12 February 1998 Internal T.I. 9725647 - 85(1)

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:

Whether the principal residence portion and the non-principal residence portion of a subject land are two separate "properties" for the purpose of subsection 85(1) of the Act ?

Position:

No,

Reasons:

Because neither the principal residence portion nor the non-principal residence portion has been legally severed from the subject land.

				                                                         	February 12, 1998
	Lorna Gray	                                          Income Tax Rulings
  	Manager, Small/Medium Business           	and Interpretations
 	Audit Section 443-00					                             Directorate
	Verification & Enforcement Division	        Daniel Wong
	Vancouver Tax Services Office	                (613)954-4949
	Attention:  Andrew Chan
	            Section 443-24	972564

XXXXXXXXXX - Subsection 85(1)

We are writing in response to your memorandum of September 12, 1997 in which you requested our opinion as to whether a taxpayer and his purchaser company can elect to transfer the principal residence portion of land at its fair market value and the non-principal residence portion of the land at its adjusted cost base under subsection 85(1) of the Income Tax Act ("Act") when, in fact, the principal residence portion of the land has not been severed. If subsection 85(1) does not permit two elected amounts in respect of the land, then how should the deemed proceeds of disposition under subsection 85(1) be allocated between the principal residence portion and the non-principal residence portion of the land.

FACTS

XXXXXXXXXX

The Taxpayer maintains that he realized no gain on the rollover transaction as the gain otherwise determined from the disposition of the Subject Land was all reduced by the principal residence exemption provided under paragraph 40(2)(b) of the Act. The Vancouver TSO disagreed and has proposed to reassess the Taxpayer with respect to his XXXXXXXXXX taxation year on the basis that the gain otherwise determined from the disposition of the Subject Land was not completely reduced under paragraph 40(2)(b). The Taxpayer concedes that only 1/2 hectare of land qualifies as his principal residence, that the quality of the Subject Land is uniform and homogeneous throughout the entire property, and that there is only one title to the Subject Land.

TAXPAYER'S POSITION

The Taxpayer argues that the definition of "principal residence" as contained in section 54 of the Act treats the Subject Land as 2 separate properties for tax purposes: the principal residence portion and the non-principal residence portion, as paragraph (e) of that definition provides that the "principal residence.....shall be deemed to include.... the land subjacent to the housing unit and such portion of any immediately contiguous land as can reasonably be regarded as contributing to the use and enjoyment of the housing unit as a residence....". He further argues that both the principal residence portion and the non-principal residence portion are considered to be properties not only for the purpose of computing gains or losses in subdivision c of division B of Part I of the Act("Subdivision c") but also for the purpose of subsection 85(1) of the Act. His rationale is that only eligible property qualifies for the rollover under subsection 85(1) and eligible property is defined in subsection 85(1.1) to mean, inter alia, a capital property (including real property that is capital property that is owned by a Canadian resident taxpayer), and the term "property" is defined broadly in subsection 248(1) of the Act to mean

"property of any kind whatever whether real or personal or corporeal or incorporeal and, without restricting the generality of the foregoing, includes

(a) a right of any kind whatever, a share or a chose in action......"

He then submits that the principal residence as defined in section 54 is a right to occupy the residence and includes the 1/2 hectare of land (as in the Taxpayer's particular situation) and it fits within the definition of "property" in subsection 248(1) as "a right of any kind whatever...." and therefore it is considered to be a property for the purpose of subsection 85(1). Even though the Taxpayer did not elaborate on why the non-principal residence portion is property for the purpose of subsection 85(1), we believe the Taxpayer will apply the same rationale in respect of the principal residence portion to the non-principal residence portion. As a result, the Taxpayer alleges that he is entitled to elect two agreed amounts in respect of the Subject Land, one amount for the principal residence portion and the other amount for the non-principal residence portion.

In addition, the Taxpayer argues that section 68 of the Act is applicable to his situation, as the principal residence portion and the non-principal residence portion are separate properties for the purposes of section 68, because the principal residence portion and the non-principal residence portion both fit within the definition of "property" in subsection 248(1) of the Act. Under section 68, the Taxpayer argues, his allocation of the deemed proceeds of disposition between the principal residence portion and the non-principal residence portion is reasonable and therefore should not be disturbed.

VANCOUVER TSO'S POSITION

Vancouver TSO disagrees with the Taxpayer in two respects: first, it is their position that the Taxpayer cannot elect to transfer the principal residence portion at its fair market value and the non-principal residence portion at its adjusted cost base under subsection 85(1) when the Subject Land has not, in fact, been severed, and secondly, section 68 of the Act cannot be used to allocate the deemed proceeds of disposition of the Subject Land between the principal residence portion and the non-principal residence portion. Section 68 would apply to ensure that the allocation of the proceeds of disposition of land (both the principal residence portion and the non-principal residence portion) and the building thereon is reasonable. In allocating the proceeds of disposition between the principal residence portion and the non-principal residence portion, as in this case, the deemed proceeds of disposition of $XXXXXXXXXX is the relevant amount and should be allocated based on the relative fair market value of the principal residence portion in relation to that of the entire Subject Land.

