Commercial real estate GST/HST and QST audit issues
INSIGHT ARTICLE |
In this article, we describe goods and services tax and harmonized sales tax (GST/HST) and Quebec sales tax (QST) compliance issues relating to commercial properties as well as mixed-use properties that have a residential component. Our objective is to describe a number of the compliance issues relating to commercial properties we often see in practice. This is not meant to be a conclusive description of all compliance issues that could arise in a particular case. Reference may also be made to our previous article entitled Construction of residential rentals and GST/HST and QST audit issues.
Audit activity by the Canada Revenue Agency (CRA) and the Quebec Revenue Agency (QRA) is again picking up in the areas of the GST/HST and QST. For nearly a year now and at the height of the pandemic, many Canadian tax authorities ceased or greatly reduced their audit activity, unless a business was expecting a refund of GST/HST, QST) or provincial sales taxes. However, refunds have been getting priority for a variety of reasons, yet these indirect tax authorities are taking a much closer look before releasing these refunds than they were over the last 10 months. As such, it may be worthwhile to review potential GST/HST and QST compliance issues that may arise in the course of an audit by CRA or QRA.
Implementing processes to correct potential compliance issues in advance of an audit are always preferred to resolving proposed assessments of tax and the application of interest and penalties. Also, an extended and sometimes more in-depth audit or enquiry may result when significant issues and errors are identified.
For brevity, in the discussion below references to GST/HST and the CRA should be considered synonymous with references to the QST and QRA respectively, as the legislation and the CRA’s and QRA’s administrative policies are generally harmonized.
Overview of GST/HST and commercial property
The development and operation of commercial properties are generally taxable activities for GST/HST purposes. As a result, GST/HST registrants are usually required to charge, collect and remit GST/HST on their sales, leases and rentals of commercial real property. In addition, they may typically recover by way of input tax credit (ITC), the GST/HST on most related development and operational costs. The main categories of activity relating to taxable commercial real property include:
- Commercial/industrial sales, leases and rentals (e.g., office buildings, manufacturing premises, warehouses, and retail establishments)
- New home sales including single and attached family homes and condominiums
- Construction and renovation services
- Hotels and other transient accommodation
Documentation to support ITCs
One of the most common issues we see in the course of the CRA’s GST/HST audits is the review of builders’ and construction companies’ source documentation to support ITC claims. The CRA views these regulatory requirements seriously and generally takes a strict interpretation of the rules.
ITC information requirements
Failure to meet the supporting documentation requirements resulting in denial of ITCs is common in both CRA desk and full scope audits, particularly in the real estate sector. The applicable GST/HST regulations specify requirements by the purchaser to support an ITC claim. Common errors include the incorrect purchaser’s name on invoices, as well as missing, incorrect or un-matched supplier GST/HST account numbers. These errors routinely result in the denial of ITCs, and it is not always possible to recover the denied claims through other means.
Centralized accounting and agency
If the purchaser is represented by an agent, particularly within a group of related entities where purchasing may be centralized, the parties should document this relationship. An agency agreement should be put in place between the legal purchaser (i.e., the principal) and the agent. Otherwise, the CRA may deny the ITC based on the understanding that the incorrect purchaser is stated on the invoice.
Taxable sales to registered purchasers
A vendor of taxable real property is not required to charge, collect and remit GST/HST on a sale (excluding sales of residential complexes to individuals) to a GST/HST registered person. The CRA’s administrative policies are generally to assess the vendor for failure to charge and collect tax if the conditions for relief are not met.
Consequently, vendors should ensure their due diligence processes include confirming with the CRA’s GST/HST online registry that the beneficial purchaser’s registration status is valid and effective on the tax payable or closing date. This diligence should include appropriate certifications by the purchaser in agreements of purchase and sale, as well as any potential recourse wording in case there are anomalies in these certifications.
It is also important that the GST/HST implications of purchasing real property be considered by the buyer in circumstances where special organizational structures or arrangements are in place. For example, the following errors can result in loss of ITCs of the GST/HST on acquisitions of taxable real property:
- Registering and claiming the ITC in a nominee corporation or bare trust rather than in the beneficial owner(s).
- Registering and claiming an ITC in a partner’s GST/HST return, rather than the partnership.
- Extending the simplified GST/HST accounting methodology available under the section 273 election for joint ventures to the purchase of the venture’s underlying taxable property. The CRA’s view is that the prescribed activities under the applicable Regulations do not apply to allow the designated “operator” of the joint venture to claim the ITCs for the other participants in this case.
Tenant inducements and any related leasehold improvements
The structure of lease inducements can have an impact on the GST/HST implications for the landlord’s GST/HST collection and remittance obligations and ITC eligibility as well as for the tenant, depending on the details of the arrangements.
