DFK Tax Newsletter
Tenant Inducement Payments
Two important 1998 Supreme Court of Canada decisions, the Canderel and Toronto College Park, provided that tenant inducement payments (TIPs) are fully deductible as a current expense by the landlord against the current year income in the year in which payments are made.
In a more recent case, the Quebec Court in the Frank Motter case, ruled that the TIPs granted by the landlord, Franck Motter, should be capitalizable and, therefore, should not be deducted as a current expense. The main reason for this conclusion, reached by the Honorable Judge Gilles Lareau, is that there was no evidence to support the purpose of the TIPs was to induce the tenant to a lease.
In this article, we attempt to identify the elements that should be considered in order to allow TIPs to be claimed as a current expense for the landlord to reduce current year income tax liability.
In the Motter case, the main elements that led Judge Gilles Lareau to conclude that TIPs are to be capitalized are the following:
- The absence of evidence suggesting that the lease negotiation took place in a difficult or competitive real estate market, etc. (Context).
- The purpose for which TIPs was made available (Purpose).
- The matching of the expense to the income (current vs. capital).
- The terms of the lease agreement and the clauses related to TIPs.
1. The Context and Facts Surrounding the Granting of TIP’s.
As the judge so aptly stated, the lease was negotiated in a difficult environment which is an important element in allowing TIPs as a current expense.
The difficult environment may be due to strong competition among landlords requiring them to induce tenants to sign leases with inducements payments.
2. Purpose of TIP’s.
Another important criterion for allowing TIPs as a current expense is the purpose for which the money was made available to the tenant.
The primary purpose of TIPS should be to induce a tenant to accept entering into a lease is in order for the landlord to earn rental income. This is an especially important criterion that could be used to justify TIPs as a current expense.
Other objectives to consider for the deduction of TIPs:
First, TIPs should ideally be used to make improvements that belong to the tenant and are available for the use of the tenant to the end of the lease.
Second, the improvements covered by TIPs must not be such as to increase the value of the building. On the contrary, TIPs are intended for improvements that do not increase the value of the building over time.
Third, the work covered by TIPs should not be on a building under construction. Ideally, they should be conducted on a building that is already built.
Lastly, the tenant should be able to use TIPs as he wishes and should not be obligated to use it for any particular purpose. This is one of the criteria that was considered by the judge in Ikea Ltd. C. Canada, 1998 CanLII 848 (SCC),  1 S.C.R. 196.
3. Current vs. Capital
The Income Tax Act (Act) does not specifically deal with TIPs. Whether an expense is current or capital in nature is primarily a question of fact.
In the case of TIPs, there are three tests the landlord can use to ascertain the nature of the expense:
- Recurring Expense Test: If the expense is recurring, it will certainly be a current expense. One-time expenses tend to be on account of capital in nature. So, if a landlord has had to use the TIPs several times to convince tenants to lease premises, this would support the case of qualifying TIPs as current expenses in computing taxable income.
- Sustainable profit test: If TIPs result in a sustainable profit, they should be treated as capital expenses. In fact, the expense must not provide any benefit to the landlord other than encouraging the tenant to sign the lease.
- Purpose test: TIPs must be incurred in the process used by a property owner of obtaining immediate income. It must not be an expenditure made in the process of future or long-term gain such as the acquisition of a capital asset or the creation, improvement, or expansion of the landlord’s business.
4. The Terms of the Lease Agreement and the TIPs Clauses.
The manner in which a lease is drafted, and the terms used can be critical in the event of a dispute. The first step is to ensure that the TIPs clauses reflect the intent of the parties.
As a landlord, if you intend to deduct TIPs as a current expense, you must ensure that the inducement payment clauses in the lease agreement meet as many of the criteria for a current expense deduction as possible.
For example, that the improvements or fixtures made are the property of the tenant and will be removed and discarded at the end of the lease is evidence that the intent was not to increase the value of the building or to make lasting improvements that benefit the property owner.
The specifics of the method of payment are also an element that may or may not allow TIPs to be deductible as a current expense. In the Motter case, for example, the inducement payment was made by way of compensation. The tenant never received any money. Frank Motter, the landlord, performed the improvements that were the subject of TIPs in return for the money he was to pay the tenant.
It is therefore important that the lease contract be drafted in such a way that the property owner does not interfere with the plans and wishes of the tenant. The property owner can simply ensure that the work is done by qualified contractors and that steps are taken by the tenant to ensure that the building is fully protected and will not be damaged.
In conclusion, prior to the Motter decision, TIPs were almost automatically deducted as a current expense in the year payments are made.
Now, landlords must ensure that leases are drafted in a fashion that would meet the criteria set out in this article. Otherwise, the landlord may be denied the deduction of the inducement payments as current expense.