Tenant‐Improvement Reimbursement After Lease Pre-Termination in the Philippines
(A comprehensive doctrinal, contractual, and practical guide)
1 | Scope & Importance
“Tenant improvements” (TIs)—also called fit-outs, build-outs, or leasehold improvements—are alterations a lessee makes to adapt leased premises to its business. In the Philippines the issue becomes thorny when the lease ends earlier than agreed (“pre-termination”) because two proprietary interests suddenly collide:
- the owner–lessor’s right to repossess its property intact, and
- the lessee’s equity in the improvements it paid for.
The questions practitioners meet most often are:
- Is the lessee entitled to reimbursement?
- If so, how much, when, and from whom?
- Can the lessee remove the improvements instead?
- How do contractual clauses interact with the Civil Code?
This article canvasses all the legal bases—statutory, jurisprudential, tax, and commercial practice—relevant as of 29 April 2025.
2 | Primary Legal Sources
| Instrument | Key Provisions on Improvements |
|---|---|
| Civil Code of the Philippines (Book IV, Title VIII, Ch. 2) | Arts. 1654, 1657, 1674 – 1679 (lease obligations & termination); Arts. 446–455, 448, 546 (accession & possessor in GF) apply suppletorily |
| RA 9653 (Rent Control Act, residential only) | Silent on TIs; Civil Code governs |
| Implementing Rules & Regulations of the National Building Code (IRR NBC) | Requires permits for interior fit-outs—helps prove good faith & actual cost |
| RA 9285 (Alternative Dispute Resolution Act) & E.O. 1008 (CIAC) | Provide arbitration fora for construction-related TI disputes |
| National Internal Revenue Code (NIRC) | Leasehold improvements: Secs. 34(F), 106(A), 109—depreciation, VAT on reimbursements |
| Local Government Code | Real property tax on permanent improvements goes to lessor once accession occurs |
3 | Civil-Code Framework
3.1 Classes of Improvements
| Class | Definition | Default Rule on Reimbursement/Removal |
|---|---|---|
| Necessary | Prevent destruction or deterioration (e.g., urgent roof repair) | Lessor must reimburse 100 % (Art. 1674, 546 ¶1) |
| Useful | Add value or productivity but not indispensable (e.g., air-conditioning, mezzanine) | Art. 1678: Lessee in good faith & without lessor’s objection → entitled at lease end to 50 % of current value or to remove if removable without damage |
| Luxurious/Recreational | Merely for convenience or ornament (e.g., designer chandelier) | No reimbursement; lessee must remove or forfeit at lessor’s option (Art. 1679) |
Good faith means (a) belief that one has the right to build, and (b) absence of express prohibition by the lessor at the time of construction.
3.2 Effect of Lessor’s Prior Consent
If the improvements were made with written consent, parties may stipulate any outcome.
Absent stipulation, prevailing view (by analogy to Art. 448) allows the lessee to choose between compensation for the actual current cost or removal, because consent converts the act into one done for the lessor’s benefit.
3.3 Security‐Deposit Set-Off
Civil Code is silent, but jurisprudence (e.g., Lequin v. Court of Appeals, G.R. 124871, 10 Dec 2004) upholds set-off between (a) refundable security deposit and (b) sums owed for improvements or restoration, so long as the right to compensation is liquidated and demandable.
4 | Scenarios of Pre-Termination & Their Consequences
| Scenario | Who Initiates | Cause | Reimbursement Consequence |
|---|---|---|---|
| A. Lessor unilaterally pre-terminates without tenant breach (e.g., owner needs premises for own use; redevelopment) | Lessor | Contractual right, Art. 1673 | Lessee may demand full indemnity for proven losses (Art. 1654 (1)), including TI cost; most contracts convert this into reimbursement of unamortized TI plus relocation expenses |
| B. Lessee validly pre-terminates due to lessor’s breach (e.g., uninhabitable condition, eviction by better title) | Lessee | Art. 1657 (1) | Lessee entitled to (i) damages + (ii) TI reimbursement under Art. 1678 or contract |
| C. Lessee voluntarily pre-terminates for business reasons | Lessee | Pure convenience | Default: no reimbursement; lessee must restore premises unless contract allows buy-out of unamortized TI |
| D. Mutual rescission/novation | Both | Negotiated | Reimbursement governed entirely by settlement agreement; Civil Code suppletory |
| E. Judicial rescission for substantial breach | Court | Either side | Court may order indemnity; Article 1191 in relation to 1678 |
Tip for drafters: Spell out a TI amortization schedule (usually straight-line over the initial term) and a pre-termination formula (e.g., remaining book value × agreed reimbursement rate) to avoid statutory default rules.
5 | Valuation Principles
- Time of valuation: moment the lease ends, not original cost.
- Basis: fair market or replacement cost less depreciation; appraisers usually apply straight-line depreciation for non-structural fit-outs (3–5 years) and diminishing-value for MEPF (mechanical, electrical, plumbing, fire-protection) works.
- Reimbursement cap: Civil Code’s “one-half” ceiling for useful improvements absent consent. Contract may override.
