26 May 2008 Internal T.I. 2008-0272771I7 - Straight-line Amortization or Averaging of Rent

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 escalating lease payments, which are deductible under generally accepted accounting principles on a straight-line basis, are deductible for tax purposes?

Position: No.

Reasons: Legislation.

 								May 26, 2008

	Toronto Centre TSO				HEADQUARTERS
								Income Tax Rulings
		   						Directorate
	Attention: Anthony Cutrara			Shaun Harkin, CMA
(613) 957-9229 

								2008-027277

Averaging of Rent Expense

This is in reply to your memorandum of March 18, 2008, wherein you asked for our views on the deductibility of rent expense where rent has been deducted using an average basis over the term of the lease. Our understanding of the facts is as follows:

• The taxpayer ("T/P") was in the XXXXXXXXXX business XXXXXXXXXX .
• The T/P incurred XXXXXXXXXX rents for the various buildings it leases. Each XXXXXXXXXX lease was unique but generally the leases were long-term leases of 25 years with escalation clauses every 5 years.
• The T/P originally filed a T2 deducting rent as it became legally required to be paid/payable or incurred on an accrual basis.
• A statutory audit was performed as part of the process of the decision to sell the XXXXXXXXXX division of the T/P.
• As a result of the statutory audit, the accounting firm restated previously filed rent expense as a result of changing from the original methodology to average rent over the term of the lease. The T/P filed amended returns to adjust for average rent for the years under audit.
• For tax purposes, the net effect was a higher rent expense in the earlier years due to the averaging of an escalating cost over a long period of time. Since the T/P sold the business in the earlier stage of the lease term, an additional $XXXXXXXXXX of rent was expensed.

Our Comments

We have reviewed the documents provided, the comments provided in your memorandum and the representations provided on the T/P's behalf. We have not been provided with a copy of any of the leases. Therefore, our comments and analysis will focus on the general issue of averaging of rent expense, without providing comments specific to any particular lease.

Where a method used to determine the amount of a particular expense is consistent both with the Income Tax Act (the "Act") and with well-accepted business principles the expense is deductible. This is consistent with the views in the case of Canderel Ltd. v. R, 98 DTC 6100, and is also expressed in the Supreme Court of Canada case of Shell Canada Limited v. the Queen, 99 DTC 5669, where the court stated, "This Court has frequently held that accounting practices, by themselves, do not establish rules of income tax law....".

Generally accepted accounting principles ("GAAP") provide for the deduction of lease payments on an average basis. However, in order for any expense to be deductible for income tax purposes it must satisfy the general limitation of paragraph 18(1)(a) of the Act, which states:

18(1) General limitations. In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(a) General limitation - an outlay or expense except to the extent that it was
made or incurred by the taxpayer for the purpose of gaining or producing
income from the business or property;

In other words, in order for an expense to be deductible an outlay must in fact be made or an expense must be incurred during a relevant period.

Accordingly, although we agree that GAAP provides for the deduction of lease payments on a average basis, we do not agree with the T/P's representative's view that using their method to determine rent expense for tax purposes is not in conflict with any rule of law. In our view, any amount in excess of the actual rent payable in respect of a taxation year would not be deductible by virtue of either paragraph 18(1)(a) or subparagraph 18(9)(a)(ii) of the Act. In order for an expense which is unpaid at the end of a taxation year to have been "incurred" for purposes of paragraph 18(1)(a) and, therefore, to be deductible for tax purposes, the expense must constitute a genuine liability of the taxpayer. In order for a genuine liability to exist, there must be an enforceable claim by the creditor with a reasonable expectation that the debt will in fact be paid by the debtor.

In our view, the amounts deducted by the T/P on an average basis which are in excess of the rent actually payable in respect of a taxation year have not been "incurred" for purposes of paragraph 18(1)(a) as the lessor does not have an enforceable claim to such amounts as at the end of the taxation year. Even if such amounts can be considered to have been "incurred" for purposes of paragraph 18(1)(a), it is our view that subparagraph 18(9)(a)(ii) would apply to deny the deduction of the excess amounts by the T/P as they represent an expense that can reasonably be regarded as having been incurred as or on account of rent in respect of a period after the end of the year.

XXXXXXXXXX

We trust that these comments will be of assistance to you.

Renée Shields
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch