[1996] 3 F.C. 858
A-348-94
Her Majesty the Queen (Appellant)
v.
Toronto College Park Limited (Respondent)
Indexed as: Toronto College Park Ltd. v. Canada (C.A.)
Court of Appeal, Strayer and Robertson JJ.A. and Chevalier D.J.—Toronto, June 6; Ottawa, June 25, 1996.
Income tax — Income calculation — Deductions — Appeal from trial judgment holding “tenant inducement payments” running expenses (not reasonably traceable directly to source of revenue), fully deductible in year of payment — After trial judgment rendered, F.C.A., in Canada v. Canderel, holding tenant inducement payments not running expenses as relate to particular source of income, capable of being matched, must be so matched — Income Tax Act, s. 18(9) requiring taxpayers to amortize certain prepaid expenses relating to more than one taxation year, enumerating exceptions — S. 18(9) not codifying rule of full deductibility, but clarifying prepaid expenses to be amortized when calculating profit — Canderel merely adding exception to statutory list — Promulgation of judicial exception to rule not rendering statutory exceptions redundant — That expense can be amortized not meaning can be matched — S. 18(9) requiring certain prepaid expenses to be amortized regardless of whether classified as running expenses — Canderel not rendering s. 18(9) meaningless — Alternatively, question not which GAAP giving truer picture, but whether expense can be matched with specific source of revenue — If so, must be amortized — Since option to renew within tenant’s control, tenant inducement payments should be matched with revenues over initial term of lease for which tenant having obligation to pay rent.
This was an appeal from the trial judgment allowing an appeal from an assessment in respect of the taxpayer’s 1983 taxation year. The Trial Judge held that “tenant inducement payments” were “running expenses” and therefore fully deductible in the year of payment. A running expense is an expense which cannot reasonably be traced or allocated directly to a corresponding item of revenue. Two years after the trial judgment was rendered, the Federal Court of Appeal in Canada v. Canderel held that tenant inducement payments were not running expenses as they relate to a particular source of income and therefore are capable of being “matched”, and must be so matched for tax purposes. The respondent submitted that Canderel was wrongly decided because it rendered subsection 18(9) redundant and meaningless. It maintained that prior to Canderel the general rule was one of full deductibility in the year the expense was incurred, and that Income Tax Act, subsection 18(9), which requires taxpayers to amortize certain prepaid expenses where they relate to more than one taxation year, codified this general rule while enumerating the exceptions. The respondent submitted that only in respect of the exceptions specifically noted in subsection 18(9) is a taxpayer prohibited from deducting fully the expense in the year it was made or incurred. That list of exceptions did not include tenant inducement payments. Alternatively, the respondent argued that the Minister had failed to show that amortization of the tenant inducement payments over the term of the leases provided a truer picture of the taxpayer’s income and, therefore, it was entitled to deduct the entire expense as was permitted under generally accepted accounting principles prevailing at the time the payments were made.
Held, the appeal should be allowed.
Subsection 18(9) was not intended to codify the so-called general rule permitting full deductibility of all expenses in the year the expenditure was made, but to clarify that, with respect to certain prepaid expenses, taxpayers would be obligated to use the amortization method of accounting when computing profit under section 9.
Furthermore, the promulgation of a judicial exception to a rule does not render the statutory exceptions redundant. At most, Canderel added another exception to the statutory list of expenses which require amortization.
Prepaid expenses of the kind specified in subsection 18(9) are not always non-running expenses. Prepaid expenses can be amortized over a period of years, but that does not mean that they can be matched to a specific source of income. For example, subsection 18(9) requires that prepaid rents and prepaid service contracts be deferred and amortized irrespective of whether they would be classified as a running expense. The rule in Canderel does not render subsection 18(9) meaningless.
As to the alternative argument, the issue is not which of the three GAAP options gives the truer picture of the taxpayer’s profit, but whether an expense can be matched with a specific source of revenue. If it can, then it must be amortized.
Since the option to renew is within the exclusive control of the tenant, and since it is mere speculation as to whether the renewal option will ever be exercised, tenant inducement payments should be matched with revenues over the initial term of the lease for which the tenant has an existing obligation to pay rent.
STATUTES AND REGULATIONS JUDICIALLY CONSIDERED
Income Tax Act, S.C. 1970-71-72, c. 63, ss. 9, 18(9) (as enacted by S.C. 1980-81-82-83, c. 48, s. 9).
