ARCHIVED - Land developers - Subdivision and development costs and carrying charges on land
DATE: October 7, 1991
SUBJECT: INCOME TAX ACT
Land developers - Subdivision and development costs and carrying charges on land
REFERENCE: Subsections 18(2), (2.2), (2.3), (2.4), (2.5), (3), (also subsections 10(1), (1.1) and the definition of "specified shareholder" and "business" in subsection 248(1), paragraphs 18(1)(a), 20(1)(c), 53(1)(d.3) and subparagraph 53(1)(e)(xi) of the Income Tax Act, and section 4301 of the Income Tax Regulations)
This bulletin replaces and cancels Interpretation Bulletin IT-153R2 dated July 20, 1981. The comments herein discuss the law as it applies after November 16, 1978. Where it is necessary to determine the application of subsections 18(2), (2.1) and (3) before November 17, 1978, please refer to the law.
This bulletin deals with the special treatment accorded to interest and property taxes on vacant land held as inventory. Emphasis is given to taxpayers whose ordinary business is holding land primarily for the purpose of resale or development. For many taxation years prior to 1988, such interest and property taxes could be deducted in the year incurred or, at the taxpayer's option, added to the cost of inventory. Such costs arising in 1988 and subsequent taxation years are subject to certain deduction limitations in the year incurred, and any portion denied as a deduction in the year must be added to the cost of the land held as inventory.
The bulletin also discusses subdivision and development costs of land developers as well as transactions described as an adventure or concern in the nature of trade.
Discussion and Interpretation
Interest and Property Taxes - Incurred after the 1987 taxation year
1. For 1988 and subsequent taxation years, subsection 18(2) applies to a taxpayer whose ordinary business is holding land (see 7 and 8 below) as inventory for the purpose of resale or development. In this bulletin, such a taxpayer is also referred to as a "land developer". Subsection 18(2) deals with the limitation on the deduction in computing such a taxpayer's income for a particular taxation year of the following expenses (also referred to as "carrying charges" in this bulletin):
(a) interest on debt relating to the acquisition of the land (see 9 below), and
(b) property taxes paid or payable in respect of the land, including assessments for school taxes and local improvements but not including any income or profits taxes or land transfer taxes.
Generally, a taxpayer's deduction for such carrying charges incurred in a taxation year is limited to the extent of the net income from the land for the year (being the gross income from the land for the year less other deductions exclusive of the carrying charges) by virtue of paragraph 18(2)(e). However, for a corporation whose principal business is the leasing, rental or sale or the development for lease, rental or sale (or any combination thereof), of real property owned by it, to or for a person with whom the corporation is dealing at arm's length, the deduction for such carrying charges incurred in a taxation year is limited to the extent of the aggregate of the net income from the land for the year and the corporation's base level deduction (see 3 below) for the year by virtue of paragraph 18(2)(f). The general criteria considered in determining a corporation's "principal business" are described in the current version of IT-290. The amount of carrying charges denied as a deduction in the year under subsection 18(2) (see 2 below regarding transitional relief) is added to the cost of inventory of land by virtue of subsection 10(1.1) (see 4 below).
The above limitations on the deduction of carrying charges do not apply in connection with land that can reasonably be considered to have been used in the course of a business other than a land development business carried on in the year by the taxpayer, by virtue of paragraph 18(2)(c), or held primarily for the purpose of gaining or producing income of the taxpayer from the land for the year, by virtue of paragraph 18(2)(d).
2. Transitional relief to subsection 18(2) provides that the amount that would otherwise be denied as a deduction under that subsection is phased-in over the years 1988 to 1992. For 1988, the portion of the carrying charges denied as a deduction is the amount that would otherwise be denied as a deduction under subsection 18(2) multiplied by 20 percent. For each calendar year after 1988, this percentage rises by 20 percentage points over a five-year period reaching 100 percent in 1992. Where a taxpayer's fiscal period straddles a calendar year, the particular percentages are prorated based upon the number of days in each calendar year. This transitional relief, therefore, allows a taxpayer to claim as a current deduction a portion of the carrying charges that would otherwise be added to the cost of inventory under subsection 10(1.1).
The following example illustrates the application of the transitional relief provision to a taxpayer whose taxation year does not coincide with the calendar year:
(i) Developco is a corporation whose principal business is the sale, ordevelopment for sale, of land, is not associated with any other corporation and has a taxation year which covers the fiscal period July 1, 1989 to June 30, 1990.
(ii) Developco has incurred the following expenses in the fiscal period in respect of a parcel of vacant land held for resale or development:
(a) interest on debt relating to the acquisition of the land $3,000,000 of debt at 10% $300,000
(b) property taxes on the land $ 25,000
(iii) Net income derived from the land in the fiscal period $ 10,000
Reference Application of subsection 18(2)
18(2)(a) interest on debt relating to the acquisition of the land $300,000 18(2)(b) property taxes on the land 25,000 Total carrying charges (A) $325,000
Aggregate of the amounts determined under paragraphs 18(2)(e) and (f) (amount not otherwise restricted by subsection 18(2)) plus transitional relief under paragraph 18(2)(g)
18(2)(e) net income derived from the land $ 10,000
18(2)(f) base level deduction (see 3 below) $1,000,000 ((13% X 92/365) + (15% X 273/365))(Note 1) 144,959 Total not restricted before transitional relief $154,959
18(2)(g) transitional relief: ($325,000 - 154,959) ((60% X 184/365) + (40% X 181/365)) (Note 2) 85,157 Aggregate income deduction in the fiscal period not restricted by subsection 18(2) (B) $240,116
Amount denied under subsection 18(2) and added to the cost of inventory of the parcel of vacant land under subsection 10(1.1) (Note 3) ((A) - (B)) or ($325,000 - $240,116) = $ 84,884
Pursuant to section 4301 of the Regulations, the prescribed rate of interest for the quarter commencing July 1, 1989 was 13%. For the three quarters commencing October 1, 1989, January 1, 1990, and April 1, 1990 the prescribed rate was 15%.
Note 2Pursuant to paragraph 18(2)(j) and (k) the specified percentage for 1989 is 60% and for 1990 is 40%.
In the above example, the amount denied as a deduction under subsection 18(2) was added to the cost of inventory of the particular parcel for which the debt was incurred. Where funds borrowed to acquire land cannot be related to a particular parcel or parcels, the amount denied under subsection 18(2) should generally be allocated to all land held during the year in proportion to the cost of each parcel.
Base Level Deduction
3. Subsections 18(2.2) to (2.5) provide the rules that determine a corporation's base level deduction for the purposes of subsection 18(2). Under subsection 18(2.2), the base level deduction of a corporation for a taxation year is the amount that would be the amount of interest, computed at the prescribed rate, for the year in respect of $1,000,000 of debt outstanding throughout the year, if the corporation is not associated with any other corporation in the year. Section 4301 of the Regulations provides for the determination of the prescribed rate of interest on a quarterly basis. The Department publishes a News Release which announces the prescribed rate in the month preceding each quarter.
Where a corporation is a member of an associated group of corporations, subsection 18(2.3) permits all of the corporations that are associated with each other in a taxation year to allocate among themselves in any proportion they choose the amount of $1,000,000 to which the prescribed rate is applied under subsection 18(2.2) if they have, in the year, filed with the Minister an agreement in prescribed form (T2005). Thus, the base level deduction of a corporation that is a member of an associated group is the amount allocated to it under the agreement multiplied by the prescribed rate of interest for the year. Where such an agreement is not filed in a particular year by any corporation in the group, the Minister is required to make the allocation to one or more of the associated corporations for that year under subsection 18(2.4). However, before an allocation is made thereunder, any of the corporations that has failed to file with the Minister the required agreement will be given an opportunity to provide it within 30 days after notice in writing by the Minister.
Where a corporation has two or more taxation years ending in the same calendar year and is associated in two or more of those taxation years with another corporation, paragraph 18(2.5)(a) provides that the corporation's base level deduction for each taxation year is determined by applying two steps. The first step is to determine the amount allocated to the corporation (before the adjustment for short taxation years under paragraph 18(2.5)(b) as discussed below) for its first taxation year ending in that calendar year. The second step in calculating the base level deduction is to apply the required proration pursuant to paragraph 18(2.5)(b).
In any case where a corporation has a taxation year that is less than 51 weeks, the base level deduction for the year is adjusted, pursuant to paragraph 18(2.5)(b), by the proportion that the number of days in the year is of 365.
A base level deduction is not available to a partnership even where all the members are corporations and the business of the partnership and the business of all the members of the partnership is the sale, or the development for sale, of real property.
