Principal Issues: The tax implications of a selection of leasing arrangements which would include leases with and without purchase options.
Position: General comments
Reasons: It is a question of fact to be determined based on the legal relationship created by the terms of the agreement- ITTN # 21
XXXXXXXXXX 2008-030365 V. Srikanth April 20, 2009
Dear XXXXXXXXXX :
Re: Tax Implications on Leasing Arrangements
We are writing in response to your December 10, 2008 e-mail, wherein you requested our comments on the tax implications of a selection of leasing arrangements with or without purchase options.
Our Comments
In your submission regarding the tax implications of leasing arrangements, you asked us several specific questions. Please note that the tax treatment of a specific leasing arrangement is a question of fact to be resolved based on documents, and we can only formally comment on it in the context of an advance income tax ruling request, submitted in the manner set out in Information Circular 70-6R5, entitled Advanced Income Tax Rulings. Your request was not submitted in this format. However, as stated in paragraph 22 of IC 70-6R5, we do provide written opinions on general enquiries which are not advance income tax rulings, and we offer you the following general comments regarding leasing arrangements.
At one time, the treatment of leasing arrangements, for tax purposes, by the Canada Revenue Agency ("CRA"), ran substantially in parallel to the accounting treatment, largely being determined by characteristics indicative of the "economic substance" of the arrangement. In this regard, CRA's Interpretation Bulletin IT-233R, "Lease-Option Agreements; Sale-Leaseback Agreements", reflected similar criteria to those applicable to the characterization of lease-option arrangements under generally accepted accounting principles ("GAAP").
However, CRA changed its administrative position with respect to the tax treatment of leasing arrangements and on June 14th, 2001, CRA issued Income Tax Technical News ("ITTN") No. 21, and officially cancelled IT-233R. CRA's new position contrasts with the previous "economic substance over form" approach, and now restricts the characterization question to examining the legal relationship created between the parties to a lease, rather than attempting to arrive at the economic results of the arrangement.
As stated in ITTN No. 21, it is now CRA's view that the determination of whether a contract is a lease or a sale is based on the legal relationships created by the terms of the particular agreement, rather than on any attempt to ascertain the underlying economic reality. Therefore, in the absence of a sham, in our view, a lease is a lease and a sale is a sale.
Option to purchase
Where a lease arrangement does contain an option to purchase, and there is evidence that at the conclusion of the term, customers have exercised the purchase option, in our view, this, on its own, should not be taken as clear evidence that the parties intended that ownership of the goods would eventually be transferred at the time that the agreement was entered into. There is no obligation on the part of the customer to assume ownership of the goods at the expiration of a lease arrangement.
Timing of sale
In Wardean Drilling 69 DTC 5194 (Ex.Ct.), the issue was the date of acquisition with respect to a conditional sale. The taxpayer claimed to have acquired the subject asset when it signed a purchase contract for the asset. The Court rejected this claim stating that the taxpayer must have title or the incidents of title and must have rights in the asset, not just rights in a contract relating to the asset. In the case of a lease, the lessee will usually be regarded as only having rights in a contract relating to the leased property and not rights in the leased property. Thus, it might be argued that the incidents of title approach is only appropriate to determine when a person becomes an owner of an asset, for income tax purposes, in circumstances where it is known that the taxpayer has, or will become, the owner.
Financial lease
Although, in the case of a typical financial lease, the lessee, at the inception of the lease, assumes the normal incidents of title, including possession, use and risk, the Income Tax Act (the "Act") recognizes financing leases as leases and has specific provisions, which have been implemented to curtail the after-tax financing aspects of leasing. A review of the specified leasing rules (Income Tax Regulations 1100(1.1)) and other sections of the Act such as section 16.1, subsections 13(5.2), and 127(9) and paragraph 181.2(3)(f), reveals that the Department of Finance intended that financial leases be considered leases for tax purposes. If we are to follow the legal form of a typical financial lease, then for purposes of the Act, such leases are leases, and will be treated as such.
Whether an agreement between two parties constitutes a lease or some other form of financing, is a question of fact, which can only be determined by reviewing the terms of the agreement between the parties. In our view, if a lease is, at law, a lease, then it will be treated as a lease for all purposes of the Act. If the true relationship between the parties were one of lessor and lessee, the inclusion of a bargain purchase option, would not, in and by itself, change the nature of the transaction.
We trust our comments will be of assistance to you.
Yours truly,
For Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch