2020-0853901E5 Replacement Property - a portion rented out

Principal Issues: Whether certain properties which were acquired to replace a former business (FBP) property would be considered a “replacement property” for purposes of the replacement property rules in subsections 44(1) and 13(4) of the Income Tax Act, in a situation where two replacement properties are acquired to replace one FBP and a portion of the replacement properties will be rented out to arm's length tenants.

Position: Question of fact and it will depend on whether all the requirements listed in subsections 44(5) or 13(4.1) are met.

Reasons: see analysis.

Author: D'Angelo, Sandro
Section: 44(1), 44(5), 13(4), 13(4.1), 248(1) - definition of former business property

XXXXXXXXXX                                                               2020-085390
                                                                                       S. D’Angelo

January 6, 2023

Dear XXXXXXXXXX:

Re:   Replacement Property Rules

This is in reply to a correspondence dated July 6, 2020, and subsequent telephone conversations with XXXXXXXXXX (D’Angelo/XXXXXXXXXX), wherein he requested our views on whether, for purposes of the replacement property rules in subsections 44(1) and 13(4) of the Income Tax Act (the “Act”), a particular property would be considered a replacement property.

A summary of the information submitted is briefly summarized as follows:

* A taxable Canadian corporation (the “Taxpayer”) is the owner of a commercial real estate building (the “Former Property”) located in XXXXXXXXXX.

* The Former Property is used by the Taxpayer and related party tenants (the “Related Party”) as a warehouse, offices and showrooms.

* The beneficial ownership of the Former Property was transferred by the Taxpayer to one of the Related Party Tenants pursuant to subsection 85(1) on July 31, 2020 (the “Disposition Date”).

* As at the Disposition date, approximately 27 % of the Former Property (measured by total space) was rented to arm’s length tenants, and the balance (approximately 73%) of the Former Property was rented out by the Taxpayer to the Related Party who use the property in their active business.

* As a result of the transfer of the Former Property, the Taxpayer has purchased two properties as replacement properties for the Former Property (together, the “Replacements”) as follows:

o the first replacement property (the “First Replacement”) will be located in XXXXXXXXXX, which will be used for offices and showrooms, will replace the office and showroom facilities of the Former Property; and

o the second replacement property (the “Second Replacement”) will be located outside XXXXXXXXXX, which will be used as a warehouse to replace the warehouse facilities of the Former Property.

* The First Replacement will be rented out by the Taxpayer to the Related Party to be used in the Related Party’s active business. The Taxpayer will be renting out part of the Second Replacement for a two or three year period to tenants with which the taxpayer deals with at arm’s length. The portion rented out will not represent more than 27% of the available space of the First and Second Replacement combined (measured by total combined space).

You have asked whether the Replacements would be considered a “replacement property” for purposes of subsections 44(1) and 13(4) of the Act, if up to 27% of the Replacements will be rented out to arm’s length tenants and remainder of the Replacements will be used in the active business of the Related party.

Our Comments

This technical interpretation provides general comments about the provisions of the Act and related legislation (where referenced). It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of a particular transaction proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R12, Advance Income Tax Rulings and Technical Interpretations.

The replacement property rules, in subsection 13(4) in respect of depreciable property or in subsection 44(1) in respect of capital property, permit a taxpayer to elect to defer the recognition of income or capital gains in case of a qualifying disposition, i.e., either where a former property is involuntarily disposed of, or a former property that is a “former business property” (“FBP”) as defined in subsection 248(1) of the Act is voluntarily disposed of, and a “replacement property” is acquired within a certain time period.

Since the Former Property was voluntarily disposed of (i.e., transferred under subsection 85(1) (footnote 1) ), in order for the replacement property rules to apply, the Former Property must be a FBP. A FBP is defined in subsection 248(1) of the Act as meaning, generally, real property or an interest in a real property that is used primarily to earn income from a business and excludes a rental property. Where the property is a FBP and the disposition is voluntary, clause 13(4)(c)(ii)(B) and paragraph 44(1)(d), in conjunction with subsections 13(4.1) and 44(5), provide that the replacement property must be acquired and used before the later of: the end of the first tax year following the initial year; (footnote 2) and 12 months after the end of the initial year.

To be considered a replacement property, a particular property must meet all the requirements outlined in subsections 44(5) or 13(4.1) of the Act. Very generally, a property is considered a replacement property, if it is acquired to replace the former property and there is a causal relationship between its acquisition and the disposition of the former property. In addition, the replacement property must be acquired and used for a use that is the same or similar to the use to which the former property was put. Furthermore, the replacement property must be acquired for the purpose of gaining or producing income from the same or a similar business.

It should be noted that a property normally will not be a replacement property acquired for the same or a similar use when it is acquired to replace a former property and at the same time provide substantial other uses. As indicated in paragraph 1.40 of Income Tax Folio S3-F3-C1, Replacement Property (“Folio”), “An insignificant secondary use of a new replacement property is not a concern. A former business property cannot be replaced with a rental property.”

In the current situation, you have indicated that the Former Property is being replaced by two properties. As indicated in paragraph 1.35 of the Folio, “In some situations, it may be necessary to purchase more than one property to replace another property. Conversely, two or more properties may be replaced with one property. However, in such situations, the specific facts must be considered to determine whether the particular property or properties purchased will be considered as a replacement property for the original property or properties.”

In the current situation, approximately 27% of the Former Property was rented out to arm’s length tenants and the balance of the Former Property was rented and used by the Related Party in an active business. You have indicated that the Replacements will be used in the same or similar business as the Former Property. However, in order for the Replacements to be considered a replacement property for purposes of subsections 44(1) and 13(4) the Replacements must also be used for the same or similar use. As indicated in paragraphs 1.39 of the Folio the same or similar use test is a separate test than the same or similar business test. Paragraph 1.39 states:

“It must be kept in mind, however, that the same or a similar use test is still a separate test from, and is not overridden by, the same or a similar business test discussed in ¶1.41 to 1.44. So, for example, a residential property used to house a company's employees would generally not be considered to have the same or a similar use as a building used to carry on the company's day-to-day operations. This would be the case even though both properties are real property and are used in the same business.”

It is a question of fact whether the Replacements would be considered a replacement property for purposes of subsections 44(1) and 13(4). However based on the information submitted, provided that the Replacements are acquired and used by the Taxpayer or the Related Party, as the case may be, before the end of the relevant time period set out in subsections 44(1) and 13(4), in the same or similar business as the Former Property and provided that approximately up to 27 % of the Replacements (measured by total combined space) are rented to arm’s length tenants, and neither the First Replacement or the Second Replacement is considered a rental property, then it is our view that the Replacements would be considered a replacement property for purposes of subsections 44(1) and 13(4).

We trust our comments will be of assistance.

Yours truly

Pamela Burnley, CPA, CA
Manager
Business Income and Capital Transaction Section
Business and Employment Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

FOOTNOTES

Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:

1 As indicated in paragraph 1.48 of the Folio; “In some cases, where a taxpayer disposes of a former business property to a taxable Canadian corporation and a subsection 85(1) election is made, a capital gain may result. In such case, a deferral of this gain is available pursuant to section 44 provided that the requirements of that section are otherwise met”

2 For purposes of the replacement property rules, the initial year is the tax year in which an amount has become receivable as proceeds of disposition for the former property.

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