2020-0873571I7 CERS Interest paid on a debt obligation as qualifying rent expense

Principal Issues: 1- What is the meaning of the “lowest total principal amount” in clause (b)(i)(A) of the description of Variable A of the definition qualifying rent expense in subsection 125.7(1) of the Act and how it is determined when there is more than one debt obligation? 2. What is the meaning of “cost amount” of a qualifying property as used in clause (b)(i)(B) of the description of Variable A of the definition qualifying rent expense in subsection 125.7(1) of the Act? If the definition of “cost amount” in subsection 248(1) of the Act is applicable, then at what point in time should the cost be determined for depreciable and non-depreciable property? 3- Whether an eligible entity can claim interest paid on a line of credit, on a demand loan, on a forgivable loan or on a debt obligation used to finance major improvements on a qualifying property as qualifying rent expense? 4- How should interest be calculated under subparagraph (b)(i) of the description of Variable A of the definition qualifying rent expense in subsection 125.7(1) of the Act?

Position: 1- The lowest total principal amount represents the lowest cumulative outstanding principal amounts of all debt obligations secured by a mortgage or hypothec on the qualifying property at any time after the qualifying property was acquired. 2- The definition of cost amount in subsection 248(1) of the Act is applicable. Pursuant to that definition, the definitions for undepreciated capital cost (“UCC”) in subsection 13(21) of the Act and adjusted cost base (“ACB”) in section 54 of the Act are relevant. Since the cost amount (UCC and/or ACB) is determined at any time, and qualifying rent expense is to be computed in respect of a particular qualifying period, the cost amount for purposes of clause (B) must be determined for a particular qualifying period. 3- Interest paid on debt obligations secured by a mortgage or hypothec on a qualifying property may be qualifying rent expense if, among other conditions, the total amount of all these debt obligations does not exceed the lesser of the amount provided under clauses (b)(i)(A) and (b)(i)(B) of the definition qualifying rent expense. Generally, any interest paid on debt obligations used to finance major improvements after the qualifying property was originally acquired would not be included in the limit under clause (b)(i)(A) and, therefore, interest would be limited in that case. 4 - The method used to determine the amount of interest that is qualifying rent expense should be reasonable in the circumstances and supportable.

Reasons: See below

Author: Couvrette, Amanda
Section: 125.7

April 19, 2022

Mr. David Gagné-Therrien                                                  Income Tax Rulings
Dedicated Telephone Service                                             Directorate
Canada Revenue Agency                                                   Amanda Couvrette, CPA, CA
David.Gagne-Therrien@cra-arc.gc.ca                                2020-087357

Re: Interest paid on a debt obligation as qualifying rent expense

We are writing in response to your questions related to the eligibility of interest paid on certain debt obligations as “qualifying rent expense”, as that term is defined in subsection 125.7(1) of the Income Tax Act (“the Act”), for purposes of the rent subsidy provided in subsection 125.7(2.1) of the Act.

You have requested clarification on the meaning of the expression the “lowest total principal amount” in clause (b)(i)(A) of the description of Variable A of the definition qualifying rent expense in subsection 125.7(1) of the Act, and how it is determined when there is more than one debt obligation. You have also asked if the definition “cost amount” in subsection 248(1) of the Act is applicable for purposes of clause (b)(i)(B) of the description of Variable A of the definition qualifying rent expense in subsection 125.7(1) of the Act, and would like to know when the cost amount should be determined.

Further, you have asked whether an eligible entity can include interest paid on a line of credit, a demand loan, a forgivable loan or on a debt obligation used to finance major improvements on a qualifying property as qualifying rent expense. Finally, you have asked how the amount of interest that is eligible for purposes of the rent subsidy is determined when one of the limitations in clauses (b)(i)(A) and (B) of the description of Variable A of the definition qualifying rent expense in subsection 125.7(1) of the Act, applies.

Our comments

Qualifying rent expense is defined in subsection 125.7(1) of the Act and means, in respect of a qualifying property for an eligible entity for a qualifying period, the amount determined by the formula A – B.

Variable A is the lesser of $75,000 and the total of all amounts paid (or payable in certain circumstances) – under a written agreement entered into before October 9, 2020, or pursuant to the renewal (on substantially similar terms) or assignment of a written agreement entered into before October 9, 2020 – in respect of the qualifying period by the eligible entity to a party with which the eligible entity deals at arm’s length.

