9 March 2004 GST/HST Interpretation 46270 - GST/HST Treatment of Real Property Partially Converted to Business Use

Please note that the following document, although correct at the time of issue, may not represent the current position of the Agency. / Veuillez prendre note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'Agence.

This is further to your telephone conversation XXXXX with Mike Place of this office, in which you requested further information concerning our e-mail response XXXXX on the captioned subject.

In your conversation with Mike, you presented four different scenarios in which certain capital real property is converted from personal to commercial use.

All references are to the Excise Tax Act (ETA) unless otherwise indicated.

SCENARIO 1

1. An individual owns and resides in a single unit residential complex, which is located on a one-acre parcel of land (the Property). A detached, personal use garage is also located on the land. The Property was originally acquired on an exempt basis as a single parcel of property.

2. At some point, the individual partially converts the garage to a bicycle repair shop. After conversion, 60% of the garage (the Commercial Portion) is used exclusively in the commercial activities of the individual.

3. The remaining 40% percent of the garage is for the personal use of the individual and is considered as an appurtenance to, and therefore to form part of, the residential complex.

4. The individual makes capital improvements to the Commercial Portion of the garage.

5. The individual later decides to sell the Property.

Questions

1. Can the individual claim input tax credits (ITCs) on the improvements?

2. What is the tax treatment of the sale of the Property?

Interpretation and Analysis

1. Eligibility for ITCs on improvements

Since Question 1 deals with an ITC claim, we will assume that the individual is a GST/HST registrant. As you know, a GST/HST registrant is generally entitled, pursuant to subsection 169(1), to claim ITCs for tax paid or payable on property and services to the extent (expressed as a percentage) that the property or service is for consumption, use or supply in the course of the recipient's commercial activities.

In this case, the availability of ITCs under subsection 169(1) is based on the extent to which the entire Property is used in the commercial activities of the individual, subject to section 208. In determining the individual's ITC entitlements, it is therefore necessary to determine the extent to which the Property is used in commercial activities.

Importantly, subsection 208(4) stipulates that a GST-registered individual may not claim an ITC for any improvement to capital real property if the property is primarily for the personal use or enjoyment of the individual, or any related individual, immediately after it is improved.

Appendix A of GST/HST Memoranda Series Section 19.5, Land and Associated Real Property, lists a series of factors that may be used in determining how a particular property is primarily used. The term "primarily" is considered as being more than 50% as determined on a fair and reasonable basis in the context of the particular property. As stated in paragraph 7 of the Appendix, the determination as to how land is primarily used is generally not based upon a single factor, but on a weighing of all relevant factors, with some factors possibly being more significant than others in making such a determination. Following is a discussion concerning the GST/HST treatment of the Property where it is determined to be primarily for the personal use and enjoyment of the individual and where it is not.

Property primarily for the personal use and enjoyment of the individual

The facts indicate that 60% of the area of garage was converted for use in the commercial activities of the individual. If after considering the relevant criteria it is determined that the use of the Property is primarily personal, no ITCs would be available in respect of the improvements, pursuant to subsection 208(4).

Property not primarily for the personal use and enjoyment of the individual

On the other hand, if it were determined that the Property is not used primarily for the personal use of the individual, ITCs would become available for the tax paid on the improvements. For example, if after considering the relevant policy criteria it is determined that the ratio of personal to business use of the Property is 45:55, subsection 208(2) would apply to deem the individual to have received a supply by way of sale of the Property and, except where the supply is an exempt supply, to have paid tax in respect of the supply equal to the basic tax content (BTC).

Given the circumstances of the present scenario, it is our view that the deemed sale of the Property under subsection 136(2) would generate a deemed acquisition of two separate properties by virtue of subsection 136(2) (Given that the Commercial Portion does not form part of the residential complex, the deemed sale of the Property is subject to subsection 136(2). Under this provision, if a supply of real property includes a residential complex and other real property which is not part of a residential complex, the supply of the complex is deemed to be a separate supply from the other real property and neither supply is incidental to the other.). As such, the tax status of the two properties created under subsection 136(2) would need to be considered separately. Under the circumstances, the deemed acquisition of the Commercial Portion would be taxable as there are no provisions to exempt it, whereas the acquisition of the residential complex may be exempt under section 2 of Part I of Schedule V (discussed below).

Pursuant to subsection 136(2), the individual is deemed to have paid tax on the deemed acquisition of the Commercial Portion equal to its BTC. For purposes of the corresponding ITC claim, it is our position that the BTC of the residential complex and the Commercial Portion should be allocated on a fair and reasonable basis between those parts. In our scenario, it would be reasonable to include all tax paid on the improvements to the Commercial Portion as forming part of its BTC; full ITCs would therefore be available on this amount pursuant to subsection 169(1).

ITCs for operating expenses

Notwithstanding the extent to which the individual may claim, or is precluded from claiming, ITCs in respect of the improvements to the Property, he or she would be entitled ITCs for the tax paid or payable on any business inputs (i.e., operating expenses) to the extent that they relate to the individual's commercial activities. Note also that if a particular input is used at least 90% for activities of the individual that are not commercial activities, the individual would not be able to claim any ITCs for the tax paid on the input, pursuant to subsection 141(4).

2. Tax status of the sale of the Property

In determining the tax status of the sale of the Property, it is first necessary to determine whether all or part of the Property forms part of the residential complex for purposes of section 2 of Part I of Schedule V to the ETA. Specifically, section 2 exempts the sale of a residential complex or an interest therein by a person who is not the builder of the complex, unless the person has claimed an ITC in respect of the last acquisition of or an improvement to the complex.

The residential complex

A "residential complex" is defined in paragraph (a) to include that part of a building in which one or more residential units are located, together with that part of any common areas and other appurtenances to the building and the land immediately contiguous to the building that is reasonably necessary for the use and enjoyment of the building as a place of residence for individuals.

For purposes of the above definition, we regard an appurtenance as something that is annexed to or belongs to another thing that is the main element of the item or object in question. To qualify as an appurtenance, an article must generally be adapted to the use of the property to which it is connected. Provided the appurtenance is reasonably necessary for the use and enjoyment of a building as a place of residence for individuals, the appurtenance may be considered to form part of a residential complex under the above definition.

Given the foregoing, it would be reasonable to consider the personal use portion of the garage as an appurtenance to the residential complex, and would thus form part of the complex for purposes of paragraph (a) above. On the other hand, given our position that an appurtenance is an article that is adapted to the use of the property to which it is connected, we would not view the Commercial Portion as an appurtenance to the complex. Moreover, we would not consider it to be reasonably necessary for the use and enjoyment of the complex as a place of residence for individuals as required by the definition. As such, it would not form part of the residential complex.

Under policy statement P-069, Land Allowance For Residential Complexes, there is a presumption that land in excess of 1/2 hectare (approximately 1.25 acres) that is subjacent and immediately contiguous to a residential building is not reasonably necessary for the use and enjoyment of the building as a place of residence and thus does not form part of the residential complex unless the taxpayer can demonstrate otherwise.

The policy further states that where a portion of the minimum lot size is not used for residential purposes but rather for commercial activities, such portion is usually not considered to be reasonably necessary for the use and enjoyment of the building as a residence. Given that the Commercial Portion is used in the commercial activities of the individual, it would not form part of the land reasonably necessary for this purpose.

Application of subsection 136(2)

As discussed above, if a supply of real property includes a residential complex and other real property that is not part of a residential complex, subsection 136(2) will apply to deem the supply of the complex to be a separate supply from the other real property. Following is a discussion concerning the application of subsection 136(2) where the Property is determined to be primarily for the personal use and enjoyment of the individual and where it is not.

Property primarily for the personal use and enjoyment of the individual

In the event that the Property is found to be primarily for the personal use and enjoyment of the individual (see discussion in our response to question 1), it would be subject to subsection 136(2) at the time of sale. At that time, the portion of the Property that constitutes the residential complex will be considered to be sold separately from the Commercial Portion.

Moreover, we will consider the Commercial Portion to undergo a change-in-use by virtue of subsection 208(2) immediately prior to the sale (This change-in-use is brought about by the deeming effect of 136(2) since (1) immediately prior to the application of subsection 136(2), the Commercial Portion was part of a capital real property (i.e., the Property) used primarily for the individual's personal use and enjoyment; and (2) upon application of subsection 136(2), the Commercial Portion became separate property used exclusively in commercial activities carried on by the individual. The change-in use occurs because the Property is put to a mixed use (i.e. primarily residential and secondarily commercial) when 136(2) separates it into two parcels, one of which is exclusively for commercial use and the other exclusively for residential use.). The result is that subsection 169(1) would permit the individual to claim ITCs equal to the BTC the individual is deemed to have paid under subsection 208(2). As discussed in our response to Question 1, the BTC attributable to the residential complex and the Commercial Portion should be allocated on a fair and reasonable basis between those two parts. In our scenario, it would be reasonable to include all tax paid on the improvements to the Commercial Portion as forming part of the BTC for that part, thus allowing full ITCs on this amount pursuant to subsection 169(1).

As mentioned previously, the supply of a residential complex is exempt, subject to section 2 of Part I of Schedule V. Under the circumstances, the individual would not be considered to be a "builder" of the residential complex as defined in subsection 123(1) since paragraph (f) of the definition excludes an individual who acquires a residential complex or interest therein otherwise than in the course of a business or an adventure or concern in the nature of trade. Therefore, as long as no ITCs were claimed in respect of the acquisition or improvements to the complex, its sale would be exempt pursuant to section 2 above.

Whether the supply of the Commercial Portion is taxable would depend on section 9 of Part I of Schedule V, which generally applies to exempt a supply of real property made by an individual unless one of the exclusions to the exemption prevails. Under exclusionary paragraph 9(2)(a), a sale of real property made by an individual or personal trust is excluded from the general exemption if, immediately before the time ownership or possession of the property is transferred, the property is capital property used primarily in a business carried on by the individual or the personal trust with a reasonable expectation of profit. Assuming that the bicycle repair business is carried on with a reasonable expectation of profit, paragraph 9(2)(a) would apply to exclude the supply from exemption. Since there are no other applicable exemptions in the circumstances, the sale of the Commercial Portion would be taxable (In cases where value must be apportioned between the portion of the land that is considered part of the residential complex and the portion that is not part of the residential complex, the apportionment must be fair and reasonable, e.g., based on the fair market value of each portion. (Paragraph 15, of Memoranda Series Section 19.2.1)).

Property not primarily for the personal use and enjoyment of the individual

Where, as a result of the commencement of the commercial use, it is determined that the Property is not primarily for the personal use and enjoyment of the individual, subsections 208(2) and 136(2) would have applied prior to the sale in the manner described in the response to Question 1 (under the heading, "Property not primarily for the personal use and enjoyment of the individual"). Consistent with our position, XXXXX (XXXXX we determined that real property acquired as a combined supply of a residential complex and other property that is not part of the residential complex to continue to be recognized for GST/HST purposes as separate properties after the acquisition of the combined property had taken place, by virtue of subsection 136(2).), the Commercial Portion and the residential complex would continue to be separate properties subsequent to the initial application of subsection 136(2) at the time of the change-in-use. As such, at the time of an actual sale of the Property, the residential and commercial components would continue to be recognized as separate properties. For the reasons given above, the Commercial Portion would thus be taxable while the residential complex would be exempt.

SCENARIO 2

1. An individual owns and resides in a single unit residential complex, which is located on a 100-acre parcel of land (the Property). A detached, personal use garage is also located on the land. The Property was originally acquired on an exempt basis as a single parcel.

2. At some point, the individual partially converts the garage to a bicycle repair shop. After conversion, 60% of the garage (the Commercial Portion) is used exclusively in the commercial activities of the individual.

3. The remaining 40% percent of the garage is for the personal use of the individual and is considered as an appurtenance to, and therefore to form part of, the residential complex.

4. The remainder of the 100 acres is for the personal use and enjoyment of the individual.

5. The individual makes capital improvements to the Commercial Portion of the garage.

6. The individual later decides to sell the Property.

Question

What are the tax consequences of the sale of the Property?

Interpretation and Analysis

As in the previous scenario, it is necessary to consider the amount of land forming part of the residential complex for purposes of section 2 of Part I of Schedule V. In this regard, P-069 will again apply such that land in excess of 1/2 hectare that is subjacent and immediately contiguous to the complex will be presumed not to be reasonably necessary for its use and enjoyment as a place of residence, and thus will not form part of the residential complex, unless the individual can demonstrate otherwise.

In the present scenario, we will assume that only 1/2 hectare of the land subjacent and immediately contiguous to the residential complex is reasonably necessary for the purposes stipulated in P-069. Moreover, we will assume that these conditions existed at the time that the individual acquired the Property, and that the remainder of the Property (the Remainder) was for the personal use and enjoyment of the previous owner. Under those circumstances, the provisions of subsection 136(2) would have applied at the time of the sale of the Property to the individual to deem the residential complex and the Remainder to be separate supplies. As explained in the previous scenario, once subsection 136(2) has applied to deem separate properties, those properties will continue to be recognized as separate properties for GST/HST purposes.

Conversion

At the time that the individual converts the garage to commercial use, the Commercial Portion would not, for the same reasons as stated in scenario 1, be considered as an appurtenance to the residential complex. It would therefore no longer form the part of the Property that is attributable to the complex and would thus form part of the Remainder.

Since the Remainder was, prior to the conversion, used entirely for the personal use and enjoyment of the individual but is now used partially in commercial activities, the individual may be entitled to ITCs in respect of the improvements if the Remainder is not primarily for the personal use and enjoyment of the individual, pursuant to subsections 208(2) and 169(1) above.

Sale

Upon a subsequent sale of the Property, the residential complex and the Remainder will continue to be considered separately for GST/HST purposes. As in the previous scenario, section 2 of Part I of Schedule V would apply to exempt the sale of the residential complex; however, the Remainder would be subject to different provisions of the ETA.

Whether the sale of the Remainder is subject to the GST/HST would again depend on the application of the exempting provisions of section 9 of Part I of Schedule V. In this case, the sale of the Remainder by the individual would be excluded from the general exemption by paragraph 9(2)(a) if, immediately before the time ownership or possession of the property is transferred, it were considered to be used primarily in the individual's commercial activities.

The facts in this scenario indicate that only a small area of the Remainder (i.e., that which is attributable to the Commercial Portion) is used in the individual's commercial activities, while the balance of the Remainder is attributed to the individual's personal use. However, a determination of how the Remainder is primarily used for purposes of paragraph 9(2)(a) requires an analysis of all of the factors relevant to the particular situation. Again, the factors listed in Appendix A in GST/HST Memoranda Series Section 19.5 should be given due consideration in making this determination.

If it were determined that the Remainder is primarily for the personal use of the individual, and provided none of the other exclusions in subsection 9(2) of Part I of Schedule V apply, the sale of the Remainder would be exempt by virtue of section 9 of Part I of Schedule V. On the other hand, if it were determined that the Remainder is primarily used in the individual's commercial activities, exclusionary provision 9(2)(a) would apply in respect of the Remainder to render its sale taxable.

SCENARIO 3

In Scenarios 1 and 2, assume the following:

1. The entire garage is considered to form part of the residential complex as it is used entirely for the personal use of the individual.

2. The Commercial Portion, instead of being located in the garage, is located in the basement of the building containing the residential complex.

3. The individual makes capital improvements to the Commercial Portion.

Question

What are the individual's ITC entitlements with respect to the improvements?

Interpretation and Analysis

The individual's eligibility for ITCs in respect of the improvements would again be subject to the provisions of subsection 208(4), which would apply to deny ITCs in respect of the improvements to the residential complex if the entire Property (as described in Scenarios 1 and 2 respectively) is primarily for the personal use or enjoyment of the individual.

Scenario 1 (modified for new facts)

If the Commercial Portion were located within the building and it were determined that the use of the Property (i.e., the complex and the land allowance under P-069, which in Scenario 1 is assumed to encompass the rest of the one-acre parcel) were primarily personal in nature, no ITCs would be available in respect of the improvements, pursuant to subsection 208(4). In this case, the entire building and its appurtenances, including the Commercial Portion and the garage, would form part of the "residential complex" pursuant to paragraph (c) of that definition. Moreover, on the assumption that the remaining land also forms part of the complex by virtue of P-069, the entire Property would qualify as a "residential complex". Accordingly, the sale of the Property would be exempt under section 2 of Part I of Schedule V.

Conversely, if the Property in Scenario 1 were determined not to be used primarily for the personal use of the individual, subsection 208(2) would apply in respect of the conversion and subsection 136(2) would apply in the manner described in our response to Question 1 in Scenario 1 under the heading, "Property not primarily for the personal use and enjoyment of the individual". The individual would be entitled to full ITCs in respect of the BTC of the Commercial Portion in the manner described under that heading. A subsequent sale of the Property would materialize in the same manner as described in the original scenario.

Scenario 2 (modified for new facts)

In establishing the ITC entitlements in the present case, the application of subsection 208(4) is again determinative. As in the previous cases, the ITC entitlement of the individual is predicated on the extent to which a particular property is used in the commercial activities of the individual.

As in Scenario 2, we will continue to assume that only 1/2 hectare of the land subjacent and immediately contiguous to the residential complex is reasonably necessary for the purposes stipulated in P-069. We will also continue to assume that these conditions existed at the time that the individual first acquired the Property, and that the Remainder was for the personal use and enjoyment of the previous owner. Again, the provisions of subsection 136(2) would have applied at the time that the individual acquired the Property to deem the residential complex and the Remainder to be separate supplies, and those properties will continue to be recognized as separate properties subsequent to that time.

As explained above, the entire building would, along with the qualifying land and appurtenances, be considered as a residential complex pursuant to paragraph (c) of the definition if it were used primarily as a place of residence of the individual.

