26 February 1979 Income Tax Severed Letter

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.

February 26, 1979

Dear Sirs:

Re: Commercial Real Estate Projects, First-time Costs

This will reply to your letter dated November 2, 1978 concerning the deductibility of so-called "first-time costs" in respect of commercial real estate projects or non-MURB building projects.

As you probably know, rulings issued in respect of MRB projects have been based on the premise that as soon as an investor acquired an ownership interest in the real estate, he was placed in the same position as any person who acquires an interest in real property for the purpose of erection (or completion) of a building to be used to generate rental income. The Department recognized that, as an owner, he is responsible for mortgage and other commitments which he is entitled to minimize through fixed price contracts and protective guarantees, etc. The fact that a particular project does not have Class 31 or Class 32 certification will not alter that premise.

In order to obtain a deduction in respect of such costs as above or, more specifically, those that are set forth in your letter, it is necessary that the investor be the beneficial owner of the particular property at the time such costs are incurred. Such costs incurred before he has acquired his interest will compare capital costs of his land and depreciable assets and will not be deductible expenses..

With respect to the timing of deductibility of expenditures, it is our view that amounts which are to be paid to third parties are not deductible before the liability arises for sub payments to be made to the third parties. Until the end of 1978, we permitted an investor who was an individual and reported his income on a cash basis to deduct amounts paid to a developer in the year for services which the developer was to provide directly to the investor. However, a re- examination of our position resulted in the Department's announcement to the Thirtieth Tax Conference of the Canadian Tax Foundation in November 1978 that, in view of the fact that the cash method of reporting income from business or property is not specifically recognized in the Income Tax Act, the calculation of profit as computed under subsection 9(1) and as modified by other specific sections of the Act is as relevant for the calculation of income from property as it is for income from a business. Accordingly, in cases where the immediate deduction of prepaid expenses would materially distort the net profit of an investor for a given year relative to other years in the profit cycle of the investment, those expenses must be matched to the period which they benefit. This practice is to be effected for all payments made after December 31, 1978.

Insofar as the various costs (excluding interest) set forth in Appendix A of your letter are concerned, they will generally be considered as deductible costs in accordance with the above criteria pursuant to paragraphs 18(1)(a), 20(1)(e), and 20(1)(aa) of the Act, subject, of course, to the particular facts of a particular project and that they are reasonable in the circumstances.

With regard to the deduction of interest by an investor we would make the following general comments. After 1978, mortgage interest incurred during the construction period will be deductible by an investor pursuant to paragraph 20(1)(c) of the Act in the year in respect of which it is payable under the terms of the mortgage document. Interest on interim financing provided by the developer will be deductible pursuant to that paragraph to the extent that it pertains to a legal obligation to pay interest on amounts payable by an investor for property actually acquired by him before the end of the particular taxation year.

We do not agree with your statements in items 19, 120, and 21 in Appendix A. We do not accept that an investor will have made a payment of interest or incurred an interest expense at the time he executes the promissory notes. The net amount received, being the amounts of the promissory notes less "prepaid interest" paid by the investor, will be determined to be the amounts borrowed on the promissory notes, and interest thereon which becomes payable pursuant to a legal obligation to pay it will be deductible pursuant to paragraph 20(1) (c) of the Act. Neither do we accept that an investor has incurred interest expense in respect of a prepaid interest element in non-interest bearing promissory notes or a second mortgage given by the investor to the vendor, the face value of which represents part of the purchase price of the project. Since the purchase price is purported to represent fair market values, the Department, in fact, expects and requires that such debt must bear a reasonable commercial rate of interest if the note is to be accepted as evidence of payment.

We trust that the views expressed herein are helpful to you. They are, of course, expressions of opinion only and cannot be considered as binding on the Department.

Yours truly,

for Director General Corporate Rulings Directorate Legislation Branch

ROE/jw