord closes an area of the center for remodeling. The question arises whether that space is “rentable” square footage under the lease. The landlord may argue that the space is not rentable because it is not being offered for rent. The tenant would argue that it is still “rentable,” despite the landlord’s decision to opt for a different use. Also, in the case of a lease that excludes anchor stores from the denominator, if anchor store space becomes vacant and is no longer used for an anchor store, there is a question whether the anchor store exclusion still applies to that space.

Once again, the tenant should examine the lease to determine the parties’ intent in calculating the proper denominator. See e.g., F.S. Associates, Inc. v. Jandi Realty, LLC, 14 Misc.3d 1204(A), 2006 WL 3718249 (N.Y.City Civ. Ct. 2006) (holding retail tenant was responsible for 100% of real estate tax increases based on plain language of the lease). The tenant should examine the lease provisions regarding taxes as well as the lease as a whole to identify support for the argument that the parties intended to include the total rentable square footage of the center in the denominator (or the largest square footage supportable under the lease). In addition, the tenant should identify communications outside of the lease that may support its interpretation of the lease.

CONCLUSION

A retail tenant should regularly audit what taxes are being charged to the tenant and how they are calculated. The tenant should evaluate what types of taxes can be included in charges to the tenant, what parcel(s) can be included, and whether the tenant’s share is being calculated consistent with the lease and the parties’ intent. A tenant should never assume that it is required to pay all taxes asserted by the landlord as a non-negotiable pass-through. Rather, a retail tenant’s obligations for taxes are governed by the lease and are subject to negotiation and interpretation just like other provisions in the lease.

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Statute Prohibiting Retailers from Requesting Personal Identification Information for Credit Card Purchases Does Not Apply to Merchandise Returns

Case: Absher v. AutoZone, Inc., Case No. B202773 (Cal. Ct. App. 6/26/08)

The One Sentence Summary: California Court of Appeal held that a consumer protection statute (Civil Code section 1747.08(a)) that prohibits retailers from requesting or requiring consumers to provide personal identification information as a condition to accepting a credit card as payment for a purchase does not apply to a refund transaction for the return of merchandise purchased with a credit card.


What They Were Fighting About: Plaintiff Absher purchased a locking gas cap from defendant AutoZone using his credit card. Within five minutes, he returned to the store and requested a credit card refund because the gas cap did not fit his vehicle. In connection with the refund process, AutoZone's clerk requested that he fill out a return voucher form that had lines for his name, telephone number, and signature, which Absher completed. The return voucher was separate from the return receipt showing the reversal of the credit card charge. Two weeks later, Absher filed a class action lawsuit against AutoZone alleging that the company's practice of requiring consumers to write their telephone number on return vouchers violates Civil Code section 1747.08. Each violation of the statute subjects the merchant to penalties not to exceed $250 for the first violation and $1,000 for each subsequent violation. AutoZone successfully moved for summary judgment on that grounds that the prohibitions of section 1747.08(a) on requesting "personal identification information" (defined in section 1747.08(b) as "information concerning the cardholder, other than information set forth on the credit card, and including, but not limited to, the cardholder's address and telephone number") do not apply to a refund of merchandise purchased by credit card. The court of appeal affirmed the trial court's judgment.

Court Holdings:

• The court of appeal rejected plaintiff's argument that the language of section 1747.08(a)(3) regarding "any credit card transaction" makes the statute's prohibitions on requesting personal identification information applicable to a refund during which the merchant reverses the original credit card purchase. Examining the language of section 1747.08(a) and other subdivisions of section 1747.08, the legislative history, and the purpose for the legislation, the court concluded that the statutory prohibitions were only intended to apply to purchase transactions.
• The court concluded that the legislature's purpose in enacting section 1747.08 was to address misuse of consumers' personal identification information by merchants, such as for marketing purposes. The legislature determined that such information should neither be requested nor required of consumers as a condition to accepting a credit card as payment for goods or services.
• However, retailers have a legitimate interest in collecting personal identification information in a return transaction to verify that the return was bona fide and to prevent employees from manipulating returns for their own benefit. Merchants may also need to contact the consumer who made the return if they discover that use or damage of the product occurred prior to its return. Thus, there is a legitimate justification for retailers to request and obtain personal identification information in return transactions relating to goods or services that were purchased with a credit card.
• It is significant that section 1747.08(a) contains no explicit reference to exchanges, refunds, or returns. In contrast, section 1747.09 (which prohibits retailers from printing more than the last five digits of a credit or debit card account number or the expiration date on receipts) is also part of the Song-Beverly Credit Card Act and specifically refers to "an exchange, refund, or return" in subdivisions (a)(2) and (a)(3), which will become effective on January 1, 2009.

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California Court Imposes Duty on Landlord to Inspect Tenant's Premises upon Entry of Unlawful Detainer Judgment of Possession

Case: Stone v. Center Trust Retail Properties, Inc., Case No. B181180 (Cal. Ct. App. 5/30/08)

The One Sentence Summary: The California Court of Appeal held that a shopping center landlord has a duty to inspect a tenant's premises upon the entry of a judgment of possession in an unlawful detainer action, creating potential liability of the landlord to third persons injured in the tenant's premises by a dangerous condition before the landlord actually regains physical possession of the premises.


What They Were Fighting About: Landlord Center Trust Retail Properties owned a mall in which Gumboz Creole Cajun restaurant was a tenant. After the restaurant defaulted on its rent, Center Trust eventually filed an unlawful detainer action and in December 2001 a court entered a judgment for possession by the landlord and issued a writ of possession. In January 2002, before service of the writ of possession by the sheriff, the restaurant continued operating and a party was held there during which plaintiff Stone while dancing slipped on water caused by a leak and fractured her ankle. The landlord knew the tenant had been operating an after-hours dance club in violation of its lease, which permitted only a sit-down restaurant. Plaintiff Stone sued Center Trust and the restaurant, proceeding to trial against the landlord. The jury apportioned fault among the restaurant, Center Trust, and Stone herself and awarded damages to Stone. Center Trust appealed. Although the court of appeal reversed the judgment and remanded the case for retrial of liability only, the court held that the landlord did owe a duty to inspect the restaurant's premises upon the entry of a judgment of possession in the unlawful detainer action.

Court Holdings:

• During a tenancy, the landlord generally can be held liable for a third person's injury due to a dangerous condition of the tenant's premises only if the landlord had actual knowledge of and the right/ability to cure the dangerous condition.
• However, the court of appeal concluded for public policy reasons that once a landlord obtains a judgment of possession to evict a defaulting tenant, a duty to inspect should be imposed on the landlord because it knows that defaulting tenants may neglect to maintain the premises in safe condition. "Upon entry of judgment, a tenant's incentive to maintain a property dissipates because continued maintenance likely benefits only the landlord. To protect the public, the incentive to maintain the property must not be an orphan abandoned by a tenant and ignored by a shortly reoccupying landlord."
• The court held that the landlord's duty to inspect the defaulting tenant's premises "attached upon entry of the judgment of possession in the unlawful detainer action and included reasonable periodic inspections thereafter."
• Because the court of appeal could not determine from the record at what point in time the jury found that the landlord owed a duty to plaintiff Stone, the case was remanded for retrial of liability only. The parties may present evidence during retrial whether inspection upon entry of the judgment of possession or at reasonable intervals thereafter would have discovered the water leak in the premises.
• The dissenting opinion criticized the majority for creating a new legal duty, when the legislature is in a better position to decide whether to expand the landlord's duty and potential liability in order to protect public safety.

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