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Tax escalation clause.

Most commercial leases contain a tax escalation clause which provides that the tenant will pay as additional rent his proportionate share of any increase in real estate taxes on the entire building. Thus, if the real estate taxes on an office building in any given year exceed the real estate taxes for a "base year," the tenant typically pays to the landlord an additional rent representing his proportionate share of the increased taxes; usually calculated on the basis of that proportion of the tenant's space which bears upon the total rentable space of the building.

Questions arise however in interpreting these tax escalation clauses when circumstances change. For example, is a tenant required to pay additional rent based upon increase in real estate taxes if the landlord itself is exempt from the payment of those taxes? Is the tenant required to pay additional rent even though a third party, not the landlord, is required to pay the real estate taxes on the building?

Bryant Imports Inc. entered into a lease in 1975 with 1100 Avenue of the Americas Associates, as landlord. The lease contained a tax escalation clause which stated that the tenant (Bryant Imports Inc.) shall pay as additional rent, 3 percent of any increase in real estate taxes over those assessed for the building for tax year 1974/1975. Such additional rent was to be payable by the tenant to the landlord, 111 Avenue of the Americans Associates, on the first day of the month following the ascertainment of such increased taxes. A tax bill would be sufficient evidence of the amount of taxes and for calculation of the amount to be paid by the tenant.

Subsequent to the commencement of the lease, 1100 Associates entered into a further net lease with Home Box Office Inc. for the entire building other than the ground floor retail space leased by Bryant Imports. The lease provided for HBO to pay all real estate taxes.

A dispute arose when Bryant Imports refused to pay to 1100 Associates the additional rent of 3 percent of the tax increase as required by its lease. It was Bryant's position that since 1100 Associates was no longer required to pay real estate taxes, it could not charge Bryant Imports for any tax escalations.

The Supreme Court, Appellate Term, New York County considered this matter on appeal. Its analysis of this ease commenced with the language of the lease itself, which called for the tenant to pay a percentage of real estate tax over the base year. Since the clause does not explicitly state whether actual payment of the tax by 1100 Associates is a pre-condition to the imposition of additional rent, the entire lease must be read as a whole to determine its purpose and intent.

The court reviewed various cases upon which it relied as precedents. It cited a number of eases which held that actual payment of real estate taxes on the part of the landlord must exist before the tenant's contractual obligations to pay additional rent is activated. "Actual payment" however does not always require that the landlord actually pay the rent, but at least, the landlord must have the obligation to pay the rent. What is intended is that when taxes are to be paid by the landlord which results in an increase of expense to the landlord, a proportionate share of those tax expenses is to be borne by the tenant.

The Court also reviewed tax escalation cases in which, although additional taxes were actually assessed, the landlord was exempted from paying those taxes. In those cases, reading the leases as a whole, the courts were persuaded that the parties had intended that no additional rent was due unless the landlord actually paid the real estate taxes. There, the parties to the leases contemplated that payment of additional rent was only for the purpose of defraying the actual expenses paid by the landlord.

The landlord in this case argued that the tax obligation on the building is increased even though the obligation to pay the taxes was merely shifted from the landlord, 1100 Associates, to another tenant, HBO; and that the shifting of the obligation to pay the tax does not nullify the effect of the tax escalation clause under the lease with Bryant Imports.

The Appellate Term, however, decided that the landlord is entitled to additional rent only to the extent that it actually paid increased real estate taxes. To hold otherwise would allow the landlord to reap a windfall not envisioned by the parties to the lease agreement. The shifting of the obligation to pay the tax from the landlord to another party must be viewed as an event which releases the tenant from any obligation to pay increase costs which are merely theoretical. Although the parties of course are free to contract otherwise, in this case the court determined that the parties' intent was not for the tenant to pay additional rent to a landlord who was in fact not responsible for payment of taxes.

Thus, the Appellate Term, by a majority vote, ruled that the landlord, 1100 Avenue of the Americas Associates, was not entitled to additional rent from the tenant due to tax increases on the building because the real estate taxes were not being paid by the landlord. They in fact were being paid by a third party, HBO.

Justice Stanley Parness dissented. He stated that he would award the landlord the additional rent under the lease tax escalation clause. He stated that the majority's reliance upon precedents was misplaced. The cases cited by the majority to support its position that the tenant was not responsible for additional rent came from cases which stood only for the proposition that if the landlord seeks additional rent under a tax escalation clause such as found in this case, the amount of the additional rent is limited proportionately by the amount of increased tax actually paid, as opposed to merely an increase in the tax assessment over the base year. Those cases simply hold that the landlord may not seek as additional rent amounts unrelated to the additional tax actually paid. Nowhere in those cases relied upon by the majority is there an express requirement that the landlord be the entity making the increase tax payment.

Justice Parness stated that the landlord in this case was liable for the increased tax, although being paid by a third party. Certainly the landlord in granting HBO a net lease accepted a reduced rent in contemplation of the fact that HBO would pay the real estate taxes along with the increase in those taxes. The Judge stated that it could hardly be said therefore that under those circumstances the landlord would enjoy a windfall if the tenant pays his share of the increased taxes. Rather, it is the tenant who will enjoy a profit to which it is not entitled. He further stated that the majority should not lightly set aside contracts forged by sophisticated business persons who are aware of the complexity of modern financial transactions. To impose, as the majority would, an obligation that the landlord must personally pay the increased tax in order to secure additional rent, is to re-write the lease under the guise of seeking to interpret the intent of the parties.

Accordingly, while the majority of the Appellate Term holds for the principal that in order for a landlord to collect additional rent resulting from a tax escalation clause, the landlord itself must be the one who pays the real estate taxes, otherwise, the landlord would receive a windfall. The minority viewpoint however holds that unless the lease specifies to the contrary, as long as the landlord is obligated to pay the taxes, even though a third party is the one who actually pays the rent, the landlord would still be entitled to additional rent because of tax escalation. For to hold otherwise would be a windfall to the tenant.

Thus, there is no unanimity in the construction of a tax escalation clauses when changes of circumstances cause the original landlord not to be the one who actually pays the real estate taxes. It is important therefore in constructing escalation clauses in commercial leases that specific language be fashioned to deal with possible changes in the future.
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Title Annotation:real estate
Author:Schiff, Edward L.
Publication:Real Estate Weekly
Date:Oct 4, 1995
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