OUR COMMENTS

There are three issues that we have to consider here:

1. whether subsection 85(1) of the Act permits the Taxpayer to elect two agreed amounts in respect of the Subject Land. This will depend on whether the principal residence portion and the non-principal residence portion are separate "properties" for the purposes of subsection 85(1) which in turn will depend on whether the definition of "principal residence" as contained in section 54 has the effect of severing the Subject Land into two separate properties: the principal residence portion and the non-principal residence portion.

2. If the principal residence portion and the non-principal residence portion are not separate "properties" for the purposes of subsection 85(1), that means only one agreed amount is permitted for the Subject Land under subsection 85(1). The issue then becomes what should be the proper basis of allocating the agreed amount under subsection 85(1) between the principal residence portion and the non-principal residence portion of the Subject Land.

3. Whether section 68 has any application with respect to the allocation of deemed proceeds of disposition between the principal residence portion and the non-principal residence portion of the Subject Land.

If the Taxpayer's position is correct, then the Taxpayer will be able to access the full amount of the capital gain which qualifies for exemption under paragraph 40(2)(b) and which has accrued to the date of transfer while at the same time defer any gain from the disposition of the non-principal residence portion by electing the fair market value of the 1/2 hectare of land as the agreed amount for the principal residence portion and the adjusted cost base of the non-principal residence portion as the agreed amount for the non-principal residence portion. On the other hand, if Vancouver TSO's position is correct, then the Taxpayer will not be entitled to an exemption under paragraph 40(2)(b) with respect to the full amount of the gain which has accrued on his principal residence at the time of the transfer and will, subject to the possible application of subsection 85(7.1) of the Act, have to realize some gain from the disposition of the non-principal residence portion.

ISSUE # 1

In our opinion, the definition of "principal residence" as contained in section 54 does not have the effect of severing the Subject Land into two separate properties: the principal residence portion and the non-principal residence portion. In our view, there is nothing in the definition of "principal residence" which deems the principal residence portion to be a separate property. This position is supported by the following analysis:

The definition of "principal residence" begins by stating that a principal residence of a taxpayer for a taxation year means a particular property and then it sets out certain criteria. In paragraph (e) of that definition, it contains two deeming provisions. The first deeming provision deems the principal residence to include land that is not in excess of 1/2 hectare and that is subjacent to the housing unit and such portion of any immediately contiguous land as can reasonably be regarded as contributing to the use and enjoyment of the housing unit as a residence, and the second deeming provision deems any land in excess of the 1/2 hectare not to have contributed to the use and enjoyment of the housing unit as a residence unless the taxpayer establishes that it was necessary to such use and enjoyment.

The Supreme Court of Canada commented on the function of deeming provisions in R. v. Verrette, (1978) 2 S.C.R. 838 and R. v. Sutherland, (1980) 2 S.C.R. 451 and stated that a deeming provision contained in a statute is a statutory fiction and the purpose of any such deeming clause is to impose a meaning to cause something to be taken to be different from that which it might have been in the absence of the clause. Therefore, even though the Subject Land consisted of XXXXXXXXXX acres, by virtue of the definition of "principal residence", only 1/2 hectare of the land qualifies as part of the principal residence.

Although, as indicated in paragraph 25 of Interpretation Bulletin IT-120R4, it is necessary to calculate the gain on the principal residence portion separately from the gain on the remaining portion of the property which does not qualify as a principal residence, the definition of "principal residence", as noted above, does not deem either portion of the property to be a separate property for purposes of the Act. Consequently, unless the Subject Land has been severed and constitutes more than one property under general principles of the law of real property (i.e. the taxpayer has a right to alienate the portions separately), it is our view that only one agreed amount can be elected for purposes of subsection 85(1).

In our view, the right of possession is one of the essential elements of ownership in the context of a principal residence, as the definition of "principal residence" in section 54 states:

"......a particular property that is a housing unit, a leasehold interest in a housing unit......that is owned ....by the taxpayer if

(a) where the taxpayer is an individual other than a personal trust, the housing unit was ordinarily inhabited in the year by the taxpayer....."

Under the law of real property "ownership" of a real property in fee simple consists of a bundle of rights which includes the right to alienate the land, that is, the right to transfer it to another person, and the right to possess the land. As the principal residence portion of the Subject Land has not been severed, the Taxpayer will not be able to alienate this portion to any person, and therefore this principal residence portion cannot be a property under the law of real property.

