23 January 2002 GST/HST Ruling 36706 - GST Treatment of Leases that Go into Default

Dear XXXXX:

Thank you for your letter of July 3, 2001 (with attachments), concerning the application of the Goods and Services Tax (GST)/Harmonized Sales Tax (HST) to the transaction(s) described below.

Statement of Facts

Our understanding of the facts, the transaction(s), and the purpose of the transaction(s) is as follows:

Your client is the XXXXX, Business Number XXXXX.

You have provided the following scenarios in respect to a capital lease of equipment whereby the Lessor retains title to asset:

1. Normal course of events: Lessee makes payments remitting GST monthly.

2. Default & asset sale: lease becomes impaired after 3 months of non-payment; at beginning of fourth month a notice is sent outlining consequences of not bringing lease to current status; equipment repossessed immediately following fourth month (lease account not made current); day following repossession, Lessee is invoiced XXXXX as remedy of repudiation; one month later equipment is sold at public auction for XXXXX (net of GST & PST); Lessor issues revised statement indicating balance owing of XXXXX.

3. Default & asset salvage: see above, but asset does not sell and an additional XXXXX (plus XXXXX of GST) of costs are incurred; Lessor issues a revised statement demanding XXXXX in settlement; equipment held for sale for one year without success; following one year, it is sold for salvage for XXXXX incl. GST & PST and a new demand that includes interest less salvage value is sent; the amount is written off (for accounting purposes) over the six months following the repossession.

You provided the standard blank contracts used by your client. The main contract provisions relevant to my analysis of the GST treatment of the above-noted scenarios read as follows:

XXXXX

Transaction(s)

My understanding of the flow of events and GST events, pursuant to the above-noted information, our conversations and the contracts is as follows:

•   your client enters into the lease agreement (which may, in some situations, constitute a sale-leaseback transaction subject to subsection 153(4.1) of the ETA, that is to say, a transaction whereby the vendor/Lessee is not required to collect tax in respect of the supply of Equipment by way of sale to the Lessor and the Lessor immediately makes a taxable supply by way of lease of the property to the Lessee under an agreement)

•   any prepaid lease payments are paid to your client who remits the GST accordingly

•   your client provides the leased equipment to the Lessee

•   your client issues monthly invoices to the Lessee and remits the GST accordingly (whether or not it receives the lease payment)

•   the Lessee fails to make payment for three months and your client sends a notice to the Lessee

•   the Event of Default occurs when the Lessee fails to make payment owing and such default continues for 15 days after notice

•   pursuant to the Event of Default, your client repossesses the leased property

•   the day following repossession, your client invoices the Lessee for the "remedy of repudiation"

•   collection action is undertaken with respect to the missed payments as well as the "remedy of repudiation"

•   at some point, either before or after the collection action is undertaken, the repossessed property is sold and your client remits GST on the sale (if applicable, general rules)

•   collection action continues with respect to: the outstanding lease payments, the remedy of repudiation and any other amounts owing

•   at a point six months, one year or 2 years following the Event of Default, the collection action either yields a portion of the money which remains owing to your client or yields no result and is discontinued.

Ruling Requested

You have requested clarification of the GST treatment of leases that go into default and provided the above fact scenarios, related worksheets and the standard Master Leasing Agreement, Schedule and Amendment. Specifically, you would like to know what happens in either case if collection action results in a 50% recovery of the balance owing after 6 months, 1 year or 2 years? What happens if nothing is recovered or received following the last lease payment received?

Ruling Given

Based on the facts set out above, we rule that the GST treatment of the transactions will be as follows:

General Treatment of Leasing Transactions:

Subsection 136(1) of the Act states that a supply, by way of lease, licence or similar arrangement, of the use or right to use real property or tangible personal property shall be deemed to be a supply of real property or tangible personal property, as the case may be.

Subsection 152(2) of the Act states that where property is supplied by way of lease, licence or similar arrangement under an agreement in writing, the consideration, or any part thereof, for the supply shall be deemed to become due on the day the recipient is required to pay the consideration or part to the supplier pursuant to the agreement.

Subsection 168(2) of the Act states that where consideration for a taxable supply is paid or becomes due on more than one day, the tax in respect of the supply is payable on each day that is the earlier of the day a part of the consideration is paid and the day that part becomes due and the tax that is payable on each such day shall be calculated on the value of the part of the consideration that is paid or becomes due, as the case may be, on that day. Consequently, tax is payable upon the prepaid rent at the time it is paid and tax becomes payable on the unpaid lease payments as they fall due under the agreement.

Event of Default:

Pursuant to the lease documents provided, in the scenario in question for our purposes, the Event of Default occurs when the "XXXXX." However, the incoming fact scenario sets out that, in fact, the "lease becomes impaired following 3 months of non-payment" and a notice is sent out at the beginning of the fourth month outlining the consequences of non-payment. In either case, the Event of Default is not a supply and, in and of itself, carries no GST consequences.

Accounting for Unpaid GST:

One of your questions relates to what happens if nothing is recovered or received after the last lease payment (prior to default) is received. Subsection 225(1) sets out the requirement that all amounts that became collectible as or on account of tax under Division II (GST) are to be included in the net tax for a particular reporting period of a person. Thus, following the Event of Default, the Lessor will have accounted for tax that has not been collected (three missed lease payments). In order to account for this amount, in the event that it becomes a "bad debt" for the purposes of the ETA (Refer to IT-442R (attached) for further information in this regard.), s. 231(1) applies; should payment be received on account of the lease interval payments in default after they have been written off, sub. 231(3) will apply (Refer to Policy Number P-058R: Recovery of Bad Debts (attached) for further information.) to adjust the net tax.

Prepaid Rent:

With respect to amounts to be applied to the unpaid lease payments, it should be noted that the Schedule to the Master Agreement contains a provision whereby "prepaid rent" may be applied by the Lessor against any amounts owing under the Master Lease Agreement. The defaulted lease payments are, in fact, amounts of "Rent" owing under the Master Lease Agreement and any amount of prepaid rent should be applied to the defaulted lease payments. Any residue may be applied to other debts of the Lessee.

You may wish to note that the GST collectible on any amounts paid as prepaid rent and defaulted lease payments may or may not have been remitted depending upon the timing of events and your client's reporting period in each case. In circumstances where the GST on the prepaid rent and defaulted lease payments has already been remitted and your client is applying the amount of prepaid rent against the defaulted lease payments, an adjustment to the GST will be necessary.

Remedies:

Section XXXXX of the Master Agreement sets out remedies that the Lessor may, at its sole discretion, choose to enforce as a result of the Event of Default. The Lessor has the option of exercising one or more of the remedies set out from XXXXX through XXXXX as well as any other remedy available to it at law. In the scenarios provided, it appears that the Lessor has chosen to exercise the remedies set out at XXXXX and XXXXX concurrently. Both scenarios are subject to the same GST treatment.

Repossession Pursuant to Lease Default:

The event of repossession does not constitute a supply from the Lessee to the Lessor of the Lessor's equipment. Upon lease default, the Lessee's rights with respect to the Equipment are extinguished.

Issuance of Invoice for Amount as Remedy for Repudiation of Contract:

The remedy of repudiation is not consideration for a supply and no GST is remittable by your client when this invoice is issued. Any payment received pursuant to this invoice will be accounted for in accordance with s. 182 at the time it is received. (The treatment of moneys received or allocated as payment for the "remedy of repudiation" is set out below.)

Sale of Asset:

The sale of the asset is a separate, taxable supply. Therefore, the asset sale is subject to normal GST treatment.

Proceeds of Sale of Asset:

The precise wording of section XXXXX requires that the net proceeds of any sale be applied toward the payment of amounts owing under the Master Lease Agreement and owing under any other obligation of the Lessee to the Lessor. In the scenario provided, the Lessee appears to still have two debts owing to your client: 1. the missed lease payments prior to notice of the Event of Default; and 2. the "remedy of repudiation" set out at section XXXXX of the Master Agreement. You have confirmed that the settlement payment ("remedy of repudiation") is separate from any lease payments.

Moneys applied to any outstanding amounts of unpaid lease payments will entail an adjustment to the net tax pursuant to s. 231(3), since the GST has already been accounted for, where the proceeds of the sale are received following the write-off of the amount as a bad debt.

Moneys applied to any amount still owing as a "remedy of repudiation," will be treated as an amount forfeited as a result of a breach of agreement. Pursuant to s. 182, which sets out the GST treatment of amounts paid or forfeited by a recipient to a supplier as a consequence of the breach of an agreement, this amount will be treated as a tax-included supply and, consequently, 7/107ths of this amount will be remittable as tax by your client.

Recovery of Amounts Owing, Following Asset Sale

You have specifically requested information about the GST treatment of the transaction where collection action results in a 50% recovery of the balance owing after 6 months, 1 year or two years.

Amounts applied to the outstanding lease payments in circumstances where the debt had been properly written off as a bad debt will require a net tax adjustment pursuant to sub. 231(3).

Amounts applied to the invoiced "remedy of repudiation" will be deemed, pursuant to s. 182 to be comprised of consideration and tax. As noted above, your client will be required to remit GST on a tax-included basis for any amounts received and applied on account of the "remedy of repudiation." Since the tax is not accounted for upon issuance of the invoice for the "remedy of repudiation," no adjustment to the net tax will be required for amounts applied to this debt.

Special Issue: Default of Lease Agreement in Context of Sale-Leaseback Transaction

In our telephone conversation of August 23, 2001, you indicated that some of the leasing transactions completed by your client are in fact sale-leaseback transactions and you wondered about any impact this might have on the GST treatment in the event of lease default. You may wish to note that the specific treatment afforded sale-leaseback transactions is subject to exceptions set out in subsections 153(4.6) and 153(5).

In the fact scenarios provided, s. 153(4.1) will have no effect upon the treatment of defaulted lease payments recovered pursuant to collections action. The value of consideration on which GST was calculated would have been reduced by the "purchase credit" when the defaulted lease payments were due. The supply by way of lease ends upon lease termination and there are no "lease payments" due following this event; therefore, subsections 153(4.1) to 153(4.6) have no impact on any amount charged as a remedy of repudiation.

This ruling is subject to the general limitations and qualifications outlined in section 1.4 of Chapter 1 of the GST/HST Memoranda Series. We are bound by this ruling provided that none of the above issues is currently under audit, objection, or appeal; that there are no relevant changes in the future to the Excise Tax Act, or to our interpretative policy; and that you have fully described all necessary facts and transaction(s) for which you requested a ruling.

Should you have any further questions or require clarification on the above matter, please do not hesitate to contact me at 613-952-9262.

Yours truly,

Sheena France
Financial Institutions Unit
Financial Institutions and Real Property Division
Excise and GST/HST Rulings Directorate

c.c.: