10 August 1989 External T.I. 58165 F - Equity-building Lease Program

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.

August 10, 1989

Dear Mr. Kremeniuk:

Re:  Equity-Building Lease Program

This is in reply to your letter dated June 2, 1989, in which you asked for our comments on a proposed "Equity-Building Lease Program" (the "Program") being considered by Farm Credit Corporation Canada ("FCC").

Since you have not requested an advance income tax ruling, our comments are of a very general nature and should not be taken as exhaustive of all the possible income tax consequences that can arise in connection with the proposal.

As we understand it, 24(1)

Lease or Sale?

The first issue that arises is whether the lease constitutes a true lease or a disguised disposition.  Generally, the presence of the following factors in a lease-option agreement indicates that a purported lease is a disguised disposition and acquisition of property:

i)     the purported lessee is required to purchase the property during, or on termination of, the lease term; or

ii)      the purported lessee automatically acquires title to the property after payment of a specified amount in the form of "rental" payments.

Even without these factors a lease might nevertheless constitute a disposition and acquisition.  While no one factor will determine this issue, the presence of the following factors may result in a lease being treated as a disposition and acquisition:

a)     the presence of a nominal option price for property that probably will have a substantial fair market value at the time the option becomes exercisable;

b)     the purported lessee has the incidents of ownership he must obtain permits, licences and registrations; pay fees, expenses and charges relating to the property; or obtain insurance on the property);

c)     the purported lessee is responsible for effecting major repairs to the property rather than merely effecting routine maintenance;

d)     the total cost of all scheduled "rental" payments, after deducting notional interest and administrative costs, is equal to the fair market value of the property at the time the purported lease is entered into;

e)     on exercise of the option, the fair market value of the property is likely to be substantially greater than the option price so that the exercise of the option is a foregone conclusion;

f)     on exercise of the option before expiry of the term, the purported lessee must pay, in addition to the option price, all "rental" payments that would have been due had the purported lease run its term; and

g)     the rights retained by the purported lessor are in substance no more than the rights retained by a vendor under a conditional sales contract in order to protect its security interest in the property.

Certain of the above criteria require a comparison of the fixed purchase price under the option and the property's probable fair market value at the end of the five-year lease term.  This will be a question of fact.

24(1)

For further information on the Department's assessing position on this issue as well as on the implications of the lease constituting a disposition and acquisition, you may wish to refer to interpretation Bulletin IT-233R.  This Bulletin is currently under revision; however, the criteria identified above are based on the latest draft of the proposed revisions.

The remainder of this letter will point out issues that may arise if the lease qualifies as a true lease.

Status of the Non-Refundable Amount

As noted above, the Non-Refundable Amount might constitute the price paid by the farmer for the option rather than a down payment.  If so, section 49 of the Act applies.  For an explanation of section 49 of the Act, please refer to Interpretation Bulletin IT-403R.

Deductibility of Lease Payments By Farmers

Even if the lease is a true lease, the income tax consequences of the lease payments will depend on their proper characterization.  The payments consist of two elements:  a Base Amount and an Additional Amount.  The Base Amount might qualify as a rental payment.  However, the Additional Amount might not constitute rent.  While application of a portion of rentals against the purchase price under an option does not of itself mean that the amounts are not rent, the Program provides that the Additional Amounts are refunded to farmers who do not exercise the option.  This indicates that the Additional Amounts might have nothing to do with the use of the leased property.  while it is not entirely clear, the Additional Amounts might be nothing more than deposits paid by the farmers in anticipation of the eventual exercise of their purchase options.

Rental Recapture Rule

If a farmer exercises his purchase option, a special rule set out in subsection 13(5.2) of the Act applies to rentals previously deducted by the farmer (or by a non-arm's length person) in connection with the property.  In effect, part of these rentals may be treated as capital cost allowance claimed in respect of the property and consequently be subject to recapture treatment if the farmer later sells the property.  For this purpose, "rentals previously deducted" includes rentals paid by the farmer (or a non-arm's length person) under any previous lease of the property.

For further information, we refer you to Interpretation Bulletin IT-233R.

Capital Cost of Farmer's Leasehold Interest

Prior to exercising the purchase option, the farmer presumably has a leasehold interest in the leased property and, depending on the circumstances, might have a capital cost of that leasehold interest.  Special rules apply in this instance on the exercise of the option.  For more information, we refer you to subsection 13(5.1) of the Act as well as to Interpretation Bulletins IT-l90R  and IT-464R.

General

The above comments are exceedingly general in nature and do no more than highlight some of the issues raised by the proposed Program.  As noted, the income tax consequences will depend on the actual structure and details of the Program, which appears to involve a high degree of complexity.  We caution you that this is not an advance income tax ruling and, consequently, the comments made in this letter are not binding on the Department.  Once you have finalized the details of the Program, you may wish to apply for an advance ruling.

Yours truly,

for DirectorFinancial Industries DivisionRulings Directorate