7 September 1999 External T.I. 9909965 - ASSUMPTION OF LEASE OBLIGATIONS

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

(1) Whether the proceeds of disposition for a rental building are affected by a payment by the vendor to the purchaser for the latter's assumption of the obligations with respect to a long-term lease, in the situation where a subsection 20(24) election is filed.

(2) Where an election is not filed, how should the purchaser treat the payment and the expenses with respect to the long-term lease.

Position:

(1) In the situation outlined, the so called "pre-paid rent," which covers a period of 20 years, may, in some circumstances, be considered proceeds of disposition, rather than a prepayment of rent. Assuming that the prepaid rent is for a shorter period, and also, assuming that the amount paid by the taxpayer to the purchaser for the assumption of the lease obligations is reasonable, so that the election under subsection 20(24) is applicable, the amount of proceeds would not be affected by a payment for the assumption of the obligations.

(2) The purchaser would include the payment in income pursuant to ss 9(1) or para. 12(1)(x). The costs incurred with respect to these obligations may be deductible if the taxpayer can demonstrate that they are made for the purpose of earning income from a business or property.

Reasons:

(1) Subsection 20(24) will apply so that the payment for the assumption of obligations is assured income, rather than capital, treatment.

(2) This amount may be considered as an amount received by the purchaser to reduce the future expenses with respect to the long-term lease. The obligations assumed with regards to the long-term lease are usual obligations from the ownership of property.

xxxxxxxxxx J. Gibbons
5-990996

Attention: xxxxxxxxxx

September 7, 1999

Dear XXXXXXXXXX:

This is in response to your facsimile of April 22, 1999, in which you requested our views concerning the interaction of paragraphs 12(1)(a) and 20(1)(m) and subsection 20(24) of the Income Tax Act in a situation involving prepaid rent and the sale of a rental building.

Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an advance ruling request submitted in the manner set out in Information Circular 70-6R3. The following comments are, therefore, of a general nature only.

Our understanding of the facts and assumptions is as follows:

1.The taxpayer acquires a rental building for $100 cash.

2.The taxpayer then leases the building to a tenant under a long-term lease.

3.The tenant prepays the rent for a 20-year period in the amount of $95.

4. Later, in the same year, the taxpayer sells the building to an arm's length purchaser for $45.

5. As part of the agreement, the taxpayer pays the purchaser $30 as consideration for assuming the obligations of the taxpayer with respect to the lease. These obligations relate to future running expenses that an owner of the property would be expected to incur.

Based on the above facts and assumptions, you ask us to confirm the following:

1.The taxpayer would include the prepaid rent in income under paragraph 12(1)(a) initially with the view to claiming a reasonable reserve under subparagraph 20(l)(m)(iii) of the Act.

2.Upon the sale of the building, the taxpayer would recognize the full amount of the prepaid rent in income (paragraph 12(1)(a)) and claim a deduction pursuant to subsection 20(24) of $30.

3.The taxpayer would recognize proceeds on the sale of the building of $45, thereby resulting in a loss of $55 ($100 minus $45) . The amount of proceeds is unaffected by the assumption of obligations by the purchaser in respect of the lease. Whether the loss is on income account or is a terminal loss is a question of fact.

In summary, you state that the taxpayer would retain a $10 cash gain ($95 (prepaid rent) plus $45 (proceeds of disposition) less $100 (cost of building) less $30 (payment to purchaser)). This $10 gain would be reflected in taxable income as follows:

Prepaid rent $ 95
Loss on building (55)
20(24) deduction (30)
Income $ 10

In your letter, you also requested our comments in the case where an election under subsection 20(24) is not made. You ask whether operating expenses incurred by the purchaser pursuant to the obligations it assumes under the lease are deductible as ordinary business expenses.

Our Comments

In the situation outlined, the so called "pre-paid rent," which covers a period of 20 years, may be considered proceeds of disposition, rather than a prepayment of rent. However, this determination requires a review of all of the facts and circumstances. For purposes of responding to your enquiry, we will presume that the prepaid rent is for a shorter period. In this case, and also assuming that the amount paid by the taxpayer to the purchaser for the assumption of the lease obligations is reasonable, so that the election under subsection 20(24) is applicable, we agree with your understanding of the application of subsection 20(24).

In the situation where an election is not filed, it is our view that the amount received by the purchaser, in the amount of $30, must be included in income by virtue of subsection 9(1) or paragraph 12(1)(x) of the Act, This amount may be considered as an amount received by the purchaser to reduce the future expenses with respect to the lease. Further, it is our view that the obligations assumed with regards to the lease are usual obligations from the ownership of property. Thus, the costs incurred with respect to these obligations may be deductible if the taxpayer can demonstrate that they are made for the purpose of earning income from a business or property.

We trust that these comments will be of assistance.

Yours truly,

John Oulton
for Director
Business and Publications Division
Income Tax Rulings and
Interpretations Directorate