15 February 1989 Income Tax Severed Letter 7-2491 -  

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.

FEB 15 1989

TO    MISSISSAUGA DISTRICT OFFICE
      Attention: Neil Persad
                 Appeals Division

FROM HEAD OFFICE Merchandising, Manufacturing and Construction Section M. Eisner (613)957-2142

SUBJECT: XXXX (the "purchaser")          
         Deduction of Soft Costs

This is in reply to your round trip memorandum dated June 8, 1988 wherein you asked whether certain initial service costs, commonly described as soft costs, are deductible by the Purchaser.

In connection with your concern, you attached a copy of 4 pages of an 18 page agreement of purchase and sale dated XXXX between the Purchaser and XXXX (the "Vendor"). In addition, you have attached a full 18 page sample agreement of purchase and sale, along with other sample agreements which, we understand, contain terms which are identical to those contained in the agreements executed by the Purchaser.

Our understanding of the relevant facts and information is as follows:

XXXX

District Office Position

It is our view that the Purchaser agreed to acquire a condominium unit under the Purchase Agreement. Since the project was not registered as a condominium until September 1, 1986 and all the soft costs were incurred prior to that time, they are not allowable. You have also indicated that the costs could be disallowed on the basis that the building in question is not a multiple-unit residential building described in Class 31.

Taxpayer's Position

Submissions on behalf of the Purchaser have been made by XXXX In the submissions, it has been indicated that at the time of the original acquisition, the Purchaser acquired an undivided interest in the project which was later converted to a specific condominium unit on registration of the project as a condominium. Under the terms of the original acquisition in 1984 the developer was required to physically complete the building and to provide certain financial and leasing services which were carried out in 1984 1985 and 1986. As a consequence, the soft costs in question should be deductible. The Purchaser's representative has also generally discussed the provisions under which the various soft costs are deductible.

Rulings Position

It has always been the Department's position that the rules with respect to soft costs are not restricted to expenditures incurred by investors who acquire Class 31 property, but may arise during the course of development of any property. Accordingly, it is not possible to disallow the soft costs solely on the basis that the building is not a MURB.

With respect to your other argument, we have proceeded to ascertain the time when the Purchaser acquired an interest in the project before discussing the deductibility of the soft costs as it is our view that the acquisition date is relevant to some of the costs.

In determining the time the Purchaser acquired an interest in the project, we feel that there are three factors to consider which are set out below:

(i) The Agreement refers to the sale of a condominium from the Vendor to the Purchaser in a number of provisions set out above (see 3(a) and 5 above). If in fact, a purchase and sale of a condominium is involved, the purchase date would be regarded as being September 1, 1986 because the condominiums were not in existence prior to that date.

(ii) Point 5 above and a number of provisions relating to soft costs suggest that the Purchaser acquired an interest in the project on the Completion Date. However, while the provision indicates that the interest in the building relates to a condominium unit which was not in existence at that date, a valid consideration is whether the interest can be regarded as an undivided interest in the project.

(iii) The wording of the terms in 7 and 10 above indicate that they may be "conditions precedent" as described in paragraphs 5 and 6 of IT-170R rather than "conditions subsequent" which would restore ownership of a unit to the Vendor. If this is the case, an acquisition of an interest in the project would not occur prior to these conditions being satisfied.

In relation to the time of acquisition, paragraph 8 of IT-170R states that possession, use and risk are the primary attributes of beneficial ownership and that the following are strong indicators of the passing of ownership.

(a) entitlement to income from property, (b) assumption of responsibility for insurance coverage, and (c) commencement of liability for interest on purchaser's debt that forms a part of the sale price.

As point 5 and 11(b)(ii) above indicate that the above criteria were satisfied on the Completion Date, it is our view that the Purchaser would have acquired an interest on the project at that time unless there are provisions which establish the contrary. It is also our view that the Purchaser's interest in the project would have to be regarded as being an undivided interest at that time as the project had not been registered under the Condominium Act of Ontario.

In considering (i) above, it can be argued that the object of the Purchase Agreement is a sale of a condominium unit. If this were to be the case, the date of acquisition would be September 1, 1986. However, this position would be in conflict with the terms in 5, 11(b)(iii), and 12 above insofar as possession, use and risk are concerned. In relation to this conflict, we have considered three factors. The first is that it seems clear that it was the intention of the Purchaser and the Vendor that possession, use and risk of an interest in the project be transferred on the Completion Date. The second factor is that it is our understanding that the purchasers of units treated their interests acquired on the Completion Date as being undivided interests. The third factor is that if a purchaser of a unit did not end up acquiring a condominium unit, he was entitled to sell his interest back to the Vendor (see 9 above). In view of these factors, it is our view that the terms in 5 and 3(a) above did not effectively result in the Purchaser not having an undivided interest on the Completion Date.

With respect to (iii) above, it can be argued that the terms in 7 and 10 above are "conditions precedent" rather than "conditions subsequent" as they refer to a return to the purchaser of monies paid by him. However, based on the two factors mentioned above in respect of (i), we feel that these conditions should be regarded as being conditions subsequent. In other words, the Purchaser should be regarded as having acquired an interest in the project on the Completion Date and if these conditions in 7 and 10 above were not satisfied, the Vendor would reacquire the Purchaser's interest. As a further point we are noting that these comments are consistent with those in 9 above wherein the aggregate cash contributions would also be returned to the Purchaser. Accordingly, we are of the view that a Purchaser should be regarded as having acquired an undivided interest in the project on the Completion Date.

