Canada: Limitations, And Capex, And Taxes! Oh, My!

Recent cases decided by the Ontario Superior Court should cause parties to take a closer look at long-used "typical" commercial lease provisions.

OF LIMITATIONS AND RECONCILIATIONS

Consider the typical net lease: the tenant, throughout the term, pays the landlord a minimum rent every month, together with an amount that has been estimated in advance for common area maintenance costs and real property taxes. The parties agree that they will adjust the estimated amounts within a certain period of time after the actual amounts become known. So just how long can the landlord take to reconcile the estimates and the actuals before it is barred from doing so? The answer might surprise both tenants and landlords.

In a recent case in front of the Ontario Superior Court of Justice, Ayerswood Development Corporation v. Western Proresp Inc., the court considered this very issue. In front of the court was a lease that contained the following language:

"Wherever under this lease the Tenant is to pay its proportionate share, the amount thereof may be estimated by the Landlord for such period as the Landlord may from time to time determine, and the Tenant covenants and agrees to pay unto the Landlord the amounts so determined in monthly installments, in advance, during such period and with other rental payments provided for in this lease. As soon as practicable after the end of such period, the Landlord shall advise the Tenant of the actual amounts for such period and, if necessary, an adjustment shall be made between the parties."

The parties had entered into a lease in May 2001, for an initial term of five years. Throughout the term, the tenant paid minimum rent as set forth in the lease and the estimated amounts for common area maintenance charges and taxes, as provided by the landlord. After the lease had expired, the tenant remained in the premises while the parties attempted to negotiate a lease, and during that time, the tenant continued to pay minimum rent and estimated charges as it had done during the term. The tenant annually requested the actual amounts owing for common area maintenance charges and taxes, but was not provided with a reconciliation statement until after the lease had expired and the parties had failed to come to terms on the renewal, in December 2007. When the tenant received the bill for the reconciled amounts, the tenant denied its liability, asserting that the landlord was barred by the Real Property Limitations Act (Ontario) and the provisions of the lease, given that the landlord had not reconciled the amounts "as soon as practicable" after the end of each period.

In a surprise twist, however, the court found in favour of the landlord, and dismissed these arguments. First, the court noted that the lease did not define the "period" over which the amounts at issue could be estimated. If the parties had intended to define the period, they would have done so, in the court's opinion. The court found that the landlord had selected a period ending in December 2007, and had billed the tenant accordingly. The inference, of course, was that it was open to the landlord to do so, given the open-ended wording in the lease. Second, the court noted that section 17(1) of the Real Property Limitations Act (Ontario) provided that arrears must be claimed within six years after they became due. Rather than becoming due after they were accrued – which may have been the intuitive answer – the court found that the amounts did not become due until they were billed, namely in December 2007.

The Ayerswood case highlights the need for tenants, in particular, to pay even greater attention to the additional rent and reconciliation provisions in their leases. While flexibility is important, the landlord in Ayerswood was certainly aided by loose drafting. A prudent tenant will insist on annual reconciliations of additional rent amounts, and will ensure that the lease clearly outlines the consequences to the landlord for failing to deliver reconciliations within that time-frame.

CAPEX: WHAT DOES THAT MEAN, EXACTLY?

Landlords and tenants often think they are on the same page when discussing treatment of capital expenditures. The general consensus is that these expenses are so large that they should not be charged fully in the year in which they are incurred, but rather excluded altogether or amortized over the life of the asset in question. But what exactly is a capital expenditure? Parties often discover to their surprise that they have different definitions of this "commonly understood" term.

In the case of RioCan Holdings Inc. v. Metro Ontario Real Estate Limited, the Ontario Superior Court considered whether a large-scale parking lot repaving project was recoverable by a landlord. RioCan, the landlord, resurfaced the pavement of the parking lot at its shopping centre in order to correct some cracking and distress created by general wear and tear. Although it maintained it was under no obligation to do so, RioCan then amortized those costs over 20 years and charged Metro its proportionate share of those costs. Metro paid its proportionate share for a few years without complaint, but then had an apparent change of heart, and alleged that the costs were capital expenditures for which it should not be liable. The lease itself allowed recoverability of paving repairs, except for those "expenditures which by accepted accounting practice" were of a "capital nature." Although the parties agreed that capital expenses should be excluded, it turned out that they had very different ideas about what, in fact, constituted a capital expense, in no small part because they had differing ideas of which accounting practices should govern the determination.

For its part, Metro argued that the lease should be governed exclusively by generally accepted accounting principles (GAAP). Under GAAP, an item would be considered capital if it "enhanced the service potential" or was a betterment of the asset; for example, where the associated operating costs are lowered, or the life or useful life of the asset is extended. In this light, Metro argued that that by so substantially repairing the parking lot, RioCan had extended the useful life of the asset and the expenditure should thus be considered capital in nature.

RioCan, in contrast, argued that while "accepted accounting practices" might include GAAP, they could also include tax accounting practices that were not inconsistent with GAAP. Under tax accounting principles, RioCan argued that one of the key factors considered by the Canada Revenue Agency in determining whether an expense was capital in nature was whether it served to restore an asset to its original condition or to materially improve the asset beyond its original condition. The former would be considered a repair, while the latter would be considered a capital expense. In RioCan's view, the rehabilitation simply restored the parking lot to its close-to-new condition. Further, RioCan argued that, under tax accounting practices, a capital expense should be one that brought a future economic benefit to the asset owner. RioCan insisted that it was not profiting from the parking lot or benefiting from any increased shopping centre revenues as a result of the parking lot repair. Finally, although RioCan agreed that GAAP looked primarily to extension of the life of the asset, RioCan insisted that Metro was looking at the wrong asset – the relevant asset to RioCan's accounting was the shopping centre as a whole, and the parking lot rehabilitation did nothing to extend its life.

The court agreed with RioCan that the failure of the lease to specifically bind the parties to GAAP meant that GAAP was not determinative, although it could be instructive. However, the court rejected RioCan's argument that the relevant asset was the shopping centre, holding instead that the relevant asset was the parking lot. RioCan's internal accounting practices, which treated the relevant asset as the shopping centre and amortized the cost of the repair to reduce overall chargebacks, were irrelevant in the court's view. The dispute was about the parking lot, and the rehabilitation undoubtedly extended the life of the parking lot. Furthermore, the indirect economic benefits to RioCan – in the form of lower operating costs, attracting new tenants, retaining old tenants, and complying with the landlord's lease obligations – were sufficient to establish an economic benefit to the landlord such that the expense could be considered of a capital nature even under tax accounting practices. It was not necessary to directly link revenue to expense to prove a capital expenditure. On the facts before it, whether one used GAAP or tax accounting practices as the determining method, the court found that the parking lot repairs were of a capital nature and not recoverable by the landlord.

This case underlines the necessity of ensuring common understanding in drafting and interpreting leases, particularly where a lease excludes recoverability or requires amortization of capital expenditures. The best way for parties to accomplish this is to properly define terms and discuss intent before the lease is signed; ideally, the lease will explain what is meant by a capital expenditure and provide examples. Alternatively, parties may wish to consider a monetary threshold for expensing repairs fully in the year in which such expenses are incurred. For example, the parties may decide that any expenditure over C$200,000 must be amortized over the useful life of such item or a specified term, such as 10 years. Finally, parties should take care to identify the appropriate accounting standards that will govern any such determination in advance – whether GAAP, International Financial Reporting Standards or tax accounting standards – and understand the resulting treatment of capital and other expenditures thereunder.