Income Tax Act, R.S.C., 1985 (5th Supp.), c. 1, s, 18(9) (as am. by S.C. 1994, c. 7, Sch. VIII, s. 8; 1995, c. 3, s. 6).
CASES JUDICIALLY CONSIDERED
APPLIED:
Canada v. Canderel Ltd., [1995] 2 F.C. 232 [1995] 2 C.T.C. 22; (1995), 95 DTC 5101; 179 N.R. 134 (C.A.); leave to appeal to S.C.C. refused [1995] 3 S.C.R. v.
CONSIDERED:
Cummings (J L) v The Queen, [1981] CTC 285; (1981), 81 DTC 5207; 37 N.R. 574 (F.C.A.).
REFERRED TO:
Minister of National Revenue v. Tower Investment Inc., [1972] F.C. 454; [1972] CTC 182; (1972), 72 DTC 6161 (T.D.); Associated Investors of Canada Ltd. v. Minister of National Revenue, [1967] 2 Ex. C.R. 96; [1967] C.T.C. 138; (1967), 67 DTC 5096; Naval Colliery Company, Limited v. Commissioners of Inland Revenue (1928), 12 T.C. 1017 (K.B.); Symes v. Canada, [1993] 4 S.C.R. 695; (1993), 110 D.L.R. (4th) 470; 19 C.R.R. (2d) 1; [1994] 1 C.T.C. 40; 94 DTC 6001; 161 N.R. 243; Canderel Ltd. v. Canada, [1994] 1 C.T.C. 2336; (1994), 94 DTC 1133 (T.C.C.).
AUTHORS CITED
Lewin, R. “Tax Treatment of Lease Inducements and At-Risk Rules and the New Limited Recourse Debt Rules” in Corporate Management Tax Conference, 1995. Real Estate Transactions: Tax Planning for the Second Half of the 1990s. Toronto: Canadian Tax Foundation, 1995.
Revenue Canada, Taxation. Interpretation Bulletin IT-417R. Ottawa: Revenue Canada, July 5, 1982.
APPEAL from trial judgment (Toronto College Park Ltd. v. Canada, [1994] 1 C.T.C. 194; (1993), 94 DTC 6172; 71 F.T.R. 30 (F.C.T.D.)) holding that “tenant inducement payments” were “running expenses” and therefore fully deductible in the year of payment. Appeal allowed.
COUNSEL:
J. S. Gill and David E. Spiro for appellant.
Michael E. Barrack and Thomas B. Akin for respondent.
SOLICITORS:
Deputy Attorney General of Canada for appellant.
McCarthy, Tétrault, Toronto, for respondent.
The following are the reasons for judgment rendered in English by
Robertson J.A.: This is an appeal from a judgment of the Trial Division allowing the respondent taxpayer’s appeal from an assessment of the Minister of National Revenue in respect of its 1983 taxation year. In the decision below, now reported at [1994] 1 C.T.C. 194, the learned Trial Judge held that certain “tenant inducement payments” made by the respondent were “running expenses” and, therefore, fully deductible in the year of payment. At law, a running expense is an expense which cannot reasonably be traced or allocated directly to a corresponding item of revenue. In concluding that the inducement payments were “running expenses” the Trial Judge relied principally on an earlier decision of this Court, Cummings (J L) v The Queen , [1981] CTC 285 (F.C.A.). In Cummings this Court characterized a payment made by a taxpayer to indemnify a prospective tenant with respect to its liability arising from the cancellation of an existing lease—a lease pick up payment—as a running expense. Cummings was decided in 1981. The decision under appeal was rendered in 1993. Two years later this Court in Canada v. Canderel Ltd., [1995] 2 F.C. 232(leave to appeal to the Supreme Court of Canada refused August 17, 1995 [[1995] 3 S.C.R. v]) was required to consider the tax treatment to be accorded tenant inducement payments.
In Canderel it was held that tenant inducement payments are not running expenses, as they relate to a particular source of income and, therefore, are capable of being “matched”, and must be so matched for tax purposes (see Stone J.A., at page 239, Robertson J.A. concurring). Assuming that the rent remains constant over the term of the lease matching can be achieved by way of amortization (see Desjardins J.A., at page 270). The Court distinguished Cummings on the basis that the characterization therein of a lease-pick up payment as a running expense was obiter. In that case, the only issue before the Court was whether the lease pick-up payment was made on account of capital or income.
The appellant’s position before us is straightforward. Applying the law as stated in Canderel, the respondent, in computing its profit within the meaning of section 9 of the Income Tax Act [S.C. 1970-71-72, c. 63] (the Act), is not entitled to deduct the entire amount of the two tenant inducement payments in the taxation year in which they were paid. Rather they must be deferred and amortized over the life of the respective leases. In the present case, one lease provides for a term of 20 years, with an option to renew for a further five years. The other lease is for a term of 11 years and five months. (With respect to the possible tax treatment of a renewal term see discussion infra.) More precisely, the appellant maintains that the tenant inducement payments must be “set off” or “matched” against revenues over the respective terms of the leases rather than being deducted entirely in the year in which they were paid. As is obvious, the issue in this case is strictly one of timing. The irony is that because of the decision of this Court in Canderel, the respondent was required to assume the role of protagonist. Thus, the success of this appeal turns on the validity of the respondent’s submissions.
The respondent’s position is equally straightforward: Canderel was “improperly” decided, the Court having failed to consider the effect of subsection 18(9) [as enacted by S.C. 1980-81-82-83, c. 48, s. 9] of the Act in reaching its conclusion. The thrust of the respondent’s argument is that the scheme of the Act allows it to deduct the inducement payments in the year they are made or incurred and that the legal effect of the decision in Canderel is to undermine that scheme by rendering subsection 18(9) “redundant” or “meaningless”. Curiously enough this argument appears to have been raised before the Tax Court in Canderel, but not addressed by the Tax Court Judge: see Canderel Ltd. v. Canada, [1994] 1 C.T.C. 2336 (T.C.C.). It is also evident that it was not pursued before the Court of Appeal.
Alternatively, the respondent argues that in the circumstances of this case the Minister failed to show that amortization of the tenant inducement payments over the term of the respective leases provides a truer picture of the taxpayer’s income and, therefore, it is entitled to deduct the entire expense as was permitted under generally accepted accounting principles (the GAAP rules) prevailing at the time the payments were made. I shall deal with each of these submissions in turn.
The respondent submitted that the rule in Canderel renders subsection 18(9) of the Act redundant or meaningless and, therefore, that case must be deemed to have been wrongly decided. The argument rests initially on the taxpayer’s understanding of the law as it stood prior to Canderel. That understanding was expressed as follows. If an expenditure is classified as a running expense a taxpayer must deduct the amount fully in the year in which it is paid. The only exception is said to arise in cases where an amount paid is not characterized as an expense at the time it was incurred, but later becomes an expense. The cases of Minister of National Revenue v. Tower Investment Inc., [1972] F.C. 454 (T.D.) and Associated Investors of Canada Ltd. v. Minister of National Revenue, [1967] 2 Ex. C.R. 96, respectively, were cited in support of those propositions. With respect to all other expenses, counsel for the respondent maintained that the taxpayer retains the option of either deducting the expense in the year incurred or deferring and amortizing it. In oral argument, counsel also submitted that the taxpayer’s decision whether to deduct in the year the payment is made remains unaffected by the GAAP rules. In its written submissions the respondent took the position that taxpayers are entitled to calculate their income in accordance with generally accepted principles and that where more than one method of calculation is acceptable taxpayers retain the option of selecting an acceptable method regardless of the type of expense involved: see respondent’s memorandum of fact and law at paragraph 21. However, for purposes of deciding this appeal, and in dealing with the substance of the respondent’s argument, I do not find it necessary to resolve the perceived inconsistency.
In summary, the respondent maintained that prior to Canderel taxpayers were not, as a general rule, required to defer and amortize current expenses. The general rule is one of full deductibility in the year the expense is incurred or made. Furthermore, it was submitted that this general rule is now codified in subsection 18(9) of the Act [R.S.C., 1985 (5th Supp.), c. 1 (as am. by S.C. 1994, c. 7, Sch. VIII, s. 8; 1995, c. 3, s. 6)] of which the relevant provisions read as follows:
18. …
(9) Notwithstanding any other provision of this Act,
(a) in computing a taxpayer’s income for a taxation year from a business or property (other than income from a business computed in accordance with the method authorized by subsection 28(1)), no deduction shall be made in respect of an outlay or expense to the extent that it can reasonably be regarded as having been made or incurred
(i) as consideration for services to be rendered after the end of the year,
(ii) as, on account or in lieu of payment of, or in satisfaction of, interest, taxes (other than taxes imposed on insurance premiums), rent or royalty in respect of a period after the end of the year, or
(iii) as consideration for insurance in respect of a period after the end of the year, other than
(A) where the taxpayer is an insurer, consideration for reinsurance, and
(B) consideration for insurance on the life of an individual under a group term life insurance policy where all of part or the consideration is for insurance that is (or would be if the individual survived) in respect of a period that ends more than 13 months after the consideration is paid;
(b) such portion of each outlay or expense (other than an outlay or expense of a corporation, partnership or trust as, on account of, in lieu of payment of or in satisfaction of, interest) made or incurred as would, but for paragraph (a), be deductible in computing a taxpayer’s income for a taxation year shall be deductible in computing the taxpayer’s income for the subsequent year to which it can reasonably be considered to relate; [Emphasis added.]
