Unintended GST/HST Consequences of Purchasing Condos with Lease-Back Agreements
The general rule regarding the application of GST/HST is relatively straightforward. The Excise Tax Act (“Act”) stipulates that the recipient of a property or service supplied by a registrant (i.e., a person required to collect and remit the GST/HST) must pay the tax at the applicable rate, with the tax generally becoming payable when an invoice is issued or when the service is rendered or transfer of possession occurs, whichever is the earlier.
However, where real property transactions are concerned, especially residential properties, different and more intricate rules may apply. For example, when a corporation or an individual builds a complex comprising multiple residential units, GST/HST becomes payable when the complex is “substantially completed” and one of the units in the complex is rented out for residential purposes. In such cases the builder must generally self-assess and remit the tax on the “fair market value” (“FMV”) of the whole complex at that time. Many taxpayers have been surprised with large, costly assessments for failing to self-assess or appropriately determine the FMV of a newly built residential complex.
This is far from the only potential pitfall relating to real estate transactions and GST/HST. This article examines an issue that may adversely affect many persons investing in condominiums who rent them out rather than occupy them as their principal residence. The matter is especially significant in markets such as Toronto and Vancouver where valuation increases rapidly and, so far, constantly.
Guaranteed Income Rental and Lease-Back Arrangements
More and more promoters are now offering condominiums to would-be investors with the option of being assured of immediately receiving a guaranteed amount of rental income, thus removing many of the financial uncertainties related to the condominium’s costs without being certain of when the condo will be rented out—or at what price—in order to offset the burden of paying for mortgage and maintenance costs. Obviously, this is an appealing incentive for many prospective buyers.
Some of these arrangements are accomplished by having the buyer of the new condominium sign an optional separate agreement to the purchase offer whereby the buyer leases back the condo unit to the vendor (or a company suggested by the vendor, usually a property-management corporation). This company then pays the owner a monthly rent for a predetermined period and sublets the unit to individual residents. The condo owner, in addition to receiving monthly guaranteed rent, is spared from the hassle of finding or dealing with prospective tenants for the duration of the agreement.
However, it appears that such arrangements, structured in the foregoing manner, may have unintended, potentially costly, GST/HST consequences for the new owner of the condominium. Indeed, the Canada Revenue Agency (“CRA”) considers that such a lease-back arrangement, where the owner effectively rents (through the lease-back agreement) the new, previously unoccupied unit to a corporation (rather than to an individual tenant), means the purchaser falls under the definition of “builder” for GST/HST purposes and, as such, is required to pay the tax on the FMV of the unit calculated at the time the unit is first occupied. This may be a much higher price than the price the new owner actually paid to purchase the unit, especially if the condo was purchased on plans or completed many years after the signing and acceptance of the purchase agreement.
The CRA’s Position
Indeed, the CRA has been sending letters to buyers of condos that have entered into such lease-back arrangements confirming that they are deemed to be the “builder” of the condo and required to self-assess on the FMV of the unit. The CRA is in the process of issuing assessments where the FMV determined under the self-supply rules exceeds the actual price paid. While this may seem to be a “new” issue, it was outlined as far back as 2014 in issue 91 of Excise and GST/HST News, as indicated by the following excerpt:
If a person purchases such housing for the purpose of supplying it by way of lease, licence or similar arrangement (lease) to an individual as a place of residence, the person will generally not be a builder of the housing for GST/HST purposes. This is the case even if the person hires a property manager for the purpose of renting the housing as long as the lease for the housing is entered into between the person and the individual or, if between the property manager and the individual, the property manager is acting as agent of the person. The person may be eligible for a partial GST/HST new residential rental property rebate with respect to the tax paid on the purchase of the completed housing.
If a particular person purchases such housing for the purpose of supplying it under a head lease to another person (lessee/sub-lessor) who in turn leases the housing to an individual as a place of residence, the particular person will be a builder for GST/HST purposes and different rules apply. Where such a builder enters into a head lease that is exempt under section 6.1 or 6.11 of Part I of Schedule V to the Act with a lessee/sub-lessor who is acquiring the housing for the purpose of making exempt supplies that include giving possession or use of the housing (e.g., under a sublease that provides for the continuous occupancy of the housing as a place of residence or lodging by an individual for at least one month) and possession of the housing is given to the lessee/sub-lessor, the builder is considered to have made a taxable sale and repurchase (a self-supply) of the housing. [Emphasis added.]
