Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

(1) Whether changes in the terms of a lease result in a disposition of a leasehold interest and the acquisition of a new leasehold interest.

(2) How do the changes in the terms of the lease impact the amortization of the leasehold improvements pursuant to Schedule III of the Regulations.

Position:

(1) Yes.

(2) In this particular case, the rules in Schedule III continue apply.

Reasons:

(1) The changes in the terms and conditions of the Original Lease, when taken together, are substantial enough to constitute the disposition of the Original Lease and the acquisition of a new lease.

(2) There is no terminal loss on the disposition of the Original Lease since a new lease was acquired in the same taxation year. The rules in Schedule III continue to apply to the "prorated portion" of the amounts incurred pursuant to the Original Lease.

		March 9, 2001

	Vancouver Tax Services Office	HEADQUARTERS
	Appeals Division	A. Seidel
	Section 431-32	(613) 957-2058

	Attention: Laurie Elias
		2001-006373

XXXXXXXXXX .

Schedule III of the Income Tax Regulations

This is in reply to your memorandum dated January 2, 2001 in which you requested our views as to the correct amortization of certain leasehold improvements made by XXXXXXXXXX.

Background

XXXXXXXXXX

Issue

You have requested our views as to the correct amortization of the XXXXXXXXXX leasehold improvements for the XXXXXXXXXX.

Analysis

Schedule III of the Regulations

Section 1 of Schedule III of the Regulations restricts the amount of capital cost allowance that a taxpayer may claim in a taxation year for a property in Class 13 of Schedule II of the Regulations. The maximum amount deductible is the lesser of:

(a) the sum of the prorated portions calculated in accordance with section 2 of Schedule III of the Regulations, and

(b) the undepreciated capital cost of the whole of class 13 in Schedule II of the Regulations before any allowance for that year is deducted.

Section 2 of Schedule III of the Regulations provides that, for the purposes of determining the "prorated portion", the capital cost incurred by a taxpayer in a particular taxation year in respect of any particular leasehold interest owned by the taxpayer is calculated separately. A prorated portion is, generally speaking, the lesser of one-fifth of the capital cost of a particular leasehold interest and the amount determined by dividing the capital cost of the particular leasehold interest by the number of 12-month periods (not exceeding 40) commencing with the beginning of the particular taxation year in which the capital cost was incurred and ending with the day the lease is to terminate.

Section 3 of Schedule III of the Regulations sets out further rules affecting the computation of prorated portions. Capital costs incurred in a subsequent taxation year in respect of the same leasehold interest will constitute a separate leasehold interest requiring a separate computation of another prorated portion.

Schedule II of the Regulations does not contain any restriction with respect to the claiming of capital cost allowance in respect of a leasehold interest that has expired or has been otherwise disposed of. Accordingly, where the rules in paragraphs (d) or (e) of section 3 of Schedule III of the Regulations are not applicable, the 50% that a taxpayer was unable to claim in the first year in respect of a unit of capital cost may be claimed in the year following the end of the amortization period even though the related leasehold interest no longer exists.

For the purpose of computing the number of 12-month periods, paragraph 3(b) of Schedule III of the Regulations provides that in the situation where the tenant has the right to renew the lease, there shall be taken into account not only the term of the lease itself but also the term of the first possible renewal thereof. In the application of this paragraph, it is necessary to determine that the terms for the possible renewal period are established in the lease. A right to re-negotiate a new lease will not satisfy this requirement.

Subsection 1102(5) of the Regulations provides the following:

"Where the taxpayer has a leasehold interest in a property, a reference in Schedule II to a property that is a building or other structure shall include a reference to that leasehold interest to the extent that that interest

(a) was acquired by reason of the fact that the taxpayer

(ii) made an addition to a leased building or structure, or

(iii) made alterations to a leased building or structure that substantially changed the nature of the property:"

Our Comments

Our response is based on the assumption that subsection 1102(5) of the Regulations does not apply to the leasehold improvements made in XXXXXXXXXX.

For purposes of Schedule III of the Regulations, the XXXXXXXXXX leasehold improvements in respect of the Original Lease are amortized over XXXXXXXXXX, pursuant to paragraph 2(b) of Schedule III. If there had been no modifications to the Original Lease, the leasehold improvements incurred in XXXXXXXXXX would have been amortized over a XXXXXXXXXX period, respectively, (the number of XXXXXXXXXX periods remaining under the Original Lease plus XXXXXXXXXX renewal) again pursuant to paragraph 2(b) of Schedule III.