It is common ground that the legal effect of the foregoing provision is that taxpayers are required to amortize certain prepaid expenses where they relate to more than one taxation year. Counsel for the respondent argued that subsection 18(9) has the effect of codifying the general rule while enumerating the exceptions. Only in respect of the exceptions specifically noted in subsection 18(9) of the Act is a taxpayer prohibited from deducting fully the expense in the year it was made or incurred. That list of exceptions does not, of course, include tenant inducement payments. Against this background the respondent argued that if amortization of a tenant inducement expense is required automatically under the rule in Canderel, subsection 18(9) becomes redundant and the “but for” language found in paragraph 18(9)(b) rendered “nonsensical”. I cannot accede to this submission for several reasons.
The initial flaw in the respondent’s submission can be traced to the mistaken belief that subsection 18(9) was intended to codify the so-called general rule permitting full deductibility of all expenses in the year the expenditure was made or incurred. The more plausible explanation is that Parliament wished to make clear that, with respect to certain prepaid expenses, taxpayers would be obligated to use the accrual or amortization method of accounting when computing profit under section 9 of the Act. In effect, taxpayers are required to defer and amortize those prepaid expenses identified in subsection 18(9) over the period to which they reasonably relate. That the purpose underlying subsection 18(9) is to remove any ambiguity is reinforced by the Department of National Revenue’s Interpretation Bulletin IT-417R which reads in part:
2. As a general rule, taxpayers are required to use the accrual method of accounting to calculate the income from a business or property as contemplated by section 9. In calculating income for tax purposes, the Department requires that the accounting for prepaid expenses and deferred charges be in accordance with the matching principle as required in generally accepted accounting principles, subject always to any contrary provision of the Act.
3. To remove any uncertainty, subsection 18(9) of the Act was enacted into law on February 26, 1981 effective from December 11, 1979 and requires a taxpayer to match certain specific expenditures to the taxation year to which they can reasonably be considered to relate. The Department takes the view that subsection 18(9) was enacted for greater certainty and notwithstanding that it does not cover deferred charges or all types of expenses that can be prepaid, it is considered that the Income Tax Act (even as it read prior to the introduction of subsection 18(9)) always required and continues to require that all costs that could clearly be related to future periods be expensed in those periods, if they are material and if failure to defer the expense would distort the net profit not only of the year during which the expense was incurred but also of the subsequent year or years to which the benefit relates.
The argument that Canderel had the effect of rendering subsection 18(9) redundant is also flawed in at least one other material respect. Assuming, and without deciding, that the general rule is as stated by the respondent, it does not follow that the promulgation of a judicial exception to a rule has the effect of rendering the statutory exceptions redundant. At most, it could be said that Canderel had the effect of adding another exception to the statutory list of expenses which require amortization. On further reflection, however, the redundancy argument is most likely premised on the assumption that prepaid expenses and tenant inducement payments fall into the same category; that is to say non-running expenses. Presumably, it is open to argue that Canderel stands for the proposition that expenses which can be matched must be amortized and therefore there is no need for subsection 18(9) to list other kinds of expenses which meet this criteria. The rule in Canderel would be broad enough to capture the statutory exceptions, thereby rendering them redundant.
In my view the flaw in the argument can be traced to the mistaken assumption that prepaid expenses of the kind specified in subsection 18(9) are, or could be, classified as non-running expenses as are tenant inducement payments. There is no doubt that prepaid expenses can be amortized over a period of years. But it does not follow that they can be matched to a specific source of income. In short, simply because an expense can be amortized does not mean it can be matched. Subsection 18(9) provides two examples which illustrate the validity of that distinction.
Subparagraph 18(9)(a)(ii) requires that prepaid rents be amortized over the period to which they relate. It is difficult to envisage a situation in which the payment of an overhead expense such as rent could reasonably or directly be attributed to the production of a specific revenue, that is matched with a corresponding item of revenue, as opposed to general expenditures paid to earn future and speculative income. Arguably, it is improbable that prepaid rent would be classified as a non-running expense and, as a result, even though amortization is possible, it would not be required but for subsection 18(9) of the Act.
