I INTRODUCTION TO THE LEGAL FRAMEWORK
i Ownership of real estate
Under Russian law there are two main legal interests in real property:
- a ownership: full title allowing possession, use and disposal of the property, including leasing it out to tenants. It is in some respects similar to freehold, although Russian law recognises separate ownership of land and of the buildings and other fixtures erected on land. Ownership rights to land extend to the surface (soil) layer of the land plot as well as to water (with some restrictions) and plants on the land plot. The subsoil is entirely state-owned; and
- b lease: an interest allowing possession and use of the property for a specified or an indefinite term.
The most common ways to acquire ownership rights to real property are as follows:
- a sale and purchase, exchange or gift;
- b privatisation of state-owned or municipal-owned real property (especially land plots);
- c by operation of law (e.g., if a legal entity is going through a reorganisation, the reorganised entity is deemed to have acquired ownership rights to the relevant real property by operation of law);
- d development of real property; and
- e inheritance.
Real property may be co-owned. There are two types of co-ownership: shared ownership (where the shares of co-owners are determined) and joint ownership (where the shares of co-owners are not determined). Shared ownership is a default option for co-owning real property unless the law provides otherwise (e.g., community property (i.e., property owned in common by husband and wife) is deemed to be a joint ownership) or it is not feasible to determine the shares of the co-owners.
The most common shared ownership is co-owners having shared ownership of the common areas in trade centres, shopping malls and office buildings. Usually, such co-owners have also been co-investors in the development of the relevant building. Co-owners may conclude a co-ownership agreement and govern the manner of use, maintenance and disposal of the co-owned real property.
Russian law also recognises a hereditary land plot right, which is in many respects similar to absolute ownership but may be acquired only through inheritance. Previously this right was granted only to individuals, and state and municipal authorities have now ceased to grant such a right.
Certain rights to property, which are at present primarily reserved for state institutions (such as ‘permanent use’), still exist. These rights are no longer granted to individuals and private entities, and are non-transferable.
In Russia, it is not possible to separate the legal interest in property from the beneficial interest.
ii System of registration
The ownership right and other rights in rem over real estate, most encumbrances and restrictions of such rights (such as long-term leases, mortgages and liens), and their accrual, transfer and termination, are subject to state registration in the Unified State Register of Real Estate. Those rights and encumbrances are deemed valid and effective once registered.
Most agreements under which rights in rem and registrable encumbrances arise are not subject to state registration (e.g., sale and purchase agreements, mortgages) and become valid and enforceable once executed by the parties. However, the law still requires registration of long-term lease agreements, as well as registration of encumbrances established by those agreements, in the Unified State Register of Real Estate. As a general rule, if a long-term lease agreement is not registered, it is deemed not to have been concluded.
The Unified State Register of Real Estate is, for the most part, a matter of public record, and any person may request an extract from it in relation to a particular property. The extract will contain a description of the property (type, address, area) and set out the type of registered rights to the property, the holder of the rights, as well as encumbrances and restrictions of the registered rights as at the date of the extract.
In addition, all real estate in Russia is required to be recorded in the State Real Estate Cadastre (which replaced the pre-existing State Land Cadastre concerning only land plots, not buildings). Once a piece of property is recorded with the State Real Estate Cadastre, it is considered real estate as a legal matter. Generally, to convey or encumber real estate, it must be subject to the procedure of official survey and cadastral record, although forward sale, forward lease and forward mortgage (whereby an agreement envisages conveying or encumbering title that is yet to be created) are also allowed.
It should be noted that starting from 1 January 2017 the Unified State Register of Real Estate is merged with the State Real Estate Cadastre, which will simplify overall procedure for registration of a real property and title to it.
iii Choice of law
Russian law provides for a strict rule that any transaction involving real property is subject to Russian law, effectively applying the principle of lex rei sitae. This means that any agreement in relation to the disposal of real property located in Russia (e.g., lease agreement, mortgage agreement, agreement establishing an easement or any other agreement under which real property located in Russia is encumbered) must be governed by Russian law.
However, it is possible for the parties to enter into a framework agreement in relation to real property that provides for certain general obligations of the parties, covenants, warranties and representations, and to choose the law applicable to this framework agreement. Usually a framework agreement is used in conjunction with a Russian law-governed agreement in relation to real property that regulates the actual transfer or encumbrance of real property.
