Principal Issues: [TaxInterpretations translation] The taxpayers' building was damaged by mould and the taxpayers have made significant renovations with a significant relative value of the work to the value of the total property. The issue is whether the distribution of expenditures by the taxpayers (between current and capital expenditures) is reasonable.
Position: Question of fact.
Reasons: Although the CRA has set out guidelines on this subject in an interpretation bulletin, it is a sound appreciation of all the characteristics that must provide the correct answer. Nevertheless, the approach taken by taxpayers is neither supported by the interpretation bulletin nor supported by the case law.
January 7, 2011
XXXXXXXXXX Tax Services Office Income Tax Rulings Directorate Business Audits Business and Partnerships Division
XXXXXXXXXX James Gibbons 2010-038241
Renovation of a building - the nature of the expenses
This memorandum is in response to your email dated October 1, 2010, requesting our comments regarding the nature of expenses incurred by taxpayers (the "Taxpayers") in the situation described below. In particular, you wish to know whether the expenses incurred by the Taxpayers are capital or current expenses.
Unless otherwise indicated, all statutory references herein are to the provisions of the Income Tax Act (the "Act").
FACTS
- The Taxpayers acquired a rental building with XXXXXXXXXX units on XXXXXXXXXX 1998.
- The price paid for the acquisition of the building was $XXXXXXXXXX, broken down as follows: building $XXXXXXXXXX; land $XXXXXXXXXX; furniture $XXXXXXXXXX.
- The following gross rental income was derived from the building: $ XXXXXXXXXX for 1998; $ XXXXXXXXXX to $ XXXXXXXXXX for the years 1999 to 2007 inclusively. In 2008, gross rental income was $XXXXXXXXXX and in 2009, $XXXXXXXXXX. The 2008 rent decrease is due to two factors:
- XXXXXXXXXX tenants terminated their leases due to renovations;
- Some months' rent was not collected due to renovations.
- On XXXXXXXXXX 2007, renovations were undertaken to change the roof of the building from a flat roof to a pitched roof.
- While the roof was uncovered, a heavy downpour occurred, causing water to infiltrate into the building.
- To counter mould problems, cleaning work was carried out. Subsequently, because of the extent of the damage, all the units were redone. The drywall was changed, and the plumbing, electricity and bathrooms were redone. Some materials such as kitchen cabinets and some toilets were salvaged, but overall, everything was redone.
- Total renovation costs for 2008 were $XXXXXXXXXX. Of this amount, an amount of $XXXXXXXXXX was considered to be attributable to capital expenditures while an amount of $XXXXXXXXXX was deducted as a current expense.
- The municipal assessment of the building, prior to construction (in 2007), was CAN $XXXXXXXXXX, i.e., $XXXXXXXXXX for the building and $XXXXXXXX for the land.
- On XXXXXXXXXX 2008, for the purpose of establishing value for a mortgage financing, the value of the building set out in an appraisal report was $XXXXXXXXXX.
- In addition to the work described above, there was a conversion of the gas heating system to electric heating, the installation of an intercom system and of four air exchanger systems. To take into account the increase in rental revenues as of XXXXXXXXXX 2008, the taxpayers adjusted the fair market value ("FMV") of the building to $XXXXXXXXXX.
- The municipal assessment of the building, as of XXXXXXXXXX 2010, was $XXXXXXXXXX (building $XXXXXXXXXX and land $XXXXXXXXXX).
- The amount of expenses incurred that were considered capital expenditures was determined based on the increase in value of the building following the work (an adjusted FMV of $XXXXXXXXXX minus an initial FMV of $XXXXXXXXXX minus the value of the time invested by the owners).
- Rental income from this building, following the work, increased slightly, i.e. by $XXXXXXXXXX (12%).
- * For the year 2009, renovations to the basement were undertaken and these expenses were considered to be expenses of a current nature.
OUR ANALYSIS
It is a question of fact whether expenses are capital or current in nature and, as you noted in your email, there are various cases on this subject that form the basis of the guidelines described in Interpretation Bulletin IT-128R, Capital Cost Allowance - Depreciable Property (the "Bulletin"). In the end, as the Supreme Court of Canada stated in Johns-Manville Canada Inc. v. R., "It is a commonsense appreciation of all the guiding features which must provide the ultimate answer.” (footnote 1).
Paragraph 4 of the Bulletin sets out six criteria to assist taxpayers in determining the nature of an expenditure. In our view, in the situation you have described to us, the following three criteria are the most important:
(a) Enduring benefit - Decisions of the courts indicate that when an expenditure on a tangible depreciable property is made "with a view to bringing into existence an asset or advantage for the enduring benefit of a trade", then that expenditure normally is looked upon as being of a capital nature.
(b) Maintenance or Betterment - Where an expenditure made in respect of a property serves only to restore it to its original condition, that fact is one indication that the expenditure is of a current nature.
(c) Relative value – The amount of the expenditure in relation to the value of the whole property or in relation to previous average maintenance and repair costs often may have to be weighed.
First, we have noted that the method adopted by Taxpayers to allocate expenses between capital and current expenses is not supported by the Bulletin or the jurisprudence.
It is evident that many of the expenses incurred by Taxpayers are of an enduring nature. For example, the modification to the roof, plumbing, electrical work (wiring and boxes), conversion of the heating system, installation of an intercom system, installation of a fire protection system and installation of air exchangers seem to be expenses that are of a capital nature.
However, expenses that are related to the restoration of the building to its original state should be considered as current expenses. For example, it would be reasonable to accept as current expenses the expenses incurred by the Taxpayers to remedy mould problems, which could include a cleaning and drying process and the replacement of drywall, floor coverings and insulation.
Finally, although the relative value of labour in relation to the value of the total property suggests that labour is a capital expenditure, the Bulletin indicates that this ratio is not necessarily decisive in itself, especially where a major repair is an accumulation of minor work that would have been deducted in computing rental income, i.e., treated as an expense of a current nature. In other words, the fact that work was not carried out earlier does not change the nature of the work when it is finished, regardless of its total cost.
Notwithstanding the above criteria from the Bulletin, it is also necessary to determine, as the Tax Court of Canada ("TCC") did in Méthé (footnote 2), whether, at the end of the work, the Taxpayers had a substantially new building, or at least a building that was very different from the original.
In Méthé, the TCC stated that the increase in rental income was the most conclusive evidence that the work done by the taxpayer resulted in a nearly new building and not the same original building. In this case, gross revenues increased from approximately $XXXXXXXX in 2007 to over $XXXXXXXX in 2009. Thus, the increase in gross rental revenues in this case, for the years following the work, will be a factor that will allow us to conclude whether the expenses incurred by the taxpayers were current or capital in nature.
Access to Information
For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should the taxpayer request a copy of this memorandum, they may request a severed copy using the Privacy Act criteria, which does not remove taxpayer identity. Requests for this latter version should be made by you to Ms. Celine Charbonneau at (819) 994-2898. In such cases, a copy will be sent to you for delivery to the taxpayer.
We hope that these comments are of assistance.
François Bordeleau, Advocate
Manager
Business and Partnerships Section
Income Tax Rulings Directorate.
FOOTNOTES
Due to our system requirements, footnotes contained in the original document are reproduced below:
1 [1985] 2 S.C.R. 46
2 Jean Méthé v. The Minister of National Revenue, 86 DTC 1364 (TCC).