22 November 2002 Internal T.I. 2002-0141627 - COSTS LAND DEVELOPMENT

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 CCRA.

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

Principal Issues:

Is a developer required to capitalize interest on borrowed money used to finance installation of services during the period between the acquisition of the raw land and construction of the buildings?

Position TAKEN:

Should be capitalized - Both GAAP and CIPPREC recommend it and 18(3.1) considered sufficiently broad enough to require it.

REASON FOR POSITION:

Policy and wording of the Act.

									November 22, 2002

VANCOUVER TSO						HEADQUARTERS
Industry Specialist						C. Tremblay
Construction Specialist						(613) 957-2139

Attention: Bernie Lum
									2002-014162

Land Development

This is in reply to your request of May 21, 2002 and subsequent to information received on July 10, 2002 wherein you seek our views on whether interest expense incurred to finance installations of services on land and other soft costs during the period of development are required to be capitalized. You refer to subsections 18(2) and 18(3.1) of the Income Tax Act (the "Act") and ask whether there exists a period between the acquisition of land and the eventual commencement of construction when certain costs are not required to be capitalized.

XXXXXXXXXX

Our Comments

Generally, a taxpayer must adopt a method of income computation, which is not inconsistent with the Act or established rules of law, which is consistent with well-accepted business principles, and which will yield an accurate picture of "profit" for that year.

The Act does not define "profit" nor does it provide any specific rules for the computation of profit. Jurisprudence has established that the determination of profit under subsection 9(1) of the Act is a question of law to be determined according to the business test of well-accepted business or accounting principles or well-accepted principles of commercial trading except where these are inconsistent with specific provisions of the Act.

In applying the Canderel approach to computing income, point 4 in the 6 principles established by the Supreme Court states that in ascertaining profit the taxpayer is free to adopt any method, which is consistent with:

(a) the provisions of the Income Tax Act;

(b) established case law principles or "rules of law";

(c) and well-accepted business principles

As you are aware, CIPPREC maintains a handbook known as "Recommended Accounting Practices for Real Estate Investment and Development Companies" which has widespread usage throughout the construction industry. CIPPREC recommends that corporations capitalize interest during the site development stage. In our view, their recommendations comprise generally accepted business principles that would yield an accurate picture of income for the year. GAAP also recognizes that items directly attributable to the development are capitalized. Once the land has reached the development stage, all expenditures are added to the cost of land.

Accordingly, in our opinion, where a payment in respect of "soft costs" advances the subdivision plans forward beyond the acquisition of raw land, then value has been added to the project and the inventory value is increased, thus any arguments relating to "hole in income" as was advanced in Canderel, where said monies were spent to "plug the hole" can be rebutted. In our view, where the costs enhance the value of the lots, capitalization would present a truer picture of the taxpayer's income.

We note that in the Canderel decision, the Supreme Court also quoted with approval the principle in West Kootenay Power and Light Co. v. the Queen (92 DTC 6023) "The approved principle is that whichever method presents the "truer picture of a taxpayer's revenue, which more fairly and accurately portrays income and which "matches" revenue and expenditure, if one method does, is the one which must be followed."

In our view the decision rendered in Urbandale Realty Corporation Limited v the Queen (2000 DTC 6118), which involved the 1986 taxation year is an inappropriate application of the Canderel approach. However, the CCRA decided not to appeal since we concluded that subsection 18(2) of the Act would have application for taxation years subsequent to 1988. We determined that the accounting treatment and well-accepted business principles in respect of costs related to land held for development and land currently under development were now clear. Such expenditures become inventory and are thus not currently deductible.

You are concerned that recent court decisions could allow a taxpayer to deduct expenses that are not consistent with accepted business principles, however a relevant Tax Court of Canada case dealing with the issue at hand is Ted Magnowski and Renee Magnowski v the Queen (2000 DTC 2244). It was found that there was no evidence that administrative or overhead costs were incurred as running expenses but rather should be added to the taxpayer's land inventory. GAAP should be followed and in accordance with the decision in the Queen v Metropolitan Properties Co. Limited (85 DTC 5128) the taxpayer must defer to future periods.

In considering the restrictions on "soft costs" and their mandatory capitalization, the parameters of the "construction period" of the legislative provisions within subsections 18(3.1) to 18(3.7) of the Act are not defined nor does the Act specify when the construction period begins. However, paragraph 8 of Interpretation Bulletin IT-153R3 states that, "Site development is considered to begin with the installation of services" and further states "where serviced lots are acquired site development is considered to begin at the earlier of the date the taxpayer starts to install further services to the lots or the date he starts to pour footings". Indeed, in 1989, we stated that the legal definition of land includes services added to the land and that the deductibility of interest on any debt related to the acquisition of services would be restricted by section 18(2) of the Act unless the services were specifically excluded from the definition of land pursuant to former subparagraph 18(3)(a)(i) of the Act.

Since subsection 18(2) limits the deduction of interest on land during the ownership period and subsection 18(3.1) of the Act restricts the deductibility of certain outlays and expenses during the construction period, in our view, the gap between such periods must also require that similar outlays be restricted; any other interpretation would offend the legislative scheme of the Act and what would appear to be the intention of Parliament. Indeed, paragraph 18(3.2)(a) of the Act expands the scope of subsection 18(3.1) of the Act to include certain interest costs, which might not otherwise be specifically identified with the construction, renovation or alteration of a particular building or the ownership of land during the construction period. In our view, by reason of paragraph 18(3.2)(a) of the Act, interest paid or payable by a taxpayer on borrowed money that can reasonably be considered to have been used by the taxpayer in respect of the construction, renovation or alteration of the building or the ownership of the land is also subject to mandatory capitalization under subsection 18(3.1) of the Act. Further, since subsection 18(3.1) of the Act begins with the words "...Notwithstanding any other provision of this Act...", in our view, a case can be made that expenditures relating to the ownership of land incurred between land acquisition and land development are to be capitalized or inventoried.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Customs and Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

If we can be of further assistance with regard to this matter, please contact the writer.

Steve Tevlin
for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch