Buying commercial property in France subject to a lease

David Anderson solicitor and tax adviser and Nicole Gallop Mildon solicitor and former French clerc de notaire both at Sykes Anderson LLP Solicitors and Chartered Tax Advisers.

Foreign investors in French commercial property need to be aware that the rules are very different to those which apply in, say England.

Property which is to be used for commercial activities must be designated as such and it can be difficult to alter the authorised use of a property. Authorisations relating to professional/commercial use are sometimes personal to the occupant, and therefore before investing in commercial property a thorough examination of the various planning and other administrative permissions should be carried out. Issues arise more frequently in old properties, where the original permits may have been lost. Generally, the planning permission for newer buildings will also spell out what the buildings can be used for.

What is a commercial lease?

Generally four elements are required:

A lease contract.
Premises to be rented.
The tenant must run a business or activity (defined by statute) from the premises. This does not generally include professional activities (such as lawyers and doctors) or agricultural property.
Generally the tenant must be registered at the local Registre des Commerces et des Sociétés (equivalent to Companies House, but including businesses).

Main elements of a commercial lease

The lease is subject to a number of mandatory rules. There is less flexibility on terms than in England.
Normally the lease must be at least 9 years long and the tenant can give notice every three years. This is unlike the position in England. The tenant cannot contract out of his right to break every three years unless they agree to a fixed lease of either six or nine years. You can agree a lease for longer than nine years, but in this case the break clauses cannot be contracted out. The tenant does not have the right to break every three years where the lease is for tourist residences.
The tenant has the right to renew the lease when it expires, or if the landlord refuses to renew the lease, the tenant has a right to an indemnity payment.
The tenant can transfer their lease to the purchaser of their business.
The tenant's rights are subject to fulfilling a series of conditions:
1. Being registered at the local Registre des Commerces et des Sociétés (each premises must be registered).
2. Running a qualifying business from the premises which are being rented.
3. Complying with the conditions set out in the lease.

The rent that is payable (monthly or quarterly, in arrears or in advance) by the tenant is agreed as a market rent, however, it will automatically be revised every three years. The landlord can also require both a deposit and premium. Normally the deposit is either 2 terms of the rent (i.e. 2 months rent if the rent is paid monthly) if the rent is paid in arrears or 1 term of the rent if the rent is paid in advance. Where the rent is paid in advance, if more than 2 terms are paid in advance, the excess must bear interest (Bank of France rate for share advances).

The premium is generally a sum which in some way represents the difference between the market rental value of the property and the actual rent payable under the lease.

Setting the Rent

At the beginning of the lease there is total freedom for the landlord and tenant to agree a rent. It is important for this to be well negotiated as subsequent rent increases are regulated.

Rent Increases

The principle is that these occur three years after the rent has been fixed (e.g. when the lease is entered into or renewed, or the previous rent increase) and relate to the rental value of the property. In principle, the increase cannot exceed the French INSEE Cost of construction index. This can be found at www.insee.fr/fr/publics/default.asp?page=particuliers/revision_baux_commerciaux.htm

As is often the case in France, attention to administrative detail is important, for example the rent increase notice must be sent out on the correct date as the rent increase applies from the date of the notice (and not its receipt).

There are two cases where the indexed rent increase can be exceeded:

if the landlord can show that the true rental value has increased by more than 10%;
if the tenant has added one of more activities connected to those provided for in the lease.

You should note that the tenant can ask for a reduction of the rent where the rental value has decreased (again by more than 10%).

There are strict criteria to be borne in mind when fixing the rental value. Whilst the principle is that the increase cannot exceed the French INSEE Cost of construction index, in fact, when concluding the lease, the landlord can choose to index the rent more frequently or on the basis of a sliding scale, thereby breaking the link to the rental value of the property. Advice should be sought in order to determine if a given index can be used. When using this system, the landlord and tenant must chose an index which is allowed and has a direct link to either the lease or to the activity carried out by either landlord or tenant.

The advantages for the landlord are:

That no notice need be served as generally the clause specifies the date of the revision of the rent.
Generally the revision is fixed more frequently, i.e. annually

However, if the rent increases or decreases by more than a quarter of the previous rent, the parties can apply to the courts for the rent to be revised by the court. In addition, the landlord can "opt back" to the default regime of using the INSEE Cost of construction index if this would be more favourable to them. This does need to be done in the same terms as given above, but does not prevent the landlord from subsequently using the sliding index.

