22 November 2004 External T.I. 2004-0100771E5 - Lease; bargain purchase option

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: Income tax treatment of lease with bargain purchase option

Position: If it is a lease (not a sale) at law and not a sham, treated as 2 properties - a lease and an option to purchase

Reasons: ITTN 21 - ITA

		2004-010077
XXXXXXXXXX 	Denise Dalphy, LL.B.
(613) 941-1722
November 22, 2004

Dear XXXXXXXXXX:

We are writing in reply to your letter dated October 21, 2004 wherein you requested our views on the income tax treatment of a particular lease.

Our Comments

Written confirmation of the consequences inherent in particular transactions are given by this directorate only where the transactions are seriously proposed in the near future and are the subject matter of an advance ruling request submitted in the manner set out in Information Circular 70-6R5. Since your question seems to relate to a contract that has already been entered into, we are providing only the following general comments.

Interpretation Bulletin IT-233R, Lease-Option Agreements; Sale-Leaseback Agreements, dated February 11, 1983 stated:

"...under conditions similar to those that follow, a transaction is considered to be a sale rather than a lease: ...

(c) the lessee has the right during or at the expiration of the lease to acquire the property at a price which at the inception of the lease is substantially less than the probable fair market value of the property at the time or times of permitted acquisition by the lessee..., or

(d) the lessee has the right during or at the expiration of the lease to acquire the property at a price or under terms or conditions which at the inception of the lease is/are such that no reasonable person would fail to exercise the said option."

On June 14, 2001, in Income Tax Technical News ("ITTN") No. 21, the Canada Customs and Revenue Agency (the "CRA") announced the cancellation of Interpretation Bulletin IT-233R. We enclose a copy of this ITTN for your information. In summary, we said that pursuant to the decision of the Supreme Court of Canada in Shell, our position is that in the absence of a sham, the determination of whether a contract is a lease or sale is based on the legal relationship created by the terms of the agreement.

Whether an agreement between two parties constitutes a lease or some other form of financing is a question of fact, which can only be determined by reviewing the terms of the agreement between the parties. It is our view that if a lease is, at law, a lease, then it will be treated as a lease for all purposes of the Act. However, in leasing or sales transactions, it is the CRA's view that an agreement between the parties can contemplate only one owner of the property in question. Thus, whether the transaction is a lease or a sale, only one party is entitled to the capital cost allowance claim and any related investment tax credits.

If the true relationship between the parties were one of lessor and lessee, the inclusion of a bargain purchase option would not, in and by itself, change the nature of the transaction. However, in our opinion, a portion of the lease payments could be considered in respect of the right to purchase the property in the future. Therefore, that portion would be considered as the "option" cost and a disposition of property with respect to the parties. In our view, where it can be said that there is an "option" to purchase the business and assets at the end of the lease, the rules in section 49 of the Income Tax Act would apply. This "option" amount may be subject to a valuation. Further, where the facts indicate that all or a proportion of the lease payments are in respect of the "option", those lease payments or the portion of the lease payments that represents those costs would not be a deductible expense to the lessee.

The foregoing comments represent our general views with respect to the subject matter. As indicated in paragraph 22 of Information Circular 70-6R5, the above comments do not constitute an income tax ruling and accordingly are not binding on the CRA. Our practice is to make this specific disclaimer in all instances in which we provide an opinion.

Yours truly,

Steve Tevlin
Manager
Corporate Financing Section
Financial Industries Division
Income Tax Rulings Directorate

Income Tax Technical News
No. 21
Date: June 14, 2001
.

In This Issue

• Cancellation of Interpretation Bulletin IT-233R

The Income Tax Technical News is produced by the Policy and Legislation Branch. It is provided for information purposes only and does not replace the law. If you have any comments or suggestions about the matters discussed in this publication, please send them to:

Director, Business and Publications Division
Income Tax Rulings Directorate
Policy and Legislation Branch
Canada Customs and Revenue Agency
Ottawa ON K1A 0L5

The Income Tax Technical News can be found on the Canada Customs and Revenue Agency Internet site at www.ccra.gc.ca

Cancellation of Interpretation Bulletin IT-233R

Interpretation Bulletin IT-233R, Lease-Option Agreements; Sale-Leaseback Agreements, dated February 11, 1983, is cancelled as of today's date.

The Canada Customs and Revenue Agency (CCRA) announced at the Canadian Tax Conference (CTF) last September that it was planning to withdraw IT-233R. As we said at that time, the bulletin was intended to curb abuses in leases in situations where the substance of the transactions disclosed that the parties intended to effect a sale. It was not meant to be used by taxpayers to avoid the legal consequences of their own transactions. As well, we invited comments in writing concerning this course of action and we received no opposition to our proposal.

The Supreme Court has held, in Shell Canada Limited v. The Queen, 99 D.T.C. 5669, [1999] 4 C.T.C. 313, and other decisions, that the economic realities of a situation cannot be used to recharacterize a taxpayer's bona fide legal relationships. It has held that, absent a specific provision of the Income Tax Act (the Act) to the contrary or a finding that there is a sham, the taxpayer's legal relationships must be respected in tax cases. Thus, generally and subject to the general anti-avoidance rule (GAAR), recharacterization is permissible only if the label attached by the taxpayer to the particular transaction does not properly reflect its actual legal effect.

Thus, it is our view that the determination of whether a contract is a lease or sale is based on the legal relationship created by the terms of the agreement, rather than on any attempt to ascertain the underlying economic reality. Therefore, in the absence of sham, it is our view that a lease is a lease and a sale is a sale. However, notwithstanding the legal relationship, GAAR may be used to assess cases in which there is an avoidance transaction that results in a misuse or an abuse of provisions of the Act.

This position equally applies to all leases including financing leases. We wish to point out that the Act recognizes the validity of financial leases since it has been amended to specifically deal with aspects of them (for example, the specified leasing rules in subsection 1100(1.1) of the Income Tax Regulations, section 16.1 and subsections 13(5.2) to 13(5.4) of the Act).

The issue as to whether taxpayers, who already entered into lease or financing lease agreements and determined their tax consequences on the basis of the position in the bulletin, can continue to do so will depend on the particular facts of a given situation. We encourage taxpayers to consult with their local tax services office on this matter. In examining each specific situation, the CCRA will consider its comments made at the 1988 Canadian Tax Foundation conference and in Income Tax Technical News No. 5. On the application of IT-233R, the CCRA stated that its position was meant to be an assessing policy and was not intended to allow taxpayers to determine their filing position by claiming that the form of their agreement does not reflect the true legal relationship, particularly where the result would be that two taxpayers owned the same property.

Finally, withdrawal of the bulletin will ensure consistency between the CCRA's position on lease characterization for the purposes of Part I of the Act and for the purposes of Part XIII, "Tax on Income from Canada of Non-Resident Persons"; Part I.3, "Tax on Large Corporations"; and the goods and services tax.

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