Adams v. R., [1996] 1 CTC 2916, 96 DTC 1145

Mogan J.T.C.C.: — The Appellant (Henry Adams) is one of 12 medical doctors whose income tax appeals were heard together on common evidence. The other 11 Appellants whose appeals are determined by these reasons for judgment are (in the numerical order of their Court File Numbers):

Court File No./Appellant

92-1571(IT)/John Banks

92-1572(IT)/John Savage

92-1573(IT)/Bemd Heikamp

92-1583(IT)/Deborah Knight

92-1584(IT)/Neville Robinson

92-1585(IT)/Anthony Lamplugh

92-1587(IT)/David Sanders

92-1588(IT)/Gerald Burns

92-1589(IT)/John F. O’ Connor

92-1590(IT)/Lorna Carter

92-1591(IT)/Roderick Lee

The 12 Appellants were members of the Dartmouth Medical Centre, a medical partnership which, in the years under appeal, had approximately 18 doctor/partners who practised their profession through the partnership in the City of Dartmouth, Nova Scotia. For convenience, the partnership will be referred to herein as the “DMC Partnership”.

Each doctor in the DMC Partnership was also an equal shareholder of Medical Realty Limited (referred to herein as “MRL”), a Nova Scotia corporation which owned land at 176 Portland Street in downtown Dartmouth for future development and which also provided certain management services to the DMC Partnership. In the early 1980’s, the DMC Partnership had outgrown its existing premises and the partners became interested in a new building to house their medical practice. In 1984, all of the 18 doctors who were members of the DMC Partnership formed a co-tenancy (referred to herein as the “Co-Tenancy” of which each doctor was a “Co-Tenant”) to develop and own the new building in which they would practice. In May 1984, No. 1577349 Holdings Limited was incorporated. Each member of the DMC Partnership was an equal shareholder in No. 1577349 which was incorporated to acquire as agent or bare trustee for the Co-Tenancy the land for a new building, and to construct and operate the new building on behalf of the Co-Tenancy. No. 1577349 was renamed Dartmouth Medical Holdings Limited in October 1984 and will be referred to herein as “DMH”.

On June 29, 1984, DMH (as bare trustee for the Co-Tenancy) agreed to purchase from MRL the lands at 176 Portland Street. Construction of the new building commenced in July 1984 and was completed in September 1985. On May 21, 1985, DMH (the registered owner of the new building) signed a lease (Exhibit B-9) with the DMC Partnership for the rental of the upper five floors (48,000 square feet) and an additional 3,000 square feet in the basement. Included in the lease were the following provisions:

(a) a lease term of ten years covering not only the upper five floors (floors 2, 3, 4, 5 and 6) but also the additional basement space, commencing on September 1, 1985 or the date of completion of the building;

(b) a rent amounting to $864,0000 per year during the first five years of the term, and a higher rent of $1,080,000 per year during the last five years of the term; and

(c) the landlord agreed to pay to the tenant a rental inducement in the amount of $26 per square foot, to be used by the tenant for any purpose as it may decide.

The DMC Partnership moved into the new building in the latter part of September 1985. On December 19, 1985, DMH as landlord and bare trustee on behalf of the Co-Tenancy paid to the DMC Partnership as tenant a rental inducement amount of $1,200,000. The DMC Partnership distributed the rental inducement amount on the basis of $66,666 to each of its 18 doctor/partners, and each partner loaned $40,000 back to the DMC Partnership. At all relevant times, each Appellant was wearing at least two hats. First, as a member of the DMC Partnership, he or she earned professional income from the practice of medicine. And second, as a member of the Co-Tenancy, he or she earned rental income from property as part- owner of the new medical building. In computing income from property, the Co-Tenancy deducted the rental inducement amount as a deferred leasing cost over a period of 10 years. In other words, the rental inducement amount ($1,200,000) was not deducted in 1985 when it was paid but one- tenth ($120,000) was deducted in computing income for each of the ten years covered by the lease.

The Minister of National Revenue disallowed the annual deduction of $120,000 to the Co-Tenancy on the basis that (i) the payment of $1,200,000 was not an expense made or incurred to earn income; (ii) the payment of $1,200,000 constituted an artificial transaction; and (iii) the payment of $1,200,000 was not reasonable in the circumstances. There are other issues of substance to be decided in these appeals but the primary issue is whether any portion of the so-called rental inducement amount may be deducted in computing the income of the Appellants as Co-Tenants. The taxation years under appeal are 1984, 1985, 1986, 1987 and 1988.

At the commencement of the hearing, counsel for the parties filed as Exhibit “A” an Agreed Partial Statement of Facts comprising 17 pages and 30 numbered paragraphs. There were 28 documents in volumes “B” and “C” filed as exhibits to support the Agreed Partial Statement of Facts (Exhibit A). An additional 65 documents in volumes “D” and “E” were filed as joint exhibits of all parties. The Appellants then called six material witnesses and one expert witness. The Respondent did not call any witnesses.