DANGERS OF "LEFT-OVER" TAX LANGUAGE IN LEASES

It is not uncommon for standard commercial leases to allow for determination of a tenant's share of realty taxes with reference to separate assessments, notwithstanding that separate assessments have not been available in Ontario since 1998. However, the recently decided case of Terrace Manor Limited v. Sobeys Capital Incorporated underscores the need for landlords to look more closely at their standard form leases.

The facts of the case in front of the Ontario Superior Court were relatively simple. The lease provided, as many still do, that if separate tax assessments for the leased premises were not made available, the parties would use reasonable efforts to have them made available, and failing that, to obtain "sufficient official information" to determine what such separate assessments would have been if they had been made. If a separate assessment was not available, the tenant would be responsible for its "share" of taxes in respect of the leased premises. The tenant's share would be determined by the landlord reasonably and equitably, having regard to the generally accepted method of assessment and applicable elements utilized by the lawful assessment authority in arriving at the assessment of similar developments, if known. The tenant would not be required to pay more than its proportionate share of such taxes. The landlord had charged the tenant on a proportionate share basis from 1998 to 2003, when the tenant disputed the allocation, whereupon the landlord began to charge the tenant on an assessed-value basis until 2009. In 2009, the landlord then renewed its attempts to obtain recovery on a proportionate share basis.

Both parties acknowledged that separate assessments were no longer available. However, Sobeys asserted that sufficient "official information" – namely the Municipal Property Assessment Corporation's (MPAC) working papers – existed in order to permit the parties to proceed on this basis. The court held that MPAC's working papers and valuation records were official and sufficient to permit the parties to determine what the separate assessment would be, had it been made, because such papers contained "all of the information necessary to work out how the current value was calculated for each of the units". Moreover, the court noted that it was untenable for the landlord to now argue that this method was unreliable when it had charged the tenant for half a decade on this basis. Although the lease stated that the tenant would not pay more than its proportionate share, this was the ceiling on their recovery, and the landlord could not simply assume that proportionate share recovery was the default, particularly when the lease required its allocation to be made with regard to "the generally accepted method of assessment". As such, the court agreed with Sobeys that its share should be determined on an assessed value, rather than on a proportionate share basis.

The court's decision in the Terrace Manor case might seem difficult to reconcile with its previous rulings regarding MPAC's working papers (see, e.g., Indigo Books & Music Inc. v. Manufacturers Life Insurance Company, and Sophisticated Investments Ltd. v. Trouncy Inc. among others). In particular, the court had ruled in such cases that MPAC's working papers were not reliable, and did not create a separate "assessed value" of the premises. In some respects, then, Terrace Manor could be forgiven if it had assumed the court would find that such papers could not be relied upon. Importantly, however, the language in Terrace Manor's lease did not appear to give the landlord any discretion in considering whether the working papers were reliable enough to determine a separate assessment – rather, the lease provided that, if sufficient, the parties were to use such papers to determine what the separate assessment would have been, had it been made. Further, even if separate assessments were not available, the lease provided that the landlord's determination should be made with reference to assessment methods. These distinctions seemed to make all the difference to the court.

Like the other cases referred to in this article, the Terrace Manor case stresses the need to pay careful attention to the wording in the lease, rather than assuming that the parties will simply proceed in accordance with commercial norms. Courts will work hard to give effect to the intent of the parties, whatever it might be. While many landlords and tenants are "stuck" with leases that pre-date the elimination of separate assessments, both parties would do well to closely examine the wording of their lease to ensure that recovery of taxes is proceeding in the manner that the parties intended when they first struck the bargain contained in the lease. Landlords should also be careful not to compound any recovery problems by carrying over language from prior standard forms of leases into new leases. If the landlord's intent is to charge back taxes on a proportionate share basis, then it should say so; and if taxes on some portion of the development are to be excluded prior to the application of the proportionate share, the manner of determining the taxes attributable to such excluded portion should be clearly identified in the lease. Needless cluttering of the lease with left-over language from days when separate assessments were available can have dangerous consequences for landlords.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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