11 February 1997 GST/HST Interpretation HQR0000355 - Mixed Residential/Commercial Property and Section167

Dear XXXXX

This is in response to an E-mail from XXXXX dated October 9, 1996, concerning the transfer of a mixed use (residential and business) property from an individual to a corporation. We apologize for the delay in responding to his questions.

Statement of Facts

Our understanding of the facts of the case is as follows:

1. A non-registrant individual purchased a property in 1993.

2. At the time of acquisition, the property consisted of a XXXXX[.] None of the property was used for any non-residential purpose.

3. The individual who purchased the property paid no GST on the property upon acquisition.

4. Since 1993, the individual owner has m oved walls and changed the interior of the building which resulted in the building's present composition of:

(a) one residential unit leased to unrelated individuals as a place of residence, left essentially the same as it was in 1993, comprising approximately 1/6th of the building,

(b) one residential unit used by the owner as his primary place of residence and accounting for approximately 1/3rd of the building,

(c) one business use space, comprising approximately 1/2 of the building, where the individual owner provides exempt music lessons to his clients.

These changes did not constitute a "substantial renovation" within the meaning found in subsection 123(1) of the Excise Tax Act (the Act).

5. The individual owner carries on his music lesson business with a reasonable expectation of profit.

6. The individual owner is now considering a transfer of ownership of the real property and/or his XXXXX music lesson business into a corporation. The individual owner will be the sole shareholder and director of this new corporation. This transfer will take place in one of the following ways:

(a) The individual owner will transfer ownership in the property and the music lesson business to the corporation. The corporation will then carry on the music lesson business and lease the residential unit described in paragraph 4(b) to the individual former owner.

(b) Alternatively, the individual owner will transfer ownership of the real property, while retaining ownership of his music lesson XXXXX business. The corporation will lease the non-residential portion and a residential unit back to the individual owner. The corporation will not register for GST.

(c) As in paragraph 6.(b) above, except the corporation will register for GST.

Interpretation Requested

XXXXX asked how the definition of residential complex applies in this particular fact scenario. He also asked about the application of the change in use rules in subsection 206(4) of the Act if the individual and the corporation file an election pursuant to subsection 167(1) of the Act. It was his understanding that section 167 and the change in use rules for ceasing use in commercial activity would have the effect of imposing a tax liability on the corporation equal to seven percent of the fair market value of the entire property.

Interpretation Given

For the purposes of this interpretation it is assumed that the corporation will be leasing the business use property to the individual at fair market value in the scenarios outlined in paragraphs 6(b) and 6(c).

Based on the information provided we give the following interpretations:

1. The transfer of the real property by the individual to his corporation would be deemed separate supplies of the part that constitutes a residential complex and the part that was used in the music lesson business.

2. The supply of the residential complex would be exempt from GST pursuant to section 2 of Part I of Schedule V to the Act. The supply of the part of the real property that was used in the music lesson business (the non-residential part) would be taxable at seven percent. If the consideration for the supply of the non-residential part is less than its fair market value, section 155 of the Act would apply to deem the consideration to be the fair market value, unless the corporation is a registrant and will be using the non-residential part exclusively in its commercial activities (see paragraph 4(c) below).

3. The individual will be entitled to a rebate of any GST paid in respect of improvements made to the non-residential part of the property since his 1993 acquisition of the building, up to a maximum of the tax payable, or tax that would be payable in the absence of an election pursuant to section 167 of the Act, on his supply of the non-residential property to his corporation. This rebate is provided for in section 257 of the Act.

4. The corporation's entitlement to an input tax credit (ITC) or rebate and the application of GST to supplies of the property by the corporation will differ depending on which course of action it pursues.

(a) The corporation carries on the music lesson business (as in paragraph 6(a) of the Statement of Facts):

Should the corporation carry on the music lesson business, at the time of its acquisition of the property the corporation will not be eligible for a rebate of the GST payable on acquisition. The Department would not register the corporation because it has no commercial activity, so an election pursuant to section 167 of the Act, although possible, would have no effect on the tax treatment of the real property (see Analysis). If the corporation eventually makes a supply of the property by way of sale, the supply of the non-residential part will be taxable, provided no change in use has occurred, and the supply of the residential part will be exempt. The corporation would then be eligible for a rebate pursuant to section 257 of the Act, assuming the corporation is still not registered at that time. The rebate would be equal to the lesser of the following two figures:

•   tax paid on the last acquisition of the non-residential part plus tax paid on improvements thereto since its last acquisition,

•   tax payable (or tax that would be payable but for section 167 of the Act) on the corporation's sale of the non-residential part of the property.

(b) The corporation leases part of the property back to the former owner but does not register (as in paragraph 6(b) of the Statement of Facts):

An election pursuant to section 167 of the Act would not be possible in this scenario (see Analysis). The corporation's lease of the non-residential part of the property would constitute a taxable supply. However, as a non-registrant the corporation would not be entitled to any ITCs. If the corporation remains a small supplier, the interpretation given in paragraph (a) above will apply to the corporation's resale of the property.

(c) The corporation registers, the individual and corporation file an election pursuant to section 167 of the Act (as in paragraph 6(c) of the Statement of Facts):

The election pursuant to section 167 of the Act would not be possible (see Analysis). The lease of the non-residential part of the property by the corporation to the individual would be a taxable supply.

Subsection 221(2) of the Act would apply to relieve the individual vendor from collecting the GST on the non-residential part. The corporation would be responsible to report the tax payable on the acquisition of the non-residential part pursuant to subsection 228(4) of the Act and would be eligible to claim an ITC for the same amount. The corporation would be required to collect and remit GST on the lease of the non-residential part.

The corporation's lease of the two residential units in the building would be exempt pursuant to paragraph 6(a) of Part I of Schedule V to the Act, in all of the scenarios provided.

Analysis

Residential Complex

In response to XXXXX specific question on the definition of "residential complex", paragraph (a) of the definition of "residential complex" in subsection 123(1) of the Act, includes that part of a building that contains one or more residential units together with that part of any common areas, appurtenances and contiguous land reasonably necessary for its use or enjoyment as a place of residence and a proportional amount of the land underlying the building. In accordance with Policy Number P-069, the portion of land that is associated with the part of the building used in the music lesson business would not normally be considered reasonably necessary for the use and enjoyment of the residential complex as a place of residence for individuals. In this particular case, paragraph (c) of the definition of "residential complex" would not apply as the building is not used primarily as a place of residence for the individual owner or a relative. The owner's use of the property as his place of residence is only 1/3rd of the use of the whole building. The individual owner's use of the property as his or a relative's place of residence would have to have been greater than 50 percent of the entire use of the building for paragraph (c) to render the entire property a residential complex.

Section 136

Subsection 136(2) of the Act provides that where a supply of real property includes a residential complex and other real property that is not a residential complex, the provision of the residential complex is deemed to be a separate supply from the provision of the other property. This applies to a supply by way of sale and a supply by way of lease.

Therefore the individual's supply of the part of the property that constitutes a residential complex would be exempt pursuant to section 2 of Part I of Schedule V to the Act. There is no exemption in the Act that would apply to the part of the building that was used in the music lesson business of the individual vendor. Section 9 of Part I of Schedule V to the Act specifically excludes real property that is capital property used primarily in a business of the individual vendor. Pursuant to the proposed amendment to this section included in Bill C-70, this exclusion is further qualified in that the business of the individual vendor has to have been carried on with a reasonable expectation of profit. This part of the proposed amendment is generally deemed to have come into force on December 17, 1990.

Also because of subsection 136(2) of the Act, the corporation's lease of the real property to the individual former owner would be deemed separate supplies: the supply of the non-residential part of the building would be taxable and the supply of the residential part would be exempt by virtue of paragraph 6(a) of Part I of Schedule V to the Act.

Section 155

Section 126 of the Act deems the individual and the corporation that he controls not to be operating at arm's length. Therefore, the supply of the property by the individual to the corporation may be governed by the provisions of section 155 of the Act. Essentially, this section deems consideration for a non-arm's length supply to be at fair market value unless:

(i) the recipient is a registrant who is acquiring the supply for consumption, use or supply exclusively in the recipient's commercial activity,

(ii) the supplier was denied an ITC for the property because of subsection 170(1) or subsection 172(2) of the Act, or

(iii) an amount in respect of the supply is deemed to be the total consideration for the supply under section 173 of the Act (taxable benefits).

If the individual transfers ownership in the non-residential part of the real property to his corporation under the circumstances outlined in paragraph 6(a) or 6(b) of the Statement of Facts for consideration that is less than fair market value, tax would be collectible by the individual on the fair market value for the non-residential part of the real property. The application of this fair market value rule to the residential part has no effect as no tax is payable on that part of the transaction.

Section 167

An election under subsection 167(1) of the Act would have no effect on the transfer of the real property under the scenario presented in paragraph 6(a) of the Statement of Facts. Pursuant to subparagraph 167(1.1)(a)(iii) of the Act, real property is specifically excluded from the effects of this election where the recipient is not a registrant. In general, the Department would not register a corporation that is not a listed financial institution and has no commercial activity. Please note that Policy Number P-045 Butterfly Transactions outlines an exception to this general rule. However, this exception is not applicable to the fact scenario that XXXXX describes.

If the transaction occurs in the circumstances described in paragraph 6(b) or 6(c) in the Statement of Facts, an election pursuant to section 167 of the Act would not be possible. The individual supplier is not supplying a business or part of a business carried on by the supplier. Only the real property is being supplied and not the business. The individual is retaining his music lesson business. He would simply be selling a piece of real property which does not, by itself, constitute a business.

In answer to XXXXX concerns about the interaction of the change in use rules and the election for the supply of a business, an election pursuant to section 167 does not impose tax on an otherwise exempt supply of property. Subparagraph 167(1.1)(b)(i) provides that capital property that would be taxable in the absence of the election is deemed to be acquired by the recipient for use exclusively in commercial activity. Subparagraph 167(1.1)(b)(ii) provides that capital property that would not be taxable in the absence of the election is deemed to be acquired by the recipient for use exclusively in non-commercial activity.

To illustrate, a registered corporation acquires mixed use (business and used residential) real property as part of a supply of a business. The supplier and the registrant corporation file a joint election pursuant to section 167 of the Act. Immediately after acquiring the business, the recipient operates a day care (exempt activity) in the business use part of the real property and continues to lease the residential part to individuals for residential use. The interaction of sections 167 and 206 of the Act results in the following:

•   subparagraph 167(1.1)(b)(i) applies to the business use part of the property, resulting in a change in use pursuant to subsection 206(4) of the Act when the corporation begins its use of the property in non-commercial activity. Tax would apply to the business use part of the property.

•   subparagraph 167(1.1)(b)(ii) applies to the "residential complex" part of the property. The property was deemed to be acquired for use in non-commercial activity. The recipient actually uses the property in non-commercial activity. No change in use occurs. Tax would not become payable on this part of the property.

Should you have any further questions or need clarification of this letter, please do not hesitate to contact the undersigned at (613) 954-8852.

Sincerely,

Heather MacLeod
A/Policy Officer
Financial Institutions & Real Property
GST Rulings & Interpretations Directorate

Legal References:                   123(1) "residential complex", 126, 136(2), 155, 167, 206, 207,
Part I of Sch. V.

Authority:                               Excise Tax Act

Reference:

b.c.c.:   H.Q.Quality Assurance