The Dartmouth Medical Centre was started in 1937 with about five medical doctors and it has been operating ever since. By 1984, it had become the DMC Partnership with 19 doctor/partners and a few associated physicians. In 1984, the DMC Partnership was operating in a two-storey building on Portland Street which had been renovated after serving as a showroom and service area for a car dealer. The facility was crowded because it had to accommodate the doctors, their staff and their patients. Having decided to explore the possibility of acquiring new premises, the DMC Partnership consulted Edward Thornley of Brampton, Ontario whose company (CMD Inc.) specialized in the development of medical centres. Mr. Thornley was a witness in these appeals and stated that, in the period 1972 to 1992, he was directly involved in the construction and development of 55 medical buildings for doctors. Prior to 1984, he had completed about 25 to 30 of such projects.

Mr. Thornley had developed a formula which he offered to a group of doctors who wanted to own the building in which they conducted their medical practices. This concept was attractive to the members of the DMC Partnership because they were already the owners of the building in Dartmouth which contained their professional offices. According to the Thornley formula, the group of doctors who wanted to own their professional building would purchase an appropriate parcel of land. They would obtain any necessary rezoning and construct a new building. The land and building would be co-owned by the doctors but title would be held by a corporation which would act as landlord. Each doctor/co- owner would then become a tenant along with other persons in the health sciences field (family physicians, medical specialists, dentists, physiotherapists, an X-ray clinic, a drug store, etc.) until the building was fully leased. If all went well, the rents obtained from all tenants including each doctor/co-owner would exceed the amounts required to operate the building and retire the mortgage; and each doctor/co-owner would accumulate equity in the build- ing which would hopefully increase in value.

In the Thornley formula, title to the land and building was taken in the name of a corporation which held it as agent or bare trustee for the doctor/owners who entered into a co-tenancy agreement which determined their rights and obligations as co-owners of the land. Although “CoTenancy” is a technical term which describes the manner in which each doctor held his or her undivided interest in the land as a “tenant-in- common”, it is a confusing term because the group of doctors as owners of the land and new building were in substance “landlords” and not “tenants”. In the facts of these appeals, it is important to remember that the corporation (DMH) which held the land as agent or bare trustee for the doctors in the Co-Tenancy was always acting as landlord.

Exhibit B-3 is a letter dated February 27, 1983 from Mr. Thornley in which he confirms the appointment of his company (CMD Inc.) as the development consultant for the DMC Partnership for the construction of a medical/office building. Exhibit B-3 included the following passage:

Our services are to provide motivation, direction and overall supervision through every phase of the project, including but not limited to the following:

1. Acquisition of site.

2. Selection and supervision of Architects, Engineers and other necessary consultants, including negotiation of contracts.

3. Selection and supervision of General Contractor, including negotiation of both general and subcontractors.

4. Arrangement of all insurance and bonds.

5. Arranging of all requisite financing both long term and interim, using Mortgage Brokers where necessary.

6. Providing all necessary standard documents for approval of owner’s lawyers including lease forms, co-tenancy agreements, etc.

7. Negotiate all leases.

8. All other ancillary functions necessary to ensure the final success of this venture.

As indicated in item six above, Mr. Thornley brought to the DMC Partnership as part of his package draft documents for leasing and the co-tenancy agreement. Mr. Gibson, the lawyer for the DMC Partnership, was able to identify a number of documents actually signed by his clients as having been provided by Mr. Thornley in draft form. There is no doubt that Mr. Thornley negotiated the interim financing with The Mercantile Bank because the letter from the Bank dated June 22, 1984 (Exhibit B-5) confirming the credit facility was addressed to Mr. Thornley’s attention. It is a nine-page letter with two schedules from which I will quote only the following parts which I consider most relevant.

Purpose: To provide the funds required to finance the construction of a medical office building on the southwest corner of the intersection of Portland Street and Canal Street in Dartmouth, Nova Scotia

Credit: Demand loan in the amount of Cdn $5,450,000. Funds to be made available on a “cost to complete” basis in accordance with the Project Loan Budget described in Schedule “B”...

Security: The following security documentation shall be completed in form and substance satisfactory to the Borrower, the Bank, and their respective Counsels:

1. $6,450,000 Collateral First Mortgage on the proposed Dartmouth Medical Centre Project described herein.

2.. ..

Conditions Precedent to Land Advance: The following conditions must be fulfilled to the satisfaction of the Bank prior to the $750,000 Land Advance (refer to Schedule “B”) being made available:

1.. ..

2. A binding Offer to Lease acceptable to the Bank from the Dartmouth Medical Clinic to the Borrower on terms which provide for absolutely net annual rental payments of $786,590 for 46,270 square feet of space for a term of ten years on the upper five floors of the proposed building shall be provided to the Bank. Said Offer to Lease to be guaranteed by the 18 Doctor-Owners of The Dartmouth Medical Clinic.

Conditions Precedent to Construction Advance: The following conditions must be fulfilled to the satisfaction of the Bank prior to the first Construction Advance being made available. For the purposes of this section, the term “Construction Advance” shall mean the advance of any moneys included in the loan budget (Schedule “B”), excluding those monies budgeted for land, the $694,050 budgeted for “Leasehold Improvements” in the space to be occupied by the Dartmouth Medical Clinic, and the $150,000 “Equity Withdrawal”.

1. …

The terms in the Mercantile Bank letter (Exhibit B-5) were accepted by DMH on June 26, 1984. In the years preceding 1984, the DMC Partnership had acquired some land adjoining their existing facility anticipating a future need when they would want a larger building. On July 20, 1984, MRL executed a deed (Exhibit E-17) transferring to DMH the adjoining land at a price of $900,000. This is the land on which the new building was constructed. Schedule B attached to the Mercantile Bank letter (Exhibit B-5) had identified $750,000 as the part of the loan available for land alone. As stated above, construction commenced immediately when the financing was in place in late July 1984 and the DMC Partnership was able to move into the new building in late September 1985.

As seen in part of the Mercantile Bank letter quoted above, an impor- tant condition to the $750,000 land advance was a binding offer to lease guaranteed by the 18 doctor/partners of the DMC Partnership. The Offer To Lease (Exhibit B-8) was a simple document of only two pages dated July 20, 1984 but signed by two doctors on behalf of the DMC Partnership to comply with the Bank’s condition. In Exhibit B-8, there is no mention of any rental inducement amount. About 10 months later, on May 21, 1985, the DMC Partnership and DMH signed the real lease (Exhibit B-9) comprising 31 pages and 24 numbered paragraphs. Exhibit B-9 provided for a rental inducement amount in the following terms:

23. Rental Inducement

In consideration of the Tenant’s agreeing to enter this Lease Agreement for the upper five floors of the building in addition to approximately Three Thousand square feet in the basement for the term and minimum rent set out herein in this Lease Agreement, the Landlord hereby agrees to pay to the Tenant a rental inducement in the amount of $26 per square foot of the Leased Premises, to be used by the Tenant for any purpose as it may decide.

The term “Leased Premises” in Exhibit B-9 was defined to include approximately 48,000 square feet in the upper five floors of the building plus approximately 3,000 square feet in the basement. In accordance with paragraph 23 quoted above, DMH paid to the DMC Partnership on December 19, 1985, the amount of $1,200,000 which was then distributed $66,666 to each of the 18 partners. Each partner then loaned back $40,000 to the DMC Partnership so that the financial statements of the DMC Partnership as at January 31, 1986 (Exhibit D-14) showed partners’ loans of $720,000. Exhibit B-9 provided for a term of 10 years commencing in September 1985 with a minimum annual rent of $864,000 during the first five years and a minimum annual rent of $1,080,000 during the last five years. The DMC Partnership was required to pay as additional rent its proportionate share of the landlord’s operating expenses in order to leave DMH (as agent for the Co-Tenancy) with a net lease.

Mr. Thornley stated that the rental inducement amount was a standard part of his development package for medical buildings. The three doctor/partners who testified (Dr. Lamplugh, Dr. Adams and Dr. Banks) all stated that the rental inducement amount was essential if they were to pay the increased rent required to finance the cost of the new building. Their evidence is corroborated by the financial statements of the DMC Partnership (Exhibit D-14). For the fiscal period ending January 31, 1985 (the last period in which the partnership was in the old building for a full 12 months), the annual rent paid by the partnership was $195,600. For the fiscal period ending January 31, 1987 (the first period in which the partnership was in the new building for a full 12 months), the minimum annual rent paid by the partnership was $864,000 plus “additional rent” (i.e. a proportionate share of operating expenses) of $418,000 making an aggregate rent of $1,282,000. Prior to 1985, the operating expenses of the old building were charged in a different manner (not as additional rent) and so it is fair to compare only that former rent of $195,600 with the new minimum rent of $864,000. It is a significant increase.

There is no doubt from the Mercantile Bank letter of June 1984 (Exhibit B-5) and the actual loan agreement with the Bank of July 24, 1984 (Exhibit B-6) that all 18 doctors in the DMC Partnership were obligated to move into the new building and occupy the top five floors (Nos. 2, 3, 4, 5 and 6). It was not, however, a matter of obligation. It was what they really wanted to do. The 18 doctor/partners did not need to be “induced” to become tenants in their own new building. They desperately wanted to be the prime tenant to ensure that it would be fully occupied. The same 18 doctors, wearing their other hat as co- owners (i.e. landlord), would benefit most if the building were fully occupied.

Counsel for the Respondent stated more than once that the Appellants, in their capacity as tenants (i.e. as members of the DMC Partnership), did not bring into income all or any part of the $66,666 which each received as his or her pro rata share of the rental inducement amount. This statement was not disputed by counsel for the Appellants and, having regard to the state of the law in 1985, I believe it is true. In the assessments which are under appeal, the Minister did not make any attempt to include in computing the income of the Appellants as tenants (i.e. the DMC Partnership) any part of that rental inducement amount. The Minister’s only assessing action with respect to the rental inducement amount was to disallow its deduction in computing the income of the Co-Tenancy (i.e. the Appellants) as landlord. Counsel for the Respondent summarized the Minister’s position when he argued that it is artificial and not reasonable for a landlord to pay a rental inducement amount to himself.

According to the Amended Reply to Notice of Appeal filed on behalf of the Minister of National Revenue, the Minister disallowed the deduction of the rental inducement amount (allocated over 10 years as a deferred leasing cost) when computing the income of the Co-Tenancy (i.e. the 18 doctors as co-owners) because the Minister concluded (i) that the rental inducement amount was not an expense incurred for the purpose of gaining or producing income within the meaning of paragraph 18(1)(a) of the Income Tax Act; (ii) that such deduction would unduly or artificially reduce the income of the co-owners within the meaning of section 245 of the Act; and (iii) that the rental inducement amount was not reasonable in the circumstances within the meaning of section 67 of the Act.

When considering the primary issue, it is important to remember that the Minister did not disallow the deduction of the rental inducement amount just because the 18 co-owners as landlord were the same 18 doctor/partners in the DMC Partnership as tenant. For example, the rent paid by the DMC Partnership as tenant was allowed as a deduction in computing the income of the partnership; and was included as revenue in computing the income of the Co-Tenancy as landlord.

I will approach the primary issue in two separate steps. First, is any portion of the rental inducement amount deductible in computing the income of the Appellants as Co-Tenants? And second, if the answer is “yes” to the first step, then how much is deductible? For the reasons set out below, I have concluded that the Appellants must succeed in the first step. I am satisfied that the Appellants did not need to be induced to become tenants in their own building. It was always an essential part of the plan that the DMC Partnership would be the biggest tenant in a professional building which would be owned by the partners. I am equally satisfied that the Appellants did need to be induced to increase their annual rent by more than 400%. In the old building, their annual basic rent immediately prior to the move was $195,600 whereas, in the new building, their annual basic rent immediately after the move was $864,000. I believe the evidence of Dr. Lamplugh, Dr. Adams and Dr. Banks when they say that they could not and would not have done the transaction without the rental inducement amount.

It is perfectly obvious in these appeals that the landlord and tenant were not at arm’s length. The 18 doctors who were landlords as co- owners in the Co-Tenancy were the same 18 doctor/partners who were tenants in the DMC Partnership. The non-arm’s length relationship could affect the reasonableness of the rental inducement amount but it does not affect the principle as to whether a landlord may pay and deduct a rental inducement amount. In Canderel Ltd. v. R. (sub nom. Canderel v. Canada; sub nom. The Queen v. Canderel Ltd.), [1995] 2 C.T.C. 11, 95 D.T.C. 5101, the corporate taxpayer had made a number of tenant inducement payments and attempted to deduct the whole amount of each payment in the year of payment. The Federal Court of Appeal affirmed the Minister’s assessment which disallowed the deduction of the whole amount in the year of payment but allowed the whole amount to be amortized over the initial term of the lease and to be deducted year- by-year. What the Minister allowed and what the Federal Court of Appeal affirmed in Canderel is precisely what the Appellants are attempting to deduct as Co-Tenants in these appeals. A rental inducement amount is not a running expense but, in principle, it is deductible over the 10 years of the lease if it was a necessary payment by the landlord in order to obtain a higher stream of rent from the tenant.

In concluding this first step in the primary issue, I refer to the following words in paragraph 26 of the lease (Exhibit D-9):

In consideration of the Tenant’s agreeing to enter this Lease Agreement ... for the term and minimum rent set out herein ... the Landlord hereby agrees to pay to the Tenant a rental inducement in the amount of -.

These words indicate to me in clear language that part of the consideration for the rental inducement amount was the obligation of the DMC Partnership to pay the minimum rent. And as I have already observed, that minimum rent ($864,000) was more than four times the rent ($195,600) which the DMC Partnership was paying in the old building. In my opinion, the payment of at least part of the rental inducement amount was an expense incurred for the purpose of gaining or producing income within the meaning of paragraph 18(1)(a) of the Income Tax Act.

The second step in the primary issue is to determine what portion of the rental inducement amount is deductible in computing the income of the Appellants as Co-Tenants. In this second step, the Minister makes two arguments. The Minister argues that the whole rental inducement amount is not reasonable under section 67; and that the deduction of any part of the rental inducement amount would unduly or artificially reduce income under section 245. These are quite different arguments.

The argument under section 67 is a question of fact. The minimum rent which the DMC Partnership was required to pay under the lease (Exhibit B-9) for 48,000 square feet on the top five floors was $864,000 for the first five years and $1,080,000 for the second five years. That rent is based on $18.00 and $22.50 per square foot respectively. The 48,000 square feet on the top five floors was much more than the DMC Partnership required for its own purposes. Therefore, the DMC Partnership embarked on a campaign to sublet parts of floors two and three in the hope that the sub-tenants would move in as soon as the building was completed. The Agreed Partial Statement of Facts (Exhibit A) describes at pages 11 to 14 six different arm’s length sub-lease agreements which were entered into by the DMC Partnership. Without going into detail, all six of those arm’s length sublease arrangements provided for rent in the range of $18.00 to $20.00 per square foot for the first five years of each lease. This is consistent with the rent which the DMC Partnership was paying to the Co-Tenancy for the first five years of its 10-year lease.

The minimum annual rent of $864,000 ($18.00 per square foot) which the DMC Partnership was paying to the Co-Tenancy in the first five years of the 10-year lease appears to be reasonable because it was consistent with the rent which six arm’s length sub-tenants were willing to pay to the DMC Partnership for smaller areas of the same space. The reasonableness of the non-arm’s length rent between the DMC Partnership and the Co-Tenancy does not necessarily mean that the rental inducement amount was reasonable but it is a place to start. Again I turn to pages 11 to 14 of Exhibit A where the terms of the six sub-leases are summarized. Three of the subtenants were paid a “tenant inducement”. Med-Pro Services received a tenant inducement equal to the average inducement paid by the DMC Partnership to other sub-tenants. Dr. Humayan received a tenant inducement of $20.00 per square foot and Bedford/Sackville Physiotherapy received $18.00 per square foot. The rental inducement of $1,200,000 paid to the DMC Partnership with respect to its 48,000 square feet is $25.00 per square foot (more than any sub-tenant received) but the DMC Partnership leased a much larger area than any sub-tenant; it was required by the Mercantile Bank to lease more space than it needed; and it had to increase its basic rent by more than 400%.

The best evidence concerning the reasonableness of the rental inducement amount came from the uncontradicted testimony of Charles Hardy, an Accredited Appraiser with the Appraisal Institute of Canada since 1976. Mr. Hardy appeared as an expert witness for the Appellants and his report is Exhibit “F”. He stated that there was significant optimism in the local economy after the recession of 1981-82. Between 1984 and 1987 ap- proximately 1,500,000 square feet of office space were added to the local market through 16 projects listed on page 4 of Exhibit “F”. The largest project was Purdy’s Wharf Tower I in Halifax with 18 storeys and 290,100 square feet. In 1984/85, Purdy’s Wharf Tower I was offering a tenant inducement of $45.00 per square foot for a 10-year lease in which the tenant was paying rent of $19.50 per square foot. The following comments are taken from pages 5 and 6 of Exhibit “F”.

The office market overview, as described above, affected office markets in the whole of the Metropolitan area. The glut of office space created between 1984 and 1987, together with the very attractive tenant inducements offered by landlords had a profound affect on the office market and there was a significant change of location for many tenants. Traditional Dartmouth businesses were attracted to the Central Business District of the City of Halifax and at the same time some Dartmouth developments, such as Metropolitan Place, were successful in attracting Halifax tenants because of their location.

It was not only new developments which were forced into giving tenant inducements. Existing developments, which had historically given very little in the way of tenant inducements, were forced to compete with the new buildings. Contract or face rental levels did not generally increase in the older buildings, although tenant inducements became necessary and therefore the net effective rent to the landlords owning older buildings started to reduce significantly.

Mr. Hardy also stated that an anchor tenant like the DMC Partnership occupying a significant portion of a building at a relatively high face rent could attract other tenants at similar rents. Therefore, it was in the interest of the landlord to pay a rental inducement to the anchor tenant if it produced a higher rent. And generally, the higher the rent, the higher the rental inducement. Under the new lease, the DMC Partnership was obligated to pay aggregate rent of $4,320,000 in the first five years and $5,400,000 in the second five years. Having regard to all of the evidence, I find that the rental inducement amount of $25.00 per square foot or $1,200,000 in aggregate was reasonable in the circumstances of the DMC Partnership lease with the Appellants as Co-Tenants. Section 67 of the Act does not apply to this transaction.

The remaining question in the primary issue is whether the deduction of the rental inducement amount would unduly or artificially reduce income within the meaning of section 245 of the Act. If there were an unassailable legal principle to the effect that a rental inducement amount was never to be included in computing the income of a tenant but could always be deducted in computing the income of a landlord, then the deduction of this particular rental inducement amount by the Appellants herein could be regarded as an artificial reduction of income. I do not know of any such legal principle. Quite the contrary. In JBM Canada Ltd. v. Minister of National Revenue, [1993] 2 C.T.C. 2860, 93 D.T.C. 1266, the issue was whether certain lease inducement payments received by IBM as tenant from seven landlords were income or capital. When dismissing the IBM appeal, I made the following statements at page 1270:

In the circumstances of this appeal, and in particular the Appellant’s denial that any lease inducement payment was conditional upon the Appellant’s acquisition of any tenant improvements, I infer that part of the consideration for each lease inducement payment was the Appellant’s acceptance of its obligation to pay the rent which had been negotiated in each respective lease. In my view, there is a real commercial link between the single lease inducement payment flowing from the landlord to the tenant and the periodic rental payments flowing from the tenant to the landlord.

And further at page 1274:

In the circumstances of this case, I find that the primary consideration granted by the Appellant for the lease inducement payments was the Appellant’s acceptance of its obligations under the various leases to pay rent during the terms of those leases. Those obligations were on revenue account. Having regard to the Appellant’s denial that any lease inducement payment was conditional upon the Appellant’s acquisition of any tenant improvements, I find that the inducement payments flowing from the various landlords to the Appellant are just as much revenue payments as the periodic rental payments flowing from the Appellant to its landlords. The inducement payment comes first in each lease but its primary purpose is to persuade the Appellant to commit itself to a subsequent stream of rental payments.

