By: Peng Du, CPA, CA, Vice President, Tax, Richter and Martin Gilbert, LL.B, Senior Manager, Tax, Richter
Business Matter Contributor: Harvey Sands, CPA, CA, Consultant, Richter
The benefits of navigating the tax maze
Many real property transactions are often much more complex than initially anticipated. While some people may only see a standard transfer of land and buildings, many other details involving compliance and planning issues have to be taken into consideration.
Looking at a purchase from a tax perspective, a single transfer may involve multiple tax consequences and opportunities for the buyer.
To illustrate, we thought that it would be interesting to decipher the transfer of a mixed-use property in a Canadian context, where the land and building located in Canada are being sold by a vendor who is a Canadian resident. The Canadian buyer originally acquired the right to purchase the property from an affiliate. The property in question consists of a commercial retail space on the ground floor and above-grade residential rental units on several upper floors.
Since we are looking at this transaction in a Canadian context, income taxes and commodity taxes have to be considered.
The following points need to be considered first and foremost when taking on this kind of transaction:
1. Purchase Price Allocation
The allocation of costs and/or value is of the utmost importance. However, as you will see below, the reasons why this is so important and the outcomes of this allocation vary depending on whether you are looking at it with income or commodity taxes in mind.
a) Allocation Matters: depreciable and non-depreciable properties
In an asset purchase transaction, the buyer always has a keen interest in the purchase price allocation of the target property’s different components. The purchaser would especially prefer a higher ratio of price allocated to depreciable properties that provide income tax deferral opportunities through capital cost allowance (“CCA”) deductions, typically referred to as tax depreciation. In a real estate context, this means the purchaser would want to maximize the price allocation for the depreciable building and minimize that of non-depreciable land. The vendor may be indifferent to the price allocation; this is especially true if the property is sold for a material gain.
Tax laws and jurisprudence provide tax authorities with a possible right to reallocate the consideration between various classes or types of property if the price allocation is considered not commercially reasonable or reflective of economic norms. This reallocation may occur in circumstances where the total purchase price is set out in an agreement as a lump sum and no allocation is indicated as having been agreed upon and stated, or where a value is specified in an agreement for each class or type of property and the total consideration for the entire sale is considered reasonable, but the component value allocation appears unreasonable. This reallocation right creates uncertainty in the income tax position of both parties in the transaction, which has always been the subject of litigation and controversy between taxpayers and tax authorities. To clarify, the Canada Revenue Agency has confirmed that when the parties are dealing at arm’s length, the agreement reached would be a good indication of the reasonableness of the price allocation and that this position is further strengthened if there is evidence that the parties bargained hard to achieve that allocation.
Based on the above, the best practice would be to specify the price allocation between the land and building in the negotiated purchase and sale agreement to maximize the likelihood that the purchaser and vendor report the transaction in a consistent manner, and that a record of their allocation agreement can be cited when an inconsistency is noted.
The right to determine CCA or tax depreciation over the intended life of ownership is critically important to the purchaser’s financial returns, the modelling and underwriting of the property investment since these tax deductions and savings acutely impact the realization of cash flow returns and the availability of depreciation-sheltered cash distributions from the property’s operations.
Commodity taxes must be considered and modelled at the same time as the aforementioned income tax issues.
From a commodity tax perspective, both the land and the building constitute real property that trigger the same consequences (i.e., the GST/HST and/or QST treatment will not vary depending on whether the transfer is a transfer of land or building). If the property was previously used for residential purposes, it will likely be GST/HST- and QST-exempt while commercial real property will likely result in the buyer having to self-assess the GST/HST and/or QST for the transaction and claim related input tax credits or refunds where available. If there are no appropriate and technically correct self-assessment filings and agreements, substantial taxes may have to be paid.
b) Allocation Matters: commercial and residential property components
From an income tax perspective, the commercial and residential components both constitute property acquired for income-producing purposes, and are subject to the same tax rules on CCA deductions during the holding period and the recaptured CCA and capital gain recognition on the disposal. The only exception is this: If at least 90% of the floor space of the building acquired was used for non-residential use on or after March 19, 2007, the building may be eligible for an additional 2% CCA deduction. In our scenario, since the residential components involve most of the building’s floor space, this additional tax benefit is not available.