It is possible to combine the sliding scale index with a revision of the rent every three years. This is particularly useful for the landlord as the sliding scale may lead to the rent being decreased.

The landlord and tenant can also fix the rent so that it does not fall within the indexation rules. The rent must be divided into two parts, one a fixed sum, the other a percentage of the tenant's income.

When a lease is renewed, the initial rent is fixed freely (as for a new lease), and the indexation follows the rules above, in other words there is freedom to negotiate as if a completely new lease was being granted. There is a tendency for the value of the rent to reduce in real terms over the lifetime of the lease due to the rent cap. This is why it can be more attractive for a landlord to enter into a new lease every 9 years, even if it is with the same tenant.

This economically dissuasive situation for landlords is beginning to alter, with more landlords renting out the property "American style"; this means that no premium is paid at the beginning of the lease, but that the rent is based on the true market rental value. Potential landlords may prefer to invest in offices where the rent is normally established at market levels with no premium on entry or indemnity payment to the tenant at the end of the lease.

Specialist commercial properties (those that have only one possible use such as hotels or cinemas) tend to be subject to specific "sector based" rules in relation to fixing rent. These rents are generally not subject to the cap described above.

Investors' leases may be an attractive option as they are subject to special rules for this situation. A company can seek financing from a group of investors in order to build a property in which they will carry out their business. The rent is allowed to be fixed so that the investors recover their investment and a return. Frequently, the rent will be well above a market rent. There will be no facility for the tenant to have the rent indexed down and the tenant will contract out of their three yearly right to break the lease. This type of lease can be used to finance any type of commercial property.

Duration of the lease

As stated above, commercial leases are generally 9 years long and the tenant is able to give notice at three year intervals. 9 years is the minimum duration for a commercial lease although there is also the facility to use a lease of less than 2 years (known as a short lease) as a trial when the tenant first enters the premises. The short lease is subject to many conditions and if it expires without notice being given, automatically becomes a 9 year commercial lease.

If a commercial lease is granted for 12 years or more, it must be granted by way of a notarial deed and registered at the French Land Registry.

Landlords may want to give notice for the end of the 9 years, even if they wish to keep the tenant so that they are in a position to create a new lease. Once a commercial lease has expired it renews tacitly with no fixed notice period.

If the lease is renewed, it is deemed to be for 9 years unless the new lease stipulates a longer term.

At the expiry of the lease the landlord is entirely free to renew or to refuse to renew the lease. The refusal can take place in one of three ways.

The landlord can give notice to the tenant at least 6 months before the expiry of the lease. The landlord may offer an indemnity payment with the notice.
1. In principle, the landlord is only not bound to offer an indemnity payment when the tenant does not meet the conditions required to benefit from commercial lease status or when they have breached the terms and conditions of the lease which is due to expire. The landlord must notify the tenant of why he is not offering an indemnity payment.
  Examples of failing to meet the requisite conditions include a tenant who has assigned their lease (even with the landlord's consent), the person running a stand in a commercial centre (where it is deemed that they do not have their own clientele separate from that of the commercial centre).
  Breaches of the terms and conditions must be serious for the landlord to rely on this and have been previously notified to the tenant (in the correct form). The tenant then has a month to remedy the situation. Some breaches are such that they cannot be remedied and in this hypothesis no notice needs to be given. Examples of this include failing to have the landlord participate in a subletting agreement.
  The landlord may also refuse to renew the lease without paying an indemnity for "good cause". Examples of this include where the property has been destroyed or is subject to an order stating that it is not to be occupied due to its insalubrious condition.
2. Indemnity payments: these are normally offered solely to compensate for the landlord's refusal to renew the lease. As such they are calculated differently where the landlord's refusal requires the tenant to move, and where the landlord's refusal amounts to closing the business (for example based on the location of the premises and the impossibility for the tenant to gain alternative premises catering to the same passing trade).
  The tenant is entitled to remain in the property until the indemnity payment is made. During this period the landlord can request a payment based on the former tenant's occupation (similar to a rent). The value of this is normally fixed by the court who has given judgement in relation to the indemnity payment. The payment can be revised in the same manner as the rent (the frequency of the revision is fixed by the courts - either every three years or annually).
The tenant can go before the courts in order to contest the lack of indemnity payment or its amount. Case law sets out how the indemnity should be calculated based on the circumstances. The indemnity may be zero where the contractual rent is the same as the market rent of alternative similar premises in the same area.
Alternatively the refusal may be in response to the tenant's request to renew the lease.
In the last six months of the lease, the tenant may choose to ask the landlord to renew the lease. They only have the right to do this if they have not already been given notice to leave. The landlord then has three months to agree or to refuse the request for renewal. If the landlord refuses the request for the renewal, whether or not an indemnity payment is due, will depend on the circumstances (see above).
The landlord may also choose not to reply; in this case the renewal is deemed to have been tacitly granted. The landlord may choose to go to court in order to have the terms and conditions (including the rent) of the new lease determined.
The third option consists of a refusal to renew by the landlord after the rent has been fixed by the courts.

Care must be taken to give notice and respond to the tenant's requests in the appropriate form (including providing the correct information) and within the statutory timeframes.

Landlords also have the right to break the contract at the three year break points if they intend to demolish or rebuild the property.

Recovering the property during the term of the lease

Initially the landlord was only allowed to cancel the lease and recover the property if the tenant failed to pay the rent. However, this has been extended to other breaches by the tenant.

In order for the landlord to recover the property for reasons other than failure to pay the rent, the lease must provide which breaches will give rise to cancellation of the lease. This means that not only should contractual obligations be listed, but also those set out by law or regulation. Any clauses allowing the landlord to recover the property are interpreted restrictively and so must be carefully drafted.

The landlord must give notice to the tenant of the breaches he alleges. The relevant formalities must be complied with, otherwise the notice is void. The tenant must be given at least one month to remedy the breach. Rather oddly, this seems to apply even where the breach itself cannot be remedied.

Obligations the tenant must abide by

The two principal obligations for the tenant are to :

use the property "as a good father would", i.e. appropriately and with due care, and in accordance with the its designated use, and
pay the relevant rent under the lease.

Other obligations are set out in the French Code Civil and these can be extended by the terms of a commercial lease. Obligations set out in the French Code Civil include maintenance, repairs and furnishing the property.

Subletting

Unless expressly permitted in the commercial lease, subletting (the whole or a part of the premises) is strictly forbidden. Where subletting is permitted, the landlord must be party to the sublease. If an authorised subletting does take place, the landlord can recover the premises from both the tenant and the sub-tenant.

A legitimate sub-tenant has similar rights to a tenant. If the tenant ceases to trade, a legitimate sub-tenant may have rights against the landlord if certain conditions are met.

Although the rent for the subletting is fixed between the tenant and the sub-tenant, it is possible for the landlord to require an alteration to the rent payable by the tenant when the subletting is carried out at a profit to the tenant.

Tenant assigning the lease

Although it is illegal to prohibit a tenant from assigning their lease to the purchaser of their business or company, it is normal to restrict the tenant's rights by requiring the landlord's consent to be sought. The landlord can then require payment of an indemnity or a rent increase. The landlord can, if the assignment of the lease involves a change of activity, include a clause such that at the expiry of the lease the rent cap is removed and the rent can be fixed based on the open market rental value.

Normal practice is for the landlord to require the outgoing tenant to be the guarantor of the incoming tenant until the expiry of the ongoing lease. In addition, the landlord can stipulate in the original lease that any assignment will be by notarial deed and require their intervention, thereby ensuring that they are kept informed as to their tenant's plans.

Location-gérance

A concept unknown in English law, this is where a person "rents" from the owner the whole of a business (i.e. clientele, goodwill, stock) to run the business at their own risk. The owner of the business may well be the tenant of a commercial lease and a location-gérance will include the right to occupy the premises. With careful drafting the tenant can be prohibited from entering into a location-gérance. Even if location-gérance is not excluded in a commercial lease it is subject to conditions.

Repairs and dilapidations

The landlord can include a clause in the lease whereby the tenant must bear the cost of:

all maintenance works (including to the walls and roof),
all internal work, even to the extent of requiring the tenant to return the property to its original state when the tenant leaves,
all current and future taxes relating to the lease.

These costs may however be taken into account by the courts if there is litigation over the rent.

The type of business carried out

This is stipulated in the lease at the outset. In principle the tenant cannot carry out any other activities and no new activity should be carried out without the landlord's consent: A new activity can give rise to an increase in rent.

However, there are two procedures allowing the tenant to extend their activities. If the proposed new activities are related or complementary to the business already authorised and carried out, the tenant simply has to follow the appropriate procedure in order to notify the landlord and unless the landlord objects, the tenant is authorised to carry out the additional activities. The landlord can only object to these new activities if they are not in fact related or complementary to the business already authorised.

If the proposed new activities are not related or complementary to the business which is already authorised and carried out, the procedure is far more onerous for the tenant. The tenant has to argue that the economic situation and the distribution of business require the change, they must also inform their creditors. The landlord can agree, refuse making objections based on serious and legitimate grounds or agree subject to certain conditions. A change to the nature of the business may have an impact on the rent at rent review and on the renewal of the lease.

Costs

In order to provide proof the lease was signed on the stated date, it can be drawn up by a Notaire or, more cheaply, registered at an appropriate tax office. A notarial deed is required for a commercial lease where the tenant's business includes the sale of drinks. If the contract is registered at the tax office, registration costs a fixed fee of €25. A Notaire will provide details of their fees on request. Notaire's fees are not fixed for this work.

In principle the responsibility and costs for maintaining the property and paying outgoing on the property are divided between tenant and landlord in the lease. There are standard divisions, but there is also a large margin of contractual negotiation on this point.

Taxation of the purchase

The property will be subject to either French TVA or the French equivalent of stamp duty based on the normal rules governing the purchase of French real estate.

If TVA is payable on the purchase, it may be recoverable.

Taxation during ownership of the property

Taxation of the landlord whilst the property is owned is dependent on a number of factors. The first of these is how the property is held. If the landlord and the business are linked the property may be included in the business's balance sheet.

Assuming that the landlord and the tenant's business are in no way linked, the ownership of the commercial property can be taxed in one of three manners:

real estate income,
industrial and commercial profits,
non commercial non professional profits.

Establishing into which category the income falls will depend on the precise structure of ownership and whether or not the property is let with any equipment. The cost of works carried out by the tenant where these works are normally paid for by the landlord can also be taxed with rental income. However, generally any indemnity payment can be deducted from the rental income.

TVA may be chargeable on the rents. Whether or not TVA is automatically chargeable will depend on what commercial property is let and whether or not it is entirely empty or whether some equipment or fixtures are included. Where the TVA is not chargeable on rent, normally another tax known as "contribution based on rental income" is due and charged at 2.5%. However, it is possible to opt to charge TVA on rental income even where it is not automatically chargeable. Whether or not it is financially astute to opt to charge TVA on rents will depend on the precise circumstances of the rental and the structure used to purchase the property. The tenant's position may also influence such a decision.

Wealth tax is payable in France on net wealth over a certain threshold, €800,000 in 2011. For French residents in principle wealth tax is levied on their worldwide assets, for non-French residents, only assets situated in France are taken into account. Generally, French commercial properties owned for investment purposes will be subject to French wealth tax.

Investors buying commercial property

Strategic decisions need to be taken as to the level of risk and yield, factors include:

defining and limiting the authorised activity in the premises;
precisely defining which works the tenant is responsible for;
choosing a property which will be easy to re-let at the original rent or higher;
limiting the possibilities for a tenant to exercise their three year break rights if the property is likely to be hard to re-let;
choosing a solvent tenant and/or requiring additional guarantees: a guarantor, an insurance policy for lost rent, a deposit equal to at least six months' rent;
the tax structuring of the investment.

If an investor wishes to aim for a higher yield they may prefer to take more risks relating to:

the tenant,
the type of premises,
the type of lease (commercial or offices),
the type of construction.

The investor needs to work out a balance between any capital gain they may make in relation to the value of the property and the yield that they will achieve during their ownership of the property

Unlike French residential property, a commercial tenant does not have a right of first refusal. However, if the commercial tenant also has a residential tenancy, this may be an issue.

Selling the commercial property on

Any landlord can sell on a commercial property, even with a sitting tenant.

Whilst investing in commercial property in France is subject to detailed regulation, traditionally it has been a source of good yields and therefore investors may find it a worthwhile market.

February 2011

David Anderson

Solicitor and Chartered Tax Adviser

Nicole Gallop Mildon

Solicitor and Clerc de Notaire

Sykes Anderson LLP
9 Devonshire Square
London EC2M 4YF

Telephone + 44 20 3178 3770

E-mail: david.anderson@sykesanderson.com

Website: www.sykesanderson.com

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