Principal Issues: Does a lessee who acquires a XXXXXXXXXX % interest in a business on a yearly basis over a XXXXXXXXXX year-period with no buy-out at the end acquire the property at the beginning of the lease?
Position: Question of fact
Reasons: ITTN #21-- Wording of the Agreement
XXXXXXXXXX
2004-007653
C. Tremblay
(613) 957-2139
July 12, 2004
Dear XXXXXXXXXX:
Re: Lease Agreement
This is in reply to your letter of May 13, 2004, wherein you seek our assistance in dealing with a specific lease agreement involving one of your clients.
You indicate that your client (Mr. A) has entered into a written agreement to lease out his XXXXXXXXXX to a lessee (Mr. B) for a period of XXXXXXXXXX years. Mr. B will pay Mr. A the sum of $XXXXXXXXXX per year and will acquire a XXXXXXXXXX% interest in the business every year and at the end of the XXXXXXXXXX year term, Mr. B will own 100% of the business. There is no buy-out at the end of the lease.
Our Comments:
Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5 dated May 17, 2002. Therefore, the following comments are of a general nature only.
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. It is our view that if a lease is, at law, a lease, then it will be treated as a lease for all purposes of the Act. However, in leasing or sales transactions, it is the Canada Revenue Agency's (the "CRA") view that an agreement between the parties can contemplate only one owner of the property in question. Thus, whether the transaction is a lease or a sale, only one party is entitled to the capital cost allowance claim and any related investment tax credits.
Where the automatic transfer of title upon receipt of the last monthly payment is in fact a right to purchase the property at the expiry of the agreement if the lessee has met all the conditions under the agreement, absence a sham, we will not consider that a sale has in fact occurred until the right to purchase is exercised. The Supreme Court held in Shell Canada Ltd. v. The Queen, 99 DTC 5682 that the economic realities of a situation cannot be used to recharacterize a taxpayer's bona fide legal relationships. It held that absent a specific provision of the Act to the contrary or a finding that there is a sham, the taxpayer's legal relationships must be respected in tax cases. Thus, it is our 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. The CRA announced in Income Tax Technical News No. 21, dated June 13, 2001, that ". . . it is our 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, it is our view that a lease is a lease and a sale is a sale."
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. However, in our opinion, a portion of the lease payments could be considered in respect of the right to purchase the property in the future. Therefore, that portion would be considered as the "option" cost to Mr. B and a disposition of property to Mr. A. In our view, where it can be said that there is an "option" to purchase the business and assets at the end of the lease, the rules in section 49 of the Income Tax Act would apply. This "option" amount may be subject to a valuation.
Where the facts indicate that all or a proportion of the lease payments are in respect of the "option", those lease payments or the portion of the lease payments that represents those costs would not be a deductible expense to the lessee.
We trust our comments will be of assistance.
Steve Tevlin
For Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Planning Branch