II OVERVIEW OF REAL ESTATE ACTIVITY
In the boom years, Russia was one of Europe’s largest property markets, with investment volumes of US$8 billion–US$10 billion annually; the figure briefly decreased during the 2008–2009 financial crisis.
However, the downward trend on the property market that began in 2014 continued in 2016, in sync with the political challenges Russia is facing because of continuing Western sanctions, and low oil prices, which brought about the weakening of the Russian currency. Though specialists see a positive tendency in market as Russia’s economy demonstrates signs of emerging from recession. Investment in the property sector for the period of three quarters of 2016 has reached US$3.088 billion and expected to be about US$4 billion by the end of 2016.2
From 2009 onwards, local investors dominated the real estate market, accounting for over 70 per cent of all deals. This proportion reached 95 per cent of all dealt for three quarters of 2016. Most cross-border players historically present on the Russian market, such as Hines, PPF or Morgan Stanley, although potentially interested in acquiring prime assets at low prices, continue to wait for less uncertainty in the market. It is expected that investment into office and retail real estate will continue to be hardest hit by the current uncertainty in the Russian economy, with new development dwindling and vacancy rates at record highs.
The majority of real investment projects are overwhelmingly located in Moscow, accounting (at the time of writing) for 88 per cent of total real estate investment in 2016, compared with 92 per cent in the same period of 2015.
III FOREIGN INVESTMENT
Subject to the following restrictions, real property can be purchased or leased by foreign individuals and companies for their own use or as an investment:
- a foreign individuals and entities are not allowed to own land in areas adjoining the borders of Russia or land located within the boundaries of a seaport; and
- b foreign individuals and entities, as well as Russian entities with over 50 per cent foreign participation, may not own agricultural land (which is a specific category of land under Russian law).
There are no specific restrictions that apply to the lease of land, or the ownership or lease of buildings and facilities by foreign nationals.
IV STRUCTURING THE INVESTMENT
i Acquisition structures
There are two main structures for the acquisition of real property: asset purchase (acquisition of real property directly from its owner) or share purchase (acquisition of a holding company that owns relevant real property).
Where a deal is structured as an asset transfer, the target’s liabilities, including tax liabilities and penalties, should not (subject to careful structuring) transfer to the purchaser.
An asset purchase is not, however, a perfect solution for the following reasons:
- a there remains a risk that the Russian tax authorities could recharacterise the asset transfer as a ‘sale of an enterprise’ under which historic liabilities would be treated as transferring to the purchaser; and
- b the authorities may attempt to establish that an asset transfer constitutes a fraud against creditors if it is proved that it was designed to evade historic liabilities.
In addition to these risks described, the key disadvantages of a sale of assets are as follows:
- a administratively, they are more cumbersome than an acquisition of shares;
- b the acquisition may require obtaining new licences and permits, novation or assignment of contracts; and
- c the acquisition may lead to Russian VAT being payable.
A typical sale and purchase transaction is a two-stage process involving the execution of a sale and purchase agreement and registration of the transfer of title in the Unified State Register of Real Estate. The sale and purchase agreement must be a single written document.
The handover of the property is effected by completing a document that formally conveys the property from the seller to the buyer (an act of transfer and acceptance).
As a general rule, if a building or other immoveable facility and the underlying land are owned by the same person, a sale of the building without the underlying land (and vice versa) is not allowed. If the land is owned by someone other than the owner of the building, the building can still be sold, and the new owner will enjoy the same rights to use the respective part of the land plot underlying the building as the previous owner of the building.
Share purchases are still a very popular way to acquire real property in Russia. The major risk of a share acquisition is, of course, that a buyer will also assume all of the target’s existing liabilities (subject to any contractual apportionment and post-acquisition risk mitigation strategies). This means that thorough due diligence of the historic activities of the target are crucial.
There are, nevertheless, numerous advantages in a share purchase structure, chief among which are avoiding the need to reapply for licences and permits, a less complex and burdensome acquisition process, no Russian VAT and the avoidance of business interruption.
ii Acquisition vehicle
If the target company does not have a dedicated offshore holding company, it may be advisable to set up a holding company to make the acquisition or, in the case of an asset transfer, to create an offshore holding company with a wholly owned Russian subsidiary (the latter being the recipient of the transferred assets). The choice of jurisdiction will largely be driven by tax issues and corporate considerations.
iii Tax implications of acquiring an interest in property
Generally, commercial property transactions are subject to VAT (the standard VAT rate is 18 per cent). Currently, the sale of land and residential property transactions are not subject to VAT.
The sale of shares of a company by its foreign parent entity is subject to withholding tax in Russia if the assets of this company directly or indirectly consist of more than 50 per cent of real estate located in Russia and of derivative financial instruments from these shares, with the exception of shares in circulation. In certain cases, the sale of these shares may be exempt from Russian withholding tax based on relevant double tax treaty provisions.
V REAL ESTATE OWNERSHIP
Planning and zoning in general are regulated by the Land Code and the Urban Planning Code, although the more technical aspects are set forth in regional and municipal legislation.
The Land Code and the Urban Planning Code operate with two main terms related to planning and zoning: the land category of the land plot; and the permitted use of the land plot. These terms determine how a particular land plot may be used.
There are seven land categories that attribute a land plot for certain general use (e.g., agricultural land, industrial land, urban land). Permitted use of the land plot is assigned to a particular land plot in accordance with zoning plans approved at each level, starting from the general zoning plan of Russia and ending with a zoning plan of a particular land plot. In comparison with the land category, the permitted use of the land plot is much more specific and determines what kind of building, structure or fixture may be erected on the land plot, or what activity may be conducted on the land plot (e.g., whether a land plot may be used for growing crops or for the development of a trade centre).
If a land category or permitted use (or both) prohibit a party from developing the relevant land plot, such a party must apply to the relevant authorities for a change of land category or permitted use; otherwise, the party will not be granted the appropriate construction permit.
As the contamination or misuse of real property is a matter of public concern, the relevant authority may conduct an inspection of the property and issue a clean-up order to the party responsible for the contamination or misuse. Normally, the liable party would be an owner or a tenant. Russian law also provides that if the owner of the land plot uses it in gross violation of its permitted use, the state authorities may confiscate the land plot (with compensation of its value to the owner).
The party responsible for contamination or misuse may also be subject to civil liability for damages caused to third parties.
Russian companies are liable to pay property tax on the average annual net book value (or in certain cases the cadastre value) of the fixed assets on their balance sheet; all moveable fixed assets acquired after 1 January 2013 are exempt from property tax (save for certain limited exceptions).
Foreign companies with a permanent establishment in Russia are subject to tax on immoveable and moveable fixed assets attributable to such an establishment (subject to the above exemption for moveable fixed assets acquired after 1 January 2013). Foreign companies without a permanent establishment in Russia are subject to property tax on immoveable property only.
Land is exempt from property tax and may be subject to a separate land tax.
The standard property tax rate is 2.2 per cent; special rates apply to property taxable on its cadastre value. Regional authorities may reduce the tax rate or, in some cases, provide a full exemption for all or certain categories of taxpayers, or based on the type of property.
Land tax is payable by landowners at a rate determined by the municipal authorities. Land tax is assessed on the cadastre value of the land, which used to be substantially lower than its actual market value; however, recently this difference has decreased or even been eliminated.
Land tax rates may not exceed 0.3 per cent of the cadastre value of agricultural and residential land. With respect to other land plots, the maximum rate is 1.5 per cent of the cadastre value.
The Russian Tax Code permits municipal authorities to establish tax incentives for certain categories of taxpayers.
Businesses leasing land are not subject to land tax. Instead, they are liable for the land lease payments established by federal, regional or local authorities, or other landowners.
iv Finance and security
Usually, financing for the acquisition or development of real property is provided by banks. The most common security in relation to real property is a mortgage, which may be established over real property, lease rights and certain rights to property that are at present primarily reserved for state institutions.
A mortgage as an encumbrance becomes effective upon its state registration and, in the absence of such a registration, is considered to be null and void. Recent amendments to the regulation of mortgages permit parties to enforce a mortgage without recourse to the courts (unless a limited number of exceptions apply).
The enforcement options for mortgagees include a public sale and taking possession of the secured asset (this option is not available if the mortgage is granted by an individual).
Where a land plot is mortgaged, all buildings and structures erected or to be erected on the land plot and owned by the mortgagor will be mortgaged by operation of law in favour of the mortgagee. Similarly, if a building or structure is mortgaged, the underlying land plot (if owned by the mortgagor) will be automatically mortgaged by operation of law in favour of the mortgagee.
VI LEASES OF BUSINESS PREMISES
Leases can be granted for an indefinite period (terminable by either party on three months’ notice) or for a specified (fixed) term. A fixed term lease can be long term (which in relation to land plots means for over one year, and in relation to buildings or parts of buildings and immoveable facilities, one year or more) or short term. Commercial leases are commonly long term (five to 10 years). In almost all parts of Russia, the maximum lease term for land is 49 years.
As noted above, long-term lease agreements must be registered with the state to be effective. Short-term lease agreements and lease agreements for an indefinite term do not need to be registered. However, following a recent liberalisation of court practice, a long-term lease that has not been registered may still be considered effective if the relevant agreement contains all material terms and conditions, and both parties have been performing their obligations under the lease (using leased real estate, paying rent, etc.).
Commercial leases are treated very much as a matter of private concern, with a limited number of mandatory rules and restrictions. While most of Russia’s land is still state or municipally owned, commercial property is predominantly privately held. Accordingly, commercial lease terms tend to deviate from the default statutory position of equal treatment of the parties, and to favour the landlord or the tenant depending on their respective economic strength and negotiation leverage and the market situation in the relevant location. In the past few years, the lease market in developed regions of Russia, such as Moscow, has been heavily in favour of landlords, and leases have therefore tended to benefit the landlord (e.g., landlords having the right to terminate without recourse to the court for the most minor breaches by the tenant, with no corresponding rights for the tenant). However, as a result of the recent economic downturn, the position of landlords has weakened, and tenants have increased their negotiating power in these regions.
Under the general rules governing leases, the tenant has a right of first refusal to renew the lease on its expiration, unless the agreement provides otherwise, but the parties are free to alter the terms and conditions of the new lease. If the tenant continues to use the property after the lease has expired and the landlord does not object, the lease is deemed to be renewed on the same terms and conditions as the old lease for an indefinite period. As such, the new lease is therefore subject to termination by either party upon three months’ notice.
In the case of state or municipally owned land, subject to certain exceptions, the tenant has a statutory pre-emptive right to purchase the land plot if it is put up for sale, though in very limited circumstances. Where land is privately held, a tenant also has a statutory pre-emptive right to purchase the land plot if it is put up for sale, provided that the tenant owns a building or facility located on the leased land plot. Where the tenant does not own such a building or facility, the issue will be determined by the terms of the lease as negotiated between the parties.
In the event that the owner sells the leased real estate, the lease survives in full. The new owner assumes the rights and obligations of the landlord by virtue of law.
Proprietors of buildings or other immoveable facilities that are situated on a land plot owned by another person are entitled by statute to rights of use as regards the land located underneath such buildings or facilities. If the land in question is state or municipally owned, the owner of the buildings or facilities is entitled to either lease or privatise (purchase) the land (effectively, ‘the land follows the building’).
As a general rule, the assignment, subleasing or mortgage of land leased by the tenant does not require the landlord’s consent, unless otherwise stated in the lease agreement. Leases of state and municipal land concluded for a term of over five years cannot, as a matter of law, require the landlord’s consent for their assignment, sublease or mortgage. Conversely, the assignment, sublease or mortgage of real estate other than land is subject to the consent of the landlord unless the lease provides explicitly that consent is not required. Such consent may be given directly in the lease agreement.
Most of the commercial leases contain rent indexation provisions. Depending on the negotiating leverage of the tenant, rent may be increased automatically each year in line with inflation or in line with inflation plus another index (e.g., LIBOR or by a fixed percentage). The landlord may review the rent no more than once a year.
VII DEVELOPMENTS IN PRACTICE
i Forward agreements
Recent court practice and amendments to the law have introduced a new concept of forward agreements, which may be entered into in relation to future real estate (either existing but not yet acquired by a party, or yet to be constructed). Currently it is possible to enter into forward leases, forward mortgages and forward sale and purchase agreements. In each case, the agreement must contain a detailed description of the future real estate to be encumbered or transferred.
This new concept allows developers and investors to form a pool of anchor tenants, obtain financing from banks by mortgaging the future building and sell the building on to third parties before it is fully constructed.
ii Registration formalities
In most instances, a real property agreement is valid and enforceable once executed by the parties. However, to transfer a title or establish an encumbrance, the parties still must register the transfer or encumbrance.
As previously mentioned, following recent changes in court practice, a long-term lease that has not been registered may still be considered effective if the relevant agreement contains all material terms and conditions, and both parties have been performing their obligations under the lease (using leased real estate, paying rent, etc.).
Despite the fact that the courts have applied the above rule only to the registration of long-term leases, the same logic may be applied to other registrable real estate agreements (real estate trust management agreement and agreement on shared participation in housing construction).
This position is further strengthened by the entry into force of amendments to the Civil Code on 8 March 2015, whereunder a party that accepted full or partial performance of a contract, or otherwise affirmed it, may not claim in court that it was not concluded, if such a claim were to contravene the principle of good faith. In other words, after performing or accepting performance of a lease, a party is estopped from claiming it was not concluded through lack of state registration.
iii Lease of state or municipal land for construction purposes
Major amendments to the Land Code became effective on 1 March 2015. Their purpose is to adjust the Land Code to the realities of the current real estate market, and to streamline the procedures for granting leases and privatising state-owned or municipal-owned land plots for all intents and purposes, including construction. Importantly, construction lease terms were limited to 10 years if won at a public tender or auction and to one and a half to nine years if no public bidding procedure was followed, thus rendering long-term holding of large leased land banks for future construction virtually impossible. Further, the Land Code outlawed the pre-existing practice of changing category and permitted use of the land (see Section V.i, supra) post factum to allow construction on land initially allocated for a different purpose, without paying statutory charges.
In addition, as of 1 June 2015, the Russian Civil Code prohibits assignment of leases won through a public bidding procedure, delegitimising direct transfer of ownership in ongoing construction projects on state and municipal land.
VIII OUTLOOK AND CONCLUSIONS
More significant changes to the legal framework are forthcoming. Russian civil law is undergoing a major reform, which started in 2012, in relation to changes made to the general provisions of the Civil Code, including changes to, inter alia, civil law principles, and the validity of transactions, pledge and objects.
The draft law on amendments to the Civil Code includes a separate section regarding real property, and the current section of the Civil Code in this regard will be completely redrafted. It is expected that the amendments to the real property section of the Civil Code will be adopted in 2017. The most notable changes envisaged by this draft law are the following:
- a the introduction of a new concept of ‘actual possession’ of real property, which generally means that any person that has actual possession over real property may defend such actual possession, even if such possession is unlawful. The procedural rules that must be adhered to while defending actual possession will be simpler and require only proof of actual possession, in comparison with the general procedural rules that require proof of title to real property. This new concept is intended to protect bona fide owners of real property;
- b new rights in rem, including the following:
- building leasehold, which may be provided for at least 50 years but not more than 100 years, and allows a person granted this right to develop a land plot (currently all developments on land plots are carried out under long-term lease agreements, which are considered to be a less secure right to a land plot than a building leasehold);
- emphyteusis or perpetual lease granted for an indefinite term or, if a term is envisaged, such a term may not be less than 50 years, with the purpose to use natural characteristics of the land plot (e.g., for agricultural activity, forestry, fishing);
- independent mortgage, which may be established and become effective even if there is no obligation to secure at the time the mortgage is established (currently, a mortgage becomes effective only once the relevant underlying obligation that is secured by the mortgage is created);
- usufruct or social lease, which may be granted to an individual or non-commercial organisation for the use of real property (land plot, premises, etc.) for a fixed term or for life (in the case of non-commercial organisations, the term must not exceed 20 years);
- right to acquire real property owned by a third party, which is an independent right of a person to purchase relevant real property on agreed terms. The maximum term for such a right is 10 years; and
- right to secure provision of consideration by the owner of real property, which gives an entitled individual the right to receive certain consideration (money, goods, etc.) from an owner of real property and, in the event of the owner’s failure to provide such consideration, to levy execution on real property. This right may be provided for life or for a fixed term (but not for more than 100 years).
Most of the above rights in rem are expected to replace lease arrangements, which are currently used for the same purposes as those rights in rem and to provide more security to the person entitled to such rights.