The rules for interest prepayments should be considered when holders of long-term debt obligations provide borrowers with an option, exercisable within a defined period after issue, to make a prepayment of interest for future years (e.g., a corporation borrows $1 million for 99 years and in Year 10 prepays the interest obligation for years 11 to 99). In short, the prepayment, equal to the present value of the future interest obligations, effectively repays a portion of the principal amount of the obligation. The economic effect is the conversion of non-deductible principal repayments into deductible interest expense. Under subsection 18(9.2), the lump sum is to be treated as a payment of principal and the amount of interest deductible is based on what the interest would have been on the lower deemed principal balance.
These calculations can be complicated and it is advisable to involve professional advisors early in the process.
These rules only apply to taxpayers that are corporations, partnerships or trusts. Novation
When terms of a loan agreement have been altered so that there is effectively a new agreement, the implications of subsection 18(9.3) should be considered. Debt
forgiveness issues under section 80 may also arise, as well as the potential for capital gains or losses when the loans are denominated in foreign currency.
The CRA has stated in Interpretation Bulletin IT-448, “Dispositions — Changes in Terms of Securities” dated June 6, 1980, that the following changes regarding the debt
obligation (unless carried out under an authorizing provision in its original terms) are considered to be so fundamental to the holder’s economic interest in the property that they almost invariably precipitate a disposition:
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A change from interest-bearing to interest-free or vice versa■
A change in repayment schedule or maturity date72■
An increase or decrease in the principal amount■
The addition, alteration or elimination of a premium payable upon retirement■
A change in the debtor, or
72
Exceptions to the general rule are made when the degree of change is minimal and of little relative importance in the circumstances.
■
The conversion of a fixed-interest bond to a bond for which interest is payable only to the extent that the debtor has made a profit, or vice versa.The CRA’s position has created some controversy and confusion. In Income Tax Technical
News No. 14 dated December 9, 1998, the CRA clarified its position and stated that, if a
debt obligation is renegotiated otherwise than as provided for in its original terms, the determination of whether a change in its terms is a substitution of a debt obligation for another should be made in accordance with the law of the relevant jurisdiction.
Interest and Property Taxes on Vacant Land
Subsection 18(2)
Subsection 18(2) overrides paragraph 20(1)(c) to prohibit a deduction on account of or in lieu of:
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Interest on debt relating to the acquisition of land, and■
Property taxes in respect of land73Unless the land can reasonably be considered to have been, in the year:
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Used in the course of a business other than a business in which, in the ordinary course, land is held for resale or development carried on by the taxpayer, 74 or■
Held primarily for the purpose of gaining or producing income of the taxpayer from the land.75Subsection 18(2) applies to “land” which is defined for this purpose and does not include: a) Any property that is a building or other structure affixed to land,
b) The land subjacent to such buildings or other structures, or
c) A parking area, driveway, yard or garden necessary for the use of such buildings or other structures and that is contiguous to the land described in (b), except land used for the provision of parking facilities for a fee or charge.
Therefore, for example, interest on borrowed funds to acquire land for the development of single family housing may be deductible upon the commencement of construction on the building site.76
Relief is allowed in the form of a deduction to the extent that gross revenue from the land for the particular year exceeds the total of all amounts deducted in computing income from the land for that year (i.e. the net operating income from the land). Income from the sale of land is excluded from this determination.
For this purpose, the CRA stated77 that the determination of net operating income from the land should include the deduction of expenses of representation under paragraph 20(1)(cc) and site investigation costs under paragraph 20(1)(dd).
Corporations whose principal business is the leasing, rental or sale of real property (or the development of real property for leasing, rental or sale) are entitled to claim a
73 Paragraph 18(2)(b) only restricts the deduction for property taxes paid to a municipality or province in Canada. The
paragraph specifically excludes i) income and profits taxes (which presumably are not otherwise deductible), and ii) taxes computed by reference to the transfer or property (e.g., land transfer taxes) (as such taxes are likely capital in nature).
74 Paragraph 18(2)(c). 75 Paragraph 18(2)(d).
76 The CRA states at paragraph 7 of Interpretation Bulletin IT-153R3, “Land Developers — Subdivision and Development
Costs and Carrying Charges on Land,” dated October 7, 1991 “A taxpayer is considered to have acquired a “building or other structure” within subparagraph 18(3)(a)(i) at the time when site development begins on land that has been unequivocally committed to use as a building site and providing the taxpayer proceeds in an orderly and continuous fashion towards completion of construction. There must be no undue delay.”
deduction equal to the lesser of their base level deduction and actual interest and property taxes capitalized under subsection 18(2).78
Under subsection 18(2.2), the base level deduction of a corporation is the amount that would be the amount of interest, computed at the prescribed rate in Regulation 4301 – Benefits, for the year in respect of a debt of $1 million79 outstanding throughout the year80
(see the example below).
The $1 million is to be allocated among associated corporations by filing a prescribed form (T2005); otherwise, the Minister is permitted to make the allocation under subsection 18(2.4).
Partnerships are not eligible for the base level deduction even where all the members are corporations and the business of the partnership and its members is real estate
development.81
Subsection 18(2) applies until construction commences, after which subsection 18(3.1) applies.
Interest on debt relating to the acquisition of land is defined in subsection 18(3) as:
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Interest that may reasonably be considered as interest on borrowed money relating tothe acquisition of land, and
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Interest on borrowings to acquire land to assist: – a non-arm’s-length person– a corporation of which the taxpayer is a specified shareholder82 (i.e., by virtue of owning 10% or more of any class of shares), or
– a partnership in which the taxpayer has a 10% interest, or more;
– unless the assistance is in the form of a loan and a reasonable interest rate is
charged.83
Regarding interest on money borrowed to service land, the CRA’s view is that the acquisition of land includes installation of services.84
An alternative position is that interest on money borrowed to service land is not interest relating to the acquisition of land. Interest on money borrowed for land servicing that does not create a building or other structure may not be subject to capitalization under
subsection 18(3.1).85
A taxpayer may defer the deduction of interest and property taxes by treating them as an addition to the cost of land inventory, provided the taxpayer does so on a consistent basis.86
78 Paragraph 18(2)(f).
79 This amount has not been indexed for inflation since subsection 18(2.2) was implemented in 1988.
80 Paragraph 18(2.5) requires a corporation whose taxation year is less than 51 weeks to prorate the base level deduction
based on the proportion that the number of days in the corporation’s taxation year is of 365.
81 Interpretation Bulletin IT-153R3, “Land Developers – Subdivision and Development Costs and Carrying Charges on
Land,” dated October 7, 1991 at paragraph 3.
82 A “specified shareholder” is defined in subsection 248(1) and includes a shareholder that holds 10 percent or more of the
issued shares of any class of the capital stock of the corporation (with rules to include shares held directly or indirectly by related persons).
83 Pursuant to the subsection 18(3) definition of “interest on debt relating to the acquisition of land”. 84 Technical Interpretation 2002-0141627, “Costs – land development”.
85 See “Revenue Canada Round Table,” in Report of Proceedings of the Forty-First Tax Conference, 1989 Conference
Report (Toronto: Canadian Tax Foundation, 1990), 45:1-60, question 46, and 45:27.
Base Level Deduction — Example
Assumptions
Net revenue from land $ 15,000 Base level deduction ($1,000,000 × 1.00%) $ 10,000 Interest and property taxes $ 2,000,000 December 31, 2011 fiscal year end
Application of subsection 18(2)
Interest and property taxes $ 2,000,000 Minus: Net revenue from land 15,000
Base level deduction 10,000
25,000 (A)
Amount added to cost $ 1,975,000
Average prescribed rate used is 1.00% 2011 rates First quarter 1.00% Second quarter 1.00% Third quarter 1.00% Fourth quarter 1.00% Average 1.00%
Treatment of Deductions Denied Under Subsection 18(2)
Costs denied under subsection 18(2) are added to the ACB of land that is capital property (paragraph 53(1)(h)) and the cost of land that is inventory (subsection 10(1.1)).
Denied costs are also added to ACB of:
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Shares when the taxpayer is a specified shareholder87 of the corporation owning the land (see paragraph 53(1)(d.3))■
Partnership interests when the interest expense is incurred by a partner holding a 10% or greater interest (see subparagraph 53(1)(e)(xi)).Interest capitalized to the ACB of shares or a partnership interest is also capitalized to the underlying land held by the corporations88 or partnership.89
Timing of Application of Subsection 18(2)
Subsection 18(2) applies until construction begins. During the construction period, subsection 18(3.1) applies to restrict the deduction of interest and property taxes. Subsection 18(2) does not apply in a year in which the land is used in a business.
Therefore, if construction begins on land during a year and is completed in the same year
87 Supra note 43.
88 Paragraph 53(1)(b). 89 Paragraph 10(1.1)(a).
and if the completed property is used in a business in the same year, then subsection 18(2) should not apply in that year.90
Payment of property taxes by a tenant on leased vacant land is rent paid and is therefore fully deductible by the tenant. However, the CRA’s view is that subsection 18(2) applies to deny the deduction to the tenant.