Notwithstanding that the individual has partially converted the residential complex for use in commercial activities, if the building remains primarily for the personal use and enjoyment of the individual, there will be no ITCs available in respect of the improvements, pursuant to subsection 208(4).

Upon a subsequent sale of the Property, the residential complex and the Remainder will continue to be considered separately for GST/HST purposes. Again, section 2 of Part I of Schedule V would apply to exempt the sale of the complex while the Remainder may be exempt by virtue of section 9 of Part I of Schedule V.

However, in the event that the building is determined not to be used primarily by the individual as a place of residence, paragraph (c) above would not be applicable to render the entire building a residential complex. In that case, paragraph (a) of the definition would apply such that the part of the building qualifying as a residential unit ("Residential unit" is defined in subsection 123(1).) would qualify as a residential complex. Under those circumstances, the Commercial Portion would not form part of the residential complex, and will thus form part of the Remainder.

Again, upon a subsequent sale of the Property, the portion of the Property qualifying as a residential complex will continue to be considered separately from the Remainder for GST/HST purposes. The sale of the residential complex would be exempt under section 2 of Part I of Schedule V, while the Remainder, which now includes the Commercial Portion, would be subject to section 9 above.

Under exclusionary paragraph 9(2)(a), a sale of real property made by an individual or personal trust is excluded from the general exemption if, immediately before the time ownership or possession of the property is transferred, the property is capital property used primarily in a business carried on by the individual or the personal trust with a reasonable expectation of profit. If the Remainder (which in this example contains Commercial Portion) can be determined to be used primarily for the purposes delineated in paragraph 9(2)(a), the sale of the Remainder would be excluded from exemption, thus rendering it taxable. On the other hand, if the Remainder were not used primarily for purposes of paragraph 9(2)(a), its sale would be exempt.

The ITC entitlements with respect to the sale of the Remainder will follow the treatment accorded to it by section 208. For example, where the Remainder were found to be primarily for the personal use of the individual, subsection 208(4) would preclude the claiming of ITCs in respect thereof.

On the other hand, if the Remainder were determined not to be used primarily for the personal use and enjoyment of the individual, subsection 208(2) would, at the time of conversion, allow ITCs to be claimed to the extent that the Remainder was used in commercial activities, pursuant to subsection 169(1) (see discussion in Scenario 1). Moreover, since the sale of the Remainder would in that case be subject to exclusionary paragraph 9(2)(a) and thus taxable, the individual would, by virtue of subsection 193(1), be able to recover any tax that was unrecoverable under subsection 169(1). Generally, subsection 193(1) allows a registrant who makes a taxable supply by way of sale to claim an ITC for some or all of the GST/HST, if any, which is embedded in the cost of the property. The appendix to Memoranda Series section 19.2.3 provides a detailed example of the calculation of a real property credit under subsection 193(1).

SCENARIO 4

1. An individual acquires a 5-acre parcel of land (the Property) containing a single unit residential complex and a detached garage.

2. At the time of acquisition, the entire Property qualified as a "residential complex" and was an exempt supply by the vendor.

3. The individual originally intends to live in the complex but instead leases it on a long-term basis to a tenant who uses it as a place of residence.

4. The individual uses the garage as a warehouse in his commercial activities.

5. The individual subsequently wishes to sell the Property.

Questions

1. What are the GST/HST consequences of the sale of the Property?

2. Would the tax treatment of the sale have changed if the individual had personally occupied the house as originally intended?

Interpretation and Analysis

As in the previous scenarios, the first step in identifying the tax status of the current sale is to determine whether the whole, or just part, of the Property qualifies as a residential complex. The building, its appurtenances and immediately contiguous land that is reasonably necessary for its use and enjoyment as a place of residence for individuals will qualify as a "residential complex" pursuant to paragraph (a) of that definition. Whether the complex is occupied by tenants or by the owner will have no impact on its status as a "residential complex" under these circumstances.

As explained above, the guidelines for determining the amount of land reasonably necessary for purposes of paragraph (a) above is set out in P-069. Under the policy, the garage will not form part of the residential complex since the policy precludes any portion of the land used in commercial activities from forming a part of it. If it is found that the "half-hectare" rule applies, the tax consequences of a sale of the Property will be the same as those described in Scenario 2. If all of the contiguous land (excepting the garage) is found to form part of the complex, the tax consequences of a sale of the Property will be the same as those described in Scenario 1.

If you require further information or clarification on any of the matters addressed in this memorandum, please do not hesitate to contact me at (613) 952-8816.