The Taxpayer argues that the principal residence portion consists of a right to occupy and therefore it meets the definition of "property" in subsection 248(1) as "a right of any kind whatever...". We disagree. The right to occupy in the context of a real property is one of the rights of ownership and will not constitute a "property" within the meaning of subsection 248(1) unless the right to occupy has been severed from the other ownership rights, i.e. a leasehold interest in the property. As the right to occupy the principal residence portion of the Subject Land has, in the Taxpayer's case, not been severed from the Subject Land, the right to occupy the principal residence portion, in and by itself, is not a property for purposes of subsection 248(1). Even if we were to accept the Taxpayer's argument that the right to occupy the principal residence portion was a separate property, such property would not, in and by itself satisfy the principal residence definition in section 54 unless a taxpayer is the owner of a leasehold interest in a housing unit. The definition of principal residence stipulates that the property in question must be a housing unit, a leasehold interest in a housing unit or a share of the capital stock of a cooperative housing unit. A right to occupy, in and by itself, will only satisfy the principal residence definition where it is in the form of a leasehold interest.

In conclusion, the principal residence portion, in and by itself, is not a property for the purpose of subsection 85(1) as it fails to meet the definition of "property" in subsection 248(1). The Taxpayer is not permitted to elect two agreed amounts in respect of the Subject Land under subsection 85(1), as the principal residence portion and the non-principal residence portion are not separate "properties" for the purposes of subsection 85(1). Therefore, there is only one agreed amount in respect of the Subject Land under subsection 85(1).

ISSUE # 2.

Our Canadian courts have taken the position that in allocating the sales price between the principal residence portion and the non-principal residence portion, the allocation has to be realistic and reasonable. Regardless what a taxpayer allocates or agrees to allocate, if the allocation is unrealistic and unreasonable, the courts will reallocate them. In Lewis Estate et. al. v. M.N.R. (T.C.C.) 89 DTC 316, Raper Estate v. M.N.R. (T.C.C.) 86 DTC 1513 and in The Queen v. Mitosinka (F.C.T.D.) 78 DTC 6432, the courts looked to the quality of the principal residence portion and the non-principal residence portion and allocated the sales price according to their respective fair market values. In the absence of such quality difference between the principal residence portion and the non-principal residence portion, we believe that the courts would allocate the sales price (i.e. the deemed proceeds of disposition for purposes of section 85) to the principal residence portion and the non-principal residence portion on a pro-rata basis.

In our case, it is not open for the Taxpayer to argue that he and his company agreed to transfer the principal residence portion at its fair market value and the non-principal residence portion at its adjusted cost base for tax purposes when the rollover agreement (dated XXXXXXXXXX) between the Taxpayer and XXXXXXXXXX only stated that the Subject Land is to be transferred at its fair market value and for tax purposes at an agreed amount. Even if the rollover agreement did stipulate this allocation formula, based on the jurisprudence as stated before, if the allocation is unrealistic and unreasonable, the courts will intervene to reallocate the amounts.

The cases cited above differ from the Taxpayer's situation in one important aspect, they do not involve subsection 85(1) of the Act while this case does. From the Taxpayer's perspective, it is significant because the Taxpayer believes that subsection 85(1) would permit him to elect two agreed amounts, one for the principal residence portion and the other for the non-principal residence portion and, therefore, his allocation of the deemed proceeds of disposition to the principal residence portion and the non-principal residence portion would be reasonable for tax purposes. But as we have concluded in Issue # 1 that subsection 85(1) does not permit such election, the Taxpayer's argument should fail.

In our opinion, the effect of subsection 85(1) is only on the proceeds of disposition of the Subject Land. Without the application of subsection 85(1), the sales price (i.e. the fair market value) of the Subject Land would be the proceeds of disposition. By electing an agreed amount under subsection 85(1), the agreed amount becomes the deemed proceeds of disposition of the Subject Land. As stated before, a deeming provision contained in a statute is a statutory fiction and therefore, even though the Subject Land is to be transferred at its fair market value, the deeming provision as contained in subsection 85(1) will deem the agreed amount to be the proceeds of disposition of the Subject Land for the purpose of computing any gain or loss under Subdivision c. Consequently, unless the Subject Land can be considered two separate properties (which is not the case), it is our view that the agreed amount (i.e. the deemed proceeds of disposition of the Subject Land under subsection 85(1)) must be allocated between the principal residence portion and the non-principal residence portion of the Subject Land based on their respective fair market values in determining the amount of any taxable capital gain to be included in the Taxpayer's income. In other words, the same principles as would have been applied to allocate the proceeds from an arm's length sale should be applied in allocating the deemed proceeds.

In conclusion, we have to fall back on the reasonableness test as provided by the jurisprudence. Given the fact that the quality of the Subject Land is uniform and homogeneous throughout the entire property, and the impact of subsection 85(1) is to deem the agreed amount as the proceeds of disposition of the Subject Land, it is reasonable and realistic to allocate the deemed proceeds of disposition of the Subject Land between the principal residence portion and the non-principal residence portion on a pro-rata basis. We therefore support Vancouver TSO's allocation position.

ISSUE # 3.

In our opinion, the Taxpayer's argument that section 68 supports his allocation position should fail as well. As the principal residence portion of the Subject Land fails to meet the "property" definition in subsection 248(1), it is not a property for the purpose of section 68 for the same reason given above when determining whether the principal residence portion is a property for the purpose of subsection 85(1).

We trust that our comments will be of assistance.

for Director
Reorganizations and International Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch
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