Principal Issues: In which class must be included certain property related to amounts expended by a taxpayer in respect of work on leased properties that the taxpayer uses in part for M&P activities?
Position: None.
Reasons: General comments.
May 18, 2022
Ouest-du-Québec Tax Services Office Headquarters
Income Tax Rulings Directorate
XXXXXXXXXX Attention: Christian Gauthier 2018-078876
Subject Capital cost allowances
This is in response to your two memoranda dated October 24, 2018 requesting our comments on the classes of property set out in Schedule II to the Income Tax Regulations (the "Regulations").
Your request primarily concerns XXXXXXXXXX (the "Taxpayer") and specifically asks in which class of this Schedule certain property is included that relates to amounts the Taxpayer has spent on work on property that it leases and uses in part for manufacturing and processing ("M&P") activities.
The classification of a property for capital cost allowance purposes is a question of fact that can only be determined after a complete analysis of all the facts and contracts related to a particular situation. In the context of this request, this determination can only be made after, inter alia, an examination of the legal relationship between the parties in each particular situation, the ownership of each of the properties and the use made of each of the properties.
In addition, since this request concerns several amounts spent on work on several leased properties, it is impossible for us to comment on each of the amounts spent on each of the leased properties. As discussed in a telephone conversation (Gauthier/Landry), the purpose of this letter is to provide you with comments so that you can determine the appropriate tax treatment for each of those amounts spent.
For the purposes of this application, we have assumed that the legal relationship between the parties is one of landlord and tenant in each particular situation. Furthermore, we do not put in issue the characterization of the Taxpayer's M&P business or the characterization of the property involved in this application as capital property within the meaning of section 54 of the Income Tax Act (the "Act"). Similarly, we will not comment in this request on the rate or period of depreciation or on the application of Schedule III of the Regulations or the general anti-avoidance rule.
Unless otherwise stated :
i. all statutory references herein are to the provisions of the Regulations;
ii. any reference herein to a particular class is a reference to that class of property described in Schedule II of the Regulations;
iii. the singular shall include the plural, and vice versa, if the context so requires.
Background
Your request is mainly related to the verification of certain amended tax returns of the Taxpayer, namely for the tax year ending XXXXXXXXXX.
The Taxpayer operates a XXXXXXXXXX network under the XXXXXXXXXX banner. The Taxpayer is a subtenant of several premises in Quebec and Ontario, some of which are used by the Taxpayer for M&P activities. Generally, at the beginning of the subleases, the premises are essentially foundations, walls and roofs ("Shells") on which the Taxpayer must perform work to make them functional for its needs. The work that the Taxpayer has performed on the Shells and that is the subject of this request includes the installation of wall and floor coverings and electrical, ventilation and plumbing work.
You indicated that the work that has been done on the Shells in this case has been performed in the following scenarios:
- work done in a new Shell built by a related or unrelated person;
- work done in an existing Shell owned by an unrelated or related person; and
- work done in a new Shell, which is an extension of existing premises, built by a related person.
Initially, the Taxpayer included certain equipment that it used directly or indirectly primarily for the M&P of goods for sale (the "M&P Properties") in Class 8. However, it is now of the view that such those M&P Properties should instead be included in Class 29.
It is further of the view that a portion of the costs of work done in a Shell, including electrical, ventilation and plumbing work, that it originally included in the capital cost of a Class 13 leasehold interest should also be included in Class 29. The Taxpayer argues that this portion of the costs should be included in the capital cost of the M&P Property as the cost of installing the M&P Property (the "M&P Installation Costs") and as the cost of goods specifically required to perform such installation and to commission the M&P Property (the "M&P Commissioning Property ").
Before looking in more detail at the Taxpayer's position and your position in this request, it is necessary to give a brief overview of the depreciation classes relevant to this application, i.e. Classes 13, 1, 29 and 8.
Relevant depreciation classes
Paragraph 20(1)(a) of the Act allows a deduction in computing income from a business for such part of the capital cost of property at a particular rate as allowed by section 1100 for each of the depreciation classes set out in Schedule II to the Regulations.
A property that is a leasehold interest is generally included in Class 13, except for the portion of the leasehold interest that is included in another Class because of subsections 1100(5) and (5.1). Under subsection 1102(4), the capital cost of a leasehold interest in Class 13 includes any amount expended by a taxpayer for or in respect of an improvement or alteration to a leased property, other than improvements or alterations that are included as a building or structure under subsection 1102(5).
Subsection 1102(5) applies where a taxpayer has a leasehold interest in a property that was acquired by reason of the fact that the taxpayer erected a building or structure on leased land, made an addition to a leased building or structure, or made alterations to a leased building or structure that substantially changed the nature of the property. Where subsection 1102(5) applies, capital costs for improvements or alterations to a leased property are instead included as a building or structure in the relevant prescribed Class, i.e. in paragraph (q) of Class 1 in this request.
Paragraph (q) of Class 1 refers to a building or other structure, or a part of it, including any component parts such as electric wiring, plumbing, sprinkler systems, air-conditioning equipment, heating equipment, lighting fixtures, elevators and escalators (except property described in any of paragraphs (a) to (e) of Class 8).
Furthermore, for property to be included in Class 29 as claimed by the Taxpayer, the property must, inter alia, be used directly or indirectly in Canada primarily for the M&P of goods for sale or lease and otherwise included in Class 8, subject to exceptions that do not apply in this case.
In the context of the present request, it is in particular paragraph (b) of Class 8 that is relevant for determining whether the property is otherwise included in Class 8 for the purposes of Class 29. Paragraph (b) of Class 8 refers in particular to tangible property attached to a building and which is, inter alia, acquired solely for the purpose of supporting machinery or equipment and/or for the purpose of manufacturing and processing.
Taxpayer's Position
As stated above, the Taxpayer is of the view that the M&P Properties originally included in Class 8 should instead be included in Class 29. With respect to the M&P Installation Costs and the costs of M&P Commissioning Property, the Taxpayer is of the view that a portion of these costs is part of the capital cost of the M&P Properties. Consequently, the Taxpayer is of the view that this portion of the costs is included in the same class as the M&P Properties. The Taxpayer argues that the capital cost of a piece of equipment includes costs exclusively for improving that equipment such as ventilation, piping and electricity. Thus, the Taxpayer is of the view that the Taxpayer can make a reasonable allocation of a portion of the costs related to the M&P Installation Costs and the costs related to the M&P Properties and include that portion of the costs in the capital cost of the M&P Properties.
In order to establish this allocation, the Taxpayer used the following methodology, which essentially consists of identifying all of its M&P Properties and then estimating the portion of the costs the Taxpayer considers to be installation and commissioning costs to be included in the capital cost of the M&P Properties:
1. Identification of departments where M&P activities were more than 50%;
2. Identification of each M&P Property in each of those departments. Those M&P Properties were included in Class 29;
3. Following this analysis, the Taxpayer identified the installation activities and the specific items required to perform this installation to commission the M&P Properties (such as ventilation, plumbing and electricity);
4. Following this identification of the installation activities and equipment specifically required to commission M&P Properties, the Taxpayer performed a detailed analysis to estimate the portion of these costs (i.e., the portion of the M&P Installation Costs and the portion of the cost of the M&P Commissioning Property) that were related to the M&P Properties. This portion of the costs was added to the capital cost of the M&P Properties that was included in Class 29.
The Taxpayer is of the view that the Taxpayer holds a leasehold interest in a property that is not subject to subsection 1102(5) in each particular situation. Consequently, it is the Taxpayer's position that any amount spent by the Taxpayer to make improvements or alterations to a leased property forms part of the capital cost of a Class 13 leasehold interest. This is consistent with the Taxpayer's initial treatment of the portion of the M&P Installation Costs and the costs of M&P Commissioning Property as part of the capital cost of a Class 13 leasehold interest.
However, it is the Taxpayer's view that an expenditure included in the capital cost of a Class 13 leasehold interest may also be a property included in paragraph (b) of Class 8 if the conditions are otherwise met. This position is based on the fact that the preamble to Class 8 does not explicitly exclude property otherwise included in the capital cost of a Class 13 leasehold interest: "Property not included in Class 1, 2, 7, 9, 11, 17 or 30 that is (...)".
Based on the documents submitted to us, we understand that the Taxpayer is arguing that the portion of the M&P Installation Costs and cost of the M&P Commissioning Property (i.e., the portion of certain costs determined under the Taxpayer's methodology) fall within paragraph (b) of Class 8. The Taxpayer states that the portion of the M&P Installation Costs and the costs of the M&P Commissioning Property was incurred solely for the purpose of manufacturing and processing since this portion of the costs was necessary for the operation of the M&P Properties. The Taxpayer states that the M&P Properties have their own particularities and require additional electrical, plumbing and ventilation work. Thus, the Taxpayer is of the view that the portion of the M&P Installation Costs and the costs of the M&P Commissioning Property determined according to the Taxpayer’s methodology can be included in Class 29 instead of Class 13.
Your Position
You agree that the Taxpayer is carrying on M&P activities and you do not dispute the Taxpayer's request to reclassify the M&P Properties from Class 8 to Class 29.
However, with respect to M&P Installation Costs and the costs of the M&P Commissioning Property, you argue, contrary to the Taxpayer, that amounts expended by a taxpayer on capital account for improvements or alterations to a leased building must, if the leasehold interest is not subject to subsection 1102(5), be included in the capital cost of the leasehold interest in Class 13. In such a situation, you are of the view that those amounts spent cannot be property included in another Class.
In your view, however, the leasehold interests in the present request fall within the scope of subsection 1102(5). The application of subsection 1102(5) results in the M&P Installation Costs and the costs of the M&P Commissioning Property being included as a building under paragraph (q) of Class 1 or, if the requirements are met, in paragraph (b) of Class 8.
You are of the view, however, that the portion of the M&P Installation Costs and the costs of the M&P Commissioning Property is not otherwise included in paragraph (b) of Class 8 since those costs were not incurred solely to support machinery and equipment or solely to manufacture or process. Consequently, you are of the view that they cannot be included in Class 29.
For these reasons, you believe that the portion of the M&P Installation Costs and the costs of the M&P Commissioning Property is included in paragraph (q) of Class 1.
Finally, you did not comment on the Taxpayer's argument that the portion of the M&P Installation Costs and costs of the M&P Commissioning Property are part of the capital cost of the M&P Properties that it seeks to include in Class 29.
Our Comments
First, we will not comment on the Taxpayer's request to reclassify the M&P Properties from Class 8 to Class 29 since you do not contest this request.
Regarding the treatment of the portion of M&P Installation Costs and costs of the M&P Commissioning Property, we identify the following as essential elements to be analyzed in this request. However, as stated above, our comments remain general so that you will be able to determine in which Class any property related to work on a leased property should be included where a taxpayer uses part of that leased property for M&P activities.
1. Capital cost of a property
The Taxpayer argues that the portion of the M&P Installation Costs and costs of the M&P Commissioning Property are included in the capital cost of the M&P Properties.
The capital cost of a property includes, inter alia, installation costs and costs incurred in bringing the property into service. However, the question of what constitutes "installation costs" or costs "to bring the property into service" is a question of fact that can only be resolved after an examination of all the relevant facts of the situation.
As a general comment, we are of the view that the costs of installing equipment and bringing it into service generally include the costs of connecting it, for example to the building's electrical system, to the extent that these costs are identifiable and serve only that equipment.
On the other hand, improvements to premises, such as to the electrical system to meet the particular needs of a piece of equipment, which are incorporated into the premises are generally not costs of installing that equipment or of bringing it into service. Similarly, a portion of the costs of such improvements may not be added to the capital cost of the equipment, even if the equipment benefits from the improvements.
If you determine that the portion of the M&P Installation Costs and the costs of the M&P Commissioning Property represents installation costs and expenses incurred to bring an M&P Property into service, the portion of those costs will therefore be included in the same Class as the M&P Property.
By the same token, if you determine instead that the portion of the M&P Installation Costs and the costs of the M&P Commissioning Property does not represent installation costs and expenses incurred to bring an M&P Property into service, the portion of those costs will not be included in the same Class as the M&P Property. Instead, the M&P Commissioning Property will be included in the Class appropriate to the M&P Commissioning Property itself, for example electrical wiring and plumbing pipes ("Particular Property"). Only in this case is the analysis seeking to determine the appropriate Class for a Particular Property relevant, including the analysis of Class 13 or paragraph (b) of Class 8.
