CAPITAL TAXES THE $90,000 PER YEAR ISSUE

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1 CAPITAL TAXES THE $90,000 PER YEAR ISSUE By: Paul Mayer of the law firm of Fasken Martineau The Court of Appeal of Quebec rendered an important decision this Spring in the case of GE Capital Realty Management Inc. v. Zellers Inc., which is noteworthy for both landlords and tenants. In fact, the Quebec real estate lease community has not had such a jolt in a while. This case concerns a dispute about whether or not a lease agreement entitled a landlord to obtain payment of capital taxes from its tenant, in respect of a building that Belcourt Ltée had built and leased to Zellers Inc. in 1987 on the Trans-Canada Highway in the City of Pointe-Claire. The argument arose in 1993 when Belcourt sent Zellers an invoice of approximately $90,000 for capital taxes for the year 1992 under the provisions of the lease. At issue was the interpretation of a section of the lease which outlined the tenant's general obligation to pay taxes. A literal reading of the following section of the lease agreement, clearly supports the existence of an obligation to pay a "tax on capital" levied against the property or the landlord. The lease provided that Zellers had to pay: All taxes, property taxes, municipal taxes, tax on capital, school taxes, ecclesiastical taxes, Montreal Urban Community Taxes, rate including local improvements rates, duties and assessments that may be levied, rated charges or assessed against the Property and /or all equipment and facilities thereon or therein, and/or any property on or in the Property owned or brought thereon or therein by Landlord, and any and every of its assignees or subtenants and it and their respective officers, agents, employees, servants, visitors or licensees and/or against Landlord or Tenant in respect thereof, whether such taxes, rates, duties, or assessments are charged by a municipal, parliamentary, school, or any other body of competent jurisdiction. (our emphasis) In addition, the following section of the lease provided that it was an entirely net lease:

2 2 It is the intention of the parties that the Minimum Net Net Rental set out in Art.4 of this lease shall be net net to the Landlord and that the Tenant shall pay for its own account, to the complete exoneration of the Landlord, all costs and expenses affecting the Property by the business carried on therein, and all Property taxes and costs other than that which is otherwise provided in this lease and other than any interest or amortization charges of Landlord in respect of mortgages, hypothecs, or other security and other than any capital gain or income tax due by Landlord. For a period of six (6) years, Belcourt did not ask Zellers to pay an amount in respect to capital taxes. Then, in 1993, Belcourt demanded that Zellers pay an amount of $90, with respect to the 1992 capital tax attributable to the leased premises by the landlord. Zellers was convinced that it did not have to pay the amount requested. Instead, it contended that the parties had agreed, during the negotiations leading up to the signing of the lease, that they would not be liable for the payment of the capital taxes. In fact, the Court of Appeal records show that one of the lease's clause dealing specifically with capital taxes had been deleted prior to the signing of the lease. Belcourt's contention was that the wording of the lease allowed it to charge all taxes, including taxes on capital levied against the property or against the landlord. As the tax on capital is a tax that is charged against the landlord, Belcourt argued that the wording of the lease entitled it to charge the tenant with the tax. Zellers took the position that the taxes were assessed against the landlord's capital assets and not against the building. The Superior Court The parties sought a declaratory judgment from the Superior Court to determine whether or not the tax was payable by the tenant. In 1994, the Superior Court held that Belcourt was not entitled to recover the tax on capital from the tenant.

3 3 The Superior Court cited a provision of the Civil Code of Quebec which stipulates that when interpreting a clause in a contract, whose meaning is unclear, one can set aside a literal construction of the clause, and rely instead, upon the interpretation given to it by the parties, either expressly or implicitly. The Court noted that the landlord had made no claim for capital taxes for a period of six (6) years. It held that the failure by the landlord to insist upon a strict performance of the obligation to pay capital taxes strongly suggested that the parties did not agree that such taxes were to be paid by the tenant. The Court also found that there was no definition of "tax on capital" outlined in the lease (as it had previously been removed!). Instead, it found that the words "tax on capital" were included in a clause referring to property taxes. These words were also situated next to "ecclesiastical" taxes, which are not currently levied and which are not likely to make a comeback in the near future. The Court concluded that it seemed "irrational" to interpret the simple words "tax on capital" as referring to the taxes on capital payable by the landlord. The Court of Appeal The new owner of the property, GE Capital, took the matter to appeal. The Court of Appeal rendered its judgment from the bench on May 16, It affirmed the Superior Court ruling, and held that the tenant was not liable for the tax on capital claimed by the landlord. The Court found that capital taxes could not be claimed from a tenant without a clear and express supporting clause, which was not present in the case before the Court. It held that the capital tax is a tax established in relation to the landlord's own personal characteristics and that the portion of the landlord's capital taxes attributable to the building was not identified. The Court concluded that the means of calculating the exact amount (la "quotité") of the capital tax applicable to the given building should have been provided for in the lease. Consequently, without such a clear stipulation, the Court of Appeal refused to recognize the landlord's right to recover the tax from the tenant.

