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IN THE NEWS | ESPACE | MARTIN GILBERT | Just When You Thought It Was Over: Settlement and Termination Payments – Some Tax Consequences

Authored by Martin Gilbert, LL.B., Partner, Richter

With contributions by Stéphanie Lincourt, CPA auditor, CA, Partner, Richter; Gavin Reiff, P.Eng., MBA, Vice President, Richter; and Jenna Schwartz, LL. B., B.C.L., Vice President, Richter

As originally appearing in Espace Montreal, volume 31, #1, 2022.

 

By definition, a lease agreement transfers control of a specific space from a landlord to a tenant for a specified period, and in turn also creates liability and opportunity costs for commercial tenants and landlords. For example, a commercial tenant’s obligation to pay rent over a long period may become problematic when we consider a shift to remote working environments and increases to B2C e-commerce. Similarly, by relinquishing its space to a tenant, a landlord may be unable to pursue value-enhancing programs such as a redevelopment or re-tenanting, as the tenant lease may contain preventative or approval-based clauses.

Accordingly, a lease termination may be beneficial to either the tenant (who would be relieved of the obligation to make contractual payments), or landlord (who would regain control of the space), or both. If either party holds a strong interest in terminating the lease, a negotiation would occur with a typical result of a lease termination payment (the “Termination Payment”) being made. In the case of a tenant making a Termination Payment to a landlord, the amount is typically based upon a portion of the remaining lease payments at a discount. In the case of a landlord making a Termination Payment to a tenant, the amount typically represents a portion of value attributed to the control of the space in relation to the landlord’s value-enhancing project.

Given that we are seeing an increasing number of Termination Payments from tenants to landlords and vice-versa, in today’s commercial environment, this article highlights the GST/HST and QST (“Sales Tax”) consequences associated with these types of arrangements. As you will see (and as is often the case with tax), understanding these consequences in advance of agreeing to the terms of the termination will make the process easier (and hopefully less costly). We will first describe a specific Sales Tax rule and then will outline how this rule may apply to Termination Payments from both the landlord and tenant’s perspective. For the reader’s convenience, we have also included income tax and financial statement presentation, as well as other sales tax commentary.

Sales Tax Rule Applicable to Termination Payments

In the context of a tenant making a Termination Payment to its landlord, there is a specific Sales Taxes rule that may result in an additional cost for the landlord. In summary, under this rule, when a tenant accepts to pay its landlord an amount to terminate or renegotiate an existing commercial lease, it is likely that the amount will be deemed to include Sales Taxes (the “Deeming Rule”).

The conditions for this rule to apply are:

  • There is an agreement (in this case, a commercial lease agreement);
  • The agreement is for a “taxable supply” (which is the case for most of the commercial lease agreements);
  • Under the agreement, the supplier is a “registrant” (which should also be the case for commercial lease agreements);
  • The agreement is breached, modified or terminated;
  • An amount is paid or forfeited as a consequence of the breach, modification or termination;
  • The amount is paid (or forfeited) to the Landlord;
  • The amount is not consideration for the supply. For example, the application of a tenant’s deposit to the last month’s rent could be considered as consideration for the supply of property and would be taxable as per the usual rules rather than the Deeming Rule.

If the Termination Payment were made by the landlord to the tenant, the Deeming Rule does not apply.

 

A person with a concerned look, looking out the window

Termination Payment made by Tenant: Impact to Landlords

Sales Taxes

An amount received by the Landlord as a Termination Payment is deemed to include Sales Taxes due to the Deeming Rule. We want to stress this nuance: the amount is deemed to include Sales Taxes rather than being subject to Sales Taxes (as is almost always the case).

As a result of the Deeming Rule, the Landlord is deemed to have collected Sales Taxes (which are calculated by reference to a mathematical formula) on this payment and is required to report and remit the deemed tax amount. Consequently, the landlord would bear the sole responsibility of having to report and remit the Sales Taxes deemed to have been collected to the tax authorities. This means that unlike other situations where Sales Taxes have been under collected, there is no way for the Landlord to charge back these taxes to the tenant if the parties were not aware of the Deeming Rule. It would therefore result in an additional cost for the landlord (such cost being equal to the Sales Taxes deemed to have been collected which could represent up to 15% of the termination payment depending on the province where the property is located). Additionally, these situations carry a high government audit risk, meaning that the Landlord, had he not reported the Sales Taxes deemed to have been collected, may also be required to pay significant penalties and interests in addition to the amount of tax.

