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Attention: XXXXX, Interpretations Officer.
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August 19, 1994
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Dear XXXXX:
I refer to your fax message dated March 17, 1994 addressed to Joy Weir of Special Sectors concerning the GST treatment of leasehold interest/improvements, cash inducements and entitlements to input tax credits (ITCs). This correspondence was subsequently transferred to General Tax Policy. This letter will confirm the response provided in your telephone conversation with Raymond Labelle of my staff.
Issuse
The issues of concern were raised as a result of an audit inquiry as to whether or not a registrant, XXXXX, must self-assess under subsection 206(4) of the Excise Tax Act (the "Act"), or if ITCs are restricted by subsection 169(1.1) of the Act at the time a cash inducement is received by XXXXX from the landlord. The auditor was seeking general guidance on these issues, while providing specifics of the XXXXX case, because other financial institutions will be audited for the same issues in the future.
Statement of Facts
The internal memorandum dated May 2, 1994 from XXXXX which was attached to your fax message provided details of this case as follows:
1. XXXXX, the registrant, is a listed financial institution.
2. The registrant operates approximately XXXXX branch offices across Canada.
3. Once leasehold improvements are completed and the registrant begins to conduct its regular business in the branch offices, the registrant uses the branch offices exclusively in the course of activities other than commercial activities.
4. The registrant enters into a lease agreement with XXXXX, an independent landlord, for the lease of commercial office space to be used as a branch office.
5. Most leases negotiated require the landlord to pay to the registrant (the Tenant) a one-time cash inducement or improvement allowance based on a specific dollar amount per square foot of leased office space.
6. The cash inducement generally becomes payable on the latest date of certain events that are required to occur in the contract.
7. The registrant is responsible to provide and carry out, at its expense, all work required to be performed in order to render the premises complete and suitable to open for business.
8. Title to the improvements reverts back to the landlord at the determination of the lease.
9. All leases contain clauses which allow for the sublease of the premises by the lessee to a third party.
10. XXXXX claimed ITCs for tax payable on the inputs used for making the improvements pursuant to the contract.
11. Audit assessed XXXXX in respect of the ITC claims related to the inputs used for making the improvements pursuant to the contract, taking the position that the claims were not valid.
Ruling Requested by Excise Auditor
1. Is the GST expense incurred by the Tenant on the cost of the leasehold improvements eligible for an ITC since it represents an input into the supply made by the Tenant of "executing the lease"? If not, does paragraph 169(1)(b) of the Act prevent the ITC in conjunction with subsection 169(1.1)?
2. If the cost of the leasehold improvements are considered to be inputs into the supply of "executing the lease" and therefore eligible for ITCs, would these inputs (leasehold improvements) be considered capital property at the time of being eligible for ITCs? If so, are they subject to subsection 206(4) of the Act when the registrant begins to use the leasehold improvements exclusively in exempt activities? If not, would these inputs be considered non-capital property at the time they are eligible for ITCs and therefore subject to section 196.1 when the registrant begins to use the leasehold improvements exclusively in exempt activities?
The Registrant's Position
In their correspondence with the XXXXX has indicated that they consider the issue in question to be whether they are entitled to claim an ITC for GST paid on the cost of the leasehold improvements, and if so whether the change in use rules would apply to "recapture" all or part of this ITC.
The registrant contends that since the act of entering into a lease is considered to be a taxable service, then, under common law, leasehold improvements become the property of the landlord at the time they are made and would, therefore, constitute a supply made by the tenant to the landlord. Further, the registrant considers that since the leasehold improvements are no longer owned by the tenant, the change in use rules would not apply to the leasehold improvements.
Department's Response
Subsection 169(1) of the Act provides a general rule for claiming ITCs. Under the general rule, ITCs related to an improvement would be determined based on the intended use of the improvements at their acquisition.
However, there is a specific rule which prevails over the general rule in the case of inputs acquired for use in improving capital property. Paragraph (b) of element B of subsection 169(1) of the Act provides for an apportionment of use in commercial activities of supplies acquired as an improvement to capital property. A registrant may claim ITCs for tax payable on an improvement acquired to the extent of the capital property is for use in a commercial activity immediately prior to the improvement being made.
Subsection 169(1.1) of the Act deals with situations where an input is acquired partly for use in improving capital property and partly for another purpose. The provision deems that portion of the input acquired for the purpose of improving the capital property to be a separate supply from, and not incidental to, the remainder of the input. The tax payable in respect of the portion of the input used as an improvement is deemed to be 7% of the amount capitalized for income tax purposes. The remaining tax payable is attributed to the portion which was not used to improve the capital property.
In this particular case, the general ITC rules would not apply to the inputs acquired for executing the lease. Under the specific ITC rules, the extent of use in commercial activities of improvements of capital property is deemed to be the extent of use in commercial activities, of the capital property that is improved, before the improvements are made. There would be no ITC entitlement in respect of the improvements in this case, because the improved property was used exclusively for activities other than commercial activities before the improvements were made.
For those inputs acquired partly for improving capital property and partly for another purpose, no ITC may be claimed for the proportion of the tax payable on the input's acquisition which relates to the proportion of the input used for improving the capital property, again because the property was for use in an exempt supply.
Change of use rules
Section 206 of the Act provides the general rules for adjustments to the ITCs claimed when there is a change in the use of capital real property. When the property ceases to be used in a commercial activity, the registrant is deemed to have made a supply and to have collected tax on that portion of the property that, immediately prior to the cessation in use, was used in the commercial activity.
In this case, the leasehold interest is used in the same manner before and after the improvements are made. The leasehold interest is used for making exempt supplies, not for supplying improvements. Therefore, there is no remittance obligation or ITC entitlement resulting from a change in the use of the leasehold interest.
Conclusion
In this particular case, to the extent that the inputs are "improvements" as defined in the Act and are for improving capital real property used exclusively in making exempt supplies, there is no ITC entitlement on the acquisition of these inputs. The same restriction would hold even where these improvements would be used to make a taxable supply of "executing a lease" to acquire a leasehold interest in the capital real property.
The position taken by XXXXX conforms with the Department's position.
If you require any further information on this matter, please do not hesitate to contact Raymond Labelle at (613) 952-8815.
Yours truly,
H.L. Jones
Director
General Tax Policy
Policy and Legislation
Excise/GST
Attachment
XXXXX
| c.c.: |
A. Venne
S. Farber
M. Matthews
R. Labelle |
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