Hill v. The Queen, 94 DTC 1078, [1994] 1 CTC 2169 (TCC), aff'd 95 DTC 5225 (FCA)

Mogan, J.T.C.C.:—The subject of this appeal with respect to the appellant's 1987 taxation year is an inducement payment by a landlord which requires an interpretation of paragraph 12(1)(x) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"). At the commencement of the hearing, the parties filed an agreed statement of facts the substance of which is summarized below.

The appellant is a resident of Ottawa, Ontario and, at all material times, was a partner in the law firm of Perley-Robertson, Panet, Hill & McDougall (the "partnership"). The fiscal year of the partnership ended on January 31 in each calendar year. During 1986 and prior years, the partnership carried on its law practice in offices rented from the Metropolitan Life Insurance Company (“Metropolitan”) under a lease for a term which was due to expire on January 31, 1987. The offices were located at 99 Bank Street, Ottawa.

On April 23, 1986, the partnership and Metropolitan executed a new lease which provided (i) a term of 10 years commencing Februar 1, 1987 for the "old space" already occupied by the partnership; and (ii) a term of 8 years 11 months commencing March 1, 1988 for “additional space" not previously occupied by the partnership. The old space contained 17,187 square feet of rentable office space and the additional space contained 6,446 square feet of rentable office space. Metropolitan granted a tenant inducement in paragraph 21.04 of the new lease which stated:

21.04 TENANT’S INDUCEMENT

Landlord will grant to the tenant an inducement in the amount of $1,542,584 which inducement is made up of the following credit:

The landlord hereby agrees to pay to the tenant upon execution of this lease $1,442,584 of the aforesaid tenant inducement allowance, provided, however, that payment be applied to the acquisition by the tenant of term deposits with a Canadian financial institution and that such term deposits be held by the tenant as follows:

17,187 square feet x $33 improvement allowance	$567,171
17,187 square feet x 18 months' rent abatement	464,049
17,187 square feet x 12 months’ operating costs abatement	137,496
6,446 square feet x $31 improvement allowance	199,826
6,446 square feet x 18 months' rent abatement	174,042
TOTAL	$1,542,584

(a) $242,584 until the tenant incurs costs for leasehold improvements, new furniture or new equipment to be used in the Premises;

(b) $1,200,000 until the term of this lease commences on February 1, 1987.

The tenant will be entitled to all interest earned on such term deposits as such interest is earned.

The landord [sic] agrees to invest and keep invested $100,000 until March 1, 1988 when this lease commences for an additional 6,446 square feet rentable, upon which date the said sum of $100,000, together with all interest earned thereon, will be paid by the landlord to the tenant or in accordance with the directions of the tenant. This sum of $100,000 will be invested by the landlord in term deposits or other investments with a Canadian financial institution.

The allocation of the amount $1,542,584 in paragraph 21.04 of the new lease as "improvement allowance”, “rent abatement” and "operating costs abatement" was required by Metropolitan. The partnership incurred expenditures on tenant improvements in the amount of $321,440. No amounts were used as rent abatements or for operating costs. The purpose of the tenant inducement payment was to induce the partnership to enter into the new lease. Metropolitan paid $1,442,584 to the partnership in June, 1986 but the remaining $100,000 was not paid until March 1, 1988. The partnership was obliged by Metropolitan to purchase the term deposits to secure its obligations both to carry out certain tenant improvements and to move into the premises. The partnership was entitled to retain the interest on the term deposits. Having regard to the aggregate tenant inducement amount of $1,542,584:

(a) the appellant and other members of the partnership elected under subsection 53(2.1) of the Income Tax Act to reduce the adjusted cost base of the term deposits by $1,221,144; and

(b) the appellant and other members of the partnership elected under subsection 13(7.4) of the Act to reduce the capital cost of depreciable property (i.e. leasehold improvements) by $321,440.

The appellant's share of the term deposits was approximately $220,000. Soon after the term deposits were acquired, the appellant borrowed from the partnership an amount equal to his share of the term deposits. The partnership in turn borrowed from the financial institution which had issued the term deposits sufficient funds to enable it to lend to the appellant and certain other partners their respective shares. The term deposits were pledged by the partnership to secure this borrowing. When the term deposits expired, the proceeds were used to repay the loan from the financial institution. The term deposits were capital assets of the partnership.

In addition to the above agreed facts, each counsel read into the record of the hearing certain questions and answers from the examination for discovery of the opposite party. From those questions and answers, I will summarize the facts which l regard as relevant.

Upon discovery, the appellant explained why the inducement amount received in 1986 was used to acquire term deposits. Metropolitan realized that it was making an inducement payment of $1,442,584 in June 1986 eight months before the new lease was to commence on February 1, 1987. Metropolitan wanted some assurance that a portion of the money would go back into the building as leasehold improvements, and that the partnership would stay in the building and retain possession of the old space at the start of the new lease. In response to these concerns of Metropolitan, it was agreed that a term deposit of $1,200,000 would be acquired and retained by the partnership until the new lease commenced on February 1, 1987; and that a term deposit of $242,584 would be acquired and retained until the partnership had actually incurred costs for leasehold improvements, new furniture and new equipment to be used in the building. The amount of $242,584 was a very rough estimate of what the partnership would have to pay for new furniture, equipment and leasehold improvements.

The appellant also stated on discovery that there had been no discussions or negotiations with Metropolitan concerning the allocation of the amount $1,542,584 among improvement allowance, rent abatement and operating cost abatement. After the parties had negotiated and settled the amount of the tenant inducement, Metropolitan presented a draft lease which contained the allocation in paragraph 21.04. When asked to explain the source or cause of the allocation, the representative of Metropolitan stated that it was his way to justify the amount of the tenant inducement to his superiors. The partnership did not spend the allocated amount of $766,997 on leasehold improvements. Although the partnership signed the new lease, the appellant and his partners reject the allocation in paragraph 21.04 as a unilateral act of Metropolitan.

Upon discovery, Mr. Raymond Seguin (representing the respondent) acknowledged that the partnership was required to acquire the term deposits under the terms of the new lease and that the purpose of the term deposits was to ensure that the partnership would acquire leasehold improvements and remain in the old space.

The real dispute in this appeal centres around the interpretation of paragraph 12(1)(x) of the Income Tax Act, a relatively new provision enacted in 1986 (S.C. 1986, c. 6, subsection 6(2)). Prior to the enactment of paragraph 12(1)(x), the decisions of the Federal Court of Appeal in Canadian Pacific Ltd. v. The Queen, [1978] C.T.C. 606, 77 D.T.C. 5383 and Consumers' Gas Co. v. The Queen, [1984] C.T.C. 83, 84 D.T.C. 6058 had established the principle that an amount received to reimburse the recipient for the cost of tangible capital property did not reduce the cost of that property for the purpose of computing capital cost allowance. Subsequent decisions of the Federal Court of Appeal in Consumers’ Gas Co. v. The Queen, [1987] 1 C.T.C. 79, 87 D.T.C. 5008 and the Federal Court-Trial Division in Woodward Stores Ltd. v. Canada, [1991] 1 C.T.C. 233, 91 D.T.C. 5090 established the collateral principle that an amount received to reimburse the recipient for the cost of tangible capital property should not be included in income. It appears that the enactment of paragraph 12(1)(x) in 1986 was intended at least in part to reverse the actual or anticipated results in the four cases just cited. It may also have been intended to confirm the principle that an amount received to reimburse the recipient for current expenses is received on revenue (not capital) account. I was required to consider this latter principle in IBM Canada Ltd. v. M.N.R., [1993] 2 C.T.C. 2860, 93 D.T.C. 1266 (T.C.C.).

