1Principal Issues: Whether paragraph 20(1)(z) would apply.
Position: No answer.
Reasons: Question of fact.
FEDERAL TAX ROUNDTABLE OCTOBER 7, 2019
2019 APFF CONFERENCE
Question 2
Payment by a landlord for the termination of a lease
A tenant has lived in a condominium unit since July 1, 2013. Every year since then, the tenant has renewed the lease for a period of 12 months. In February 2019, the unit inhabited by the tenant was sold and a new owner acquired it. Since the unit was rented, the lease and other rights pertaining to it were transferred to the new owner at the time of the transaction.
In Quebec, the law provides that a tenant can stay in his or her dwelling as long as the tenant wishes, if all the conditions of the lease are respected. This is called the right to maintain occupancy. There are exceptions to this rule, however, and repossession is one of them.
The lessor/owner may retake possession of a dwelling, notably for the purpose of living there, by notifying the tenant at least 6 months before the end of the lease. Thus, for a lease ending on June 30, 2019 (as in this case), the notice had to be given no later than December 31, 2018. Considering that retaking possession of the dwelling could not take place, in this case, before July 2020, the new landlord offered the tenant an amount of $15,000 to vacate the dwelling on of April 1, 2019 and the landlord will begin to live in the dwelling at that time. This is therefore an amount paid by the landlord to the tenant to cancel the lease.
Interpretation Bulletin IT-359R2, entitled "Premiums and Other Amounts with Respect to Leases", discusses, among other things, amounts paid to terminate a lease. Paragraph 10 of that Bulletin deals with the termination of a lease prior to December 2, 1982, while paragraph 11 deals with the termination of a lease prior to November 13, 1981. With respect to a lease terminated after December 1, 1982, paragraph 12 provides, in part, as follows:
“12. Where a lease is cancelled after December 1, 1982 and the cancellation was not pursuant to an agreement in writing entered into before December 2, 1982, a payment by a landlord to a tenant for the cancellation of the lease is deductible only in the following manner:
(a) If at the end of a particular taxation year the property remains in the ownership of the landlord who agreed to make the payment or was owned by a person with whom the landlord did not deal at arm's length, a deduction is permitted for that particular year, under paragraph 20(1)(z), of the pro rata portion of the amount paid or payable in respect of the cancellation, amortized over the number of days that remained in the term of the lease (including all renewal periods), not exceeding 40 years, immediately before its cancellation.”
Since the new owner still owns the condo at the end of 2019, it seems possible, under paragraph 20(1)(z), to deduct the entire $15,000 in computing the new owner's rental income for the year 2019.
It is important to note that subsection 20(1) begins by specifying that, notwithstanding paragraphs 18(1)(a), 18(1)(b) and 18(1)(h), in computing a taxpayer’s income for a taxation year from a business or property, there may be deducted amounts listed in the following paragraphs as are wholly applicable to that source or such part of the amounts as may reasonably be regarded as applicable thereto.
In addition, paragraph 18(1)(q) provides that an amount paid or payable by the taxpayer for the cancellation of a lease of property of the taxpayer leased by the taxpayer to another person, is not deductible in computing income from a business or property, except to the extent permitted by paragraph 20(1)(z) or 20(1)(z.1).
Paragraph 20(1)(z) provides that the following is deductible:
“the proportion of an amount not otherwise deductible that was paid or that became payable by the taxpayer before the end of the year to a person for the cancellation of a lease of property of the taxpayer leased by the taxpayer to that person that
- (i) the number of days that remained in the term of the lease (including all renewal periods of the lease), not exceeding 40 years, immediately before its cancellation and that were in the year
is of
- (ii) the number of days that remained in the term of the lease (including all renewal periods of the lease), not exceeding 40 years, immediately before its cancellation,
in any case where the property was owned at the end of the year by the taxpayer or by a person with whom the taxpayer was not dealing at arm’s length and no part of the amount was deductible by the taxpayer under paragraph 20(1)(z.1) in computing the taxpayer’s income for a preceding taxation year;”
On reading the wording of paragraph 20(1)(z), it appears that the $15,000 payment made by the new owner is deductible, since it is an amount that was paid by the taxpayer before the end of the year to a person, the tenant, for the cancellation of a lease of the new owner's condo that was leased by the new owner to the tenant. In addition, subsection 20(1) provides that it applies notwithstanding paragraphs 18(1)(a), (b) and (h).
