Rental Schemes

The scheme of splitting rental payments is a method of tax optimization in which a single large payment is divided into several smaller sums, passing through different contracts and legal grounds. This practice was especially widespread in the early 1990s, when enterprises sought ways to reduce their tax burden amid high tax rates.

The general structure of the scheme

The classic rent-splitting scheme is built on concluding three different contracts between the tenant (or structures under his control) and the landlord. Each contract has a formally lawful basis, yet the combination of these contracts serves a single purpose — to conceal the real amount of the rent, and reduce the taxable base.

Contract No. 1: Minimal rent

The first contract is drawn up as a standard lease agreement for premises. The rent under this contract, however, is set at a minimal level — significantly below the market rate for comparable space. A low official rent allows the tenant to minimize expenses recorded in tax filings, and allows the landlord to understate income subject to profit tax.

The minimal rent rate can be justified by various factors:

• Poor technical condition of the premises
• The need for repairs at the tenant's expense
• Remote location of the property
• Special contract terms (for example, a long-term lease)
• A partnership relationship between the parties

Such an understated rent is not formally against the law, as long as the parties agreed on the price themselves. Tax authorities of the period rarely challenged contract prices unless they were clearly nominal.

Contract No. 2: Performance of research work

The second contract is drawn up as a contract for research, development, or consulting work. This contract is concluded between the tenant (or a firm connected to him) and the landlord. The tenant acts as the client, and the landlord as the contractor.

Advantages of using a work contract:

• The cost of the work is charged to the client enterprise's expenses, reducing its taxable profit
• The difficulty of verifying whether research work was actually performed — its results can be presented as reports, analytical memos, or technical findings
• The absence of a physical result that could be checked
• The possibility of inflating the cost of intellectual services

Under Contract No. 2, a significant portion of the real rent is transferred, disguised as payment for work performed. The subject matter of the research is chosen to match the landlord's profile of activity. For example, if the landlord is a research institute, studies on a relevant topic are commissioned.

The mechanism for performing "fictitious" work

In fact, no work is performed under Contract No. 2, or it is performed only formally, for appearance's sake. The process is organized as follows:

1. Terms of reference are drawn up for the research or development
2. Deadlines are set for completing the work (usually several months)
3. The cost of the work is determined, which includes the second part of the hidden rent
4. Once the deadline has passed, a certificate of completed work is drawn up
5. A report on the research performed is handed over to the client (which may be a purely formal document)
6. Payment is made for the work performed

Verifying whether research work was actually carried out is extremely difficult. The report may contain general reasoning, well-known facts, and a compilation of information from open sources. Tax inspectors do not have the necessary qualifications to assess the quality and value of scientific research.

Contract No. 3: Supply of materials

The third contract is drawn up as a purchase-and-sale agreement for materials needed to perform the work under Contract No. 2. The scheme works as follows:

1. The tenant purchases materials, equipment, or components from third-party suppliers for cash
2. Documents are drawn up for the purchase of these materials
3. The materials are handed over to the landlord for use in the work under Contract No. 2
4. The cost of the materials is also charged to the tenant's expenses

The key element of this part of the scheme is the use of cash. The tenant writes off funds for purchasing materials that were allegedly bought for cash from third-party organizations. In reality, these materials are either not purchased at all, or purchased in significantly smaller quantities or at a lower price.

The role of cash settlements in the scheme

The use of cash is a critically important element of this tax-minimization scheme. Cash settlements make it possible to:

• Conceal real financial flows from the tax authorities
• Justify expenses without an actual purchase of goods
• Transfer money directly, bypassing bank accounts
• Avoid leaving a documentary trail of the transactions

The mechanism for handling cash:

1. The tenant withdraws cash from the company account, ostensibly to purchase materials
2. Documents are drawn up for purchasing materials from small suppliers or individuals
3. In reality, the cash is handed directly to the landlord, as the third part of the real rent
4. In the documents, this is recorded as a supply of materials for the performance of the work

Documenting the cash purchase of materials could be done in several ways:

• Drawing up purchase certificates from small enterprises and sole proprietors
• Purchasing through front persons
• Using receipts for materials purportedly bought at markets
• Recording purchases from nonexistent organizations, or ones that had ceased operating

The tax advantages of the scheme

Splitting the rent into three parts made it possible to achieve several tax-optimization goals:

For the tenant

• Increased expenses: Costs under all three contracts are charged to the cost of production or services, reducing taxable profit
• Diversification of payments: Spreading the total across different legal grounds makes it harder to identify the real rent
• Justification of expenses: Each type of expense has formal documentary support
• Reduced VAT: When purchasing materials, the tenant can claim a credit for input VAT

For the landlord

• Understated taxable income: The official rent is minimal
• Diverse income sources: Income is divided among rent, revenue from performing work, and the sale of materials
• Increased expenses: The cost of the materials received can be charged to expenses
• Access to cash: Part of the payments comes in as cash, which is harder to trace

Variants for complicating the scheme

The basic three-contract scheme could be made more complex, to increase its reliability and make it harder for the tax authorities to detect:

The use of several intermediary firms

Instead of the tenant concluding all three contracts directly, additional legal entities are brought into the scheme. For example:

• The lease agreement is concluded in the name of one firm
• The work contract — in the name of a second firm
• The supply of materials is carried out through a third firm

All these firms are in fact controlled by one person or group of people, but are formally independent organizations. This makes it harder to establish a connection between them and to detect the payment-splitting scheme.

