WHAT ARE CAPITAL COSTS IN A COMMERCIAL LEASE?

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1 WHAT ARE CAPITAL COSTS IN A COMMERCIAL LEASE? By: Paul Mayer of the law firm of Fasken Martineau Capital costs incurred by a landlord in the operation, maintenance and repair of a property are among the most controversial expenses that may be included in the operating costs charged to a tenant under a commercial lease. This article examines what are capital costs, whether or not they should be included in the operating expenses of a property to be paid by a tenant and how their costs should be depreciated. What are Capital Costs? What is or is not a capital cost is an important issue. This is particularly the case where the lease provides that capital costs are an expense which the parties have agreed to either depreciate, cap or exclude rather than treating them as operating expenses that can be charged and recovered from the tenant as additional rental payments over a period of one year. According to generally accepted accounting principles, capital costs are amounts that are spent to acquire, to replace, to add to or to effect major repairs on a building and to some of its equipment. Because they are expenditures that create long lasting value, capital costs are usually depreciated over a period of years instead of being included in the operating expenses in one year. A range of accounting principles have gained general acceptance in the real estate industry. In Canada, the primary source of accounting principles applied on a consistent basis are set out in the Canadian Institute of Chartered Accountants' (CICA) Handbook. Since the CICA Handbook has few rules dealing specifically with real estate, the industry has largely adopted the accounting principles established by the Canadian Institute of Public Real Estate Companies (CIPREC) to deal with the latter. The CICA Handbook defines capital costs in the following manner:

2 2 "The cost incurred to enhance the service potential of a capital asset is a betterment. Service potential may be enhanced when there is an increase in the previously assessed physical output or service capacity, associated operating costs are lowered, the life or useful life is extended, or the quality of output is improved. The cost incurred in the maintenance of the service potential of a capital asset is a repair, not a betterment. If the cost has the attribute of both a repair and a betterment, the portion considered to be a betterment is included in the cost of the capital asset." The CICA Handbook defines what is considered to be a current expense as follows: "Expenses are generally recognized when an expenditure or previously recognized asset does not have future economic benefit. Expenses that are not linked with specific revenues are related to a period on the basis of transactions or events occurring in that period or by allocation. The cost of assets that benefit more than one period is normally allocated over the periods benefited." Thus, it is generally, agreed that expenses that enhance the value, use, life expectancy, strength or capacity of a property as compared with the status of the property prior to the expenditure should be capitalized. The distinction between capital costs and current expenditures is not always clear cut. The treatment of certain expenditures requires considerable analysis and judgement before a proper distinction can be made. A characterisation of the type of expense can be useful. There are four major types of expenditures that are incurred relative to existing assets: (i) additions, (ii) improvements and replacements, (iii) re-arrangements and re-installations and (iv) repairs. Each of these are treated differently when one tries to determine whether an expenditure is to be treated as a capital cost or whether it is to be treated as a current expense. Additions. An addition to a property should be capitalized since a new asset is thereby created. For example, the addition of a floor to a building or the addition of an air-conditioning system, which increases the service potential of that building are to be capitalized. Improvements and replacements. Improvements (which are often referred to as betterments) and replacements are the substitution of one asset for another. An improvement is

3 3 the substitution of a better asset for the one currently used (i.e.: a concrete floor for a wooden floor). A replacement, on the other hand, is a substitution of a similar asset (a wooden floor for a wooden floor). The problem in characterising such an expenditure is resolved by examining whether the expenditure increases the future service potential of the property or if it merely maintains the level of service. The answer is not always clear. Analysis and judgement need to be used to classify the expenditure properly. If it is determined that the expenditure increases the future service potential of the asset, it should be capitalized. Re-arrangements and re-installations. Re-arrangement and re-installation costs, which are expenditures intended to derive a benefit over a period of more than one year, are different from additions, replacements and improvements. For example, if the re-arrangement or reinstallation is to facilitate future production, the cost of such work, should be capitalized as an asset to be amortized over the years of the expected benefit where the amount is material. If the cost is not material or if it cannot be separated from other operating expenses, or if the future benefit is questionable, the cost can be charged as an expense instead of being capitalized. Repairs. Ordinary repair costs are expenditures made to maintain the property in operating condition. They are to be charged as an expense in the period in which they are incurred. Examples of maintenance expenses that occur regularly and that are treated as ordinary operating expenses include the replacement of small portions of the property, repainting and cleaning. If a major repair is undertaken and the benefit will last for several years, the cost should be characterized as an addition, improvement or replacement. Tax Law The Income Tax Act (Canada) contains provisions that deem certain expenditures to be either capital costs or current expenditures. An abundance of case law exists on this issue illustrating a range of situations and providing examples that can be followed in determining whether or not a given expense can and should be treated as a current expense as opposed to being capitalized. The criteria that have been used by the Courts to determine whether or not an expense is a capital cost or a current expense in tax law can be summarized as follows:

