21 February 2013 Internal T.I. 2012-0455081I7 - Regulation 1102(5)

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: Would the tenant be required to capitalize construction costs relating to the new building pursuant to Regulation 1102(5) of the Act?

Position: Yes.

Reasons: Question of fact.

February 21, 2013

XXXXXXXXXX John Parker CMA
Audit Division Corporate Financing Section
XXXXXXXXXX TSO Income Tax Ruling
Directorate

2012-045508

Regulation 1102(5) of the Income Tax Act (the "Act")

We are writing in response to your July 11, 2012 enquiry wherein you asked our opinion in regard to certain transactions involving a non-arm's length tenant and the allocation of construction costs. You have provided us with the following facts:

1) Company A ("ACo") and Company B ("BCo") are owned by the same individual shareholder.

2) ACo owns the land and contracts to have a new building constructed by a general contractor. ACo is invoiced for the construction costs and payment is made directly to the general contractor.

3) ACo, who is the landlord, enters into a commercial lease agreement with BCo (tenant) wherein it states that BCo will pay certain construction costs such as building permits, professional fees, equipment rental etc.

4) The landlord pays for all such costs per the contract with the general contractor.

5) BCo makes a journal entry to set up the amount due to ACo for these costs. BCo then deducts these amounts as current expenses. In addition, BCo also expenses other building improvements such as flooring, kitchen, bathroom, and specialized windows.

Your Question

Would the tenant be required to capitalize the construction costs, relating to the new building, and include them into CCA Class 1 as per subsection 1102(5) of the Income Tax Regulations ("ITRs")?

Our Comments

If a tenant is required to pay for certain construction costs in accordance with a legally valid agreement, we would accept that responsibility in the evaluation of the tax implications. The determination of the income tax treatment of construction costs, as described in your inquiry, involves a question of fact that can only be determined after reviewing all of the relevant documentation, nature of the expenditure and the terms of the lease agreement. Costs that are capital in nature cannot be expensed by BCo pursuant to paragraph 18(1)(b) of the Act.

Interpretation IT-464R, Paragraph 20 states:

"The capital cost of a leasehold interest that qualifies for inclusion in Class 13 does not include that part of a leasehold interest that is included in another class by reason of subsection 1102(5) of the Income Tax Regulations (the "ITRs"). This subsection provides that a reference to a property that is a "building or structure" in Schedule II of the ITRs includes a leasehold interest to the extent that the interest

(a) was acquired by reason of the fact that the taxpayer

(i) erected a building or structure on leased land,
(ii) made an addition to a leased building or structure, or
(iii) made alterations to a leased building or structure that substantially changed the nature of the property,"

Leasehold interests which are in the nature of a building or structure pursuant to subsection 1102(5) of the ITRs are required to be included in the respective class of Schedule II. All other capital costs respecting leasehold improvements would be included in Class 13 "Leasehold Improvements". Whether or not BCo should include capital expenditures into Class 1 or Class 13 is a question of fact.

We trust our comments will be of assistance.

Doug Watson
for Director
Reorganization Division
Income Tax Rulings Directorate