Periodically changing counterparties

To reduce risk, the firms participating in the scheme are periodically changed. This is done for the following reasons:

• Preventing the accumulation of suspicious transactions in one legal entity
• Making it harder for tax authorities to analyze financial flows
• Taking advantage of tax breaks available to newly registered small enterprises

Including preferential organizations in the scheme

To increase the effectiveness of tax optimization, an organization enjoying tax privileges could be used as one of the scheme's participants. These might include:

• Public organizations of disabled people
• Religious organizations
• Sports societies
• Charitable foundations
• Educational institutions

Such organizations enjoyed significant tax preferences in the early 1990s, making them attractive for use in tax-minimization schemes.

Risks and vulnerabilities of the scheme

Despite its apparent reliability, the rent-splitting scheme had a number of vulnerable points:

Documentary contradictions

An audit could reveal inconsistencies in the documents:

• An absence of tangible traces of the work performed under Contract No. 2
• A mismatch between the volume of materials supplied and the work claimed
• Inflated cost of the work compared with market prices
• The formal, boilerplate nature of the research reports

Connections between the scheme's participants

If the tax authorities established that all the participants in the scheme were connected, this could become grounds for reclassifying the transactions:

• Shared founders or managers across different firms
• Family ties between the officials involved
• Use of a single legal address
• A single settlement account or bank
• Matching IP addresses in electronic reporting

Economic implausibility of the transactions

Tax authorities could question the business purpose of the transactions:

• An understated rent compared with the market rate
• Commissioning research unrelated to the core business
• Purchasing materials not used in operations
• The absence of any economic effect from the work performed

Problems with cash settlements

The use of cash created additional risks:

• Limits on the amounts of cash settlements between legal entities
• The need to justify the withdrawal of large sums of cash
• The difficulty of documenting the intended use of the cash
• The risk of nonexistent suppliers being uncovered

Documentation and paperwork flow

Successfully implementing the scheme required careful preparation of all documents:

For the lease agreement

• A lease agreement with a detailed description of the premises
• An acceptance certificate for the premises
• Monthly certificates of rental services rendered
• Invoices and payment orders
• Documents justifying the low rent (inspection reports, expert opinions)

For the work contract

• A contract for research or consulting work
• Terms of reference with a detailed description of the work
• Interim progress reports
• A final report on the work performed
• A certificate of completed work
• An invoice and payment order
• Documents confirming the contractor's qualifications

For the materials-supply contract

• A purchase-and-sale or supply agreement
• A specification of the materials
• Invoices from the suppliers
• Delivery notes
• Acceptance certificates for the materials
• Cash disbursement vouchers (for cash settlements)
• Powers of attorney for receiving materials

Psychological and organizational aspects

Successfully carrying out the scheme required coordinating the actions of all participants, and maintaining secrecy:

Division of roles

Every participant in the scheme had to clearly understand their role and its limits:

• The heads of the organizations signed the documents
• Accountants ensured the transactions were properly recorded in the books
• Intermediaries organized the transfer of cash
• Lawyers drafted the contracts and advised on legal questions

Confidentiality

Information about the real scheme had to be accessible to the smallest possible circle of people:

• Rank-and-file employees should not know the full picture of the scheme
• Documents were stored separately
• Written references to the real purpose of the transactions were avoided
• Negotiations were conducted without witnesses

Preparing for audits

The scheme's participants had to be ready for a possible tax audit:

• Explanations for all transactions were prepared in advance
• Testimony was coordinated in case of interrogation
• Additional supporting documents were prepared
• An analysis of the scheme's vulnerable points was carried out

The economic effectiveness of the scheme

Splitting the rent made it possible to significantly reduce the tax burden. Consider a hypothetical example:

Suppose the market rent for the premises is 300,000 rubles a month. Under a standard lease arrangement:

• The landlord receives income of 300,000 rubles, on which he pays profit tax
• The tenant charges 300,000 rubles to expenses, reducing the taxable base

Using the splitting scheme:

• 50,000 rubles passes through the lease agreement
• 150,000 rubles — through the work contract
• 100,000 rubles — through the materials-supply contract

The advantages of such a split:

1. The landlord reports lower rental income
2. Part of the funds comes in as payment for work, which may be taxed at different rates
3. The cost of the materials can be charged to the landlord's expenses
4. Part of the payments passes as cash, providing additional flexibility

The scheme's modern relevance

It's important to note that the scheme described belongs to the realities of the early 1990s. Under modern conditions, applying such methods of tax optimization is difficult, for a number of reasons:

• Improved methods of tax control
• The development of electronic document flow and the traceability of transactions
• Tighter legislation on liability for tax offenses
• The introduction of the concept of unjustified tax benefit
• Automated monitoring of large transactions and suspicious activity
• Restrictions on the use of cash settlements

Tax authorities have gained the right to challenge transactions carried out solely for the purpose of obtaining an unjustified tax benefit. Court practice shows that business-splitting schemes and the artificial division of transactions can be found illegal.

Conclusion

The scheme of splitting rental payments through a system of interrelated contracts was a widespread method of tax optimization during the formative period of Russia's tax system. The scheme's complexity and multiple stages made it relatively resistant to detection by the tax authorities, especially given insufficient automation of oversight and imperfect legislation at the time.

The key elements of the scheme were the formal division of a single payment among different contractual grounds, the use of cash settlements to make it harder to trace money flows, and the creation of a plausible documentary base to justify all the transactions. The scheme's effectiveness depended on the care taken in preparing documents, the coordination of all participants' actions, and their readiness to withstand possible audits.

Understanding how such schemes worked is important for the historical analysis of the development of tax relations in Russia, and for studying the evolution of methods of tax control.