Before commenting on whether a Particular Property falls within paragraph (b) of Class 8 as argued by the Taxpayer, we will first comment on the extent to which the capital cost of a Particular Property is included in the cost of a Class 13 leasehold interest.
2. Legal nature of the contractual relationship - Leasehold
In order to determine whether the capital cost of a Particular Property is included in the cost of a Class 13 leasehold interest, it is necessary to determine whether the Taxpayer holds a leasehold interest in each particular situation based on the legal nature of the contractual relationship between the parties.
As discussed in paragraphs 3 and 4 of Interpretation Bulletin IT-464R (archived) Capital Cost Allowance - Leasehold Interests ("IT-464R"), a leasehold interest is the interest of a tenant in any leased tangible property. A tenant who leases property acquires a leasehold interest in that property regardless of whether or not any capital cost is incurred in respect of that interest. However, a depreciable property is not considered to have been acquired until a capital cost has been incurred in respect of that property. A tenant who has acquired a sublease is considered to have acquired a leasehold interest.
In order to continue the analysis of this request, we have assumed for the purposes of this request that the Taxpayer holds a leasehold interest in each particular situation. If, however, it turns out after analyzing the nature of the legal relationship between the parties that the Taxpayer has not acquired a leasehold interest in a particular situation, then the comments on Class 13 would not apply in that case.
3. Amount spent on improvements or alterations to leased property pursuant to subsection 1102(4)
Subject to the application of subsection 1102(5), subsection 1102(4) provides that the capital cost of a property that is a Class 13 leasehold interest includes any amount expended by a taxpayer for or in respect of an improvement or alteration to a leased property.
We are of the view that an amount expended is for the making of improvements or alterations to a leased property within the meaning of subsection 1102(4) where such expended amount relates to property that is incorporated into the leased property and becomes the property of the lessor.
Similarly, we are of the view that an expended amount is not for the making of improvements or alterations to a leased property within the meaning of subsection 1102(4) where the expended amount spent relates to a property that is not incorporated into the leased property or relates to a property that is incorporated into the leased property but remains the property of the lessee.
Generally, the owner of a building owns everything that is joined to the building. Consequently, a tenant generally only acquires a leasehold interest in a property owned by another person when the improvements or alterations made by the tenant to that property are incorporated into it. However, the contract between the parties may provide otherwise. An analysis of each contract is therefore necessary in determining the ownership of a Particular Property in a particular situation.
This issue was discussed as a general matter in The Queen v Mount Robson Motor Inn Limited (footnote 1) where the Federal Court of Appeal held that a tenant's right to remove improvements or alterations made by the tenant to a leased property and incorporated into it did not make the tenant the owner:
“The law on the subject seems to be reasonably clear. When chattels are physically attached to land they may either retain their identity and remain chattels or become part of the land, in which case they are called fixtures. As fixtures are really part of the land once attached to the land, they become the property of the owner of the land; and this is true, as long as the articles remain attached to the land, whether or not the person who affixed them to the land has retained the power to sever and remove them.
It may be difficult, in certain cases, to determine whether or not a chattel has been so attached to the land as to become a chattel. However, it is clear, I think, that ordinary buildings and an asphalt pavement like the improvements here in question are normally considered to be fixtures. When such improvements are constructed by a tenant, they become the property of the owner of the land. In order for the buildings and pavement here in question to have retained their identity as chattels and remained the property of the lessee, if it were at all possible, a clear indication of that intention should have been found in the lease. Now the sole clause of the lease which, at first sight, would appear to have a bearing on the subject is clause 10 which gives to the lessee the right to remove the buildings and improvements at the end of the lease. That clause, however, has in effect no bearing at all on this question since, as long as it remains attached to the land, an improvement made by a tenant remains a fixture even if it may be removed by the tenant either during or at the end of the lease.” (Our emphasis)
In addition, in Park Mobile Home Sales Ltd et al v MNR (footnote 2) , the Tax Court of Canada adopted this test from The Queen v Mount Robson Motor Inn Limited and concluded that improvements or alterations made by a lessee to a leased property and incorporated therein, when they become the property of the lessor at the end of the lease, were amounts expended for the purpose of making improvements or alterations to a leased property within the meaning of subsection 1102(4) :
“Whereas the systems within the ground, such as water system, electrical system, sewer system are all fixtures in land to be reverted to the grantor at the end of the lease, they constitute only a leasehold interest for the appellant company and should be classified in Class 13 as leasehold interest to be amortized over the period of the lease.[…]” (our emphasis)
If you determine after analyzing a particular situation that the capital cost of a Particular Property is not an amount expended to make improvements or alterations to the leased property pursuant to subsection 1102(4), the capital cost of the Particular Property will not be included in the capital cost of the Class 13 leasehold interest. Whether this Particular Property otherwise falls within paragraph (b) of Class 8 will be discussed later in this document under a separate heading.
If you instead determine after analyzing a particular situation that the capital cost of a Particular Property is an amount spent to make improvements or alterations to the leased property pursuant to subsection 1102(4), that cost must be included in the capital cost of the Class 13 leasehold interest unless the leasehold interest is subject to subsection 1102(5).
A Particular Property, the capital cost of which is otherwise included in the capital cost of a leasehold interest that is included in Class 13 pursuant to subsection 1102(4) and that is not subject to subsection 1102(5), could nevertheless be included in Class 29 instead of Class 13 if all the requirements of Class 29 are satisfied. One of those requirements is that the Particular Property be otherwise included in paragraph (b) of Class 8. As stated in paragraph 4 of Interpretation Bulletin IT-472 (archived) Capital Cost Allowance - Class 8 Property, it is not necessary that the building, to which this property is attached, be owned by the taxpayer to qualify for the inclusion of that property in Class 8.
Alternatively, if you determine after analyzing a particular situation that the leasehold interest falls within the scope of subsection 1102(5), the capital cost of the Particular Property should instead be included as a building or structure in the relevant prescribed class, i.e., in such a situation, within paragraph (q) of Class 1, unless it falls within, in particular, paragraph (b) of Class 8.
Before commenting on whether a Particular Property falls within paragraph (b) of Class 8, we will comment on the application of subsection 1102(5).
4. Application of subsection 1102(5)
Pursuant to subsection 1102(4), the capital cost of a Class 13 leasehold interest does not include the portion of the leasehold interest that is included in another Class pursuant to subsection 1102(5). Recall that subsection 1102(5) applies, inter alia, where the taxpayer has a leasehold interest in a property that was acquired by reason of the fact that the taxpayer
- erected a building or structure on leased land,
- made an addition to a leased building or structure, or
- made alterations to a leased building or structure that substantially changed the nature of the property.
Where subsection 1102(5) applies, the property described in subsection 1102(5) is included in another Class such as a building or structure. In this case, it may be necessary in some instances to allocate the capital cost of a leasehold interest among various prescribed classes.
The Act does not define the expressions "erected a building or other structure on leased land", "made an addition to a leased building or other structure" or "made alterations to a leased building or structure that substantially changed the nature of the property". Determining whether a leasehold interest is included in another class by virtue of subsection 1102(5) is therefore a question of fact that can only be determined after a full analysis of all the circumstances of each particular situation of the Taxpayer. Having said this, the following general comments can be made.
Regarding the concept of "erecting a building or other structure on leased land" within the meaning of subsection 1102(5), paragraph 1 of Interpretation Bulletin IT-79R3 (archived) Capital Cost Allowance – Buildings or Other Structures ("IT-79R3") indicates that "building" is a term of wide range covering any structure with walls and a roof affording protection and shelter, and that the word "structure" includes anything of substantial size that is built up from component parts and intended to remain permanently on a permanent foundation.
In light of the meaning of the terms "building" and "structure" in paragraph 1 of IT-79R3, a Shell, which is a structure with walls and a roof, may generally be considered a building or other structure for purposes of subsection 1102(5). Consequently, the Taxpayer is not considered to have erected a building, i.e., the Shell, for purposes of subsection 1102(5) where that building was erected by another taxpayer.
As for the concept of "addition", we are of the view that it generally refers to an extension to a leased building or other leased structure.
Finally, with respect to what constitutes "alterations to a leased building or structure that substantially changed the nature of the property,” paragraph 21 of IT-464R indicates that it is difficult to provide general rules on this subject and that it is a question of fact that depends on the extent of the modifications. The following may serve as a guide:
(a) the conversion by a tenant of one room into an office, or of one room into two rooms, is not such a change;
(b) a new store front, in itself, is not such a change; but
(c) the conversion by a tenant of a house into a duplex, apartment, offices or stores is such a change.
Generally, alterations to a property do not materially change the nature of the property if, after the alterations, the use and size of the property remain the same. For example, work on a property that was, prior to the work, used for the operation of a grocery shop will not, in and of itself, generally have the effect of substantially changing the nature of the property if, after the work, the property is still used to operate a grocery shop of the same size. However, we are of the view that the addition of M&P space that was not present in the grocery shop prior to the work may result in a substantial change in the nature of the property.
Similarly, we are of the view that alterations to a property materially change its nature where the property has no particular purpose before the work is carried out but does have a particular purpose after the work is carried out. Consequently, we are generally of the view that work done to a Shell is an alteration that materially changes the nature of the property for the purposes of subsection 1102(5).
Finally, here are our comments on whether a Particular Property comes within paragraph (b) of Class 8.
5. Paragraph (b) of Class 8
The Taxpayer states that the wording of paragraph (b) of Class 8, reproduced below, does not expressly exclude property otherwise included in Class 13:
“Property not included in Class 1, 2, 7, 9, 11, 17 or 30 that is
[…]
(b) tangible property attached to a building and acquired solely for the purpose of
(i) servicing, supporting or providing access to or egress from, machinery or equipment,
(ii) manufacturing or processing, or
(iii) any combination of the functions described in subparagraphs (i) and (ii);”
We agree with the Taxpayer on this point. That said, in order to be included in paragraph (b) of Class 8, a property must still meet the requirements of that paragraph, whether or not it is otherwise included in Class 13.
The word "solely" used in the phrase "acquired solely" in paragraph (b) of Class 8 is not defined in the Act and consequently must be given its ordinary meaning. The electronic version of Le dictionnaire français Larousse defines it as meaning "de façon unique, exclusive" or "indique une restriction". The Oxford Dictionary, in its electronic version, gives the following meaning to the English equivalent term "solely": "only; not involving somebody/something else".
However, the Taxpayer refers to Technical Interpretation 2002-0139357 to argue that the term "solely" in paragraph (b) of Class 8 should be interpreted broadly. This interpretation effectively indicates that a strict interpretation of the term "acquired solely" in paragraph (b) of Class 8 would result in no property being covered by that paragraph. As a result of that commentary, we concluded that columns and walls supporting a crane runway system used to carry a large capacity overhead crane could be included in Class 8 to the extent that they were acquired "solely" to support machinery or equipment. However, we also concluded in that interpretation that columns and metal cladding that form the walls and roof of a building were not acquired solely for the purpose of manufacturing or processing since their use was twofold. In fact, these assets acted both as walls and roof for the building and as support for manufacturing and processing machinery.
You must therefore ensure in a particular situation that the acquisition of the improvements was not for any purpose other than manufacturing or processing. Generally, property is not acquired solely for supporting machinery or equipment and/or to manufacturing or processing for the purposes of paragraph (b) of Class 8 if it is necessary for the proper functioning of the building, such as the walls, roof and electricity of or for a building. While it is necessary to make a detailed analysis of all the facts surrounding a particular situation to determine whether a Particular Property qualifies for inclusion in paragraph (b) of Class 8, we are of the view that a portion of a Particular Property is not acquired solely for the purpose of supporting machinery or equipment and/or for manufacturing or processing for the purposes of paragraph (b) of Class 8 where it is necessary for the proper functioning of the building.
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. After a 90-day waiting period, a severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. You may request an extension of this 90-day period. The severing process removes all content that is not subject to disclosure, including information that could reveal the identity of the taxpayer. The taxpayer may ask for a version that has been severed using the Privacy Act criteria, which does not remove taxpayer identity. You can request this by e-mailing us at: ITRACCESSG@cra-arc.gc.ca. A copy will be sent to you for delivery to the taxpayer.
Best regards,
Isabelle Landry
Interim Manager
Business and Employment Income Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
FOOTNOTES
Due to our system requirements, footnotes contained in the original document are reproduced below:
1 [1981] CTC 345
2 [1983] CTC 2635