10 December 1991 Internal T.I. 9130447 F - Allocation of Salaries — Treatment of Leasing Commissions

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.

7-913044

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We are responding to your October 24, 1991 request for an opinion from Head Office clarifying the Department's position with respect to the following two issues:

(1)     The allocation of salaries between Property Income and Active Business Income where the only Active Business Income relates to the sale of property.

(2)     The treatment of Lease Commissions and other lease inducement payments.

General

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Issue I - ALLOCATION OF SALARIES

Facts

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Taxpayer's Position

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District Office Comments

You take issue with the Taxpayer's position because:

(i)         The Taxpayer's argument is not consistent with the facts reported in  their audited financial statements. 

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(ii)        Generally when the gain from the sale of property is calculated, the components of the calculation include proceeds, adjusted cost base, and expenses associated with the disposition.  Salary costs, unless they effect the adjusted cost base, do not enter the calculation.  

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(iii)       You also have difficulty accepting the Taxpayer's basis of  allocation.  It is common in G.A.A.P. to allocate items based on specific activities.  For example overheads are allocated based on direct hours when valuing inventory.  However, you are unaware of any precedent using soley type of income as an allocation base.

(iv)       

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Issue 2 - TREATMENT OF LEASING COMMISSIONS

Facts         

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District Office Position

In your view, the leasing commissions should be deferred and amortized over the term of the lease.

This position is supported by the following:

(i)         The deferral and amortization over the term of the lease is consistent with GAAP as is evidenced by the reporting in Mantella's own financial statements.  This treatment is based on matching lease costs with lease revenues.  Note that generally commissions paid are based on a percentage of lease revenues.

(ii)        In the book entitled "Creative Tax Planning for Real Estate Transactions - Beyond Tax Reform and into the 1990s", Brian Darling and Ted Harris of Revenue Canada state that lease commissions should  receive the same tax treatment as lease inducement payments which  is  set out in question 49 of the 1985 Round Table.  (Note: in the      Department's answer to question 49, it stated IT-359R2 will be revised). 

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      Informal discussions with Brian Darling, Ted Harris and their  staff   indicated that they agree with our proposed treatment.

Taxpayer's Position    

"Once an expenditure is incurred on revenue rather than on capital account, there is nothing in the Income Tax Act or in jurisprudence decided thereunder that require a taxpayer to defer or amortize the expenditure."  "It takes a  specific statutory provision such as subsection 18(9) of the Income Tax Act to require the deferment or amortization, as opposing to the immediate expensing of an expenditure that is incurred on revenue account... No such specific  statutory provision comes into play here."  The taxpayer has referred to two  key court cases to support its position as well.  In Jack L. Cummings vs Her Majesty The Queen 81 DTC 5207 the fee for finding a tenant was apparently allowed as a period expense (disallowed as a contingent liability).  Secondly, in Baker Lovick vs MNR 91 DTC 1041, the leasing agent's commission and other lease inducement payments relating to the sublet of "excess office space" was allowed as a deductible expense by the Tax Court of Canada.

District Office Comments

In disagreeing with the Taxpayer's position, you considered the following:

(i)         It is the Department's position that G.A.A.P. is normally applied for tax purposes unless specific provisions in the Income Tax Act over-ride it.  Court rulings such as Metropolitan Properties (85 DTC 5128) support this position.

(ii)        The particulars in the Baker Lovick case are different then in the 19(1) situation.  In the Baker Lovick case only excess space was being sublet (we are interpreting this to mean that the lease was to a "non-anchor tenant"). 

24(1) The Department's position as set out in question 49 of the 1985 Revenue Canada Round Table affords different tax treatment to the same type of expenses based on whether the tenant is a anchor or non-anchor tenant.  The difference being that owners leasing to anchor tenants should either capitalize the lease inducement payment or treat as an Eligible Capital Expenditure, while owners leasing to non-anchor tenants should treat the items as period expenses. 

In addition lease inducement payments relating to the initial lease of space in the building are to be deferred and amortized over the term of the  lease.  (Note: in the book entitled "Creative Tax Planning for Real Estate Transactions - Beyond Tax Reform and into the 1990s", Chapter 8 written by Brian Darling and Ted Harris of Revenue Canada states leasing commissions should be accorded the same tax treatment as lease inducement payments.)

You would appreciate a clarification of the Department's position relating to the above two issues.  You enclosed copies of correspondence from both the Department and 19(1) representatives, a copy of question 49 of the 1985 Revenue Canada Round Table, and Chapter 8 of the above-noted book. 

Our Comments

Issue 1 - ALLOCATION OF SALARIES

1.          The Department publicly stated its position with respect to the reasonableness of bonus payments to shareholder- managers in Question 42 of the Revenue Canada Round Table at the 1981 Canadian Tax Foundation Conference.  Our position remains unchanged and excerpts from this position follow:

      "No specific guidelines have been established to determine the reasonableness of salaries paid to employee- shareholders where a private company earns substantially all its income from property.  The amount, if any, that is considered to be reasonable must be based on the facts of each particular case....(T)he Department generally accepts that a principal shareholder-manager is entitled to determine a mix of salary and dividend that he considers appropriate....In general, the Department will not challenge the reasonableness of salaries and bonuses paid to the principal shareholders-managers of a corporation when (a) the general practice of the corporation is to distribute the profits of the company to its shareholder- managers in the form of bonuses or additional salaries; or (b) the company has adopted a policy of declaring bonuses to shareholders to remunerate them for the profits the company has earned that are in fact, attributable to the special know-how, connections, or entrepreneurial skills of the shareholders."

2.          In one of the court cases dealing with the deductibility of bonuses, V R Enterprises Ltd v MNR 74 DTC 1089, assistant chairman Lucien Cardin, OC, stated:

      "I do not believe that all bonuses are deductible expenses.  Before a bonus can be considered as an integral part of salary and a deductible expense, it must, in my view meet certain criteria.  Some of the criteria would be -

1. The amount of bonuses paid or accrued must be reasonable in comparison with the profit earned by the company and the services rendered by the recipients.

2. The services for which the bonuses are paid must be real and identifiable.

3. Though the quantum of the bonuses, which are usually based on the amount of profit realized by a corporation, need not necessarily be precisely determined beforehand, there must be some justification for expecting an amount of income over and above the regular yearly salary.

4. There must be some relationship between the bonuses paid or accrued and the income earned or to be earned at least in the form of a well-established and well-known incentive.

5. Bonuses to be paid or accrued in a particular year must be established within a reasonable time from the moment the corporation's profit for that year has been determined.   

3.         

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4.         

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Issue 2 - TREATMENT OF LEASING COMMISSIONS

1.          From our understanding of the facts as presented, the commissions paid in 1988 and 1989 each related to the initial lease of one half of the building and, in our view, related to the entering into of anchor leases. 

2.          The Department's position with respect to the tax treatment of leasing costs was well documented at both the 1985 Revenue Canada Round Table and at the 1989 Corporate Management Tax Conference.  At the 1985 Round Table it was noted that revisions to IT-359R2 would be made in due course. 

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      The Department's position has been publicly available since 1985, and in our view, you would be correct in reassessing on this basis.

3.          We note that the taxpayer has placed much emphasis on the Cummings case. However, at the Corporate Management Tax Conference 1989, as reflected on page 8:7 of the report, the Department said: "We have been asked whether the general position considers the decisions rendered in Oxford Shopping Centres and Cummings.  These cases were considered; however, the department's view is that they were decided on the basis of their particular facts and may not be applicable in other situations."  We also note that the Baker Lovick case dealt with a sublease in which case we agree with your comments that the lease in question was to a `non-anchor tenant' and would not be applicable to this particular situation.

4.          In support of the use of CIPREC recommended accounting practices, ie., normal commercial practice, for calculating income for tax purposes, we refer you to the decision in West Kootenay Power and Light Co. Ltd. v MNR 91 DTC 5214 (FCTD) where the judge determined that the taxpayer had to use the same generally accepted accounting principles (GAAP) for income tax purposes as for financial statement purposes.  The judge noted that the principles laid down by the Federal Court of Appeal in Neonex International Limited v MNR 78 DTC 6339 and MNR v Cyprus Anvil Mining Corporation 90 DTC 6063 supported the conclusion that the Act does not permit reporting revenues for tax purposes on a different basis from that adopted for purposes of accurately portraying the financial picture of the company for its shareholders and creditors, unless the Act itself otherwise specifies.  In the West Kootenay case the Act did not so specify; nor did the Act require nor permit the taxpayer to report its income on two different bases for tax and accounting purposes.  

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5.     We trust that our comments will be of assistance.

     E. WheelerChiefBusiness and Property Income, and Exempt Organizations SectionRulings DirectorateLegislative and Intergovernmental  Affairs Branch