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CRA Confirms Tax Treatment of Escalating Rent Payments - by Lorne Shillinger 

Canadian Tax Adviser


April 24, 2012


Lorne Shillinger
Toronto, Canadian Corporate Tax


In a recent technical interpretation, the CRA confirmed that prepaid rent is not deductible in the year paid and that escalating annual rent payments are not deductible on a straight-line basis. In its response, the CRA cited legislation and relevant jurisprudence to support its view.

In a previous TI, the CRA confirmed that, although GAAP generally requires smoothing of rent expenses for accounting purposes, the same approach is not permitted in computing income for tax purposes.


Legislative background
Generally, taxpayers must amortize any prepaid rent over the future periods to which it relates, under subsection 18(9) of the Act. This provision specifically denies a deduction made for an outlay or expense to the extent that it can reasonably be regarded as having been made or incurred as, or on account of or in lieu of the payment of rent which is in respect of a period that is after the end of the year.


The "General Limitation" rule in paragraph 18(1)(a) of the Act denies a deduction for an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property. The CRA notes that the requirement contained in this provision that the outlay or expense be "made or incurred" contemplates the actual payment of the expense or a legal obligation to pay the expense in that particular taxation year. Escalating lease payments made in future years cannot be amortized over previous years as there was no legal requirement to pay the higher rents in the earlier taxation years. Generally, a taxpayer "incurs" an expense when there is a legal obligation to pay a sum of money.

The taxpayer is a tenant in a lease agreement that calls for annual lease payments that escalate after a certain number of years. The taxpayer paid lease payments using an average basis over the term of the lease. For financial statement purposes, the taxpayer set up a Prepaid Rent asset on its balance sheet. For income tax purposes, the taxpayer claimed the full amount of the rent paid in a particular taxation year.


At issue is whether prepaid rent is deductible in the year paid and whether escalating annual rent payments are deductible on a straight line basis.


CRA comments
In the TI, the CRA confirmed that a taxpayer must amortize any prepaid rent over the future periods to which it relates under subparagraph 18(9)(a)(ii) and noted the Supreme Court of Canada's (SCC) decision in Canderel Ltd v The Queen, in which the SCC stated that it is possible "that some of these expenses could be treated otherwise for the purposes of GAAP or business; perhaps they might be deducted entirely in the year incurred, or even capitalized. However, this possibility is negated for tax purposes by their specific legislative treatment".


The CRA said that its view was that, where the lease terms called for escalating rent payments, the Act does not allow for the straight-line amortization or averaging of the increasing rental payments over the earlier periods. The CRA cited the Federal Court of Appeal's decision in The Queen v Burnco Industries Ltd et al., in which it stated:

In our opinion, an expense, within the meaning of paragraph 18(1)(a) of the Income Tax Act, is an obligation to pay a sum of money. An expense cannot be said to be incurred by a taxpayer who is under no obligation to pay money to anyone. Contrary to what was decided by the Trial Division, an obligation to do something which may in the future entail the necessity of paying money is not an expense.

The CRA also clarified that where there are escalating rental payments, the taxpayer is under no legal obligation to pay the increased rent until later periods. Therefore, any additional rental expense as a result of the application of averaging would not be "incurred" until later periods and would be denied under paragraph 18(1)(a).


For more information, contact your KPMG adviser.


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