17 October 2011 External T.I. 2011-0398711E5 - Tax treatment of prepaid amounts

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: In a hypothetical fact situation provided, a charitable organization receives a donation of $XXXXXXXXXX . This amount is then paid to a corporation as an advance towards rent to be paid for a period of XXXXXXXXXX years. What are the tax consequences to the charitable organization and the corporation.

Position: The amount received by the corporation may be included under subsection 9(1) or paragraph 12(1)(a). A deduction under paragraph 20(1)(m) may be available.

Reasons: It is a question of fact.

XXXXXXXXXX
								2011-039871
								V. Srikanth

October 17, 2011

Dear XXXXXXXXXX :

Re: Tax treatment of prepaid rent

This is in response to your correspondence dated March 9, 2011 wherein you requested our views on the tax treatment of certain prepaid amounts.

Specifically, you have described a hypothetical situation wherein a charitable organization ("Entity A") receives an amount of $XXXXXXXXXX as a charitable donation to assist it in securing a location to carry out its charitable activities. Entity A then advances this amount to a corporation ("Entity B") to secure a spot in the building that it owns. You would like our views on the tax treatment of the amounts received in the hands of Entity A and Entity B.

Our Comments

The particular circumstances in your request appear to represent a specific factual situation. As mentioned in paragraph 22 of Information Circular IC 70-6R5, Advance Income Tax Rulings, dated May 17, 2002, it is not this Directorate's practice to comment on specific proposed transactions other than in the form of an advance income tax ruling. This Information Circular and other Canada Revenue Agency ("CRA") publications can be accessed on our website at http://www.cra-arc.gc.ca. Your request was not submitted in the format required for an advance income tax ruling request, however, as stated in paragraph 22 of IC 70-6R5, we do provide written opinions on general enquiries which are not binding and we are prepared to provide you with the following comments.

It is our understanding that an officer from this Directorate contacted you by phone to discuss the tax implications of the amount received by Entity A. Hence, in this letter, we have only addressed the issue of the tax consequences to Entity B.

Scenario # 1- Entity A enters into a XXXXXXXXXX -year rental agreement with Entity B wherein the latter requires an upfront lump sum amount equivalent to the fair market rent for the XXXXXXXXXX year period.

Interpretation Bulletin IT-261R, entitled 'Prepayments of Rents', deals with prepayments of rent and the treatment of the prepayments for tax purposes. As indicated in this IT, it is essential that it be determined whether the amount received is a payment of a premium or a prepayment of rent, because the tax treatment is different depending on the nature of the payment. Specifically from paragraphs 3 and 4 of IT-261R, "[a] payment is a prepayment of rent where a tenant makes a payment to his landlord and, as a result pays no rent or pays rent at a rate that is less than what he would otherwise have had to pay. The payment of an amount for the right to assume, from the payee, an existing lease whose rental is below current market values is considered a premium.

In determining whether a payment is a premium or is prepaid rent or contains an element of both, each case must be considered in the context of the factual circumstances of the transaction. It is the substance of the transaction that determines what the payment is rather than the name agreed on by the parties to describe that payment."

With respect to the treatment of a premium or other amounts received by a landlord as consideration for granting or extending a lease, paragraph 1 and 2 of IT-359R2, entitled 'Premiums and Other Amounts With Respect to Leases', states that:

"A premium or other amount received by a landlord or tenant, as the case may be, as consideration for granting or extending a lease or sublease, permitting a sublease, or cancelling a lease or sublease is business income to the recipient if renting property forms part or all of a business being carried on.

Where a landlord, not in the business of renting property, receives a premium for granting or extending a lease and the rent charged is less than fair market value, the premium is included in income to the extent that it can reasonably be regarded as being in the nature of rent..."

Subparagraph 12(1)(a)(i) provides for the inclusion in income of amounts received by a taxpayer in the year in the course of a business that is on account of services not rendered or goods not delivered before the end of the year or that, for any other reason, may be regarded as not having been earned in the year or a previous year. Paragraph 12(1)(a) does not apply to amounts received as an advance in respect of income from property rather than business. This paragraph is also not applicable where the amount received is considered a deposit as such amounts are not considered as income for tax purposes at the time they are received.