Paragraphs 9, 10 and 11 of Interpretation Bulletin IT-464R ("IT-464R") provide some general discussion concerning the disposition of a leasehold interest. Interpretation Bulletin IT-448 ("IT-448") discusses dispositions that are considered to have occurred in those situations where there has been a change in the rights, preferences, terms, conditions, restrictions or limitations attaching to shares, bonds, debentures, notes, certificates, mortgages, hypothecs, agreements of sale or similar obligations, which would include a lease agreement.

Paragraph 2 of IT-448 makes the distinction between a change in a right attaching to a "security" effected by an amendment to its original terms and the cancellation of the original security and its replacement by another security identical in all respects except that the changed right is now incorporated in the agreement. Where the change is by way of amendment, the significance of the change will determine whether or not there has been a disposition. As stated in paragraphs 3 and 4 of IT-448, as a general rule, the CCRA examines the effect achieved by a particular set of changes, rather than the method adopted to accomplish it and that we endeavor to establish whether or not it is reasonable to regard the amended security as being the same property as that which underwent the change.

The determination as to whether a particular change to an agreement is sufficiently material such that it results in a new agreement can only be made on a case-by-case basis. The courts have generally concluded that fundamental changes, which substantially affect the basic elements of an agreement, represent a new agreement. For example, in Ronald J. Wiebe and Ray Bastien v. Her Majesty The Queen (87 DTC 5068, FCA), Hugessen, J. stated that "What is important is that these were new conditions, ... they were conditions which substantially affected the "basic elements" of any earlier purported ... agreement". He then went on to conclude that "Changes as fundamental as this are inconsistent with the continuing existence of the alleged prior ... agreement; rather they represent a whole new agreement".

The Second Modification of the Original Lease included changes to XXXXXXXXXX All of these changes, taken together, would be considered to be new conditions which "substantially affected the basic elements" of the Original Lease. Accordingly, the Second Modification of the Original Lease would be considered to have resulted in a disposition of the Original Lease and an acquisition of a new lease (the "New Lease").

Paragraph 10 of IT-464R states that where a leasehold interest is disposed of and proceeds of disposition, XXXXXXXXXX, are less than the undepreciated capital cost at the end of the year in class 13, a terminal loss under subsection 20(16) is deductible provided the lessee disposes of all leasehold interests in Class 13 by the end of that year and does not acquire any new leasehold interests in the same class in the year. However, as stated in paragraph 3 of IT-364R, a tenant who leases property acquires a leasehold interest in that property regardless of whether or not any capital cost is incurred in respect of that interest. Therefore, regardless of whether or not the Company can claim an amount pursuant to Schedule III of the Regulations for taxation years after XXXXXXXXXX, the Company is considered to have acquired a leasehold interest in its XXXXXXXXXX taxation year. The Company would therefore not be entitled to claim a terminal loss, in respect of the XXXXXXXXXX leasehold improvements, in its XXXXXXXXXX taxation year.

Paragraph 3 of IT-464R then goes on to state that a depreciable property is not considered to have been acquired until a capital cost has been incurred in respect of that property. It is our view that the amounts expended in respect of leasehold improvements in XXXXXXXXXX would continue to be the capital cost of depreciable property to be included in Class 13 of Schedule II of the Regulations for the XXXXXXXXXX and subsequent taxation years of the Company.

Schedule III of the Regulations does not provide for a re-calculation of the amount determined pursuant to paragraph 2(b) of Schedule III of the Regulations in those situations where subsequent events change the number of twelve-month periods contained within a lease agreement or in those situations where the number of consecutive renewal periods is revised. Since there is no change in the "prorated portion" of the capital cost of the XXXXXXXXXX leasehold improvements, the amount of capital cost allowance that the Company would be entitled to claim in respect of these leasehold improvements, for the XXXXXXXXXX and subsequent taxation years, would continue as previously determined pursuant to Schedule III of the Regulations. The XXXXXXXXXX leasehold improvements would therefore be amortized over a seven year period and the XXXXXXXXXX leasehold improvements would be amortized over a six year period.

Although the Second Modification of the Original Lease results in the disposition of the Original Lease and the acquisition of the New Lease, the prorated portion of the capital cost of the New Lease would be nil since no costs have been incurred by the Company subsequent to the acquisition of the New Lease in the XXXXXXXXXX taxation year of the Company.

We hope our comments are of assistance.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the Department's mainframe computer. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the LAD version or they may request a copy severed using the Privacy Act criteria which does not remove client identity. Requests for this latter version should be made by you to

Jackie Page at 613 957-0682. The severed copy will be sent to you for delivery to the client.

John Oulton, CA
Section Manager
Business and Individual Section
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch

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