Paragraph 12(1)(x) has two companion provisions: subsections 13(7.4) and 53(2.1). I will attempt to express in non-statutory language what I regard as the intention of these three recent additions to the Income Tax Act. Under paragraph 12(1)(x), there must be included in computing income any amount received which can reasonably be regarded as an inducement or as a reimbursement in respect of an expense or the cost of property unless the recipient elects under subsection 13(7.4) to apply a portion of the amount to reduce the cost of depreciable property or elects under subsection 53(2.1) to apply a portion of the amount to reduce the cost of capital property. If the recipient makes an election under either subsection 13(7.4) or 53(2.1), then the amount so elected will not be included in income under paragraph 12(1)(x) but will reduce the cost of designated depreciable property or capital property.

Before considering the interpretation of paragraph 12(1)(x), I should make some observations on paragraph 21.04 of the new lease. The partnership and Metropolitan agreed upon a total tenant inducement amount of $1,542,584. Within paragraph 21.04, that amount was allocated in three different ways. Firstly, $1,442,584 was payable in June 1986 on the execution of the new lease while the remaining $100,000 was not payable until March 1, 1988. 1 shall refer to those amounts respectively as the "down payment" and the “final payment". Secondly, the total amount was allocated by Metropolitan among leasehold improvements, rent abatement and operating costs abatement. Although the appellant (and his partners) reject this unilateral allocation by Metropolitan, it is a fact that Metropolitan allocated $766,997 to depreciable property and $775,588 to the abatement of current expenses like rent and operating costs. In Metropolitan's thought process, the total inducement amount was 49.7 per cent for depreciable property (or possibly capital property) and 50.3 per cent for current expenses.

And thirdly, the down payment was allocated on the basis that $242,584 was for leasehold improvements, new furniture or new equipment (such amount to be released to the partnership when it had incurred costs for such property) and the balance of $1,200,000 was for the partnership to use at its discretion on February 1, 1987, the first day of the new lease. The above three allocations all appear within the terms of paragraph 21.04 of the lease itself. There is a fourth allocation which was made by the appellant and his partners when they were considering the effect of paragraph 12(1)(x) on the income of the partnership. Under subsection 13(7.4) they allocated $321,440 to depreciable property (leasehold improvements) and under subsection 53(2.1) they allocated $1,221,144 to capital property (term deposits).

In the assessment which is under appeal, the Minister of National Revenue accepted the election under subsection 13(7.4) for the amount $321,440 but refused to accept the election under subsection 53(2.1) for the amount $1,221,144. Accordingly, the Minister included the amount of $1,221,144 in computing the income of the partnership, and the appellant's pro rata portion thereof was added to his reported income. It is necessary to set out the relevant provisions of the Income Tax Act but I shall quote only those words which, in my view, apply to the facts herein:

12 (1) There shall be included in computing the income of a taxpayer for a taxation year as income from a business or property such of the following amounts as are applicable . . .

(x) . . . any amount . . . received . . . in the course of earning income from a business . . .

where the amount can reasonably be considered to have been received

(iii) as an inducement. . . or

(iv) as a reimbursement, contribution, allowance or as assistance . . . In respect of the cost of property or in respect of an expense

to the extent that the amount

(vii) does not reduce, pursuant to subsection 13(7.4) or paragraph 53(2)(s),

the cost or capital cost of the property, as the case may be, or. . . .

13 (7.4) . . . where a taxpayer has in a taxation year received an amount that would, . . . be included in his income under paragraph 12(1)(x) in respect of the cost of a depreciable property acquired by him in the year, . . . and the taxpayer elects under this subsection . . . the capital cost of the property to the taxpayer shall be deemed to be the amount by which the aggregate of

(a) the capital cost of the property to the taxpayer otherwise determined . . .

exceeds the amount elected by the taxpayer under this subsection. . . .

