By Harvey Sands, CPA, CA, ICD.D, Richter Real Estate Advisory and Me Mali Leclair-Vance, LL.B., Richter Taxation Richter LLP
With special contribution on legal matters by Donna Shier, Robert Woon, and Serin Remedios of Willms & Shier Environmental Lawyers LLP
Toxic environments can literally and figuratively poison real estate transactions, and not just at the negotiating table. While there are many things to consider when making a commercial property purchase, the potential for existing environmental hazards should be top of mind – and this goes beyond just asbestos. In addition to dangerous building materials used commonly in past years, what is often overlooked are possible pollutant vestiges and other long-shelf life toxic products that may be/have been used by current or past tenants Many office and commercial buildings have housed a variety of tenants over the years. Do you as a purchaser know if these tenants used or stored different forms of equipment, service assets or inventories? There is a possibility that materials or residues now reside under the surface or within the walls. More often than not, these hidden defects go unchecked by the purchaser. Should these toxic environmental hazards rise to the surface (figuratively or literally) after the deal is closed, the purchaser is held legally liable for any environmental damages and impact. Moreover, the purchaser will need to undertake remediation which is a potentially costly and lengthy process. Finally, any fines that may arise from the non-abidance to governmental laws and municipal bylaws will be at the expense of the purchaser - regardless of any warranty rights and claims against the vendor or experts utilized during the acquisition due diligence.
Within the commercial property business world there are several horror stories of good deals gone bad when the purchaser overlooked factors that seemed to be non-issues, initially. There are two such examples that come to mind that we have experienced in assisting client transactions. The first: as part of its concierge service to tenants and clients, a major downtown office building and retail complex housed a small, on-site dry cleaner. This dry cleaner occupied only a small 1,200 sq. ft. portion of the building’s 35 storeys. However, it was discovered during a refinancing of highly appreciated values that the dry cleaner’s chemicals, effluents, and chemical storage polluted the surrounding environment. This transaction now required a $3 million environmental risk and remediation holdback and the final cost after determination of toxic derivative pools and seepage aggregated to a $1.8 million expense in cleanup costs. Another such example is an office building investment that had a car wash and minor service area. The car wash also offered services such as undercoating, tire rotation, and oil changes – all which made use of hydraulic lifts – lifts which needed to be maintained with hydraulic fluid. The refill of the fluid, the leakage and the maintenance on lift replacements left several pools of contaminants that went uncontained and had spread over several thousand square feet of soil and underpinnings in the surrounding area. It became a costly containment and cleanup process, needless to say.
Even when an initial inspection concludes that current tenants are not using chemicals, it’s still important to seek historical records as this inspection may come up positive. During the purchase of a single-tenant retail complex on a major downtown shopping strip, a Phase I had originally reported no material findings. It was only when a 15 foot, below grade concrete slab was discovered noted and challenged as to its history and installation (which no one had questioned previously) that a below slab toxic pollutant pool (chemicals, fluids, heating oil, etc.) was uncovered. It was originally assumed that the concrete slab was part of an add-on renovation for material handling facilities and/or the upgrading of legacy freight elevators. However it was actually used by a previous manufacturing tenant; this tenant ran a dye plant and opened a drain hole in the installed concrete slab to flush all effluents. Gone undetected, this slab was now supporting freight facilities, shipping and receiving facilities, laneways and support pillars, all the while containing below slab secreted hazardous materials! The building was on acquisition being converted to a luxury retail center. Oftentimes, such cleanup and remediation costs are significant and involve six to eight figures of shock, breach of lease obligations and derivative financial exposure.
These examples demonstrate the critical importance for a purchaser to go through a verification process of the possible toxic environmental hazards that can be hidden – sometimes in plain view – when negotiating a commercial purchase of land or a building. If toxic environmental hazards are discovered pre-closing, then the purchaser will either need to terminate the transaction or need to negotiate and carefully consider the potential cost of cleanup with the seller. In relation to the potential costs the purchaser must consider, it is also wise to understand the taxable treatment of such remediation costs, as this might influence the outcome.
Tax Treatment of Remediation Costs
What is one to do if such a discovery is made? How should a business treat the costs of remediation? In the case of contaminated grounds, is the cleanup cost a capital expense or a current expenditure? Below are some general pointers for companies who are faced with contaminated environments that need to undergo decontamination.
The generally-excepted rule regarding the tax treatment of cleanup costs is that such claims are considered to be a capital expenditure, as these expenses contribute toward adding value to the land. Nevertheless, there is a possibility that such cleanup costs be considered a current expense. For example, if the cleanup costs were incurred in direct relation to remedy a situation caused by the business then such an expense could be considered current. This was the case in the technical interpretation 9413377  where the taxpayer had started activities of producing chemical toxins such as phosphorous, nitrogen and ammonia; this caused serious environmental damage that needed to be remediated. The Canada Revenue Agency (CRA) concluded that the decontamination costs constituted current expenses. Therefore, when the decontamination happens on a regular basis due to the nature of the activities of the business and such decontamination does not contribute value to the land beyond what it would be worth in an undisturbed state, such costs could generally be considered current expenditures.
When determining if clean-up expenditures are incurred for the purpose of earning income for the business and therefore may be expensed in the year of the clean-up cost, the CRA has considered eight factors that originate from the Supreme Court of Canada’s Johns-Manville Canada Inc. v. The Queen  decision . The factors are as follows: 
- The purpose of the expenditure, viewed from business outlook, is to correct, treat, remove pollutants, where the conditions corrected is a direct result of activity for the purpose of gaining or producing income from business or property.
- The expenditure is recurring or continuous as an integral part of the day-to-day operations;
- The expenditure is made necessary or the need for the expenditure arises as a result of a more or less constant element that is part of the day-to-day operations of the business;
- The expenditure produces a transitional benefit that is not of an enduring benefit because similar expenditures would be required to be made in the future if the business operation continued;
- The expenditure is not for the purpose of creating or acquiring a benefit of an enduring advantage of the business or another business or property of the person making the expenditure;
- The expenditure does not add to or enhance the value of existing property or land (compared to the value in its natural state and not polluted state);
- Depreciable property is not acquired or created as a result of the expenditure;
- The relative amount of the expenditure is not material in comparison with the relative cost of the business operations.
The general rule of thumb regarding these types of expenses is to examine if the decontamination procedure has been undertaken to increase the value of the land or if it is part of the day-to-day undertakings of the business. The former will be a capital expenditure whereas the latter will be treated as a current expense. Unfortunately, such distinctions are often not black and white and the CRA has been transparent in communicating that each case is to be analyzed on an individual basis as the categorization of such expenses are highly dependent on facts. This was explicitly addressed in a 2001 interpretation, where the CRA addressed the costs of a gas station’s fuel tank cleanup.With regard to costs incurred in relation to the clean-up of leakage from an underground fuel tank at a gas station, the CRA said that the nature of costs depends on the facts in a given situation. The CRA made the following distinction with regard to costs:
While the nature of any cost depends upon the facts in a given situation, generally, costs incurred to remove pollutants or to modify a condition that was caused or is directly attributed to the business, and that will not contribute value to the land beyond what it would be worth in an undisturbed state, would generally, be considered to be current expenses.
Costs incurred for the purpose of improving the location in preparation for development or sale or to alter the land beyond its natural state would generally be considered capital in nature if the land itself is a capital property.
Finally, what is the case for asbestos removal costs? Generally, this is considered a capital expense. This is in line with the above explanations that the removal of asbestos has an enduring benefit in addition to materially improving the property. Not only will the removal of asbestos extend the useful life of the building but it will attract additional tenants and consequently lead to the charge of higher rent. The CRA has confirmed as much in their technical interpretation 9309747.
In summary, the purchaser will need to analyze the purpose of the expenditures in order to determine if they are to be treated as capital or current. No one case being black and white, each case must be analyzed on its individual merit. These are all considerations if the deal has already closed, but what is to be considered before you buy?
Responsibilities and Due Diligence
For guidance here, we sought the expertise of environmental law experts Me Donna Shier, Partner and Certified Environmental Law Specialist, Me Robert Woon, Associate, and Me Serin Remedios, Associate, of Willms & Shier Environmental Lawyers LLP.
Here, Mes Shier, Woon and Remedios provide the top five environmental mistakes to avoid:
1. Failing to negotiate the environmental terms before inking the deal
Purchasers tend to fixate on the purchase price in a real estate deal and make environmental considerations an afterthought. By not negotiating environmental terms before the parties sign, the parties may be subject to unfavourable and unintended consequences. The number one thing that purchasers dislike is a surprise.
An environmental framework for the purchase creates certainty and avoids confusion when environmental issues are identified through due diligence. Both purchasers and vendors should include specific clauses to (i) structure the environmental due diligence, and (ii) allocate the known and unknown environmental liabilities. Incorporating the proper protections up front will avoid the purchaser being left with no escape and forced to deal with someone else’s mess.
