Canada: Ontario Superior Court Sheds Light On "Capital" Costs

Clauses dealing with the allocation of "operating costs" in a commercial lease are often heavily negotiated. The parties want to be clear as to which costs can be charged back to the tenant and which costs the landlord is to absorb. In the event a dispute goes to court, the wording of the lease plays a significant role. The importance of clear drafting was illustrated in RioCan Holdings Inc. v. Metro Ontario Real Estate Limited¹, a trial decision of the Ontario Superior Court.

The lease clause at issue reads as follows:

The Facts

In 2002, RioCan Holdings Inc. (the "Landlord") performed extensive repairs to the parking lot pavement of a commercial plaza in Windsor, Ontario. The cost of the repairs was $431,000.00. The Landlord sought to pass this cost on to Metro Ontario Real Estate Limited (the "Tenant"), amortized over 20 years, arguing that the job amounted to a repair or maintenance and was therefore properly included in the operating costs payable by the Tenant. The Tenant eventually disputed the additional monthly cost, arguing that the expenditure was capital in nature and therefore was to be excluded from additional rent charges. The Tenant refused to make any further payments and began to offset the amounts already paid to the Landlord against rent.

The Landlord made an application to the court seeking payment of sums withheld by the Tenant and a declaration that the Tenant continued to be responsible under the terms of the lease for the cost of the rehabilitation.

The Decision

Morawetz J. dismissed the application, finding that the expenditure was indeed capital in nature and could not be charged to the Tenant as additional rent. The Landlord argued that the reference to "accepted accounting practices" should include not only GAAP but tax accounting practices, which suggests that for there to be a finding that the rehabilitation of the parking lot was capital in nature, there must be a future economic benefit to the Landlord by way of increased rental income, which was not the case here. However, the Court found this interpretation to be "flawed". The Court ruled in favour of the Tenant, taking into account the extension of the parking lot's life, the significant reduction in on-going operating costs, and the fact that the Landlord chose to amortize the costs over an extended period of time (rather than passing it on as a lump sum), which in and of itself suggests that this was a "capital cost" for the purposes of the lease provision. It is also interesting to note that Morawetz J. found that the Tenant was entitled to set-off the adjustments made by the Landlord against rent even though this was not specifically provided for in the lease, pointing out that there was no agreement that the Tenant would not dispute the payment of common area maintenance costs even if the Tenant had already made the payments.

Conclusion

The takeaway from this case, as Morawetz J. notes, is that "the dividing line between a capital expense/betterment and a repair/maintenance is not black and white. Indeed it is decidedly grey. The relevant case law and the expert opinions proffered in this case are reflective of this". These terms do not have clear meaning. To avoid disputes, the parties should endeavour to be as explicit as possible, as to what is included and excluded from operating costs, in the negotiation and drafting of the lease.

The authors of this article gratefully acknowledge the assistance of Azim Remani, student-at-law.

Footnote

1. 2012 ONSC 1819

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