53 (2) In computing the adjusted cost base to a taxpayer of property at any time, there shall be deducted such of the following amounts in respect of the property as are applicable:

(s) the amount, if any, by which

(i) the amount elected by the taxpayer before that time under subsection (2.1)

exceeds. . . .

53 (2.1) . . . where in a taxation year a taxpayer receives an amount that would . . . be included in the taxpayer's income under paragraph 12(1)(x) in respect of the cost of a property . . . acquired by the taxpayer in the year . . . the taxpayer may elect under this subsection . . . to reduce the cost of the property by such amount as the taxpayer specifies. . . .

The appellant argues that, under paragraph 21.04 of the new lease, the obligation on Metropolitan to make the down payment of $1,442,584 in the spring of 1986 was conditional upon the partnership acquiring term deposits and holding such term deposits for a specific period. Metropolitan insisted on this application of the down payment as security to ensure that the partnership would improve the premises and stay in possession after January 31, 1987. In other words, there is a connection between the down payment and the term deposits, and the connection is the partnership obligation to use the down payment to acquire term deposits for a specific period. The appellant further argues that the term deposits were "property" within the meaning of subparagraph 12(1)(x)(iv); and that the appellant and his partners were therefore entitled to make an election under subsection 53(2.1) with respect to the cost of such property.

The respondent argues that the total amount of $1,542,584 was paid by Metropolitan to obtain a responsible tenant. Both Metropolitan and the partnership agreed that only a portion of the total amount would be expended on leasehold improvements; and term deposits of $242,584 were set aside in paragraph 21.04 for such leasehold improvements. The remaining term deposits of $1,200,000 were not in respect of any property of any kind used by the partnership in carrying on its business. The only purpose of the term deposits was to provide Metropolitan with some security to ensure that the partnership would acquire some leasehold improvements and would remain on the premises to commence the new lease on February 1, 1987.

The parties agree that the total amount of $1,542,584 was received as an inducement and therefore falls within subparagraph 12(1)(x)(iii). In order to succeed in this appeal, however, the appellant must rely on subparagraph 12(1)(x)(iv) and argue with more precision that the total amount of $1,542,584 "can reasonably be considered to have been received . . . as a reimbursement, contribution, allowance or as assistance . . . in respect of the cost of property”. The link between the total amount and the "cost of property" in subparagraph (iv) is essential for the appellant because the words "the property" in subparagraph 12(1)(x)(vii) refer back to the word "property" in subparagraph (iv); and the appellant has used subparagraph 12(1)(x)(vii) to allocate the total amount between leasehold improvements and term deposits, and to reduce the cost thereof. The fundamental question in this appeal is whether the total amount of $1,542,584 can reasonably be considered to have been received as a reimbursement, contribution, allowance or as assistance in respect of the cost of leasehold improvements and term deposits within the meaning of subparagraph 12(1)(x)(iv).

The words reimbursement", contribution”, "allowance" and assistance" in subparagraph 12(1)(x)(iv) indicate strongly that the recipient of the inducement amount is receiving help with respect to the cost of certain property or with respect to certain expenses. The help, of course, is the inducement amount itself. The recipient would welcome such help if it were a contribution to the cost of property or to an expense which the recipient would ordinarily incur in the course of earning income from its business. A good example of such property is a leasehold improvement. A good example of such expense is a rental payment. But the recipient would not need any help with respect to the cost of a particular property if the recipient would not ordinarily acquire such property in the course of earning income from its business.

On the facts of this case, the partnership invested $321,440 in leasehold improvements as a result of entering into the new lease. Those leasehold improvements were acquired for the purpose of carrying on the partnership business. Therefore, a portion ($321,440) of the inducement amount can reasonably be considered to have been received as a "contribution" or as "assistance" in respect of the cost of those leasehold improvements within the meaning of subparagraph 12(1)(x)(iv). But the remaining portion ($1,221,144) of the inducement amount does not appear to be linked in any way to the cost of property which the partnership would ordinarily acquire in the course of earning income from its business. That remaining portion went into the pockets of the appellant and his partners on February 1, 1987 when the new lease commenced.