As a “builder”, the purchaser of the condo unit is required to self-assess on the FMV of the unit and remit the difference between this amount and the tax actually paid on the purchase from the vendor. This is a consequence of the very elaborate definition of “builder” included in subsection 123(1) of the Act. The relevant portion of the definition is as follows:
“builder” of a residential complex or of an addition to a multiple unit residential complex means a person who …
(d)acquires an interest in the complex
(i)in the case of a condominium complex or residential condominium unit, at a time when the complex is not registered as a condominium, or
(ii)in any case, before it has been occupied by an individual as a place of residence or lodging,
for the primary purpose of
(iv)making one or more supplies of the complex or parts thereof by way of lease, licence or similar arrangement to persons other than to individuals who are acquiring the complex or parts otherwise than in the course of a business or an adventure or concern in the nature of trade, … [Emphasis added.]
At first blush, this appears to confirm the validity of the CRA’s position. However, as the underlined portions of the definition indicate, to fall under the definition of “builder”, the condominium must be acquired for the primary purpose of renting to persons other than an individual. Persons buying condominiums for investment purposes with the intent of renting them out are unlikely doing this with the primary purpose of renting it out to corporations. Over the long term, especially, the purpose is to rent the condo unit to individuals and, over time, the condo will be primarily rented out to individuals. Accordingly, the CRA’s position may surely be challenged on this basis.
On the other hand, this far from guarantees that the CRA’s position will not be confirmed by the courts, where the issue will likely end up, as it is a long-standing position of the CRA that is unlikely to be resolved in favour of buyers at the audit or objections levels.
Indeed, the CRA will counter that the buyer, in fact, signed an agreement whereby the condo is, without doubt, rented to a corporation and not an individual. The CRA’s position will then likely be that the contract effectively confirms the primary purpose of the agreement was to rent the condo to a person other than an individual one or more times, thus including buyers in the definition of “builder” and subjecting them to the self-assessment rules. Do note that the “builder” definition refers to “one or more supplies” (to a person other than an individual), strengthening the CRA’s argument that the intent, as evidenced by the lease-back contract, was to make one or more supplies primarily to a corporation even if over time the condo should be rented primarily to individuals. This becomes a very thorny issue. As such, it is a question of “form or substance”: What is more important, the wording of the contract or the true intentions of the parties?
This was addressed by the Supreme Court of Canada in Sattva Capital Corp. v. Creston Moly Corp., 2014 SCC 53,  2 S.C.R. 633 (“Sattva”). There, the Court explained the role of the surrounding circumstances in the interpretation of a contract as follows:
While the surrounding circumstances will be considered in interpreting the terms of a contract, they must never be allowed to overwhelm the words of that agreement (Hayes Forest Services, at para. 14; and Hall, at p. 30). The goal of examining such evidence is to deepen a decision-maker’s understanding of the mutual and objective intentions of the parties as expressed in the words of the contract. The interpretation of a written contractual provision must always be grounded in the text and read in light of the entire contract (Hall, at pp. 15 and 30-32). While the surrounding circumstances are relied upon in the interpretive process, courts cannot use them to deviate from the text such that the court effectively creates a new agreement (Glaswegian Enterprises Inc. v. B.C. Tel Mobility Cellular Inc. (1997), 101 B.C.A.C. 62).
In The Queen v. Friedberg, 92 DTC 6031, 135 N.R. 61, the Federal Court of Appeal stated: In tax law, form matters. A mere subjective intention, here as elsewhere in the tax field, is not by itself sufficient to alter the characterization of a transaction for tax purposes. If a taxpayer arranges his affairs in certain formal ways, enormous tax advantages can be obtained, even though the main reason for these arrangements may be to save tax (see Irving Oil Ltd. v. Minister of National Revenue, (1991), 126 N.R. 47; 91 D.T.C. 5106, per Mahoney, J.A.). If a taxpayer fails to take the correct formal steps, however, tax may have to be paid. If this were not so, Revenue Canada and the courts would be engaged in endless exercises to determine the true intentions behind certain transactions. Taxpayers and the Crown would seek to restructure dealings after the fact so as to take advantage of the tax law or to make taxpayers pay tax that they might otherwise not have to pay. While evidence of intention may be used by the courts on occasion to clarify dealings, it is rarely determinative. In sum, evidence of subjective intention cannot be used to “correct” documents which clearly point in a particular direction.
Accordingly, while common sense, would tend to confirm that signing a lease-back agreement as discussed above should not trigger the self-assessing rules, as their intended purposes is not to apply tax differently based on the nature of the tenant, jurisprudence usually relies more on precedents than common sense, and the two cases quoted above appear to favour the CRA’s position. It is a shame that the “guaranteed income” incentive is not achieved through the use of an agency contract between the buyer and the property manager rather than by a lease-back arrangement, as this would resolve the issue. Unfortunately, it is difficult to read a clearly-worded lease-back contract as an agency agreement and this does not seem like a situation where the contract may be rectified retroactively. It will be very interesting to see how the courts eventually deal with this issue.
Could the FMV Be the Actual Purchase Price?