Inventory Cost Adjustment
4. Subsection 10(1.1) provides for an addition to a taxpayer's cost of inventory of land of the amount of carrying charges for which no deduction is permitted under subsection 18(2). Subsection 10(1.1) also provides that the amount of interest for which no deduction is permitted under subsection 18(2) by reason of subsection 18(3) to another taxpayer (as described in 9(a), (b) and (c) below) connected to the taxpayer, may be added to the taxpayer's cost of inventory of land. (See 10 and 11 below for further details on subsection 18(3).) No addition may, however, be made to a taxpayer's cost of inventory in circumstances where that other taxpayer adds the amount denied by reason of subsection 18(3) to the cost of any property. (Note) Generally, the carrying charges that relate to a particular part or parcel of land must be deducted from the net income from that land and not against the net income of any other land the taxpayer may have in inventory, and to the extent that there is insufficient income from that particular part or parcel the remainder must be added to the cost of inventory of land. However, where a corporation meets the "principal business" test noted in 1 above, it must also offset this remainder with its base level deduction before making an addition to the cost of inventory of land. Therefore (insofar as the base level deduction is concerned), when that part or parcel of land is disposed of, any resulting gain or loss for financial statement purposes, may, for income tax purposes, have to be adjusted to reflect the portion of the base level deduction that was deducted in prior years.
Developco purchased land for $2,000,000 in 1991 and sold it for $3,000,000 in 1994. Interest of $150,000 was paid in each of 1991, 1992 and 1993 in respect of the purchase. Developco claimed a base level deduction of $100,000 in each of years 1991, 1992 and 1993 in computing income for tax purposes. For financial statement purposes $150,000 was added to inventory in each year. On the sale of the land Developco realized a gain of $550,000 for financial statement purposes. For income tax purposes, $300,000 should be added to the income reported in the financial statements in respect of the previously claimed base level deductions.
Bill C-18 tabled in the House of Commons on May 30, 1991 proposes an amendment to subsection 10(1.1). The amendment, if enacted as proposed, would be effective for the 1988 and subsequent taxation years to permit an addition to a taxpayer's cost of inventory where the amount is also added to another taxpayer's cost of shares or interest in a partnership, pursuant to paragraph 53(1)(d.3) or subparagraph 53(1)(e)(xi).
Paragraph 53(1)(d.3) and subparagraph 53(1)(e)(xi) are discussed in 11 below.
5. Where the carrying charges on vacant land held as inventory are not limited as a result of the application of subsection 18(2), they nevertheless are subject to other requirements of the Act for deductibility (such as subsection 18(9) or paragraph 18(1)(a) or 20(1)(c)). However, the taxpayer may defer the deduction otherwise permitted for these carrying charges by adding them to the cost of inventory of land, provided this is done on a consistent basis.
Interest and Property Taxes -- Incurred after November 16, 1978 and before the 1988 taxation year
6. Interest paid or payable before the 1988 taxation year on borrowed money used to acquire land (see 7 to 9 below) or to finance the development or improvement of the land that is held in the course of carrying on a business is not restricted by subsection 18(2) and hence may be deducted in computing income for the year provided the provisions of paragraph 20(1)(c) are met. Similarly, reality or property taxes paid or payable to a province or a municipal body may, subject to subsection 18(9), be deducted in the year paid or payable. However, the taxpayer may defer the deduction of interest and property taxes by considering them as an addition to the cost of inventory provided the taxpayer does so on a consistent basis. Where the carrying charges incurred are in connection with land acquired as an adventure or concern in the nature of trade, see 12 below.
7. For the purposes of subsection 18(2), paragraph 18(3)(a) specifies that land excludes a building or other structure affixed to land, the land beneath it and any contiguous parking area, driveway, yard, garden or similar land that is necessary for the use of that building or structure. "Land" expressly includes land to the extent that it is used for the provision of parking facilities for a fee or charge. A taxpayer is considered to have acquired a "building or other structure" within subparagraph 18(3)(a)(i) at the time when site development begins on land that has been unequivocally committed to use as a building site and providing the taxpayer proceeds in an orderly and continuous fashion towards completion of construction. There must be no undue delay.
8. Site development is considered to begin with the installation of services. Often an agreement to subdivide is entered into, with the municipality setting out the terms of subdivision. While the agreement firmly commits the land developer to proceed with the development of the subdivision, it is considered that development does not commence until the land developer starts to install the services, roadways, and so on. Where serviced lots are acquired, site development is considered to begin at the earlier of the date the taxpayer starts to install further services to the lots or the commencement of the pouring of footings. However, should there be an undue delay during the installation of services or in the midst of construction, the applicable property will not be regarded as one described in subparagraph 18(3)(a)(i). Site development may, of course, occur with respect to only a portion of a particular piece of land and only the developed portion will be considered to be a property described in subparagraph 18(3)(a)(i).
