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: Does subparagraph 18(9)(a)(ii) of the Income Tax Act deny the rental expense deduction of $XXXXXXXXXX?
Position: Perhaps. Dependent on the facts in the lease agreements.
Reasons: It is a question of fact whether or not an expense is a prepaid expense or a period expense.
August 27, 2012
XXXXXXXXXX Tax Services Office Income Tax Rulings Directorate
Large File Audit John Parker, CMA
Attention: XXXXXXXXXX
2012-044283
Prepaid rent and the application of subparagraph 18(9)(a)(ii) of the Income Tax Act (the “Act”).
We are writing in response to your referral of April 10, 2012 wherein you asked our opinion on whether subparagraph 18(9)(a)(ii) of the Act would deny the deduction of $XXXXXXXXXX made by XXXXXXXXXX (“XXXXXXXXXX”) in the taxation year ending XXXXXXXXXX. Our understanding of the facts is as follows:
* XXXXXXXXXX is a XXXXXXXXXX corporation.
* As of XXXXXXXXXX, XXXXXXXXXX operated XXXXXXXXXX , XXXXXXXXXX of which were owned and the remaining XXXXXXXXXX were held under long term leases.
* As of XXXXXXXXXX, XXXXXXXXXX of the XXXXXXXXXX long term leases were step-down leases. A step down lease is generally a lease where the annual lease payments are higher in the initial years of the lease and decline in subsequent years.
* Prior to XXXXXXXXXX, XXXXXXXXXX deducted rent payments as an expense for accounting and tax purposes with respect to the XXXXXXXXXX step down leases.
* Due to a change in accounting requirements, XXXXXXXXXX had to retroactively report lease expense on a straight line basis. As a result of this change, XXXXXXXXXX determined that they had reported excess rent expense in prior years of $XXXXXXXXXX. Accordingly, they credited that amount to their income statement and set up a debit of the same amount on the balance sheet. For accounting purposes, this amount was amortized to rent expense in subsequent years.
XXXXXXXXXX deducted the $XXXXXXXXXX on their XXXXXXXXXX tax return.
* XXXXXXXXXX recorded adjustments to rent expense for XXXXXXXXXX for accounting and tax purposes. The adjustments have been summarized as follows:
Accounting XXXXXXXXXX
Prepaid Rent (balance sheet asset) $XXXXXXXXXX
Income Statement
Rent/lease expense paid and/or accrued $XXXXXXXXXX
Adjustments to setup prepaid rent asset -$XXXXXXXXXX
Rent expense deducted for accounting $XXXXXXXXXX
Tax
T2S(1)–reversal of journal entry for rent
paid in prior years $XXXXXXXXXX
Rent expense reported for tax purposes $XXXXXXXXXX
- CRA audit has proposed to disallow prepaid rent deducted by XXXXXXXXXX in its tax return for XXXXXXXXXX in the amount of $XXXXXXXXXX, pursuant to subparagraph 18(9)(a)(ii) of the Act. Audit has concluded that the prepaid rent $XXXXXXXXXX reported for accounting purposes is reasonably regarded as having been made or incurred as, on account of, rent in respect of a period that is after the end of XXXXXXXXXX.
- CRA did not audit rent expense in years prior to XXXXXXXXXX.
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.
Paragraph 2 of Interpretation Bulletin IT-417R2, entitled “Prepaid Expenses and deferred charges” states: “A prepaid expense occurs where an outlay or expense has been made or incurred by a taxpayer in a particular taxation year and it represents, for example, all or part of the cost of services which will be provided to the taxpayer after the fiscal year end.”
In order to establish that an amount is prepaid, it is necessary to understand the business and legal relationship between the lessor and lessee. We have examined two of the lease agreements and can find no basis to conclude that XXXXXXXXXX was making payments for rent for subsequent years.
In regard to the accounting, it is important to understand why current outlays were deferred as prepaid. It is then necessary to compare the accounting principles to the provisions of the Act. While the accounting provides a useful guide to understanding the nature of the expenses, it is not determinative for tax purposes. In this case, the prepaid amount was in respect to rent paid in periods prior to XXXXXXXXXX, as required by a change in accounting.
We would also point out that in such cases it is useful to examine how the lessor interpreted the provisions of the lease. One would expect the two parties to the contract to take a similar view of its purpose and provisions. No such information was included in your submission.
Whether or not a rent payment is actually a prepaid expense, which is specifically not deductible pursuant to subparagraph 18(9)(a)(ii) of the Act, is a question of fact.
In our opinion, based on the facts submitted, there is insufficient audit evidence to support the conclusion that the lease agreements contain “prepaid rents” within the meaning of 18(9)(a)(ii) of the Act. Furthermore, the amount of $XXXXXXXXXX is a journal entry that relates to prior periods and cannot be subject to tax in XXXXXXXXXX.
We trust our comments will be of assistance.
Doug Watson
for Director
Financial Industries Division
Income Tax Rulings Directorate
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