2. Failing to obtain a quality Phase I Environmental Site Assessment
Environmental due diligence often starts by obtaining a Phase I Environmental Site Assessment (ESA). A quality Phase I ESA will identify current and historic on-site and off-site land uses that have potential to affect the environmental condition of the property. A Phase I ESE will also identify if intrusive investigations, such as soil and groundwater testing, are advisable or required.
Phase I ESAs are important because environmental issues are commonly caused by historic operations that are not always apparent from the existing use of a property. However, not all Phase I ESAs are alike. Purchasers should be aware of standards to which the Phase I ESA is being conducted (e.g. CSA, ASTM, O.Reg. 153/04), so they know what the Phase I ESA is designed to accomplish and, more importantly, what it may not accomplish.
3. Failing to retain a reputable environmental consultant
Retaining a reputable environmental consultant is essential to any quality due diligence. Purchasers should check the qualifications of their environmental consultant. Investing in a reputable professional engineer or geoscientist to assist in the due diligence is important, regardless of the purchase price of the property. The cost of environmental liabilities can easily exceed the purchase price, so purchasers should not cut corners by hiring the cheapest cost consultant.
4. Failing to have enough time to complete due diligence
Quality environmental due diligence cannot be rushed. Purchasers often do not leave enough time to complete due diligence and are forced to make uninformed decisions.
Due diligence should be structured to provide enough time to retain an environmental consultant, complete the Phase I ESA and assess other environmental liabilities (e.g. permits and approvals). Time should also be incorporated in the due diligence period to account for a Phase II intrusive investigation if recommended. Purchasers who buy industrial properties or commercial properties with high-risk land users, such as gas stations and dry cleaners, should expect that a Phase II ESA will be required. Wait time for consultants and drillers is longer in the summer, and laboratory analyses takes time.
Due diligence periods should be a minimum of 60 – 90 days. Do not put pressure on yourself or your clients to make uninformed decisions by assuming you can complete a quality due diligence within 30 days.
5. Failing to set out a thorough framework for post-closing obligations in the agreement of purchase and sale
Setting out purchaser and/or vendor’s post-closing obligations is easier done before the deal closes. Parties making simplified commitments in a deal, with the hope that all the details will be worked out later will inevitably feel regret and be faced with delays and costs.
Items such as access, confidentiality, indemnities, and releases should be contemplated before the deal closes. A detailed framework should be established that incorporates a clearly defined end point (e.g. applicable standards for clean up or filing of a Record of Site Condition), time frames, costs allocation and contingencies. For example, in-situ remediation can require multiple applications and may not achieve the desired end point within the time allotted. Ministry accepted Risk Assessments can take several years to complete and require additional field work that was not originally contemplated.
Establishing a thorough post-closing framework will help the parties maintain an amicable relationship well after the ink dries.
In performing buy-side due diligence, these examples and their recurring message of investigating by look back previous tenants and the type of property that was previously operated becomes apparent as an essential best practice, especially with the current trend of converting older properties such as warehouses and manufacturing plants into loft-style office spaces. Many current tech hubs and incubator centers were originally manufacturing facilities, including textile, leather and dye plant operations, or have had vehicle service and maintenance operations.
The gentrification and change-of-use of properties of all kinds makes it essential to look beyond a building’s current activities and major tenants. A diligent purchaser must receive, review and risk assess past years’ tenants and lease rolls, and review the historical vocations of the property.
We would like to thank Me Donna Shier, Me Robert Woon and Me Serin Remedios for their expertise and contributions to this article.
The information and comments herein are for the general information of the reader only and do not constitute legal advice or opinion. The reader should seek specific legal advice for particular applications of the law to specific situations.
 This article provides general guide lines. However, the tax treatment outcome can vary based on facts, and seeking the advice of a tax professional is always recommended when a company is faced with such issues.
 CRA Views, Technical interpretation #9328197 – Capital v. Current expense, (herein after, “TI 9328197”).
 CRA Views, Interpretation – Internal #9413377 – Reclamation and clean-up costs, (herein after, “TI 9413377”).
 CRA Views, Technical interpretation (external), 2001-0101055 – Gas station fuel tank leakage cleanup costs, (herein after, “TI 2001-0101055”).
 Johns-Manville Canada Inc. v. The Queen,  2 S.C.R. 46, 1985 CanLII 43 (SCC), (herein after, “Johns-Manville”).
 Johns-Manville, note 5, par. 28.
 TI 2001-0101055, note 4.
 CRA Views, Technical interpretation #9309747 – Asbestos removal costs.