- Kelly Ehler, CPA, CA, LPA, TEP
Real estate, an interesting case!
To follow up where I left off in a previous note, I mentioned the AON Inc tax court decision. My original intention was to search for rulings or cases on the issue of whether cost to complete is deductible for tax purposes. Unfortunately, I’m still searching! What I was directed to was the Aon case. It is an interesting case of the classic issue of whether expenditures are capital in nature, therefore depreciable, or a current period deductible expense. The Income Tax Act does not provide guidance as to what is a depreciable asset, but only how to calculate CCA. As would be expected, each situation is fact specific and conclusions or judgements are to be made on the particular facts. In the AON case, the expenditure was over $4,000,000 to replace a major portion of a garage roof for a mixed use rental property. AON claimed it as a current expense. CRA claimed it was depreciable property.
Some questions or issues considered included whether the work increased any parking spots or revenue, were the aesthetics materially changed, how significant were the improvements to the new garage. On the latter, there were many given 30+ years had passed since the original construction. The cost of the new roof was compared to the cost of building a new building, which was interesting.
Reference was made to S. 18(1)(a) and (b) on the fundamentals of computing business income. In this case, it was clear, the expenditure was incurred for the purpose of producing income from business. The issue as noted, was whether the expenditures were current or capital in nature. The tax implications on $4,000,000 thus very significant.
The oft used analysis of future benefits, enduring benefits, duration were all explored. A more broad based approach was considered, and takes into account, the provisions of the Income Tax Act, case law and well accepted business principles ( and reference was made to GAAP). But all must be considered in coming to a defendable conclusion. So if the taxpayer can show that all three of these approaches result in an accurate picture of income then CRA must prove otherwise.
In the case, it’s noted, and to quote from the case
a distinction must be drawn between a repair to a building (normally a deductible expense) and an acquisition of independent assets for use within a building (generally a capital outlay);
the use of new technology will not alone cause the work done to constitute a capital outlay, but improvements or an upgrading will;
the sheer quantum of the work done tends to be accorded less significance than formerly but may be a factor where the court is of the opinion that what has really resulted from the work is a new building; and (note, this goes to the point above where the cost of replacing building was compared to the cost of the work done on the garage – this appeared to carry a lot of weight)
the carrying out all at one time of repairs that have accumulated over a number of years will not alone cause the outlay to be classified as capital, but where a badly rundown building has been acquired at a low cost and greatly increases in value as a result of substantial repairs, at least part of the cost may be found to constitute a capital outlay.
A review of the application by the courts of the foregoing criteria gives the impression that over time the courts have tended to become more liberal in classifying renovation work as repairs that are eligible for deductibility as current expenses, thereby narrowing somewhat the area occupied by capital outlays.
So to quote the final conclusions…
while the expected duration of the work, the significance of the work and the fact that the roof uses better construction techniques make this a close case, the scale of the work in relation to the complex, the expected duration of the new portion of the roof and the technical improvements, technical improvements that do not increase the functionality of the garage, are not such as to tip the balance and make this a depreciable expenditure as opposed to a current expenditures.
While this particular case was real estate specific, I decided to share it as it’s relevant in general to the question of is the expenditure capital or current in nature.
This is just one example, but as you can see, real estate issues remain!
Join us Thursday, December 7th, 2017, live or via webinar, to learn more of the issues related to real estate.
Real Estate - Tax, Legal, and Financing Considerations
Speakers Lloyd Newton, CPA, CA Scott Cameron Ryan Morris, LLB