Dear Mr. Collins:
We are writing in response to your letter which we received on November 8, 1991 and the subsequent telephone discussions you have had with Allan Nelson.
It is our understanding that you are interested in receiving our general comments concerning the appropriate income tax treatment for capital and operating leases of property. You have asked us to distinguish between when a lessor or a lessee is allowed to claim the capital cost allowance and/or investment tax credit in respect of a leased property.
Normally, it is the owner of the leased property that is entitled to claim capital cost allowance and/or investment tax credit in respect of that property. The lessee is entitled to claim, as a current expense, the full amount of lease payments it makes to the lessor .
We have enclosed for your information a copy of Interpretation Bulletin IT-233R, dated February 11, 1983. This bulletin discusses our Department's position concerning whether payments in respect of leasing agreements are in substance payments of rent (operating leases) or payments on account of the purchase price of property (capital leases). In particular, reference is made to paragraph 3 thereof, which lists certain conditions which, if present in a leasing arrangement, indicate a sale has taken place rather than a lease.
If it is determined that in substance a sale has taken place under the terms of a lease agreement, the lessee will be required to account for the transaction as an acquisition of an asset and an assumption of a liability, as at the date the lease was entered into. The lessor will also be required to account for the transaction as a sale of the property and the establishment of a receivable. In these circumstances the lessee-purchaser, rather than the lessor- vendor, may be entitled to capital cost allowance and any investment tax credit in respect of the cost of such property. In addition, the specified leasing property rules, as discussed below, would not apply since there would not be recognition of a lease in respect of that property.
In April, 1989, draft Income Tax Regulations were introduced which have commonly become known as the specified leasing property rules. In March, 1991, section 1100 of the Income Tax Regulations was amended so as to restrict the capital cost allowance deductible by a lessor in respect of specified leasing property owned by the lessor at the end of a taxation year. As requested, we have enclosed a copy of these rules as reported in the March 27, 1991 issue of the Canada Gazette. We have also included a copy of the February 2, 1990 Department of Finance Information Release #90-017, which contains a further explanation of these rules.
Specified leasing property is defined in subsection 1100(1.11) of the Regulations. It refers to all depreciable property leased for a term exceeding one year, with the exception of exempt property, non-arm's length leases and leases of property having a fair market value of $25,000 or less, and in addition excludes certain intangible assets such as certified films, systems software, etc.
Exempt property is defined in subsection 1100(1.13) of the Regulations. It refers to general office equipment and furniture included in Class 8, provided no particular piece has a cost in excess of $1,000,000, furniture, appliances, etc. for residential use, automobiles, trucks or tractors designed for use on highways and trailers therfor, railway cars and buildings, unless leased to a tax exempt entity.
The lessor's available capital cost allowance claim in respect of a specified leasing property is restricted to the lesser of
a) The return of principal during the year based on the following assumptions:
i) that the lessor made a loan to the lessee;
ii) the loan principal for this purpose is equal to the fair market value of the property at the time the lease is entered into;
iii) the rental payments received by the lessor are treated as blended payments of principal and interest; and
iv) the interest rate to be used is prescribed in section 4302 of the Regulations to be 1% above the Government of Canada long term bond rate (bonds of 10 years or more), set on the last Wednesday of the second month preceding the month in which the lease is taken out; and
b) The capital cost allowance otherwise allowable to the lessor for the year if the specified leasing property rules are ignored.
From this formula it can be seen that the specified leasing property rules, in certain instances, effectively look through the lease transaction and treat the lease as a sale and financing of the leased assets by the lessor. This is done by treating the lease as a loan and the lease payments as blended payments of principal and interest. The amount of capital cost allowance the lessor may deduct is then restricted to the notional amount of principal received or receivable.
These specified leasing property rules are for lessors and will not generally alter the tax treatment of lessees. Lessees will continue to be able to deduct the full amount of rental payments in computing income unless they file a joint election under section 16.1 of the Act (section 16.1 provides that a lessee may elect to treat the lease of a specified leasing property as a purchase rather than a lease).
As a result of making this election, rather than claiming a deduction for the lease payments over the term of the lease, the lessee adds the fair market value of the leased property to its appropriate capital cost allowance pool and claims capital cost allowance, thereon.
The lessee is also deemed to have borrowed money from the lessor equal to the fair market value of the property and each payment is deemed to be blended payments of principal and interest. The lessee is able to deduct the interest element of each lease payment.
When the lease expires, the lessee is deemed to have disposed of the property for proceeds equal to the remaining principal amount of the notional loan and the normal rules for recapture of capital cost allowance and for terminal losses apply.
The second paragraph of the Regulatory Impact Analysis Statement (attached to the issue of the Canada Gazette referred to above) gives a brief overview of the after-tax financing advantages which were being experienced prior to the introduction of these new rules. It is our understanding that one of the objectives of the specified leasing property rules was to make the decision as to whether to buy or lease a property tax neutral.
As can be seen from the above discussions, taxation of leases is quite a broad and complex topic. We hope that our general comments will be of assistance to you.
Yours truly,
Section ChiefLeasing & FinancingFinancial Industries DivisionRulings Directorate
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