4 4 What are Capital Taxes? The capital tax in the Province of Québec is payable by corporations that have an establishment in Quebec. The capital tax is payable on a corporation's "paid up capital" as shown on its financial statements prepared in accordance with generally accepted accounting principles. In general terms, the paid up capital of a corporation is measured by adding up the items on the right side of the corporation's balance sheet (i.e. liabilities and shareholders' equity). It includes, for instance, the share capital, retained earnings, secured debts, certain loans and advances and any other debt outstanding for a period in excess of six (6) months. The corporation can deduct certain elements in computing its paid up capital, including the value of its investments in shares and bonds of other corporations and the amount of loans and advances to other corporations. The capital tax in the Province of Quebec is presently 0.64% of its paid up capital. An example: if a building has a cost of $8M for accounting purposes and a market value of $10M and the landlord has a bank loan of $1M and a mortgage loan of $7M, then its paid up capital tax is 0.64% of $8M (i.e. mortgage and loan) = $51, Assuming the building has 75,000 square feet of rentable area, this would result in a capital tax of $0.68 per square foot, per year to be paid by the tenant. Another capital tax imposed in the Province of Quebec and customarily passed on by landlords to their tenants, is the federal large corporations tax, which, in general terms, is presently payable by all corporations at a rate of 0.225% of their capital in excess of $10M. Depending on the value of the property, it has been estimated that capital taxes can amount to anywhere between $0.80 to $2.00 per square foot for downtown Montreal office buildings. Controversial There are essentially two reasons this expense is considered controversial in the context of commercial leases.

5 5 Firstly, some ask whether such a tax should be properly chargeable to tenants. The capital tax is influenced by the legal structure chosen by the landlord. Therefore, if the landlord holds the property as an individual or as part of a partnership and not in a corporation, then no such tax would be payable. In addition, tenants should be aware that a company's taxable paid up capital is based on its financial statements and can be affected by numerous factors, including decisions made by the landlord which have little to do with the operation of a property. A careful review of the list of the inclusions and exemptions of what is considered to be paid up capital demonstrates the extent to which a corporation can adjust paid up capital and therefore influence the amount of capital tax payable. From the tenant's point of view, capital taxes are personal and should therefore be the landlord's responsibility in the same manner as he is responsible for his own income taxes. From a landlord's perspective, however, capital taxes are a cost incurred to own a property and they are not an income tax. Capital taxes are not levied on the landlord's income, and are payable whether or not the landlord makes a profit. It is argued, from the landlord's point of view, that the paid up capital used to acquire, develop, expand, redevelop and improve the property should be charged to tenants. The second controversial issue surrounding capital taxes is that certain landlords, because of their legal structure, such as pension funds, do no pay such a tax. Landlords who are compelled to pay the tax argue that this is unfair. They believe that there is not an even playing field when competing for tenants because of the difference the tax makes in the property's operating costs to be paid by tenants. Nevertheless, capital tax clauses, which outline the landlords' ability to recover same from their tenants, are used in most commercial leases. Even though there has been some resistance by tenants to the introduction of capital taxes as a landlord's recoverable expense, most tenants now agree to pay it.

6 6 What are the consequences of the GE case? The Court of Appeal's ruling in the GE case will have significant repercussions in the area of real estate lease law. Even though the case can be distinguished on many points, it will clearly have an impact on both existing and future leases. As for existing leases, the object will be to examine on a case by case basis, whether the lease clearly stipulates the intent of the parties to have the tenant pay the landlord's capital taxes. In this regard, the decision of the Court of Appeal reaffirms the existing case law principles in the Province of Ontario, which state that capital taxes cannot be charged to a tenant in the absence of a specific provision in the lease. A lease which merely contains the usual "net" clause which requires the tenant to pay all taxes relating to the property (except the landlord's income taxes and other taxes personal to the landlord) will not enable a landlord to recover capital taxes, as it is not a tax on property, but a tax which is personal to a corporate landlord. As well, the capital tax is not an operating cost of the property, unless so specified, because it is a tax which is not an expense incurred for the maintenance, repair, operation, supervision, administration or management of a property. There can be no doubt that this case will create an opportunity for lease audits and lead to discussions between landlords and tenants concerning whether or not the landlord can validly charge the tax in accordance with the words used in their leases. How clear must the wording of the lease be? Most commercial leases currently provide that a tenant will pay its proportionate share of the taxes on capital which the landlord will have allocated to the property. Is this sufficient to enable a landlord to recover capital taxes? If they heed the words of the Court of Appeal, landlords will

7 7 want to consider modifying their standard lease forms for future leases in order to deal with capital taxes in greater detail. The Court of Appeal stated that a landlord needs a "clear and complete" clause in order to claim the tax from a tenant. It also held that a lease needs to spell out some method of allocation regulating how a landlord's overall capital taxes is to be allocated amongst the landlord's various assets. Capital taxes which are paid by a landlord who owns several properties are paid on a corporate basis. The amount to be allocated to each property must somehow be divided by the landlord between each of the rental properties and any other assets owned by the landlord. As we have seen from the Court of Appeal's decision, there should be some method stipulated in the lease which sets out how the landlord is to allocate the tax to a specific property. The following are some of the possibilities: One method of allocation, which may not be acceptable to a tenant, would be the allocation of capital taxes based on the debt secured by each of the properties owned by the landlord. If this allocation is adopted, there is a risk that a landlord could finance, to as large an extent as possible, its operations by mortgages on rented properties and attempt to keep non-rented properties, such has a head office, free from debt. This would enable the landlord to collect as much of its capital tax from tenants as possible. Another possible method of allocation is based on the fair market value of the various properties owned by the landlord. In order to equalize fair market values, all of the landlord's properties should be deemed to be rentable and rented, since properties which are leased may have a higher fair market value than owned and occupied properties. The allocation of capital taxes can also take place on the basis of the book value of the landlord's properties stipulated in its financial statements. The risk here for a tenant is that if

8 8 this method of allocation is used, a corporate reorganization of the landlord could change the book value of the property. This could result in a dramatic change in the amount of capital tax payable by the tenant. Some lease forms provide that in computing capital tax, the landlord must treat the property as its only asset in the jurisdiction in which the capital tax is imposed. This will enable the parties to isolate the capital tax on a particular rental property from the landlord's other assets included in the computation of the landlord's taxable capital. In such a case, the landlord could assume that the book value of the property is the paid up capital on which the tax is to be computed. This appears to be a reasonably fair method of calculation. If the landlord owns equipment, patents, trade marks, licenses, franchises or other personal properties or carries on any other businesses, then some part of the capital tax should be allocated to those forms of property as well. To the extent that capital taxes, such as the federal capital tax, are imposed only in excess of a specific limit or exemption, the amount of the limit or exemption should also be attributed by the landlord amongst its properties in an equitable manner. Otherwise, tenants may claim the full amount of the limit or exemption with respect to their property and deprive the landlord from the ability to recover the tax. As well, the landlord could attempt to attribute the limit or exemption entirely to non-rented properties. When the landlord in the lease is only a nominal landlord, the capital tax clause should make it clear that the capital tax payable by the beneficial owners can be recovered. Conclusion The Court of Appeal's decision in the GE case serves to emphasize a basic statutory principle outlined in the Civil Code of Quebec that in order for an obligation to be enforceable, it must be determined or determinable.

9 9 As such, a landlord will want to ensure that it can recover payment of capital taxes in the most specific manner possible. If the landlord does not succeed in passing on all operating expenses, including the payment of capital taxes, to its tenants, the effective rental stream obtained from the property will be reduced. This could translate into a reduced capital value for the property in the event of a sale. It is essential, therefore, for a landlord to create a lease agreement that sets out every possible expenditure that tenants are expected to pay, including the payment of the capital taxes. For a tenant, the objective is obviously quite different. He will want to ensure that he pays the lowest possible operating expenses and that he will not be subject to taxes which are not clearly stipulated in the lease. A tenant who is willing to assume the payment of the landlord's capital taxes will also want to ensure that he will not be subject to the risk of unpredictable increases that have little to do with the operation of the leased property.