14 February 2012 Internal T.I. 2012-0435241I7 - Prepaid Rent and Escalating Rent Payments

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: 1.Whether prepaid rent is deductible in the year paid. 2. Whether escalading annual rent payments are deductible on a straight line basis.

Position: 1. No; 2. No

Reasons: Legislation

								February 14, 2012

	Toronto Centre Tax Services Office		HEADQUARTERS
	Large File Audit					Income Tax Rulings
								  Directorate
	Attention: XXXXXXXXXX 				John Parker CMA

								2012-043524

Tax treatment of Prepaid Rent and Escalating Rent Payments

We are writing in response to your correspondence dated January 26, 2012 wherein you asked our views on the deductibility of prepaid rent for tax purposes. Our understanding of the facts is as follows:

• The taxpayer is a tenant in a lease agreement.
• Lease term is for XXXXXXXXXX years (from XXXXXXXXXX ).
• The lease calls for annual lease payments of $XXXXXXXXXX for the years XXXXXXXXXX and annual lease payments of $1XXXXXXXXXX for the remaining XXXXXXXXXX years.
• The total lease payments over the term of the lease are $XXXXXXXXXX . The average rent per year is $XXXXXXXXXX .
• For financial statement purposes the taxpayer set up a Prepaid Rent asset on its balance sheet. In XXXXXXXXXX the prepaid asset amount on the balance sheet was $XXXXXXXXXX
• For income tax purposes, the taxpayer claimed the full amount of the rent paid in the XXXXXXXXXX taxation year $XXXXXXXXXX .

Our Comments

We are of the opinion that the taxpayer is required, by the Act, to amortize any prepaid rent over the future periods to which it relates. Subparagraph 18(9)(a)(ii) of the Income Tax Act (the "Act") entitled "Limitation respecting prepaid expenses" specifically denies a deduction made in respect of an outlay or expense to the extent that it can reasonably be regarded as having been made or incurred as, or on account of or in lieu of the payment of rent which is in respect of a period that is after the end of the year.

In the Supreme Court of Canada decision in Canderel Ltd v The Queen, Docket: 24663 para. 39 of the Reasons for Judgement, Justice Iacobucci stated:

"A good example of the relationship among the provisions of the Act, the principles developed in the case law, and G.A.A.P. or well-accepted business principles can be found in s. 18(9) of the Act, which requires the amortization of certain prepaid expenses over the periods of time to which they relate. It is possible, although I express no specific opinion on this matter, that some of these expenses could be treated otherwise for the purposes of G.A.A.P. or business; perhaps they might be deducted entirely in the year incurred, or even capitalized. However, this possibility is negated for tax purposes by their specific legislative treatment."

The taxpayer's representative queried about situations where instead of prepaid rent, the lease terms called for escalating rent payments. In our opinion, the Act does not allow for the straight-line amortization or averaging of the increasing rental payments over the earlier periods.

Paragraph 18(1)(a) of the Act entitled "General Limitation" denies a deduction for 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. The requirement contained in this provision that the outlay or expense be "made or incurred" contemplates the actual payment of the expense or a legal obligation to pay the expense in that particular taxation year. Escalating lease payments made in future years cannot be amortized over previous years as there was no legal requirement to pay the higher rents in the earlier taxation years. Generally, a taxpayer "incurs" an expense when there is a legal obligation to pay a sum of money.

In the Federal Court of Appeal decision, The Queen v Burnco Industries Ltd et al., Docket: A-851-81, 84 DTC 6348, the court stated:

"In our opinion, an expense, within the meaning of paragraph 18(1)(a) of the Income Tax Act, is an obligation to pay a sum of money. An expense cannot be said to be incurred by a taxpayer who is under no obligation to pay money to anyone. Contrary to what was decided by the Trial Division, an obligation to do something which may in the future entail the necessity of paying money is not an expense."

In the situation of escalating rental payments, the taxpayer is under no legal obligation to pay the increased rent until later periods. Therefore, any additional rental expense as a result of the application of averaging would not be "incurred" until later periods and would be denied as per paragraph 18(1)(a) of the Act.

In Buck Consultants Ltd. v The Queen, Docket , FCA, A-527-96, 2000 DTC 6015, Justice Isaac, in para. 9 of the Reasons for Judgement states:

"Although the amortization of the benefits over the life of the lease might be acceptable for accounting purposes, we do not agree that that fact alone mandates the legal result for the purposes of paragraph 18(1)(a) of the Act. In this connection, the following passage taken from the reasons of McLachlin J. for a unanimous Court in Shell Canada Limited v. the Queen, et al, at paragraph 73 is instructive:

"First, the manner in which Shell recorded the net foreign exchange gain for its no-tax financial accounting is not determinative of the proper tax treatment. This Court has frequently held that accounting practises, by themselves, do not establish rules of income tax law. Canderel, supra, at paras 32-37, per Iacobucci J. At any rate, non-tax financial accounting is generally designed to reflect the overall economic position of the entire corporation. Section 20(1)(c)(i) of the Act, in contrast, applies to the tax treatment of specific transactions. It therefore should not be surprising that the same transaction may be properly assessed differently for different purposes."

For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the CRA's electronic library. 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 the taxpayer request a copy of this memorandum, they may request a severed copy using the Privacy Act criteria, which does not remove taxpayer identity. Requests for this latter version should be made by you to Mrs. Celine Charbonneau at (613) 957-2137. In such cases, a copy will be sent to you for delivery to the taxpayer.

We trust our comments will be of assistance.

Yours truly;

Doug Watson
for Director
Business and Trusts Division
Income Tax Rulings Directorate
Legislative and Policy Affairs Branch