Principal Issues: [TaxInterpretations translation] Should a payment be allocated between the lease and the amount paid for an option to purchase? If so, how should it be allocated?
Position: Yes. The amount must be allocated in such a way as to obtain an accurate picture of the taxpayer's profit.
Reasons: The payment is for both the lease and the cost of the option. The Canderel decision directs the determination of profit in order to produce an accurate picture.
XXXXXXXXXX 2010-037056 Michel Lambert CA, M.Fisc. July 18, 2011
Dear Sir,
Subject: Lease agreement with option respecting real estate
This is in response to your letter of June 7, 2010 in which you asked questions about a lease with a purchase option.
As stated in paragraph 22 of Information Circular 70-6R5 - Advance Income Tax Rulings of May 17, 2002, it is our practice not to issue a written opinion regarding proposed transactions otherwise than by advance rulings. Furthermore, when it comes to determining whether a completed transaction has received appropriate tax treatment, that determination is made first by our Tax Services Offices as a result of their review of all facts and documents, which is usually performed as part of an audit engagement.
However, we can offer the following general comments, which we hope will be helpful. These comments may, however, under certain circumstances, not apply to your particular situation.
In this letter, the Act means the Income Tax Act.
Your Questions
In brief, you asked us the following questions.
1. Does the Canada Revenue Agency (the "CRA") maintain its position that in the absence of sham, a lease is a lease and a sale is a sale?
2. Is the landlord deemed to have disposed of the option when granting it?
3. Does the CRA maintain its position that a portion of the rent paid under a lease with a bargain purchase option should be allocated to the option?
4. How can the landlord prevail where it has determined the value of the option?
5. Can the CRA provide guidelines for valuing a bargain purchase option in a lease agreement?
Our Opinion
The legal relationship between the parties
6. In the Shell case (footnote 1), the Supreme Court of Canada pronounced that true legal relationships take precedence over the economic realities of a situation.
7. Section 8.1 of the Interpretation Act provides, unless otherwise provided by law, that if in interpreting an enactment it is necessary to refer to a province’s rules, principles or concepts forming part of the law of property and civil rights, reference must be made to the rules, principles and concepts in force in the province at the time the enactment is being applied.
8. The question of whether an agreement is a lease contract with an option, or something else must be analyzed under the applicable private law, whether the civil law or the common law. It is that analysis of the applicable private law that will guide the CRA in determining the tax consequences of an agreement.
9. Thus, we are of the opinion that the question of whether a contract is a lease agreement or a sales contract must be resolved on the basis of the legal relationships created by the contract. Consequently, in the absence of a sham or an express provision in the Act which provides that legal relationships must not be respected, we are of the view that, for the purposes of the Act, a lease agreement in civil law is a lease agreement and a sales contract in civil law is a sales contract. However, despite the legal obligations of the parties to a contract, the general anti-avoidance provision could be used in the case of transactions that result in an abuse of the application of provisions of the Act.
Deemed disposition of the option
10. Subject to subsections 49(3) and 49(3.1), subsection 49(1) provides that, for the purposes of Subdivision c of Division B of Part I of the Act, the granting of an option represents a disposition of property whose adjusted cost base is nil. Some options are specifically excluded. That rule, which deems there to be a disposition, applies only for the purposes of Subdivision c referred to above.
The allocation of a payment
11. Where the landlord receives a payment during the term of a lease with a bargain purchase option, we are of the view that the landlord must allocate a portion of that amount to the lease and another portion to the purchase option, where that option has a value.
Determining the income of the landlord
12. In the Canderel decision (footnote 2), the Supreme Court of Canada set out six principles for computing profit for the purposes of the Act that must be applied in each particular case in order to determine whether the income was computed in accordance with the existing legal framework and whether that income gives an accurate picture of the taxpayer's profit for the year in question.
13. Those six principles are as follows:
1. The determination of profit is a question of law.
2. Profit is determined by deducting, from income, expenses incurred to earn such income.
3. The goal is to obtain an accurate picture of the taxpayer’s profit for the given year.
4. The taxpayer is free to adopt any method which is not inconsistent with the provisions of the Income Tax Act, established case law principles or “rules of law”, and well-accepted business principles.
5. Well-accepted business principles are not limited to generally accepted accounting principles, which are not rules of law but simply interpretive aids, and which are applied on a case-by-case basis in order to obtain the most accurate picture possible of the profit.
6. On reassessment, once the taxpayer has shown that the taxpayer has provided an accurate picture of income for the year, which is consistent with the Act, the case law, and well-accepted business principles, the onus shifts to the Minister to show either that the figure provided does not represent an accurate picture, or that another method of computation would provide a more accurate picture.
14. We are of the opinion that those principles should guide the taxpayer to allocate a payment between the portion attributable to the lease and the portion attributable to the option.
15. We are of the view, however, that a method of allocating a payment between the lease and the proceeds of disposition of the option that unduly defers the inclusion of the rent in the lessor's income will not give an accurate picture of profit.
The amount to be allocated to a bargain purchase option
16. The CRA has not issued guidelines to determine the amount to be allocated to a bargain purchase option, and the Income Tax Rulings Directorate does not intend to issue such guidelines. Such a determination can only be made after considering all relevant facts. In addition, it involves a valuation of the value of the option. Our Directorate does not comment on valuation issues.
As stated in Information Circular 70-6R5, this opinion does not constitute an advance ruling with respect to income tax and does not bind us.
Best regards,
Manager of the Financial Institutions Sector
and Exempt Entities Section
Income Tax Rulings Directorate
Legislative Policy
and Regulatory Affairs Branch
FOOTNOTES
Due to our system requirements, footnotes contained in the original document are reproduced below:
1 Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622.
2 Canderel Ltd. v. Canada, [1998] 1 S.C.R. 147.