Under GST/HST and QST legislation, the sale of a used residential complex is an exempt supply while the sale of commercial real property constitutes a taxable supply, although, as mentioned above, the supplier may not have to collect GST/HST and/or QST on that supply.
In addition, under a specific provision where the real property includes a residential complex and another non-residential component, the residential complex and the other part shall each be deemed to be a separate property.
Given these specific rules, the parties have to know the value of the residential component (which is exempt) vs. the value of the commercial component (which is taxable, but subject to self-assessment by the purchaser if the purchaser is registered for GST/HST and QST purposes).
This allocation will determine the amount for which the purchaser has to self-assess the GST/HST/QST (and claim related input tax credits and refunds where available).
c) Allocation Matters: real property and tangible personal property
Along with land and a building, the purchaser may also acquire other moveable components such as furniture, fixtures and appliances of significant value, often seen when dealing with student residences, hotel and extended stay hotel facilities or furnished apartments. Since these types of moveable property belong to CCA classes that have much higher deduction rates, maximizing the price allocation in favour of these assets could result in much greater tax benefits for the purchaser. Vendors often do not capitalize these assets, which would then be free of recapture exposure, and they would not object to including a material allocation for these moveables. If, however, the vendor has capitalized these assets, the vendor will tend to bargain for the least price allocation for these moveables to avoid depreciation recapture. Following the aforementioned price allocation principle between land and building, the price allocated to furniture, fixtures and appliances should be clearly set out in the purchase and sale agreement. Ideally, a list of all assets should be provided for additional support.
The allocations between various types of assets will determine the GST/HST and/or QST amount the vendor has to collect or the amounts subject to the self-assessment rules, which will impact cash flow facilities.
As mentioned above, the transfer of residential real property will either be GST/HST/QST-exempt while the self-assessment rule will likely apply to the transfer of commercial real property.
However, all tangible personal property transferred (like furniture) remains subject to GST/HST and/or QST.
In addition, specific GST/HST/QST rules may apply to the transfer of property acquired in the course of non-commercial activities (for example, GST/HST/QST-exempt activities) resulting in such transfer not being subject to GST/HST/QST.
In light of the above, not only should there be an allocation between real property and tangible personal property but also, as per section b) above, between property used in the course of commercial activities and property used for non-commercial activities.
2. Right to purchase real property
The right to purchase a real property interest as a separate and distinct asset has become more commonplace and such asset or right is considered transferable and marketable in many situations. This right is considered a property for income tax purposes and, given the nature of the underlying real property, is eligible for certain tax elections. An initial right holder may transfer the right to a purchaser on a fully taxable or a tax-deferred basis if the purchaser is a taxable Canadian corporation or a Canadian partnership. Any gains realized by the right’s owner will be on a capital account. The cost of acquisition, either at the right’s fair market value in the case of a straight sale or the elected price if tax election is filed, will be added in a reasonable manner to the respective tax cost of the land and building.
Although related to real property, a right to purchase a residential or commercial property constitutes intangible property subject to GST/HST and QST. Therefore, the supply of such right constitutes a taxable supply and the person granting the right has an obligation to collect GST/HST and QST on the consideration charged for such right. For mixed-use properties involving both residential and commercial components, a pro-rata allocation of the right is strongly recommended to properly reflect the value of each component and ensure that GST/HST and QST can be fully recovered on the commercial portion of the right, and to minimize the sales tax cost for the right to purchase the residential component.
Note that the tax authorities reached this conclusion based on the Quebec Civil Code, and as such, differences with the common law provinces may arise.
Who said that taxes for a real property purchase were a straight-forward flow through or just a “tax in, tax out” issue? Today’s fiscal reality is a maze of tax issues, obligations and benefits!
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