PROPERTY TAX UPDATE: CURRENT ISSUES AND DISPUTES Paper to be delivered at the Law Society of Upper Canada Six-Minute Commercial Leasing Lawyer 2007 By: Michael Steinberg February 2007 Michael S. Steinberg Barrister & Solicitor 95 Wellington Street West Suite 1200 Toronto, Ontario Canada M5J 2Z9 Tel: (416) 365-3728 Fax: (416) 941-8852 Email: mss@steinberglaw.ca
2 PROPERTY TAX UPDATE: CURRENT ISSUES AND DISPUTES PART (A) OVERVIEW Starting in the year 1998, the Province of Ontario underwent massive property assessment and tax reform. Not only did this involve a massive overhaul of the historical system for assessing properties and the introduction of current value assessment or CVA. In addition, to mitigate against the otherwise huge property tax increases and tax shifts that could have occurred in consequence of the conversion to CVA, properties in the commercial, industrial and multiresidential classes were made subject to tax capping and claw backs. Tax capping serves to protect commercial properties from experiencing tax increases that exceed the legislated maximums. The revenue that a municipality would otherwise lose due to capping is essentially funded by its ability to claw back tax decreases to which other commercial properties would otherwise be entitled. Concurrent with the introduction of CVA, the former business taxes and separate tenant assessments for multi-tenanted commercial properties were both abolished. Since 1998, only one annual assessment and one yearly tax bill is made for each property in Ontario. It became the landlord s obligation to allocate the tax bill to its tenants. That obligation required an understanding of both the tax recovery clause in the lease, and complicated rules with respect to capping eligibility for certain tenants and the right to recover any shortfall of tax
3 recoveries from certain others. In many cases, that obligation has involved applying commercial realities because the legislation was either silent or inadequate. Not surprisingly, major tenants began to review the landlord s allocation of the property tax bill. In some cases the review or audit of the tax charges occurred years after the landlord s allocation. The major tenants were (are) typically located in a retail shopping centre or office building. These types of commercial properties are assessed according to the income approach to valuation. In general, the income approach involves the determination of a fair market rent for each tenancy which is then capitalized into a resulting estimate of value. The sum of all tenant values, together with any other applicable portions (such as parking or storage) add up to the total assessment of the property. The major tenant obtains a copy of the assessor s valuation records or working papers which shows the tenant s fair market rent, rate of capitalization and resulting value. The tenant multiplies this value by the applicable commercial tax rate, and then compares the resulting amount with the amount that it was allocated (billed) by the landlord. Where the landlord does not explain the discrepancy between its billing and the tenant s calculation, disputes arise. PART (B). DISPUTES OVER TAX RECOVERIES
4 The disputes, in general, tend to fall into one out of the following three areas of disagreement: (1) The interpretation of the tax recovery clause in the lease; (2) The methodology of the landlord in calculating the landlord s tax shortfall and/or the tenant s cap; or (3) The landlord s methodology in apportioning the shortfall among all tenants eligible to contribute toward it. A brief discussion of these three categories follows. (1) Interpretation of the Tax Recovery Clause As most commercial leasing lawyers are aware, the Ontario Court of Appeal in Orlando Corporation v. Zellers Inc. (2002), 62 O.R.(3d) 220(S.C.J.) affirmed (2003), 63 O.R.(3d) 535(C.A.) accepted the landlord s argument that the post- 1997 assessment regime had eliminated the previous separate assessment of individual tenancies of a building or property. The Court further stated that the fact that MPAC (Municipal Property Assessment Corporation) maintains its own valuation documents indicating a notional apportionment of the total property assessment to each tenancy does not elevate those documents into the status of an assessment of the tenancy.
5 While the Orlando decision is familiar to legal practitioners and consultants in this field, still an ongoing source of confusion is the separate assessment language found in the tax recovery clause of older leases. In Orlando, the particular lease contained a separate assessment tax recovery clause, but specifically contemplated that if separate assessments for each tenant were no longer available, then that tenant s tax burden would be based on a proportionate share methodology. Therefore, the Court approved of the landlord s allocation of taxes based on proportionate share. However, a different result might well have occurred if the lease had provided for an alternative method other than proportionate share, as for example, resorting to the valuation of the tenancy according to the assessor s records or valuation documents. The point is, just because the tax recovery clause stipulates a separate assessment approach to determine the tenant s taxes, this does not in and of itself prevent the use of the assessor s records if they are specified in the lease as the alternative method. What is required in every case is a careful examination of the entire tax recovery clause. (2) Disputes Over the Calculation of the Shortfall and/or Tenant s Cap
6 As mentioned, Ontario property tax reform in 1998 introduced limits or caps on tax increases for existing commercial properties. The same capping protection was filtered through to tenants whose tenancies commenced on or before December 31, 1997, known as tenant caps. The tenant caps were initially based on specified percentage increases each year over the combined realty and business taxes of the tenant for the year 1997. To the extent that the landlord suffers a shortfall, being the difference between the amount of the tenant cap and the amount determined under the tax recovery clause of the lease, it is entitled to recover such shortfall from other eligible tenants. Essentially, eligible tenants are those tenants under pre-1998 leases whose tax payments determined from the lease are below the tenant cap, as well as those tenants who entered into their leases before June 11, 1998 (in Toronto) or before December 18, 1998 (outside of Toronto). The error that some landlords have made stems from the change in the calculation of the property cap and therefore also the tenant cap starting with the year 2001. Whereas the 1998 to 2000 calculation was based on the tenant s combined 1997 realty and business taxes, starting in 2001 the 1997 taxes were no longer relevant in calculating the tenant cap. Instead, the tenant s cap became calculated as a percentage increase over the tenant s tax payment made for the previous year, plus any municipal budgetary increases. For the years 2001 to 2004, the specified annual percentage increase was 5%. Starting
7 in 2005, both the property cap and the tenant s cap can exceed 5% over the prior year s taxes if the municipality has chosen to invoke one or more of the new options available, such as increasing the annual cap from 5% to 10% of the previous year s paid taxes. The impact from the change in the calculation of the tenant cap starting in 2001 can be rather dramatic. The following example is based on a real situation where the anchor tenant had paid 1997 realty and business taxes of $300,000: Year Total Property Tax Bill Tenant Lease (Pro-Share) Tax Tenant Cap 1998 1,000,000 300,000 330,000 1999 950,000 280,000 345,000 2000 990,000 290,000 360,000 2001 1,200,000 320,000 304,500 2002 1,150,000 310,000 319,725 Notes: (1) Municipal levy charges are ignored. (2) Property located outside Toronto. (3) No shortfall was allocated to tenant in any year before 2002. This example demonstrates that: (a) Because of the change in the calculation of the tenant cap for the year 2001, the tenant cap ($304,500) is dramatically less than the tenant cap for the year 2000 ($360,000).
8 (b) Whereas the tenant cap in 2001 protected the tenant from being billed for a greater amount under the lease for the following 2002 year, the tenant cap actually exceeded the tax recovery amount under the lease by $9,725 and accordingly the landlord was entitled to recover up to this amount in respect of the tax shortfall arising from other tenants protected by capping. (3) Disputes over the Methodology of the Shortfall Allocation Whether the landlord can allocate the tax shortfall only to certain eligible tenants and not others was, until recently, a source of contention in some quarters. The issue appears to have been effectively settled by the Ontario Court of Appeal decision Omers Realty Corporation v. Sears Canada Inc., (2006) CanLll 16477 (Ontario Court Of Appeal). In this case, Sears argued that the landlord s allocation of tax shortfall was discriminatory and unfair in that the allocation was not made to all eligible tenants. Instead, the landlord had chosen to recover the shortfall from 31 eligible tenants under leases that dated prior to January 1, 1998. There were another 23 eligible tenants whose leases dated after January 1, 1998 and before December 18, 1998. Had the landlord allocated shortfall to those 23 other eligible tenants, obviously the contribution required from Sears would have decreased substantially.
9 The Court of Appeal rejected Sears contention that the landlord was obligated to allocate to all eligible tenants, noting that there was nothing in the legislation which required the landlord to do so. Further, the evidence showed that the methodology used by the landlord was consistent with industry practice and that the 23 eligible tenants from whom no shortfall was recovered were already contributing a fair share of the total property tax burden. The lesson from Omers v. Sears decision is clear. If the landlord has allocated the shortfall on a rational basis its methodology should withstand attack, and particularly so if the methodology conformed with standard industry practice. PART (C). POTENTIAL FUTURE AREAS OF DISPUTE (1) Compliance with Lease Provisions CT Securities Inc. v. Oxford Properties Canada Ltd. [2002] O.J. 2312, affirmed [2003] O.J. 240 (Ontario Court of Appeal) is the leading authority in Ontario on the issue whether the landlord, absent express language in the lease, is entitled to gross up the calculation of taxes and to retain the benefit of the lower tax rate applicable to the vacant portions of its building. The lease in effect in CT Securities stipulated a proportionate share determination of all occupancy costs, including taxes. There was no provision stating that the taxes were to be calculated on the basis of the building being assessed as fully leased and occupied.
10 The landlord argued that it was entitled to gross-up its tax calculations as if the building had been fully occupied. It further argued that the tax rebate for vacant units was personal to it, was not a reduction of tax and therefore it should retain 100% of the benefit of the lower tax rate on vacant units. The Ontario Court of Appeal, in affirming the decision of the Superior Court of Justice rejected those arguments and allowed all tenants to share pro-rata the benefit of the lower tax rate on the vacant units. Perhaps no less worthy of note for commercial leasing lawyers is how the Court dealt with the landlord s argument that the tenant s claim was barred for having contravened the lease requirement that it be made within twelve months of the delivery of the landlord s Statement of occupancy costs. Under the lease, the landlord s Statement was a written statement setting out in reasonable detail the amount of occupancy costs for the fiscal year and certified as correct by an officer of the landlord. In this case, however, the landlord s Statement was signed by its property manager, not an officer. The Statement also did not address the property tax component of the occupancy costs. The Court stated that these deficiencies were a fatal flaw to the landlord s argument, and accordingly the tenant s claim was not barred.
11 Commercial leasing lawyers take note. If you are drafting or reviewing any provision dealing with the landlord s certification or statement of taxes and/or the tenant s right to challenge the taxes billed to it, you must ensure that your client s ability to provide the certification, on the one hand, or to challenge the taxes billed, on the other hand, are capable of being performed in actual practice. If not, your client s position on any future dispute will be compromised if it failed to comply with the express provisions in the lease. (2) The New Limitations Act, 2002 A full discussion of this topic lies beyond the scope of this paper. However, the following three points are noted as they might well impact on future disputes concerning the landlord s allocation of taxes and/or the tenant s right to challenge that allocation. First, the new Limitations Act, 2002 came into force January 1, 1004. Any claim of an overpayment of taxes that was not discovered before January 1, 2004, is now subject to the basic limitation period of two years running from the date that the claim was first discovered or discoverable. The Act defines this date essentially as the earlier of: (a) the day on which the tenant first knew that an overpayment of taxes occurred by reason of the landlord s error and that having regard to
12 the nature of the injury, loss or damage, a proceeding would be an appropriate means to seek to remedy it ; and (b) the day on which a reasonable person with the abilities and in the circumstances of the tenant first ought to have known of the matters referred to in clause (a). In our view, different factual circumstances are bound to raise controversy over the interpretation of this definition, and resort to the courts will eventually be made. Second, the new Act does not apply to lease agreements made before January 1, 2004 that vary or exclude a statutory limitation period. New lease agreements were initially made subject to the basic limitation period. However, effective October 19, 2006, the Act was amended to provide that a business agreement, (i.e. no party is a consumer as defined in the Consumer Protection Act) can vary or exclude the basic two year limitation period. Commercial leasing lawyers might therefore wish to ensure that a new lease provides its own limitation period dealing with the tenant s right to challenge the landlord s tax billing. Otherwise, the basic two-year limitation period will apply as will the uncertainty created by the statutory definition for the discovery of the claim.
13 Third, the new Limitations Act, 2002 does not apply to proceedings by landlords to recover deficient payments of taxes by tenants. Such proceedings are governed by the Real Property Limitations Act, R.S.O. 1990, C.L. 15, whereby the landlord has six years from the payment due date of any sum of money charged upon or payable out of any land or rent to recover the arrears by levying distress or initiating an action. Rent includes periodical sums of money charged upon or payable out of land, which presumably applies to the landlord s allocation of taxes.