4 4 was the expense incurred "once and for all"? does the expense increase the value of the asset? was the expense incurred for the creation of revenue? does the expense become an integral part of the asset or is it a distinct capital asset? was the purpose of the expense incurred in order to replace another asset or was it incurred in order to create a totally new asset? was the expense incurred in order to allow the asset to maintain its value? Another criterion that appears to be used in borderline situations to determine whether an expense should be capitalized is an examination of the cost or value of the expense in relation to the value of the capital asset. This is known as the "materiality" test. Revenue Quebec's Position When determining whether an expense is a capital cost, Revenue Quebec applies the conclusions of the 1987 Court of Appeal decision reached in Sous-ministre du revenu du Québec v. Denise Goyer. In the Goyer decision the Court had to determine whether the replacement of balconies, plumbing, windows and doors in an apartment building constituted capital costs. The work had been done because the pipes of the building were entirely deficient and the balconies, windows and doors were rotting. The Court concluded that the expenses incurred were not of a capital nature because these elements were not capital assets in and of themselves, but only components of a larger capital asset. The replacement of these items did not constitute the replacement of the capital asset. In the Court's view, the owner was merely repairing them. Thus, according to Revenue Quebec's position, in order to have incurred an expenditure of a capital nature, it is necessary to have created either a new asset or to have upgraded the normal value of the asset. Following the criteria established in the Goyer case, Revenue Quebec considers as deductible expenses, those expenses incurred to replace the windows of a building, to redo the

5 5 roof or to redo the plumbing if the effect of the work is to restore the property to its normal market value. On the other hand, Revenue Quebec takes the position that if a taxpayer acquires a property at a price less than the normal market value due to the poor state of repair of the property at the time of its acquisition and incurs expenses to restore the property to its normal market value, such expenditures must be capitalized. Adding a fireplace to a house must also be capitalized, according to Revenue Quebec, since the normal market value of the property will be increased. As well, adding a garage to a property will be treated as a capital expense since in this way a new property is created. The Materiality Test As mentioned before, the materiality of an expense is a criterion that is sometimes applied by Courts in determining whether or not an expense is a capital cost. Materiality is measured by the importance of an expense in relation to the value of the capital asset and the building. Despite the fact that this materiality test should not, in itself, determine whether or not a specific expense constitutes a deductible cost or a capital expense, the significance and the cost of the work does influence the Courts in borderline situations, especially where the result appears to be the replacement of a former asset by a new one. Several court decisions illustrate this point. In the 1959 case of MNR v. Lumor Interests Ltd., a new elevator was installed in a building at a cost of $28,000 an amount representing approximately 18% of the value of the building. The expense was considered to be a capital cost. The Court noted that it was influenced by the magnitude of the expense incurred. The 1979 case of Dubé & al v. MNR deals with repairs to two commercial buildings. Although the costs of the repairs substantially exceeded the average annual maintenance costs for the buildings, the owners sought to deduct the total cost in the computation of income for each of the taxation years in which the expenses were incurred. The expenses related to the following items: repairs to certain parts of the roof of both buildings; the replacement of certain rows of bricks in the upper portion of both buildings; the demolition and removal of two brick chimneys; the removal of certain roofs peeks from the front of both buildings; the repair of a wooden veranda; a large amount of painting; and repairs to a portion of the sidewalk in front of