Rent free period or rent reductions
A landlord may offer a rent-free period or a reduction in rent for one or more lease periods as an incentive to enter into the lease agreement. As there is no taxable payment or consideration for the rent-free period, there is no applicable GST/HST. In the case of a rent reduction, the GST/HST is calculated on the reduced amount.
The rent-free period or rent reduction should be documented in the lease agreement or an addendum to the agreement. This will help ensure that the CRA does not assess the landlord for failure to charge and collect tax. In addition, if the rent free period or rent reduction is effected by the issuance of a credit or debit note, special rules apply to support the adjustments to the landlord’s GST/HST net tax calculation. Also, the tenant may be required to adjust the tenant’s net tax calculation if GST/HST is adjusted on the reduced rent and the tenant had previously claimed an ITC or rebate.
If a landlord makes a cash payment to a tenant as a lease inducement, the tenant is considered to have made a taxable supply to the landlord of a service of entering into a lease. Tenants registered for GST/HST should charge and collect the tax on the cash payment.
Alternatively, a landlord may make a cash payment to the tenant in order for the tenant to carry out lease improvements as part of a lease inducement. In this situation, the tenant is considered to have made a taxable supply of the improvements to the landlord and should charge and collect the GST/HST on the cash payment. The landlord should be able to recover this tax as an ITC, subject to appropriate supporting documentation. The tenant should also be able to claim ITCs for the GST/HST paid on the cost of undertaking the leasehold improvements.
If the landlord pays for the improvements and does not make a cash payment to the tenant, the landlord may claim ITCs for the GST/HST paid on the taxable improvements. There are no GST/HST implications for the tenant in this scenario.
In summary, there are significant variations in the tax treatment of lease inducements for landlords and their tenants. The approach and documentation supporting these arrangements should be reviewed from a GST/HST perspective to avoid assessments and to take advantage of ITC recovery opportunities for the person making the improvements.
Determining the amount of taxable rent and adjustments to lease and rental payments
It is not always obvious that certain charges and adjustments to rent for a commercial property are taxable for GST/HST purposes (e.g., payment of property taxes).
Common area maintenance (CAM) charges
In particular, various adjustments to commercial lease transactions such as CAM charges, can affect the landlord’s GST/HST obligations. For example, a year-end adjustment by a commercial landlord to take into account an increase in property taxes over the previous rental period will result in additional GST/HST due from the tenant. Conversely, a reduction in property taxes may result in a refund or credit of GST/HST.
Where a landlord issues a refund or credits GST/HST to the tenant, the landlord must comply with the credit note rules when adjusting the landlord’s net tax. For example, the reduction of the landlord’s net GST/HST calculation could be denied if the landlord does not claim the amount in time (i.e., in the return for the reporting period in which the credit note is issued) or does not properly document the credit note. The tenant may also be required to adjust previously claimed ITCs or rebates if the GST/HST is reduced.
Rent deferrals and reductions during COVID-19
The GST/HST implications of rent deferrals and rent adjustments during the COVID-19 crisis have important GST/HST implications. A rent deferral should be properly documented so that it is not improperly characterized by CRA, potentially resulting in the landlord being assessed for failing to charge and collect tax when due. The GST/HST implications of rent reductions under the government’s Canada Emergency Commercial Rent Assistance (CECRA) program can be found in our 2020 article, GST/HST under the Canada Emergency Commercial Rent Assistance (CECRA) Program.
New home rebate assigned to homebuilders by homeowners and certain relatives
A new home GST/HST rebate is available to purchasers of certain taxable purchases of new homes. These rebates are often assigned to the builder, who then credits the purchaser with the amount of the rebate. The builder recovers the rebate that was credited to the purchaser, by filing the rebate application with the builder’s GST/HST return. Consequently, the purchaser does not have to pay the full amount of tax subject to the qualifying criteria and purchase price.
Builders should ensure that sale agreements properly provide for the assignment of the rebate, and the builder has processes in place to help ensure the new home and purchaser qualify for the rebate and that the calculation is accurate. For example, CRA will deny rebates where the purchaser (or a relative of the purchaser) did not intend to and actually use the home as a primary place of residence.
If a rebate is assigned to the builder, but the builder knew or should have known that the purchaser did not qualify, both the builder and the purchaser will be jointly and severally liable to repay the rebate. As a result, builders should exercise extra care in this regard, especially in the condominium market where multiple rebates have been known to be incorrectly obtained on multiple units by the same or similar named purchaser.
Commercial and residential mixed-use properties
As discussed in a previous article, where a new long-term residential rental property is constructed or commercial property is converted to a residential rental property as a place of residence for individuals, special GST/HST implications result under the “self-supply rules”. In certain cases, these rules may apply to conversions of commercial properties, such as hotels, to special purpose residential housing, such as rent-geared-to-income housing.
