24 February 2004 External T.I. 2004-0056861E5

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.

Principal Issues: Whether financing costs ("Financing Expenses") incurred in the course of a borrowing of money used to fund the construction costs of a building may be: capitalized in full in the year incurred pursuant to subsection 18(3.1); or capitalized in equal portions over a five year period pursuant to the subparagraph 20(1)(e)(iii) and subsection 18(3.1)?.

Position: The Financing Expense amount capitalized in a taxation year pursuant to subsection 18(3.1) will be equal to the amount of the Financing Expense that is deductible in the taxation year pursuant to paragraph 20(1)(e).

Reasons: Paragraph 18(3.1)(a) of the Act is not an enabling section with respect to the deductibility of amounts. Instead, it precludes a deduction for certain outlays and expenses, generally referred to as construction period soft costs (including interest and Financing Expenses) that would have been otherwise deductible. Therefore, until an amount that is a Financing Expense described in subparagraph 20(1)(e)(ii) is deductible pursuant to paragraph 20(1)(e), subsection 18(3.1) of the Act will not have any application.

XXXXXXXXXX 					2004-005686
P. Diguer, CGA

February 24, 2004

Dear XXXXXXXXXX:

Re: Inter-action of subsection 18(3.1) and 20(1)(e) of the Income Tax Act (Canada)

We are writing in response to your facsimile dated January 15, 2004 in which you request our views on the application of subsection 18(3.1) and paragraph 20(1)(e) of the Income Tax Act (Canada) (the "Act") in circumstances where financing costs in respect of the borrowing of funds to finance the construction of a building are incurred during the construction period.

In particular you describe a situation where:

1. Corporation A begins construction of a building on day 1 of year 1. The building will be capital property used by Corporation A to earn rental income;

2. On day 2 of year 1, the corporation arranges for a demand loan to finance construction of the building. The corporation incurs legal fees and bank set up fees ("financing expenses") of $50,000 in the course of securing the financing;

3. On day 1 of year 2, the building is completed and the tenants move into the building and commence their lease terms.

You ask

(a) Is the financing expense amount that must be capitalized pursuant to subsection 18(3.1) $50,000, $10,000 or some other amount?

(b) If the answer to (a) above is $10,000 is the financing expense amount that must be capitalized pursuant to subsection 18(3.1) in each of years 2-5 $10,000 (i.e. $50,000 @ 20% per year)?

Our comments

The situation that is described in your letter appears to involve a series of completed transactions involving specific taxpayers. Written confirmation of the tax implications inherent in particular transactions are given by this Directorate only where the transactions are proposed and are the subject matter of an advance ruling request submitted in the manner set out in Information Circular IC-70-6R5 dated May 17, 2002. Where the particular transaction is completed, the inquiry should be addressed to the relevant Tax Services Office. Although we are unable to provide any opinion in respect of the specific transactions described in your letter, we have set out some general comments which we hope are of assistance to you. However, written opinions are not advance tax rulings and, accordingly not binding on the Canada Revenue Agency.

Paragraph 20(1)(e)

Subparagraph 20(1)(e)(ii) of the Act provides that an amount that is an expense incurred by a taxpayer in the course of a borrowing of money used by the taxpayer for the purpose of earning income from a business or property may be deducted in computing the taxpayer's income. The type of expense to which subparagraph 20(1)(e)(ii) applies includes legal fees, bank fees and other similar expenses ("Financing Expenses") incurred in the course of a borrowing. Subparagraph 20(1)(e)(iii) of the Act provides that Financing Expenses may only be deducted in equal portions over a five year period. However, there are exceptions to this general rule, for example a pro-rata reduction for a short taxation year or where the related borrowing is repaid.

Subsection 18(3.1)

Subsection 18(3.1) of the Act denies the deduction, on a current basis, of certain outlays and expenses incurred in the construction, renovation or alteration of a building or in respect of the ownership of the related land. These outlays and expenses are commonly referred to as "construction period soft costs" and include, among other items, interest, legal and accounting fees, and property taxes. These soft costs are required to be added to the cost or capital cost, as the case may be, of the building to which they relate.

Subsection 18(3.1) of the Act applies only to those soft costs that are attributable to the period of construction, renovation or alteration. Subsection 18(3.3) of the Act provides for the determination of the date on which the construction, renovation or alteration is completed.

Subsection 20(29)

Additionally, subsection 20(29) operates to permit a deduction of the construction period soft costs that would otherwise be required to be capitalized pursuant to subsection 18(3.1) up to an amount that is equal to the lesser of:

(a) the total of all such outlays and expenses , and

(b) the taxpayer's income for the year from renting the building or the part thereof.

Inter-action of subsection 18(3.1) and paragraph 20(1)(e) of the Act

Paragraph 18(3.1)(a) of the Act is not an enabling section with respect to the deductibility of amounts. Instead, it precludes a deduction for the construction period soft costs, which also includes Financing Expenses, that would have been otherwise deductible. While paragraph 18(3.1)(b) of the Act permits the deduction which has been so denied by paragraph 18(3.1)(a) of the Act to be added to the cost or capital cost of the building, it will only do so once paragraph 18(3.1)(a) has already applied to the amount of the soft cost. In this regard, it is our view that the words "to the extent that it would otherwise be deductible in computing the taxpayer's income for the year" in paragraph 18(3.1)(b) of the Act ensures that the amount of "an outlay or expense" in paragraph 18(3.1)(b) of the Act refers to those amounts where paragraph 18(3.1)(a) of the Act applied to preclude a deduction.

Therefore, until an amount that is a Financing Expense described in subparagraph 20(1)(e)(ii) is deductible pursuant to paragraph 20(1)(e), subsection 18(3.1) of the Act will not have any application.

To illustrate, using the present case, the Financing Expenses in the amount of $50,000 incurred by Corporation A would, pursuant to subparagraph 20(1)(e)(iii), be deductible in equal portions over a five year period (i.e. $10,000 per year). In each of these five taxation years, paragraph 18(3.1)(a) of the Act would apply to preclude the $10,000 deduction to Corporation A and paragraph 18(3.1)(b) of the Act would permit the deduction which has been so denied by paragraph 18(3.1)(a) of the Act to be added to the cost or capital cost of the building.

We trust our comments will be of assistance to you.

Yours truly,

Steve Tevlin
for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Planning Branch