6 6 one of the buildings. The Court treated all of the expenses in question as current expenses rather than capital costs because the costs were incurred to maintain rather than to replace the capital assets and were reasonable considering the value of the buildings involved. The 1987 decision of Goldbar Developments Ltd. v. The Queen involved an apartment building acquired in In 1979, an inspection revealed that the bricks were falling loose from the walls and the entire brick facade on one wall had become unsound due to inferior work by the original brick sub-contractor. The owner carried out the necessary repairs, but used metal cladding instead of replacing the original brick or using a brick veneer. The Court held that the owner was entitled to deduct the cost of these repairs instead of capitalizing them. To get to this result the Court found that it was useful to examine the purpose of the repairs. The owner intended to repair a condition that had become dangerous rather than to improve the asset. In this case, the Court concluded that the owner had no choice and that the expenditure was not so substantial as to constitute a replacement of the asset, since it represented only a small percentage of the value of the building. With respect to the materiality test, the Court made the following comment: "while the sum of money is certainly substantial, the undisputed evidence is that the building's value was in the range of 8 million dollars, so that the sum invested (approximately $241,000) represents less than three percent of the value of the asset." In the 1993 decision of June Earl v. The Queen, the Minister of Revenue disallowed a deduction of $33,000 made by the owner of a commercial property for the purposes of replacing the roof on the property. From the Court's perspective, the new pitched roof created an improvement to the building that was of an enduring nature because it was different from the old flat roof that had leaked badly. Admittedly, the new roof did not change the appearance of the building nor did it result in an increase in the value thereof. Nevertheless, it was substantially different and constituted an integral part of the capital asset comprising the building. These decisions are particularly relevant in leases where the landlord has agreed to abide by generally accepted accounting principles.

7 7 Lease Disputes The issue of whether or not an expenditure is a capital cost sometimes arises in disputes between a landlord and a tenant in interpreting their commercial lease. In the 1995 case of De Forte v. Poly Selection Inc., the Court of Québec determined that the costs incurred to repair and to enlarge (by seven percent) the parking lot of a shopping centre as well as to replace exit doors constituted operating costs instead of capital expenses. The Court held that the shopping centre was the capital asset while the parking lot and the exit doors were merely components of this capital asset. In the Court's opinion, the end result of the repair of the parking lot was only to re-establish the normal market value of the asset and was not undertaken as an investment. With respect to the expansion of the parking lot, the Court held that this was not a capital cost. The Court stated: «L'agrandissement fait exception, certes, mais il représente seulement 7% de la superficie initiale. Cela suffit pour appliquer le principe que l'accessoire suit le principal.» In the 1991 Court of Appeal case of Executive Investments Canada Ltd. v. Rourke Bourbonnais and Associates Ltd., the Court referred to taxation case law in its determination of whether or not the installation of atomizers in the garage and on an underground floor of a commercial building constituted an operating cost or a capital cost. The Court held that these expenses constituted capital costs since the installation of this equipment had the effect of increasing the value of the building. The Court found that the owner of the building had added a structural component to the building which did not previously exist. Should Capital Costs be Charged to Tenants? Whether or not capital costs are to be included in the operating costs of a property to be passed on to tenants is a business decision. For a landlord, a building is an investment which should provide a steady return on the capital invested. The object of investing in real estate, like any investment, is to enhance the property's value. This is done by increasing revenues derived from the base or minimum rent, when market conditions permit, and by insuring that all possible expenditures (including capital costs) are passed on to tenants. If expenditures cannot be passed on to tenants, a property's value

8 8 can be adversely affected given that its value is often established on the basis of a percentage or multiple of its net revenues. That is why many landlords understand the importance of passing on all expenses to tenants to the fullest extent possible in order to ensure a net rental stream. From a tenant's point of view, the base or minimum rent is supposed to cover the cost of acquiring and constructing the property, as well as the cost of major repairs and replacements of the main components and equipment of the property. The property is only being leased not bought. A tenant will generally view the structure of a building, including the roof and the major mechanical systems, such as the elevators, escalators, heating, ventilation and the airconditioning system, as belonging to the landlord and will argue that the cost of repairing and replacing the structure and the mechanical systems of the building, which provide the landlord with value in terms of equity in the property should not be passed on to tenants. A tenant will also argue that it should not be obliged to incur expenses during the term of the lease that will provide the landlord with a benefit at the end of the term due to improvements made to the building at the tenant's expense. Imagine the burden placed on a tenant by a lease agreement that requires the tenant to pay for the whole cost of replacing the roof of a building in the last few years of the term. Sometimes a tenant with significant bargaining power will be able to have a landlord exclude or cap certain capital costs. However, there appears to be an increasing acceptance in the current market for prime downtown office space that certain capital costs form part of the operating expenses paid by tenants in a "net" commercial lease, provided they are properly depreciated. Need to be Clear to be Enforceable In order to pass on the cost of capital expenditures and major repairs to a tenant, a landlord needs to be as specific as possible in its lease document. Such clauses need to be clearly worded in order to be enforceable. In fact, the Civil code of Quebec specifically stipulates that in order to be enforceable an obligation must be determinate or determinable. The decision rendered in the 2000 Court of Appeal case of Skyline Holdings Inc. v. Scarves and Allied Arts Inc. illustrates the importance of clearly drafting the operating costs

9 9 clause in a lease if a landlord wants to be able to recover capital costs and the cost of major repairs or replacements. In this case, a landlord incurred an expenditure of $262,000 to replace the roof of a building. The landlord included this expense in the operating costs charged to the tenants of the building over a period of three years. Two of the tenants of the building, having leases for five year terms, objected to paying for this expense. The definition of operating costs in the lease indicated that capital expenses were not recoverable: "Operating Costs shall include all reasonable costs ordinarily chargeable against income from the building and without restricting the generality of the foregoing, shall include, heating, light and power, insurance, special taxes, licenses and fees, repairs, maintenance, building and cleaning costs and supplies, salaries, superintendence, refinancing and all other costs and expenses paid or payable in connection with the operation of the building, but shall not include income of profit taxes or payments on account of capital and loans or mortgages." (our emphasis) The landlord argued that the cost to replace the roof could be charged as an operating expense because it was not a capital cost on the basis of the position taken by Revenue Quebec and the Goyer decision. The Court held that the case law relating to taxation was not a reliable guide in attempting to interpret the lease agreement between the parties. The Court found that the definition of operating costs in the lease was not clear enough to enable the landlord to charge such a major expenditure given that the enumeration of the expenses outlined in the operating costs clause were recurrent expenses. The Court concluded that the cost to replace the roof was an extraordinary expense that could not be characterised as a current expense. Such a characterisation would only have been possible had a specific clause of the lease provided for this expense more clearly. How to Depreciate Capital Costs? The time period selected by a landlord to depreciate capital costs will affect the operating costs to be paid by the tenants of the building during the term of the lease.

10 10 For a tenant, the period of time over which a capital cost should be depreciated should be as long as possible. A tenant will argue that anything with a life expectancy of more than one year should be depreciated over its useful life expectancy. In this way, the tenant will not pay during the term of the lease for improvements which it will not benefit from when the lease expires. A landlord will want to depreciate expenditures in accordance with generally accepted accounting principles or by means of an accelerated method of depreciation which allows it to have as much flexibility as possible in selecting the period of time over which it shall depreciate capital costs. A landlord will also want to be able to adjust depreciation on a year-to-year basis. If a landlord is given the flexibility of depreciating capital costs over a short period of time or to readjust on a yearly basis, a tenant may be penalised by assuming a greater burden and having to pay for capital costs which will benefit a number of years beyond its tenancy. A landlord will also usually want to charge interest on the undepreciated or unamortized balance of capital expenditures. This interest component is meant to reimburse the landlord for the cost of funds which it has expended and made available to the tenant. The landlord regards itself as a banker for the tenant and usually charges an interest component on capital costs. A tenant will want to have some input during lease negotiations in deciding what rate of interest will be charged by the landlord and will not usually want to pay more than a few percentage points over the current "prime" rate of interest or will want to use the interest rate chargeable to the landlord by its financial institution. Conclusion To conclude as we have seen, capital costs have a certain meaning in virtue of accounting principles and fiscal laws. The numerous case law on that matter indicate that this is an evolving concept. Leases being contracts negotiated between two parties having certain negotiating powers, can contain provisions that have nothing to do with accounting principles and fiscal laws. However, the provisions dealing with the payment of capital costs have to be clearly stipulated to avoid disputes and to avoid an argument to the effect that it is not enforceable as it is not clear enough.