Paragraph (b) of the description of Variable A of the definition qualifying rent expense in subsection 125.7(1) of the Act, provides the qualifying rent expenses in respect of a qualifying property owned by an eligible entity (provided the qualifying property is not used by the eligible entity primarily to earn rental income or, where the qualifying property is used primarily by the eligible entity to earn rental income directly or indirectly from a person or partnership not dealing at arm’s length with the eligible entity, that is not used by that person or partnership primarily to earn rental income).

Subparagraph (b)(i) of the description of Variable A of the definition qualifying rent expense in subsection 125.7(1) of the Act, provides that interest on a debt obligation secured by a mortgage or hypothec on a qualifying property can be qualifying rent expense, subject to certain limits and requirements. Generally, a debt obligation is considered to arise whenever a binding liability is created and the principal amount of the liability can be quantified. It is a question of fact whether a particular arrangement creates a debt obligation.

In order for interest paid on a particular debt obligation to be eligible as qualifying rent expense under subparagraph (b)(i) of the description of Variable A of the definition qualifying rent expense in subsection 125.7(1) of the Act, the debt obligation must be secured by a mortgage or hypothec on the qualifying property. Whether a particular debt obligation, such as a line of credit, a demand loan or a forgivable loan, is secured by a mortgage or hypothec on the qualifying property is a question of fact and law that can only be determined after a review of all of the relevant facts and circumstances that are applicable to the particular situation, including the particular details of the debt obligation agreement.

Once this particular condition is satisfied, interest on such a debt obligation may be qualifying rent expense to the extent that the amount of the debt obligation does not exceed the lesser of the amounts established under clauses (b)(i)(A) and (b)(i)(B) of the description of Variable A of the definition qualifying rent expense in subsection 125.7(1) of the Act. For the purpose of this determination, the total amount of all the debt obligations secured by a mortgage or hypothec on a particular qualifying property should be summed and the total compared to the lesser of the two limits provided under clauses (b)(i)(A) and (b)(i)(B) of the description of Variable A of the definition qualifying rent expense in subsection 125.7(1) of the Act.

The LTPA Limit

The first limit, described in clause (b)(i)(A) of the description of Variable A of the definition qualifying rent expense in subsection 125.7(1) of the Act, is the lowest total principal amount secured by one or more mortgages or hypothecs (provided the mortgage or hypothec has an amortization period) on the qualifying property at any time after it was acquired by the eligible entity, excluding any temporary period in the course of a refinancing transaction between the time when an existing mortgage is discharged and a new mortgage is registered (“the LTPA Limit”).

The expression “lowest total principal amount” in the LTPA Limit is not defined in the Act. The term “principal amount”, however, is defined in subsection 248(1) of the Act as meaning the amount that, under the terms of the obligation or any agreement relating thereto, is the maximum amount or maximum total amount, as the case may be, payable on account of the obligation by the issuer thereof, otherwise than as or on account of interest or as or on account of any premium payable by the issuer conditional on the exercise by the issuer of a right to redeem the obligation before the maturity thereof. The definition of principal amount in subsection 248(1) of the Act is relevant in determining the meaning of the LTPA Limit. However, since the definition of principal amount does not specify the time at which it is determined, the time of determination depends on the context of the wording of a particular provision and the intent and purpose of that provision. In the context of the LTPA Limit, we are of the view that the principal amount of a debt obligation means the outstanding amount of the debt obligation at a particular time after the qualifying property was acquired and not the original amount for which the debt obligation was issued.

Another consideration is that the principal amount of a debt obligation secured by a mortgage or hypothec on a qualifying property requires an amortization period in order to be included in the LTPA Limit. Whether a particular debt obligation secured by a mortgage or hypothec on a qualifying property has an amortization period is a question of fact that can only be determined after a review of the particular agreement.

Further to this, since the LTPA Limit refers to the “total principal amount” secured by one or more mortgages or hypothecs on the qualifying property, the amount computed must be the sum of the principal amounts of all debt obligations secured by a mortgage or hypothec on the qualifying property. Also, as the expression “lowest total principal amount” is followed by “at any time after the property was acquired,” the entire time period that the particular qualifying property has been owned must be considered. The amount that represents the lowest cumulative principal amount of all debt obligations with an amortization period that are secured by a mortgage or hypothec on the qualifying property at any time after the qualifying property was acquired, is the LTPA Limit.

The timing of determination of the LTPA Limit may not necessarily coincide with the qualifying period for which the qualifying rent expense is being calculated. In some cases, the LTPA Limit may arise before the qualifying period, (i.e., at some other time during the period the qualifying property has been owned). For example, in the case of an eligible entity that has had only one debt obligation secured by a mortgage on the qualifying property since its acquisition, we would expect the principal amount for the current qualifying period to be the lowest. In this situation, the amount of the debt obligation secured by a mortgage or hypothec (i.e., as described in subparagraph (b)(i) of the description of Variable A of the definition qualifying rent expense in subsection 125.7(1) of the Act) at that time would likely equal the LTPA limit.

However, consider a situation where an eligible entity acquired a qualifying property in 2017 and, at that time, obtained a $1,000,000 loan secured by a mortgage (with an amortization period) on the qualifying property. By January 1, 2020, the value of the qualifying property had substantially increased and, as a result, the eligible entity was able to refinance their loan for $2,000,000. Immediately before refinancing, the principal amount on the loan was $800,000. The eligible entity is in the process of determining its qualifying rent expense in respect of the qualifying property for the twelfth qualifying period, which began on January 17, 2021 and ended on February 13, 2021. Although the interest paid on the loan in respect of the twelfth qualifying period was calculated on the current principal amount of $1,800,000, in this case, the LTPA Limit would be $800,000, which is the lowest total principal amount at any time since the acquisition of the qualifying property. Therefore, if an eligible entity refinances or obtains a new debt obligation secured by a mortgage or hypothec on a qualifying property after its acquisition, the new debt obligation would not increase the amount of the LTPA Limit.

The Cost Limit

In addition to the LTPA Limit, the second limit that may apply to the amount of interest eligible as qualifying rent expense under subparagraph (b)(i) of the description of Variable A of the definition qualifying rent expense in subsection 125.7(1) of the Act, is described in clause (b)(i)(B) of the description of Variable A of the definition qualifying rent expense in subsection 125.7(1) of the Act. This limit refers to the cost amount of the qualifying property (“the Cost Limit”). For the purpose of the Cost Limit, the definition of “cost amount” in subsection 248(1) of the Act is applicable. Generally, in the case of non-depreciable property, the cost amount is its “adjusted cost base” (“ACB”), as defined in section 54 of the Act. In the case of a depreciable property, the cost amount is the “undepreciated capital cost” (“UCC”), as defined in subsection 13(21) of the Act, of the class allocable to the particular property (on a pro rata basis, based on the capital cost of the particular property as a fraction of the capital cost of all properties in the class). Pursuant to both definitions, ACB and UCC are determined “at any time”. As qualifying rent expense is determined in respect of a qualifying property for an eligible entity for a qualifying period, the cost amount of a qualifying property for purposes of the Cost Limit should also be determined in respect of a particular qualifying period. For example, the UCC of a depreciable property for a particular qualifying period would also be its Cost Limit.

Interest eligible as qualifying rent expense

If the amount of the debt obligation that meets the requirements to be included in subparagraph (b)(i) of the description of Variable A of the definition qualifying rent expense in subsection 125.7(1) of the Act, is greater than the lesser of the LTPA Limit and the Cost Limit, the amount of interest that is qualifying rent expense paid in respect of a qualifying period on the debt obligation(s) would be limited. In such a situation, only a portion of the total interest paid on the debt obligation(s) may be claimed as qualifying rent expense (i.e., interest on the portion of the debt obligation(s) that exceeds the lesser of the LTPA Limit and the Cost Limit would not be qualifying rent expense). There may be several methods that may be used to determine the portion of the total interest that is qualifying rent expense, however, the method used should be reasonable in the circumstances and supportable.

Therefore, in respect of the question posed, although interest paid on a debt obligation (such as a line of credit, a demand loan or a forgivable loan) secured by a mortgage or hypothec on a qualifying property may be considered qualifying rent expense, if it has no amortization period, the principal amount of the debt obligation would not be included in the LTPA Limit described in clause (b)(i)(A) of the description of Variable A of the definition qualifying rent expense in subsection 125.7(1) of the Act.

Furthermore, if an eligible entity refinances an existing loan or obtains a new debt obligation secured by a mortgage or hypothec on a qualifying property to fund major improvements to the property (where the qualifying property was initially acquired before the additional financing occurred), the principal amount of the new debt obligation would not increase the amount of the LTPA limit described in clause (b)(i)(A) of the description of Variable A of the definition qualifying rent expense in subsection 125.7(1) of the Act. In such a case, the amount of interest that is qualifying rent expense paid in respect of a qualifying period on the debt obligation(s) would be limited.

We trust our comments will be of assistance.

Yours truly,

Amanda Couvrette, CPA, CA
Manager
For Division Director
Business and Employment Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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