It is true that during the eight months from June 1986 until February 1,1987 the partnership was obliged to use the whole down payment to acquire term deposits. Those term deposits, however, were acquired only as security for the landlord, and they were not acquired in the ordinary course of earning income from the partnership business. Counsel for the appellant put forward the main thrust of his argument in the following words:

Under paragraph 21.04 of the lease, the specific precondition to Metropolitan, the landlord, paying the inducement payment was that the payment be applied to the acquisition of the term deposits, and that the term deposits be held for a specified period. This application of the funds was at the insistence of the landlord to provide security that the partnership would improve the premises and move in as promised.

Thus, the nexus between the inducement payment and the term deposits was the contractual obligation on the part of the partnership to use the money to acquire the term deposits. That clearly meets the “in respect of” definition as defined in Nowegijick v. The Queen, [1983] 1 S.C.R. 29, [1983] C.T.C. 20, 83 D.T.C. 5041.

The argument thus stated is not consistent with paragraphs 9 and 10 of the agreed statement of facts which state:

9. The purpose of the tenant inducement payment was to induce the partnership to enter into the lease. Metropolitan paid $1,442,584 to the partnership in June, 1986 while the remaining $100,000 was paid on March 1, 1988.

10. The partnership was obliged by Metropolitan to purchase the term deposits to secure its obligations to both carry out certain tenant improvements and to move into the premises.

I do not accept the appellant's basic argument that the specific precondition to the payment of the inducement amount was that the amount be applied to the acquisition of term deposits. Firstly, the argument fails to distinguish between the whole inducement amount ($1,542,584) and the down payment ($1,442,584). Only the down payment was used to purchase term deposits. And secondly, the only condition precedent for the partnership to receive the down payment was the signing of the new lease. When the new lease was signed, the down payment vested in the partnership. The final payment of $100,000 was not delivered until March 1, 1988 when the partnership satisfied a different condition precedent by occupying the additional space. The require- ment that the partnership continue to occupy the old space after January 31, 1987 and acquire some leasehold improvements was a condition subsequent.

The appellant's argument does not distinguish between a condition precedent and a condition subsequent. A condition precedent delays the vesting of a right until an event happens. Thus, the partnership was not entitled to the down payment until it signed the new lease. A condition subsequent defines an event which may cause an existing right to be divested or destroyed. Thus, the partnership was obliged to occupy the old space after January 31, 1987 and acquire some leasehold improvements or it would forfeit part or all of the down payment. The down payment was used to purchase term deposits only as security for the landlord to ensure that it would recover part or all of the down payment if the conditions subsequent were not fully satisfied.

Having regard to the agreed statement of facts, the terms of paragraph 21.04 of the new lease, and the conduct of the appellant and his partners following the execution of the new lease, I make the following findings of fact:

1. The partnership and Metropolitan agreed to the total amount of $1,542,584 as a payment to induce the partnership to sign the new lease. There was a down payment of $1,442,584 upon the execution of the lease in June 1986 and a final payment of $100,000 on March 1, 1988.

2. There was no agreement between the partnership and Metropolitan which required the partnership to use any specific portion of the total amount to acquire any property used in carrying on the partnership business, but there was an understanding that some portion (not less than $242,584) would be expended by the partnership tor leasehold improvements, new furniture and new equipment.

3. After the new lease was signed, the partnership expended $321,440 on leasehold improvements.

4. The partnership was obligated to use the down payment to acquire term deposits in the amount of $1,442,584 for the purpose of providing some security to Metropolitan to ensure (i) that the partnership would expend some money on leasehold improvements; and (ii) that the partnership would continue to occupy the old space after January 31,1987.

5. Any portion of the down payment not used for leasehold improvements, new furniture or new equipment was available to the partnership to use in its unfettered discretion on February 1, 1987 if it continued to occupy the old space. The final payment of $100,000 was available to the partnership to use in its unfettered discretion on March 1, 1988 if it occupied the additional space.

6. The acquisition of the term deposits was a temporary use of the down payment for a period of approximately eight months. Whether the term deposits were capital property of the partnership or property of some other kind is irrelevant in the determination of this appeal except to qualify the election under subsection 53(2.1) of the Act if that election should be valid.

If words like "reimbursement", “contribution”, allowance” and "assistance" in subparagraph 12(1)(x)(iv) indicate that the recipient is receiving help with respect to the cost of property, how can I regard the remaining portion ($1,221,144) of the inducement amount as help for the partnership in respect of the cost of term deposits if those term deposits were acquired only for the benefit of the landlord and would not have been acquired in the ordinary course of earning income from the partnership business? The acquisition of the term deposits did not assist the partnership. On the contrary, it delayed for eight months the time when the appellant and his partners could enjoy absolute right to the funds. On this last point, I purposely ignore the borrow- ing and pledging arrangement in June 1986 which permitted the appellant and some of his partners to have access to their pro rata shares of the down payment.

I stated above that the fundamental question is whether the total amount of $1,542,584 can reasonably be considered to have been received as a reimbursement, contribution, allowance or as assistance in respect of the cost of leasehold improvements and term deposits within the meaning of subparagraph 12(1 )(x)(iv). I have already concluded that a portion ($321,440) of the total amount was received as a contribution or as assistance in respect of the cost of leasehold improvements. The partnership election under subsection 13(7.4) was therefore valid. I find that the remaining portion ($1,221,144) of the total amount was not received in respect of the cost of any property of any kind. Therefore, that remaining portion cannot “reasonably be considered to have been received" in respect of the cost of property within the meaning of subparagraph 12(1 )(x)(iv). The purported election under subsection 53(2.1) of the Act was not valid.

When interpreting paragraph 12(1 )(x) of the Act and applying it to the facts of this case, I have attempted to follow the guidance provided by the Supreme Court of Canada in Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32, [1987] 1 C.T.C. 117, 87 D.T.C. 5059 in which Dickson, C.J.C. (speaking for the Court) stated at pages 52-53 (C.T.C. 128, D.T.C. 5066-67):

. . . just as there has been a recent trend away from strict construction of taxation statutes (see Stubart Investments Ltd. v. The Queen, [1984] S.C.R. 536, [1984] C.T.C. 294, 84 D.T.C. 6305), so too has the recent trend in tax cases been towards attempting to ascertain the true commercial and practical nature of the taxpayer's transactions. There has been, in this country and elsewhere, a movement away from tests based on the form of transactions and towards tests based on what Lord Pearce has referred to as a “commonsense appreciation of all the guiding features" of the events in question: B.P. Australia Ltd. v. Commissioner of Taxation, [1966] A.C. 224, [1965] 3 All E.R. 209 (P.C.) at page 264 (All E.R. 218). . . .

This is, I believe, a laudable trend provided it is consistent with the text and purposes of the taxation statute. Assessment of taxpayers’ transactions with an eye to commercial and economic realities, rather than juristic classification of form, may help to avoid the inequity of tax liability being dependent upon the taxpayer's sophistication at manipulating a sequence of events to achieve a patina of compliance with the apparent prerequisites for a tax deduction.

In my opinion, the commercial and economic realities for which paragraph 12(1)(x) was enacted were payments made in a business context to help the recipient with respect to costs of property or current expenses which the recipient would ordinarily incur in the course of its business. On the facts of this case, the partnership would never have acquired the term deposits in the ordinary course of carrying on its law practice. Those term deposits were acquired only to provide short term security to the landlord pending commencement of the new lease. The appeal is dismissed with costs.

Appeal dismissed.