Interest on Debt Relating to the Acquisition of Land
9. The expression "interest on debt relating to the acquisition of land", as noted in 1 above, (and the former expression "interest on borrowed money used to acquire land" - as discussed in 6 above) in subsection 18(2) includes interest paid or payable by a taxpayer in a year on borrowed money that can be identified with the acquisition of particular land. The relevant expression is given an expanded meaning in paragraph 18(3)(b). Subparagraph 18(3)(b)(i) includes interest paid or payable on borrowed money that cannot be identified with the acquisition of particular land, but that may nonetheless reasonably be considered (having regard to all the circumstances) as interest on borrowed money used in respect of or for the acquisition of land. Subparagraph 18(3)(b)(ii) includes interest paid or payable in the year by a taxpayer (the connected taxpayer) on borrowed money that may reasonably be considered (having regard to all the circumstances) to have been used to assist, directly or indirectly,
(a) another person with whom the taxpayer does not deal at arm's length (see the current version of IT-419), and additionally, for taxation years commencing after April, 1988,
(b) a corporation of which the taxpayer is a "specified shareholder" (as defined in subsection 248(1)), or
(c) a partnership of which the taxpayer's share of any income or loss is 10 percent or more, to acquire land that is used or held by that person, corporation or partnership primarily for the purpose of resale or development, unless the assistance consists of a loan to that person, corporation or partnership for which the taxpayer charges a reasonable rate of interest.
Subparagraph 18(3)(b)(ii) does not include interest paid or payable by a land developer before the 1988 taxation year, since subsection 18(2) does not apply to limit a land developer's deduction of carrying charges throughout this period. For purposes of paragraph 18(3)(b), the relationship between the borrowing of funds and the acquisition of land is a question of fact to be determined from the circumstances of each particular case. If no such relationship exists, no part of the interest paid or payable will be disallowed.
10. The borrowed money referred to in subparagraph 18(3)(b)(ii) includes borrowed money used by a taxpayer who meets one of the tests noted in 9(a), (b), or (c) above, to subscribe for shares in a corporation, to contribute capital to a partnership or to make an interest-free loan to a corporation or a partnership. Where it may reasonably be considered (having regard to all the circumstances) that the corporation or partnership used the money received from the issuance of the shares, the contribution of capital or the interest-free loan to acquire land to be used or held primarily for the purpose of resale or development, the taxpayer who subscribes for shares, contributes capital or makes the interest-free loan will be subject to subsection 18(2) and accordingly, will be denied any deduction for the interest paid or payable on the borrowed money. Furthermore, the interest expense so denied is not added to the taxpayer's inventory cost of land because it is in respect of land that the taxpayer does not own.
11. For 1988 and subsequent taxation years, where a taxpayer holds on capital account shares of a corporation or an interest in a partnership as a result of a transaction described in 10 above, paragraph 53(1)(d.3) and subparagraph 53(1)(e)(xi) respectively provide for an addition to the adjusted cost base of such properties equal to the amount of the interest expense denied to the taxpayer under subsection 18(2) by reason of subparagraph 18(3)(b)(ii).
Adventure or Concern in the Nature of Trade
12. The definition of "business" in subsection 248(1), for purposes of paragraph 18(2)(c), does not include an adventure or concern in the nature of trade. Consequently, subsection 18(2) will apply to deny a deduction for carrying charges incurred. However, the disallowed amount, subject to the comments in 11 above, may be added to the cost of inventory of land. In all cases where land is held as an adventure or concern in the nature of trade, the amounts added to the cost of inventory of land may only be deducted when the land is disposed of. For a discussion of an adventure or concern in the nature of trade, see the current version of IT-459.
Subdivision and Development Costs
13. The costs in respect of installations within the subdivision area discussed in this paragraph include, but are not necessarily restricted to, costs of roads, sewers, watermains, street lighting, sidewalks, landscaping and recreational facilities. These costs are considered to constitute a component of the cost of the inventory of land for the purposes of subsection 10(1). This treatment is in accordance with generally accepted accounting and commercial reporting practices designed to achieve a reasonable and proper matching of costs with revenue. Where a portion of the property in the subdivision area is transferred from the land developer to a municipality or other government body under the requirements of the subdivision authorization, the cost of such land, including the applicable portion of the above-mentioned installation costs, should be reallocated on a reasonable basis to the remaining parcels of land for the purposes of subsection 10(1). (Utility service connection costs are covered in the current version of IT-452.)
14. Costs directly attributable to the development of land, for example, legal, consulting, mortgage, and survey fees, should be added to the cost of land in the taxation year incurred. On the other hand, costs that are in the nature of recurring operating overheads and are not specifically identifiable with a given project of subdivision or development may be claimed, for tax purposes, in the year incurred within the general limitations of paragraph 18(1)(a).
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