Subsection 9(1) of the Act provides that, "...a taxpayer's income for a taxation year from a business or property is the taxpayer's profit from that business or property for the year". The application of subsection 9(1) of the Act to prepaid income results in an upfront inclusion of amounts received, but not earned, in a taxpayer's income.

Whether a prepayment in respect of the services not yet rendered or goods not yet delivered before the end of the year should be included into a taxpayer's income pursuant to paragraph 12(1)(a) or subsection 9(1) of the Act, is a question of fact. Only an examination of all the facts and circumstances surrounding a particular situation will determine the correct treatment.

Paragraph 20(1)(m) of the Act provides that, where amounts described in paragraph 12(1)(a) have been included in computing the taxpayer's income from a business for the year or a previous year, the taxpayer is entitled to deduct a "reasonable amount" as a reserve in respect of services that will have to be rendered (subparagraph 20(1)(m)(i)) or goods that will have to be delivered after the end of the year (subparagraph 20(1)(m)(ii)), or, in the case of prepaid rent, to the extent that the amount relates to periods after the end of the year for which the rent was prepaid (subparagraph 20(1)(m)(iii)). Further, any reserve deducted in a year under paragraph 20(1)(m) is to be included in computing income from a business for the taxpayer's immediately following taxation year pursuant to paragraph 12(1)(e) of the Act.

In the May 24, 2004 Income Tax Technical News ("ITTN") No. 30, we indicated that, as a general rule, the income inclusion/deduction mechanism provided under paragraphs 12(1)(a), 12(1)(e) and 20(1)(m) of the Act should apply to prepaid income (rather than income inclusion pursuant to subsection 9(1) of the Act, without the possibility of deducting any amount as a reserve under paragraph 20(1)(m)), since those provisions are a specific statutory scheme dealing with such prepaid income. However, it should be noted that in the July 15, 2005 ITTN No. 32, we clarified our position regarding paragraph 20(1)(m) of the Act in light of the decision of the Tax Court of Canada (the "TCC") in Ellis Vision Incorporated v. the Queen, 2004 DTC 2024, wherein the TCC ruled that a reserve may be applicable to income included under subsection 9(1), provided that the amount is "described" in paragraph 12(1)(a) of the Act. As stated therein, CRA examines the nature of prepaid income, and when it is realized, to determine whether an amount is eligible for a reserve under paragraph 20(1)(m).

Scenario # 2- Entity A makes a payment to Entity B in order to secure a place in the latter's proposed new building addition.

Paragraph 12(1)(x) applies to include in income amounts received in respect of an outlay, an expense or the cost of a property, whether received as a refund, reimbursement, contribution, allowance, or as assistance of any kind (including assistance in the form of a grant, subsidy, forgivable loan or deduction from tax), unless one of the exceptions in subparagraphs 12(1)(x)(v) to (viii) applies. Paragraph 12(1)(x) similarly applies to inducements of any kind.

Pursuant to subparagraphs 12(1)(x)(v) and (vi) of the Act, amounts which, under GAAP or well-accepted business principles, are otherwise included in income or used to reduce an outlay or expense or the capital cost of property, are not subject to income inclusion under paragraph 12(1)(x).

Pursuant to subparagraph 12(1)(x)(vii) of the Act, amounts which, by election, are used to reduce an outlay or expense or to reduce the capital cost of property, are not subject to income inclusion under paragraph 12(1)(x). The incoming requested our views on whether the elective provisions of subsection 13(7.4) would be available to the given scenario. Subsection 13(7.4) of the Act permits a taxpayer to elect to reduce the capital cost of depreciable property by the amount of a related inducement, contribution, reimbursement or allowance that would otherwise be included in the taxpayer's income under paragraph 12(1)(x), i.e., for subsection 13(7.4) to apply, the taxpayer must have received an amount in respect of the cost of the property, which would otherwise be included in income by virtue of paragraph 12(1)(x). We cannot comment further on this as the hypothetical situation was not clear as to whether the amount was received in respect of the cost of the property.

Pursuant to subparagraph 12(1)(x)(viii) of the Act, amounts that can reasonably be considered to be in respect of the acquisition, by the payer, of an interest in the taxpayer, or the taxpayer's business or property, are not subject to income inclusion under paragraph 12(1)(x).

The facts of a particular situation will determine which of the above-noted provisions may apply.

We trust our comments will be of assistance to you.

Yours truly,

R.A. Albert, CA
For Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch