Commercial Rent Deposits – A brief overview

Rent Deposit

What is a rent deposit?

A rent deposit is money provided by a tenant to its landlord as security for payment of the rent and performance of the tenant’s covenants contained in the lease. A rent deposit deed will specify the circumstances in which the landlord can draw on this money and the conditions that must be satisfied for the deposit to be repaid to the tenant.

Landlords like rent deposits because they are easily accessible sources of money that can be drawn upon as soon as the tenant is in breach of a relevant covenant in the lease. Court action is not required to recover the debt or enforce performance of obligations. Tenants are not generally too keen on rent deposits as they can lock up sizeable amounts of capital, often for a lengthy period.

When will a rent deposit be taken?

A rent deposit will be put in place on the grant of a lease or on assignment of an existing lease. If the landlord does require a rent deposit it will usually be for one of the following reasons:

• The tenant’s financial position is weak and therefore unsatisfactory to the landlord without some additional comfort
• The tenant may be an overseas company with few, if any, UK assets
• The tenant is a new business and so is unable to provide evidence of settling its debts or meeting rent obligations

As many tenants will not want to lock up the capital required to fund a rent deposit, possible alternatives include:

• A bank guarantee or bond
• A parent company guarantee
• A guarantee from a director
• A letter of credit from a bank

All of these alternatives have potential disadvantages. Both the bank guarantee or bond and a letter of credit will require a payment to the bank from the tenant to secure the payment. The value of any guarantee will depend upon the strength of the party providing the guarantee.

How much should the landlord require?

There is no prescribed level or statutory constraint on the size of the sum. However, the size of the rent deposit usually reflects a combination of:

• The rent payable under the lease
• The likely period that it would take for the landlord to re-let the property
• The landlord’s perception of the risk that granting the lease to the tenant poses

Landlords tend to require a rent deposit equal to 6 – 12 months of the rent due under the lease. As there are no constraints on the sum that can be required, rent deposits are commonly made up of a combination of principal rent, insurance rent, and service charges. Other factors, although less common, can be considered in calculating a required rent deposit, such as how unique the property is, and likely costs the landlord may incur if the tenant defaults.

Tax on rent deposits

SDLT

Historically rent deposits did not form part of the “consideration” on the grant or assignment of a lease, so no SDLT charge was incurred. However, the Finance (No.2) Act 2005 contains provisions to enable SDLT to be charged on premiums that are disguised as rent deposits.

Under these statutory provisions, rent deposits are held to be “consideration” for the purpose of the grant or assignment of a lease (and therefore potentially liable for SDLT) unless the rent deposit is less than twice the highest amount of annual rent payable in any 12 month period in the first 5 years of the lease term; or in the case of an assignment, in the first 5 years of the term outstanding at the date of the assignment.

It is argued by some advisors that these provisions only apply to the type of the rent deposit structure where the tenant transfers ownership of the deposit monies to the landlord. However, most rent deposits are drafted to provide that the money is held by the landlord but owned by the tenant.

VAT

Where a landlord has opted to pay VAT, VAT is payable on the annual rent.

However, charging VAT on rent deposits is often a contentious point. The parties may not consider VAT when negotiating the amount payable, as VAT is not payable on the sum deposited with the landlord. VAT is only payable when a supply is made; this only occurs when, and if, the landlord draws on the rent deposit. VAT is therefore only payable in the event of a breach of covenant by the tenant, when the landlord must draw on the rent deposit.

Accordingly, where the landlord has exercised the option to tax or is likely to do so, the negotiated rent deposit should be an amount that includes a sum equivalent to the VAT that will be payable if the tenant is in default.

No VAT invoice is required when a rent deposit deed is entered into if a sum equivalent to VAT is paid.

When will the rent deposit be returned to the tenant?

It will generally be returnable in the following circumstances:

• Assignment under the lease in accordance with the lease. (On such an occasion the landlord may, if appropriate, want to require a new rent deposit from the assignee)
• Expiry of the lease term without any holding over under the Landlord and Tenant Act 1954
• Early termination of the lease by agreement (such as by way of surrender or exercise of an option to break). Early termination by agreement would exclude a case of forfeiture and disclaimer

The landlord may also agree to return the rent deposit if the tenant demonstrates that its financial position has improved sufficiently to reassure the landlord that it will meet its financial obligations under the lease. Common indicators are the “net profit” test, where the net profits of the tenant are shown to equal or exceed a multiple (commonly 3 times) of the rents reserved by the lease for up to 3 years; and the “net assets” test, where the net assets of the tenant are equal to a multiple (commonly 5 times) of the rents reserved by the lease.

Further information

This article contains only initial considerations in relation to rent deposit deeds. These documents are often drafted in a complex way, and further questions will arise on each form of rent deposit deed used; for example, whether a landlord can draw against a rent deposit if a corporate tenant becomes insolvent, and what happens when the landlord sells its interest in the property.

If you have any queries on any of these points or the point referred in this note or any other matters relating to rent deposit deeds please contact our Commercial Property Solicitors.