In that regard, paragraph 13 of Interpretation Bulletin IT-359R2 clarifies that the expression "leased by the taxpayer" in paragraphs 20(1)(z) and (z.1) do not limit the application of these paragraphs to a lessor who was a party to the original lease of the property. It states that the CRA considers that this expression also applies to a subsequent owner (landlord) who takes assignment of a lease and remainder interest upon purchase of the leased property. This would clearly be the case for the new landlord in this case.
Finally, since the lease that was terminated was due to expire in June 2019, the formula in paragraph 20(1)(z) would therefore allow the entire amount paid in 2019 to be deducted.
Questions to the CRA
(a) Can the CRA confirm that the $15,000 paid by the new owner to cancel the tenant's lease would be fully deductible in calculating the new landlord’s rental income in 2019, even if the new landlord moves into the unit following the cancellation and the condo ceases to generate rental income?
(b) In Advance Ruling 2007-0254721R3, the CRA confirmed that an amount received for the early termination of a lease could qualify for the principal residence exemption. The CRA was of the view that the amount received could represent consideration received for the disposition of a property, being the leasehold interest in a housing unit. Furthermore, in the definition of "principal residence" in section 54, such a type of property is specifically stated as one that may be designated as a principal residence.
In order to be able to exempt the gain on this disposition through application of the principal residence exemption rules, the individual will be required to follow certain administrative procedures and designate the unit in question as the individual’s principal residence for a number of years. In this case, can the CRA clarify whether the leasehold interest in the unit was held by the tenant since July 2011, when the tenant moved into the unit, or only since July 2018, when the lease, which was cancelled, was entered into?
CRA Responses
Question 2(a)
In general, paragraph 20(1)(z) allows the lessor of a property to deduct for a year in the manner provided for, a fraction of the amount paid or payable for the termination of a lease, depending on the term of the lease remaining at the time of termination, to the extent that the property was owned at the end of the year by the landlord or a person with whom the landlord was not dealing at arm’s length and no part of the amount was deductible by the taxpayer under paragraph 20(1)(z.1) in computing the taxpayer’s income for a preceding taxation year.
Paragraph 20(1)(z) is applicable notwithstanding paragraphs 18(1)(a), 18(1)(b) and 18(1)(h). However, the amount to be deducted must be applicable wholly or in part to income from a business or property.
Consistently with Stewart v. The Queen (footnote 1), in determining whether a particular activity constitutes a source of income, the taxpayer must demonstrate that the taxpayer intended to carry on that activity in order to realize a profit and to present evidence supporting that intention.
In this case, the leasing activity does not appear to be free from personal aspects and it would be necessary to consider whether it is carried on in a sufficiently commercial manner so as to establish the existence of a source of income.
Whether there is in reality a source of income is a question of fact which can only be determined by taking into account all relevant facts. We cannot make a definitive determination solely on the basis of a summary example.
Furthermore, by virtue of section 67, no deduction can be made in respect of an expense in computing income, except to the extent that such expense was reasonable in the circumstances. The CRA may question the reasonableness of an expense with respect to the source, if the existence of that source requires demonstration.
Furthermore, where an amount is part of the cost of a property, such an amount should not be deducted under subsection 20(1). Whether an amount is part of the cost of a property remains a question of fact.
Question 2(b)
As explained in paragraphs 7 and 8 of Interpretation Bulletin IT-359R2 [archived] (footnote 2), where the tenant of a leased property receives from the owner of that property an amount to obtain the termination of its lease, the CRA considers that that amount constitutes a capital amount for the tenant and that the tenant relinquished a right or rights in respect of a leasehold interest, and that consequently such an amount represents proceeds of disposition of part or all of the leasehold interest.
In Quebec, where there is a civil law system, leasehold interests are generally understood, for the purposes of the Income Tax Act, as a right in a lease. In addition, by virtue of paragraph 248(4.1) and for the purposes thereof, a lease is included in real rights.
The definition of "principal residence" in section 54 provides that a leasehold interest may be a principal residence.
In the context described, the CRA understands that there was a continuation of the residential lease each year and on the transfer of ownership between the old and the new owner. Consequently, there would have been no leasehold disposition until the lease was terminated and the date of acquisition of the leasehold interest should be the time that the lease was acquired by the tenant from the former owner.
Michel Ostiguy
(514) 496-1890
October 11, 2019
2019-081261
FOOTNOTES
Due to our system requirements, footnotes contained in the original document are reproduced below:
1 [2002] 2 S.C.R. 645, 2002 SCC 46.
2 CANADA REVENUE AGENCY, Interpretation Bulletin IT-359R2 [archived], “Premiums and Other Amounts with Respect to Leases”, December 20, 1983.