The decision of this Court in IKEA Ltd. v. R. (sub nom. IKEA Limited v. The Queen; sub nom. IKEA Ltd. v. Canada), [1994] 1 C.T.C. 2140, 94 D.T.C. 1112, reached a similar result. I understand that both IBM and Ikea have been appealed to the Federal Court but that neither has been heard. I therefore assume that the principle established by this Court in IBM and Ikea is good law. If the amount received by a tenant as a rental inducement cannot be regarded as reimbursement for the tenant’s acquisition of any tangible capital property (see Woodward Stores Ltd. v. R. (sub nom. Woodward Stores Ltd. v. Canada, sub nom. Woodward Stores Ltd. v. The Queen), [1991] 1 C.T.C. 2334, 91 D.T.C. 5090, then the inducement amount is income to the tenant. This principle would apply to the DMC Partnership because paragraph 23 of the lease (quoted above) stated that the rental inducement amount ($1,200,000) may be “used by the Tenant for any purpose as it may decide”. In my opinion, the rental inducement amount was reasonable as to quantum and it had the character of revenue or income to the DMC Partnership.

I assume from what was said by counsel that the rental inducement amount was not included in computing the income of the DMC Partnership either by the Appellants when filing their income tax returns or by the Minister upon reassessment. I think the Minister made a mistake. He should have assessed the DMC Partnership to include the rental inducement amount in income in the same way that IBM and Ikea were assessed. It appears to me that in 1985, the Department of National Revenue had been intimidated by the decisions of the Federal Court of Appeal in R. v. Canadian Pacific Ltd. (No. I) (sub nom. Canadian Pacific Ltd. v. The Queen; sub nom. The Queen v. Canadian Pacific Ltd), [1977] C.T.C. 606, 77 D.T.C. 5383; and Consumers’ Gas Co. v. R. (sub nom. Consumers' Gas Co. Ltd. v. The Queen; sub nom. The Queen v. The Consumers' Gas Co. Ltd. (No. 1)), [1984] C.T.C. 84, 84 D.T.C. 6058. By the same token, professional income tax advisors and their clients (like the Appellants) were encouraged to think that any inducement amount would be tax free to the recipient. Paragraph 12(l)(x) was added to the Act in 1985 but does not apply to these appeals.

As I stated in IBM, the Canadian Pacific and Consumers’ Gas cases were about reimbursements for the cost of tangible capital property. When a tenant has unlimited discretion with respect to the use of a rental inducement amount, we are not concerned with the acquisition of tangible capital property but with the intangible rights and obligations which arise under a lease. The tenant’s main obligation is to pay rent. If a landlord pays an amount to a tenant to induce the tenant to pay a higher rent than he might otherwise pay, and if the rent is deductible in computing the income of the tenant, then the inducement amount is revenue (not capital) to the tenant.

The Minister’s failure to include the rental inducement amount in computing the income of the DMC Partnership may make it appear that the deduction sought by the Appellants as Co-Tenants is an artificial reduction of income within the meaning of section 245 but I do not agree. In my view, the Minister assessed the wrong side of the transaction when he disallowed the deduction to the Co-Tenants. It is as simple as that. The rental inducement amount is reasonable in the circumstances and therefore deductible over the term of the lease under the principle of Canderel. If the Minister had included the rental inducement amount in the income of the DMC Partnership, the transaction would have been a “wash” for income purposes under the principle of IBM and Ikea; and the deduction of the rental inducement amount would not have reduced other income at all, unduly or artificially or otherwise.

The amount in issue ($1,200,000) is described as a “rental inducement” in the lease. I have already explained above why the DMC Partnership (as tenant) did not need to be induced to enter into the lease but probably needed to be induced to pay the higher rent. The amount in issue is therefore, in substance, a rental subsidy. Using the term “subsidy”, it is easier to regard the amount as a deductible expense to the landlord and as revenue to the tenant. The Appellants succeed on the primary issue in these appeals.

There are three subsidiary issues concerning (i) the deductibility of the developer’s fees; (ii) the character of the Medi-Dent leases; and (iii) the deductibility of amounts paid to the Miramichi Salmon Club.

(i) Developer’s Fees

Under the agreement with Mr. Thornley’s company (Exhibit B-3), Thornley’s fee was to be 5% of the total development cost plus travel expenses. In accordance with that agreement, the Co-Tenancy paid Mr. Thornley’s company fees of $350,000 and expenses of $55,911.77 for a total outlay of $405,911.77. Many of the invoices appear as Exhibit C-28. According to subparagraph 14(x) and paragraph 22 of the Reply to Notice of Appeal, the Minister allocated approximately 50% of the Thornley fees and expenses as part of the cost of the new building in accordance with subsection 18(3.1) of the Act and the other 50% was allowed as deductible expenses. The amounts capitalized were

1984: $110,787

1985: $93,069

TOTAL: $203,856

The Appellants claim that 100% of the developer’s fees and expenses are deductible and should not be capitalized. Certain services like arrangement of financing, legal representation and site investigation are deductible under paragraphs 20(1 )(e), (cc) and (dd) but, in the circumstances of these appeals, there was no work required with respect to locating the new site because it was owned by the doctor/partners long before Mr. Thornley was retained.