Income Tax and Financial Statements Presentation

The income tax and financial statement presentation impact mirror one another. A Termination Payment due to a lease cancellation will be recognized in income immediately by the landlord. In addition, it is important to ensure all tenant improvements, tenant inducements, leasing commissions capitalized in respect of the tenant departing be written off to income in the year the cancellation is taking place.

Termination Payment made by Tenant: Impact to Tenants

Sales Tax

As mentioned above, when the conditions of the Deeming Rule are met, a Termination Payment made by a tenant to a landlord is deemed to include Sales Taxes.

We noted that in these circumstances, the Landlord is deemed to have collected Sales Taxes on this amount, but it is worth mentioning that, under this rule, the tenant is also deemed to have paid Sales Taxes (determined based on the same formula). As a result of this deeming rule, tenants who made a Termination Payment in the course of their commercial activities (as per the Sales Tax legislation) are entitled to claim an input tax credit (“ITC”) and an input tax refund (“ITR”) equal to the Sales Taxes deemed to have been paid and collected. In other words, the nasty surprise described above for the landlord serves as a windfall for the tenant.

Therefore, as a tenant, every time you make a Termination Payment, it is imperative to ensure you claim the ITCs and ITRs you are entitled to.

Income Tax and Financial Statements Presentation

Again, the income tax and financial statement presentation impact mirror one another. A Termination Payment is an expense in the period in which the lease has been cancelled. Any leasehold improvements capitalized on the tenant’s books should also be written off in the year the cancellation is taking place.

Termination Payment made by Landlord: Impact to Landlords

Sales Taxes

As mentioned, Termination Payments made by the Landlord are not subject to the Deeming Rule. As a consequence, the general rule applies, and such transactions should be considered as taxable supplies meaning that these Termination Payments would be subject to applicable Sales Taxes.

The landlord making this payment should be entitled to claim an ITC and an ITR in order to recover these Sales Taxes paid to the tenant provided proper supporting documentation is available.

Income Tax

An amount paid by a landlord to a tenant as a Termination Payment is generally not immediately deductible. Rather, the amount received is to be amortized over the number of days that remained in the term of the lease (including all renewal periods), not exceeding 40 years. If the property is disposed of within this period, a deduction of the remaining amount (or ½ of the remaining amount, in the case of capital property), is permitted.

Financial Statements Presentation

The Termination Payment is an expense in the period in which the lease has been cancelled. In addition, it is important to ensure all tenant improvements, tenant inducements, leasing commissions capitalized in respect of the tenant departing be written off to income in the year the cancellation is taking place.

Termination Payment made by Landlord: Impact to Tenants 

Sales Tax

Again, these payments are not subject to the Deeming Rule, with the result that the general rule applies. Such transactions should therefore be considered as taxable supplies meaning these Termination Payments are subject to applicable Sales Taxes.

Accordingly, the tenant receiving the payment would have to collect, report and remit said Sales Taxes to the tax authorities.

Income Tax

An amount received by a tenant from a landlord as a Termination Payment is generally considered to be capital rather than an income receipt. More specifically, the amount would represent proceeds of disposition in relation to the lease obligation. The usual rules relating to capital dispositions and depreciable property (if the property were used to gain or produce income and had a capital cost) would apply.

Financial Statements Presentation

From the tenant’s perspective, the treatment of the lease termination will be recognized in income in the year paid or received as there are no future benefits to the tenant. It’s also important to write-off any leasehold improvements capitalized over time.

Lessons Learned

The insight of this article is to ensure that tenants and landlords add a layer of sophistication to their negotiations surrounding Termination Payments. As evidenced by the above discussion and particularly in the case of Termination Payments made by tenants to landlords, the tax treatment could result being more beneficial to tenants. If parties are aware of this, it could form part of the negotiations with the result that the amount of the Termination Payment can be adjusted to reflect the burden on the landlord. Additionally, parties would be well placed to insert language into the agreement to avoid ambiguity and ensure compliance in a timely fashion. Another situation where Sales Taxes are way more than just an in and an out!

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