For your further information, we are also noting that, in our view, each purchaser, following registration under the Condominium Act, would have acquired all the undivided interests in a particular unit and disposed of all his undivided interest in other units. However, notwithstanding that dispositions are involved, it seems that there would not be any gains involved since the project was registered under the Condominium Act within a few months of the Completion Date.

From the above comments it is apparent that we do not agree with the Purchaser's representative that an undivided interest was acquired on the day the Purchaser and Vendor executed the Purchase Agreement. In this regard, it is our view that the Purchaser would only have had an equitable interest in the project which merely constitutes a right to acquire an interest in the project at some future time.

With respect to the deductibility of soft costs based on the acquisition date, paragraph 9 of Legislation Branch Letter 79-12 ("LBL") indicates that to qualify for deductions, the investor must have ownership of the "MURB". However, it must be pointed out that those comments were intended to address the type of situation where a purchaser entered into a MURB purchase agreement under which deductible costs are carved out of the purchase price and the costs were previously incurred by the developer. In the case at hand, the circumstances are different as the taxpayer signed a Purchase Agreement on December 24, 1984 which provides that the costs in question were to be incurred for and on behalf of the taxpayer, and, in most cases, it would not appear that the services had been rendered prior to the execution of the agreement. Consequently, we feel that the costs would be allowable unless a particular cost or part thereof fails to satisfy the relevant provisions of the Income Tax Act (the "Act"), can be regarded as not having been incurred on behalf of the taxpayer or was incurred prior to the time the Purchase Agreement was executed. However, a further consideration is whether any soft cost is reasonable in amount for the purposes of section 67. Subject to the comments below, we are not aware of any basis under which the costs could be disallowed.

We have the following comments to make concerning the deductibility of the soft costs subject to our further comments concerning reasonableness.

(a) In the case of the bank fee, it seems possible that the related cost may have been incurred by the Vendor prior to the time that the Purchaser signed the Purchase Agreement. If this is the case, it is our view that it should be allocated on a pro rata basis to land, building and other assets. On the other hand, if this fee was not payable or incurred by the Vendor until a purchaser entered into the arrangement, the fee would be deductible under paragraph 20(1)(e) of the Act.

(b) With respect to financing costs related to the Blanket Mortgage, funds therefor were used by the Vendor in constructing the project. To the extent that the fees relate to this use, they would not be allowable under paragraph 20(1)(e) by the Purchaser as they would have benefitted the Vendor while it owned the project prior to the Completion Date; and

(c) Paragraph 1 (b) of IT-296 states that for landscaping costs to be deductible under paragraph 20(1)(aa), the taxpayer must own the building at the time the landscaping is being done. Since the landscaping costs were incurred prior to the Completion Date, it is our view that they are not deductible under paragraph 20(1)(aa) and should be added to the cost of land.

As an additional comment, we are mentioning that, in our view, the operating deficit, the rental revenue guarantee, the mortgage interest buy-down and the mortgage guarantee fee would not be deductible by the Purchaser unless they related to a period of time during which the Purchaser owned an interest in the project. However, in the case at hand this would, in fact, appear to be the case.

While all soft costs must also be reasonable, it is not possible to provide specific comments without a review of all the relevant facts. However, the Department's general view is set out on page 4 of the Addendum to the LBL wherein it is indicated that the reasonableness of an expenditure is based on whether a prudent investor could be expected to pay such an amount for the particular service. Additional comments concerning specific types of expenditures are also set out therein. For your further information we are also making general comments concerning the operating deficit and the mortgage interest buy-down:

(a) The amount of the interest buy-down should not exceed the maximum amount that might be paid to the mortgage to reduce the interest rate on the principal involved by the amount of XXXX for the XXXX time period (i.e. principal of mortgage(s) bought down x XXXX. In addition, it appears that some discount factor might be warranted in view of the fact that the mortgage rate reduction could have been less than XXXX.

(b) The amount charged in respect of the operating deficit should represent a reasonable estimate of the cash loss the Purchaser would have been incurred from the Completion Date to the Transfer Date and should not include any amount for costs which the Purchaser himself is otherwise required to pay.

We are also mentioning that the Purchaser's representative, in his letter of March 22, 1988, has made comments to the effect that the Purchaser commenced to carry on business at the time the Purchase Agreement was executed. While we do not feel that those comments are relevant for the purposes of determining the deductibility of the soft costs in question, it would appear that the Purchaser is not carrying on a business as insufficient services are being provided (See paragraphs 2 to 6 of IT-434R ).

From the above comments, it would appear that not all the soft costs are allowable. However, proper documentation should be obtained with respect to disallowed costs and all investors, of which the Vendor would have a listing, should be treated in the same manner.

It would, therefore, seem that since the Vendor is closely connected to XXXX which is under the jurisdiction of the Ottawa District Office this Office should be contacted by you with respect to the necessary audit action. As a final comment, we are mentioning that we contacted Mr. Franerone of the Ottawa District Office who advised us that, while an audit was recently carried out on XXXX, this particular project was not audited.

Chief Merchandising, Manufacturing and Construction Section Small Business and General Division Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch