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Lease cancellation payments don’t qualify as capital
By Richard Weiland

March 14 2008 issue

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The efforts of landlords to characterize lease cancellation payments from former tenants as anything but fully taxable income have generally failed when tested in Canadian courts. Any hope that lease cancellation payments might not be income, given the right circumstances, has faded as the result of a recent Federal Court of Appeal decision.

Spezzano v. The Queen (sub nom. Bueti v. The Queen), [2007] F.C.J. No. 1199, was an appeal by the taxpayers from the decision of the Tax Court of Canada, [2006] T.C.J. No. 238. The taxpayers, four related individuals, purchased a single-tenant commercial property in Winnipeg in 1994 for $1,050,000.

A few months after the purchase, the tenant informed the new owners of its decision to leave. Efforts to arrange a sublease were unsuccessful, and ultimately the parties agreed to terminate the lease with a fee of $762,500. Shortly before finalizing the termination, the landlords agreed to sell the building in its untenanted state to a third party purchaser for $750,000, realizing a loss of $300,000 on the building in less than a year.

The owners advanced two arguments to support their position that the tenant’s payment was on account of capital. First, they maintained that the lease was a capital asset to them, and the payment should be viewed as proceeds of disposition of that asset.

At trial, Justice Valerie Miller had rejected that argument, and the Federal Court of Appeal upheld her ruling. The capital property acquired by the taxpayers was the building, the appeal court confirmed, and the lease was merely the means of earning income from the property.

The owners’ other argument was that the payment was compensation for the reduction in the value of their building. Although the circumstances made it easy to establish the amount of the loss and a causal relationship between the termination and the loss, they lost on this point at trial as well. Justice Miller concluded that the payment was made to replace lost income because the evidence showed that in negotiating the quantum of the payment, the parties had consistently made reference to the tenant’s rent obligations under the lease rather than to any decline in the value of the building.

Despite the taxpayers’ loss on all issues at trial, Justice Miller  offered a possibility that a portion of the payment might have been properly characterized as compensation for loss in property value. The decision rested on the application of the surrogatum principle, which states that the tax treatment of a settlement or damages payment follows the treatment of the item for which the payment is a substitute.

In discussing this principle, Justice Miller relied on the decision of the Tax Court of Canada in R. Reusse Construction Co. Ltd. v. The Queen, [1999] T.C.J. No. 181, which in turn followed the Federal Court of Appeal decision in Canadian National Railway Co. v. The Queen, [1988] F.C.J. No. 524. In both of those cases the courts held that the surrogatum principle requires an examination not only the purpose of the payment, but also of its effect.
Justice Miller found that the purpose of the payment was clearly to replace rental income, but that the payment also had the effect of reducing their loss on the building.

On that basis, she commented,“I floated one possible scenario to both counsel, and that was that, in accordance with the idea of two effects to the payment, would either side consider the possibility that $300,000 of the payment is attributable to capital, as it restored the value of the property to its fair market value as a single-tenant occupied building, with the balance to income as compensation for foregone rent. Neither side bit on what I thought was a logical supportable resolution and I will, therefore, not pursue this further, but will decide on the all-or-nothing approach demanded by both sides.”

The taxpayers asked the Federal Court of Appeal, as an alternative to deciding entirely in their favour, to reconsider the middle ground carved out by Justice Miller. However, Justice Marc Noël, representing a unanimous appeal court, rejected this argument as well. In doing so he relied on the formulation of the surrogatum principle set out by the Supreme Court of Canada in Tsiaprailis v. Canada, [2005] S.C.J. No. 9, which makes reference only to the “nature and purpose” of the payment.

Based on that formulation, Justice Noël stated that the application of the principle “does not hinge on the effect of the payment,” and that as a result, Justice Miller’s findings with respect to the purpose of the payment were determinative.

While it stood, the trial decision in Spezzano left room for landlords to argue that a lease cancellation payment was on account of capital where it had the effect of compensating for a reduction in value of a capital asset. But the approach taken by the appeal court would require compensation for lost property value to be the purpose of the cancellation payment to be considered of a capital nature.

A creative lawyer might consider drafting a lease or lease termination agreement under which a termination payment is made for the stated purpose of compensating the landlord for the reduced value of the premises resulting from termination. In most cases, however, it will be difficult to ignore the commercial reality that a lease termination payment replaces lost rents, and therefore is taxable income to the landlord.

Richard Weiland is a tax lawyer with Vancouver business law firm Clark Wilson LLP. He provides tax advice in relation to real estate transactions and in a broad range of other business contexts.

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