In a decision issued yesterday in Saturday Family and Techspec Inc. v. Commonwealth, the Pennsylvania Commonwealth Court reversed the decisions of the administrative boards and rejected the Department of Revenue’s attempt to impose Realty Transfer Tax on a lease with an initial term of 29 years and 11 months and six five-year renewal options at fair market value rent, where fair market value rent would be determined by agreement of the parties or by appraisals absent agreement.
Leases with a term of 30 years or more are subject to Pennsylvania Realty Transfer Tax. The question arises how to treat renewal options for purposes of the 30-year test. The statute provides that a renewal option is presumed to be exercised for the 30-year test "if the rental charge to the lessee is fixed or if a method for calculating the rental charge is established." 72 P.S. §8103-C.1. The regulations adopted by the Pennsylvania Department of Revenue elaborate as follows:
(v) In determining the term of a lease under this paragraph, it shall be presumed that a right or option to renew or extend a lease will be exercised if the lessor and lessee cannot renegotiate the rental charges for the renewal or extension period unconditionally. A lessor and lessee cannot renegotiate a rental charge unconditionally if it is fixed at a set amount for the period or a method for establishing the rental charges is established. Renewals or extensions at the option of the lessee at fair rental value at the time of the renewal or extension are not included in determining the term of a lease.
61 Pa. Code §91.193(b)(24)(v).
The lease at issue in Saturday Family had an initial term of 29 years, 11 months and six five-year renewal options at fair market value rent. If the renewal options were included for the 30-year test, the lease would be subject to Realty Transfer Tax. If the renewal options were not included, no tax would be due.
The dispute centered on how fair market value rent would be determined for the renewal options. The lease provided that renewal term rent would be fair market value, at the time the renewal option was exercised, as agreed to by the parties. If the parties were unable to agree, the lease provided a detailed appraisal process to determine fair market value rent. The Department argued that because the parties had agreed in advance to the appraisal process to determine fair market value rent, they did not have the right to "renegotiate the rental charges for the renewal or extension period unconditionally," so under the first sentence of the regulation quoted above, the renewal terms were required to be included in the 30-year test, and the lease was taxable.
The taxpayers argued that the Department’s interpretation ignored the last sentence of the regulation, which excludes renewal options at fair market value rent from the 30-year test, and that under the rules of statutory construction the last sentence is an exception to the first two sentences of the regulation because the specific controls the general and the latter is an exception to the former to the extent they are irreconcilable.
The Commonwealth Court agreed with the taxpayer, reasoning that the Transfer Tax regulation’s "provisions are clear." "The critical third sentence [of the regulation] explains in clear language that if the rental charge is based upon the 'fair rental value at the time of the renewal or extension,' the extension period is not included in the total lease term."
In response to the Department’s argument that the lease’s inclusion of an appraisal method to determine fair market value rent constituted an impermissible "method for establishing the rental charges," the Court opined: "The mere fact that the Ground Lease established a mechanism for determining the fair market value rent in the event that Taxpayers cannot agree on a fair market value rent does not alter the salient fact that the Ground Lease provides that renewal periods shall be at fair market value rent."
The Court also dispatched the Department’s argument that its interpretation was entitled to deference, writing "the Department’s interpretation is at odds with the clear language of the regulation itself, and, therefore, the Department’s interpretation is not entitled to deference."
The Court’s decision clarifies that landlords and tenants may agree to determine fair market value rent for renewal options via appraisals without causing the renewal options to be included in the lease term for purposes of the 30-year Transfer Tax test. This is a victory for Pennsylvania’s commercial real estate industry by eliminating an uncertainty over which leases are subject to Transfer Tax and solidifying the industry’s understanding of how rent may be determined in lease renewal options without the risk of incurring Transfer Tax.
Your reporter represented the taxpayers.