- Betterment exclusion: If TI supersedes existing landlord works (e.g., ceiling grid upgrade), only incremental value is compensable.
6 | Removal vs. Accession
Art. 1678 allows lessee to remove improvements provided removal causes no substantial damage.
Where removal is possible but costly, parties often negotiate “make-good” cash settlement: lessee pays the lessor an amount equal to removal and restoration cost; in turn it leaves the fit-out behind.
7 | Tax Treatment (NIRC & BIR Rulings)**
| Item | Lessee Perspective | Lessor Perspective |
|---|---|---|
| Initial TI outlay | Capitalizable “leasehold improvement” — depreciable over shorter of useful life or remaining lease term incl. renewals (Sec. 34 F) | None, unless TI reverts immediately |
| Reimbursement received | Ordinary income; subject to 12 % VAT if lessee is VAT-registered supplier of the fit-out | Capital addition; input VAT creditable if lessor is VAT-registered |
| Residual value at surrender | Remainder of unexpended depreciation may be written off | TI becomes part of building; real property tax base increases next assessment year |
8 | Security, Liens & Retention Rights
Philippine law does not give the lessee an automatic statutory lien on the real property.
However, contractual liens and “no-removal” undertakings (allowing lessor to retain improvements until payment) are enforceable, subject to the prohibition against pactum commissorium (Art. 2088) when treated as a mortgage.
9 | Dispute-Resolution Pathways
- Negotiation / Letter-Demand – Always first step; gather permits, receipts, as-built plans, photographs.
- Mediation – Under the ADR Act; building administrators often host.
- Arbitration –
- CIAC if the dispute is construction-related (fit-out works ≥ ₱1 M).
- Ad-hoc or institutional (PDRC, SIAC, HKIAC) if contract provides.
- Regular Courts –
- MTC up to ₱300 000 (outside Metro Manila) / ₱400 000 (MM); otherwise RTC.
- Action may be sum of money (for reimbursement) or specific performance with damages.
- Prescriptive period: 10 years for written contracts; 4 years for quasi-delict.
Provisional remedies (preliminary attachment, injunction to prevent demolition of TIs) are available upon showing of prima facie right.
10 | Checklist for Lessees Claiming TI Reimbursement
- Review the lease: look for
- Pre-termination clauses
- Make-good vs. reimbursement formulas
- Notice periods and time-bar.
- Document your improvements:
- Approved drawings & permits (for good-faith presumption)
- Cost breakdown, ORs, invoices, progress billings
- Photographs and completion certificates.
- Compute depreciated value or contract-defined unamortized cost.
- Serve written demand within contractual or reasonable period after notice of pre-termination.
- Offer inspection to mitigate dispute on physical condition.
- Prepare to offset against security deposit or future rent if lease allows.
- Escalate (mediation/arbitration/court) only after compliance with escalation ladder in the lease.
11 | Selected Supreme Court Cases
| Case | G.R. No. / Date | Ratio on TIs |
|---|---|---|
| Spouses Lequin v. CA | 124871 / 10 Dec 2004 | Art. 1678 applies even when improvements not expressly objected to; reimbursement can be offset against unpaid rent |
| San Miguel Properties, Inc. v. Huang | 137290 / 01 Oct 2001 | Lessor who pre-terminates must indemnify lessee for unrecovered TI cost despite “contract revocable at will” clause—principle of abuse of rights |
| Iglesia ni Cristo v. CA | 119673 / 26 Jan 1999 | Lessee who voluntarily vacates before term cannot compel lessor to pay for church improvements absent stipulation |
| Joven v. IAC | 68201 / 22 Aug 1989 | Where removal feasible but would injure the property, lessor may elect payment of ½ value instead |
12 | Drafting & Negotiation Tips
- Define TI & classify (base building, landlord works, tenant works).
- Amortization schedule + pre-termination reimbursement formula (e.g., (Original TI cost × Remaining months) ÷ Total months).
- Consent & approvals clause: Clearly state whether consent = obligation to reimburse.
- Restoration vs. retention dialectic: give parties option windows (e.g., lessee must elect removal or surrender within 30 days).
- Security-deposit mechanics: allow application toward restoration or reimbursement balance with audit.
- Tax gross-up clause: whichever party receives reimbursement bears its own VAT/withholding but net-of-tax numbers are maintained.
- Dispute-resolution: pick forum; specify rule set; adopt expert determination for valuation to avoid full litigation.
13 | Conclusion
Philippine law strikes a middle path: it safeguards the lessor’s ownership through the doctrine of accession while acknowledging the equitable interest a tenant acquires after investing capital. Article 1678—tempered by party autonomy, good-faith considerations, and modern commercial practice—remains the default compass. Because statutory rules can be economically unforgiving (only 50 % reimbursement for useful TIs), sophisticated leases now contract around those defaults through amortization tables and clear buy-out formulas.
Whether you represent a landlord planning an early redevelopment or a tenant relocating mid-term, meticulous drafting, thorough documentation, and a calibrated understanding of Civil-Code principles are your best tools for avoiding post-termination quarrels.
(This article provides general legal information and is not a substitute for individualized legal advice. Consult Philippine counsel for specific transactions.)