Mr. Thornley stated in evidence that 90% of his work was done before a shovel went in the ground but I put little weight in that statement. First, it is not supported by the terms of his retainer (Exhibit B-3) quoted above. He was to provide “supervision through every phase of the project”. Also, his services included: (7) “Negotiate all leases” and (8) “All other ancillary functions necessary to ensure the final success of this venture”. The building was never fully leased; the DMC Partnership was in serious financial difficulty because of its obligation to pay high rent for the top five floors parts of which were vacant; two of the doctor/partners became insolvent; and the remaining partners were required to sell the building in an arm’s length transaction in 1988. The concept of owning their building as a longterm investment for the doctor/partners was not a success. It was not explained in evidence why Mr. Thornley did not have on-going obligations to negotiate leases so long as there were vacancies in the building. According to Exhibit A (paragraph 30), $275,000 of the Thornley fees were invoiced after September 30, 1984 and construction had commenced in July 1984.

My second reason for not placing much weight on Mr. Thornley’s evidence is my perception that he was not objective. He appeared too willing to say whatever would assist the Appellants’ case. Perhaps he was embarrassed by the fact that the dream which he had carried from Ontario to Nova Scotia was not fulfilled in the hands of the Appellants. On this issue, I have no reason to change the assessments which capitalized 50% of the developer’s fees as part of the cost of the new building and allowed the remaining 50% as deductible operating expenses.

(ii) Medi-Dent Leases

The DMC Partnership entered into a “Master Equipment Lease” (Exhibit C-23) with Medi-Dent Service (a division of Citibank Leasing Canada Limited) in order to finish and equip its new office space. Under Exhibit C-23, the DMC Partnership agreed to lease certain property from Medi-Dent pursuant to the terms of the lease and a series of separate lease schedules including these four:

The Master Equipment Lease and the schedules do not contain any option to purchase but, by separate agreements, Medi-Dent granted to the DMC Partnership the option to purchase the equipment or leasehold improvements after 60 months at the option price shown in the above table. The DMC Partnership exercised its option to purchase under all four schedules. The real question is whether the Medi-Dent leases were genuine leases requiring the DMC Partnership to pay “rent” for the use of property owned by Medi-Dent or whether the so-called leases were in substance loan agreements under which the DMC Partnership financed its own purchase of certain equipment and leasehold improvements and made equal monthly payments which were a mixture of principal and interest.

The law relating to this issue is well summarized in the decision of this Court in Viceroy Rubber and Plastics Ltd. v. Minister of National Revenue, [1993] 1 C.T.C. 2343, 93 D.T.C. 347. An agreement which is in the form of a lease with respect to certain property will be regarded as a sale of that property rather than a lease in any one of the following situations:

(a) the lessee following the payment of specific rental costs, automatically acquires title to the property;

(b) the lessee is required to purchase the property from the lessor during or upon termination of the lease agreement or is required to guarantee that the lessor will receive the entire option price from the lessee or a third party;

(c) the lessee has the right during or upon the expiry of the lease to acquire the property at a price which at the commencement of the lease is substantially less than the probable fair market value of the property when the lessee is permitted to acquire the property; or

(d) the lessee has the right during or upon the expiry of the lease to acquire the property at a cost and pursuant to terms and conditions which at the commencement of the lease are such that no reasonable person would fail to exercise the option to purchase.

The Medi-Dent leases do not fall within items (a) or (b). They may, however, fall within items (c) or (d). Under item (c), I would have to know the probable fair market value of the property at the end of 60 months. And in substance, I would have to know the same value for item (d). I do not recall any evidence with respect to such fair market value but there are other relevant amounts in evidence.

The Master Equipment Lease contains the usual terms one would ex- pect to see when Medi-Dent is a lessor and the DMC Partnership is a lessee. The substance of the relationship is better found in the schedules (Exhibits C-24 to C-27) which contain the monthly rental amounts that appear in the above table. Exhibit C-24 is the schedule for the leasehold improvements in the top five floors to accommodate the 18 doctor/partners. Exhibits C-25 and C-26 are schedules for equipment which they needed in their professional work. And Exhibit C-27 is the schedule for the leasehold improvements for a sub-tenant of the partnership.

Exhibit E-26 is a letter dated September 6, 1985 from Medi-Dent to the DMC Partnership which I will quote in part:

I would like to update our original proposal to you and the Dartmouth Medical Clinic based on our current information. Looking at the package that we currently have signed up with most of your doctors, we have a possible lease of $1.5 million dollars. This breaks down approximately as this:

Leasehold: $900,000

Equipment: $600,000

The term of the contract would be as follows:

Leaseholds: 65 months with an option to purchase for 10% of the Original cost at month 60 or continue payments until the end of 65 months and you are finished;

Equipment: 65 months with an option to purchase for 10% at month 60 or continue to 65 payments and then purchase for fair market value or 3 annual renewals.

I would recommend in this case that you exercise your purchase option at month 60 as the other conditions are put in for tax considerations only and are not a good alternative for you.

The leaseholds would be done on a one-time purchase payback to set up the lease and the equipment would be paid as delivered.

According to this letter, the “option price” in the above table is equal to 10% of the original cost of the property. Exhibit E-26 estimated the leasehold improvements to be $900,000 as at September 6, 1985. According to the above table which is taken from Exhibit A (paragraph 27), the option price for the leasehold improvements is $86,888.89. If that amount is 10% of the original cost, then the original cost of the leasehold improvements was $868,888.90. This is close to the amount ($900,000) estimated in Exhibit E-26. I would make the following computations with respect to leasehold improvements:

Option price (10% of original cost): $86,888.89

Original cost: $868,889.90

Monthly rent: $19,743.20

Rent for last five months (Nos. 61-65) if option not exercised: $98,716.00

According to the above amounts, any lessee would exercise the option to purchase at month 60 because the option price at that time was less than the aggregate rent for the remaining five months if the option were not exercised. This would bring the transaction within item (d) above as an option to purchase which no reasonable person would fail to exercise. Also, it is apparent that Medi-Dent had recovered 90% of the original cost out of the first 60 monthly payments.

Having regard to the other schedules in the above table, I have performed the necessary computations and, in each case, the aggregate monthly payments for the last five months of the term (months 61-65) exceed the option price in each schedule. Therefore, why would any so- called lessee not exercise the option and “purchase” at month 60 the property which was the subject of the agreement? The doctors who testified and their accountant (Mr. Deegan) stated that they worked out together the cost/benefit of exercising the options in the Medi-Dent leases. According to my computations, there was not much to work out. No reasonable person would have failed to exercise the “purchase” option. All of the documents connected with the so-called Medi-Dent leases (Exhibits C-23 to C-27 and E-26) indicate that the transactions were financing and not leasing. The purported “lessor” is a division of a bank.

If I were in any doubt concerning the Appellants’ need to exercise their option with respect to their own leasehold improvements (and I have no such doubt), I would hold against the Appellants because I have concluded that Medi-Dent never had title to the leasehold improvements. The general contractor (Fundy Construction) which constructed the new building also did the leasehold improvements. Those fixtures would have become part of the building as they were installed. The evidence was that DMH (as agent for the Co-Tenancy) paid the contractor for the leasehold improvements and was merely reimbursed by Medi-Dent. It appears that Medi-Dent never had any proprietary interest in the leasehold improvements which would have permitted Medi-Dent to “lease” them to the DMC Partnership.

In my opinion, the Medi-Dent leases were not genuine leases but only loan agreements which assisted the DMC Partnership to finance the purchase of its equipment and leasehold improvements over five years (60 months). I would not grant to the Appellants any relief concerning the Medi-Dent agreements.

(iii) Miramichi Salmon Club

In 1984 and 1985, the 18 doctor/partners in the DMC Partnership decided to go away from Dartmouth for a weekend to discuss partnership affairs without any interruption from patients or family. Each year, they reserved a weekend at the Miramichi Salmon Club in New Brunswick where they combined business meetings with some fishing. The amounts expended were:

1984: $4,647

1985: $7,405

Upon reassessment, the above amounts were disallowed as deductions under paragraph 18( 1)(1) which states:

18(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(1) an outlay or expense made or incurred by the taxpayer after 1971,

(i) for the use or maintenance of property that is a yacht, a camp, a lodge or a golf course or facility, unless the taxpayer made or incurred the outlay or expense in the ordinary course of his business of providing the property for hire or reward, or

(ii) as membership fees or dues (whether initiation fees or otherwise) in any club the main purpose of which is to provide dining, recreational or sporting facilities for its members;

Only subparagraph (i) could apply because the above amounts were not for “membership fees or dues”. The Appellants argue that the expenses paid to the Miramichi Salmon Club were solely for business services provided by the Club, and the partners did not have the “use” of the Club within the meaning of subparagraph 18( l)(l)(i) of the Act.

Having regard to the decisions of the Federal Court of Appeal in R. v. Jaddco Anderson Ltd. (sub nom. Jaddco Anderson Ltd. v. The Queen; sub nom. The Queen v. Jaddco Anderson Ltd.), [1984] C.T.C. 137, 84 D.T.C. 6135, and Sie-Mac Pipeline Contractors Ltd. v. Minister of National Revenue (sub nom. The Queen v. Sie-Mac Pipeline Contractors Ltd.), [1992] 1 C.T.C. 341, 92 D.T.C. 6461,1 conclude that the amounts in issue were paid “for the use” of the salmon club, and that the club was a “camp, lodge or facility” within the meaning of subparagraph 18(l)(l)(i). The appeals are dismissed with respect to this third subsidiary issue.

Conclusion

The Appellants succeed on the primary issue but fail on the three subsidiary issues. Because the primary issue dominated the evidence and argument, the Appellants are entitled to their costs. I would allow one set of costs as if there were only one Appellant plus an arbitrary amount of $2,200.00 with respect to documents required for the other 11 Appellants.

Appeals allowed in part.