There may be another avenue available to challenge the position of the CRA with respect to the consequences of entering into such lease-back arrangements. Let’s assume that the buyer of the condo is caught by the definition of builder. The buyer is then subject to self-assessment on the FMV of the condo pursuant to subsection 191(1) of the Act:
For the purposes of this Part, where
(a)the construction or substantial renovation of a residential complex that is a single unit residential complex or a residential condominium unit is substantially completed,
(b)the builder of the complex
(i)gives possession or use of the complex to a particular person …
the builder shall be deemed
(d)to have made and received, at the later of the time the construction or substantial renovation is substantially completed and the time possession or use of the complex is so given to the particular person or the complex is so occupied by the builder, a taxable supply by way of sale of the complex, and
(e)to have paid as a recipient and to have collected as a supplier, at the later of those times, tax in respect of the supply calculated on the fair market value of the complex at the later of those times.
“Fair market value” is a defined term in subsection 123(1) of the Act but the definition is not very helpful:
“fair market value” of property or a service supplied to a person means the fair market value of the property or service without reference to any tax excluded by section 154 from the consideration for the supply…
This effectively only means that the FMV does not include tax amounts (such as provincial taxes). More information is available in Policy Statement P-165R, which states that, generally, the CRA’s position is that FMV represents the highest price, expressed in terms of money or money’s worth, obtainable in an open and unrestricted market between knowledgeable, informed, and prudent parties acting at arm’s length, neither party being under any compulsion to transact.
This Policy Statement also states that for purposes of applying the GST and HST, the FMV of real property is calculated on each property supplied (whether or not it is a deemed supply). As a result, if a person is deemed a builder of a condo property purchased in an arm’s length transaction, the person must establish the property’s FMV generally calculated at the time the condo is first occupied as a residential unit.
Under section 191, the “builder” is deemed to have sold to himself and deemed to have paid the tax (which needs to be remitted to the CRA). It is important to remember that, under the scheme of the Act, tax is payable on the consideration paid for the supply. Consideration is also a defined term under the Act and essentially means the actual price paid for the supply. Therefore, pursuant to section 191, the buyer is paying tax on a “deemed” consideration, which must be equal to the FMV of the property.
In the context of the situation described in this article, wherein a person who paid tax to the actual supplier of the property (this tax having been calculated on the consideration paid in the course of an arm’s length transaction), attention must also be given to section 155 of the Act . This is the only section of the Act generally allowing the use of “fair market value”—instead of the consideration paid—as the basis on which tax should be calculated. Without doubt, however, section 155 is only applicable in the case of non-arm’s length transactions or where no consideration is actually paid. The consideration paid cannot be challenged, as a value for tax, other than in the context of non-arm’s length transactions. This suggests that if the actual transaction was made at arm’s length, the consideration or price paid is the FMV and it simply cannot be challenged by the CRA.
Naturally, one may oppose that position by stating that the “deemed transaction” contemplated by section 191 is a different transaction than the actual purchase, and being deemed to sell to oneself (as deemed by section 191) can hardly be considered an arm’s length transaction. This is a valid point. The issue then becomes how should the deemed consideration be determined to represent the FMV of that specific unit? It is important to note that FMV must be determined with respect to the specific unit. However, one of the most common calculations is the comparative method with other sales. Therefore, what could be a better comparative than to look at the actual price paid for the specific unit, as long as the actual sale (i.e., the closing of that sale) occurred roughly at the same time the FMV has to be calculated under section 191?
The fact that the actual price to be paid may have been established many years before the unit was completed and occupied, and the actual purchase transaction closed, should not be relevant. The vendor agreed to sell, in an arm’s length transaction, at a given price, and the buyer agreed to pay, with both parties knowing that the unit would not be completed and/or occupied until many years down the road. If the tax was paid when the transaction closed, shortly or not long before actual occupancy or transfer of possession of the unit to a tenant (the time at which the FMV must be established), this actual selling price would arguably remain the best reflection of the FMV of that specific property, having been determined in an arm’s length transaction.
This may be an additional argument to challenge the CRA’s position. Finally, recognizing that the outcome of the eventual court decisions on the issue is uncertain and may still take years to be finalized, and that this is a costly process that may not be justified by the savings of a winning argument, other solutions could be considered. For instance, it may be worthwhile to negotiate, at time of audit or during the appeals process, an acceptable lower FMV, bearing in mind that this FMV used to compute the GST/HST payable should exclude any tax element. Accordingly, a FMV based on municipal tax valuation or comparable sales should be adjusted to take into consideration any element of tax (including the GST/HST new housing rebates) that may be “built-in” the value, if only to ensure tax is not paid on an already included GST/HST element. While this may be more costly than having the courts confirm that the buyer is not a builder, closure and certainty may be achieved more quickly than by waiting for the courts to settle the dispute.
We will continue to monitor this most interesting and complex GST/HST issue.