Similarly, subparagraph 18(9)(a)(i) relates to prepaid service contracts which would include, for example, a two-year contract for the repair and maintenance of a building. This is a classic example of an overhead expense which cannot be related directly to a specific source of income: see Naval Colliery Company, Limited v. Commissioners of Inland Revenue (1928), 12 T.C. 1017 (K.B.), at page 1027. This is certainly true if the building in question were occupied by the taxpayer, and the same holds if the building were being rented to tenants. Once again, subsection 18(9) has the effect of requiring that that type of prepaid expense be deferred and amortized, irrespective of whether it would be classified as a running expense. Accordingly, in my opinion, the rule in Canderel does not render subsection 18(9) meaningless and, therefore, the respondent’s argument must also fail on this ground. This leads me to the alternative argument.
The respondent’s final argument is that the Minister failed to establish that the deferral and amortization of the tenant inducement payments provides a “truer picture” of the taxpayer’s net income when contrasted with the expensing or capitalization methods. The respondent relies on the fact that at trial it was agreed that GAAP permitted either the deferral, expensing or capitalization of tenant inducement payments and that neither party would produce evidence as to which of the three options was preferable. That the onus rests on the Minister to establish whether the deferral method represents a truer picture of the respondent’s income is said to arise from the fact that in reassessing the respondent the Minister treated the tenant inducement payments as eligible capital expenditures, while at trial the Minister took the position that the payments should be deferred over the term of the respective leases, including any renewal term. The respondent submits that in changing his position, the Minister assumed the onus of adducing evidence in support of its position. In my view, this argument also fails.
According to the analysis provided in Canderel, the issue is not which of the three GAAP options gives the truer picture of the taxpayer’s profit or net income. Rather the question is whether an expense in question can be matched with a specific source of revenue. If it can, then it must be amortized. In Canderel this Court was unanimous in holding that tenant inducement payments could be so matched and therefore the “amortization method is the only method acceptable for income tax purposes” (per Desjardins J.A., at page 270). That conclusion stands as a matter of law and is unaffected by whatever expert testimony might have been proffered with respect to the suitability or appropriateness of any one of the options outlined in GAAP. As is well known, the calculation of “profits” under section 9 of the Act is a question of law: see Symes v. Canada, [1993] 4 S.C.R. 695, at page 723.
Parenthetically, I note that the materials filed with the Court refer to the fact that as of 1990 GAAP states: “Where the costs are associated with negotiating and executing of a specific lease and these costs have a useful life no longer than the lease to which they relate, the costs should be amortized”: see R. Lewin, “Tax Treatment of Lease Inducements and At-Risk Rules and the New Limited Recourse Debt Rules”, in Real Estate Transactions: Tax Planning for the Second Half of the 1990s , Corporate Management Tax Conference, 1995 (Canadian Tax Foundation, 1995) at page 5:4. That this Court in Canderel came to the same conclusion, albeit by a different route, is a testament to the fact that tax law and accounting principles can be, on occasion, in harmony.
There is one other matter which was touched on during oral argument, but not pursued by the parties. While the matter may or may not be relevant to the ultimate resolution of this case, a brief discussion is warranted. The appellant seeks a judgment to the effect that the tenant inducement payments are to be “set off (or ‘matched’) against revenues over the respective terms of the leases”. While the appellant is entitled to such a judgment, in accordance with the law stated in Canderel, no mention is made of whether the term of the lease containing the renewal option should be extended to include the renewal term. If I were required to decide the issue, I would have given a negative response. Since the option to renew is within the exclusive control of the tenant and not the respondent, and since it is mere speculation as to whether the renewal option will ever be exercised, it seems only logical and practical that tenant inducement payments be matched with revenues over the initial term of the lease for which the tenant has an existing obligation to pay rent.
Finally, it is to be noted that by order of the Court this appeal was heard together with the appeals in Court File Nos. A-349-94 and A-350-94. A copy of these reasons will be filed in those Court files and shall thereupon become the reasons for judgment therein.
For the foregoing reasons, the appeals will be allowed, with one set of costs, the judgments of the Trial Judge dated June 3, 1994 set aside and the assessments referred back to the Minister for reconsideration and reassessment in a manner consistent with these reasons.
Strayer J.A.: I agree.
Chevalier D.J.: I agree.