There has been a trend in conversions of commercial properties where older commercial office properties and older motels and hotels are converted, in whole or in part, to contain long-term residential rentals. In some situations, these conversions become fully residential, while others may have a combination of long term and short-term residential rentals, a ground-floor retail component, several floors of office space and sometimes, or a combination of all of these uses.
Calculating GST/HST on the residential rental component
For GST/HST purposes, the fair market value (FMV) of the residential rental component of the newly constructed, substantially renovated or converted property (including the land and building), is the basis for the GST/HST payable on the builder/landlord’s GST/HST return as discussed in our previous article. Any commercial or retail component of the residential rental property does not factor into the GST/HST self-supply rule for the residential component of the property.
Mixed-use properties such as these, present some of the most complex FMV calculations, which are often challenged by the CRA. As such, it is important to ensure that builders/landlords obtain a professional real estate valuation report of the residential portion of the land and building, that is defendable and supportable should there be a CRA valuation challenge.
“Residential complex” versus hotels
A building or part of a building, that is a hotel, motel or other similar premise and also includes a certain percentage of long-term residential rentals, may not be considered to be, in whole or in part a “residential complex” for GST/HST purposes. This will have implications for purposes of the GST/HST treatment of the long-term residential rentals.
The definition of “residential complex” in the GST/HST legislation excludes a building or part of a building that is a hotel, motel or other similar premises where 90% or more of the rentals of residential units in the building or part are provided for periods of continuous possession or use of less than 60 days.
If the residential rental units are excluded from the definition of a “residential complex” on the basis that they are part of a hotel, motel or other similar premises, the long-term rentals will be taxable. The long-term rentals will not fall under the GST/HST exemption for rentals of a unit in a residential complex as a place of residence of an individual for at least one month.
In addition, the self-supply rule mentioned above will not apply to conversions of individual units to long-term rentals in these circumstances, provided they are not condominiums. Consequently, it is important to consider the particular circumstances involving mixed-use rentals of short-term and long-term residential rentals for GST/HST application purposes.
Allocation of costs
The landlord’s approach to allocating taxable costs to the commercial portion of the property for ITC purposes may be subject to review at audit. This allocation approach will be relevant for purposes of determining the FMV of the residential and commercial portions of the land and building at the time of self-supply in the case of new construction, substantial renovations and conversions; and for purposes of allocating operating costs between the exempt residential and taxable commercial portions of the property on an ongoing basis. It is important to implement an allocation approach that is “fair and reasonable”.
Allocation of consideration at sale
If a mixed-use property is sold, such as a building that contains residential rental units and retail or other commercial space, the GST/HST legislation will deem there to be separate sales for GST/HST purposes. Therefore, it can be important to value each portion of the property in a mixed-use scenario, particularly if the purchaser is not validly registered for the taxable portion of the property where GST/HST must be charged by the vendor.
For example, if a person sells a single property that includes an apartment building and a large portion of undeveloped land, the undeveloped land that is not necessary for the use and enjoyment of the rental property by the tenants is not included in the definition of “residential complex”. The GST/HST legislation deems there to be two separate supplies in this case; one taxable and one exempt from GST/HST.
Change in use
Special rules in the GST/HST legislation apply to changes of use of capital real property. These rules can result in a recapture of ITCs previously claimed if there is a decline in commercial use of the property, or an increase in ITCs if there is an increase in commercial use. In view of disruptions caused by the COVID crisis, it may be worthwhile to review for GST/HST purposes significant changes in the use of properties.
The rules relating to changes of use of capital real property can vary depending on the status of the person, including special rules for individuals, public service bodies (PSBs) and financial institutions. Generally, a registrant is entitled to claim ITCs for the GST/HST paid or payable on the acquisition of capital real property to the extent that the property is used in commercial activities.
Subsequent changes in the use of capital real property from exempt to taxable can result in additional ITCs; whereas changes from taxable to exempt use or from a taxable commercial use to personal use can result in a recapture of ITCs previously claimed. The calculation is based on the definition of “basic tax content”, which includes a factor that takes into account any depreciation in the fair market value of the property since the property was last acquired.
As a general guideline, if the change in use is 10% or more it may be necessary to adjust ITCs previously claimed, either increasing or decreasing ITCs based on the increase or decrease in commercial use of the property. In the case of individuals and PSBs that are not financial institutions, if the change in use affects whether the property is used primarily (i.e., more than 50%) in commercial activities, 100% of ITC entitlement could be impacted, subject to the basic tax calculation.
Significant changes in the use of capital real property are very likely to be reviewed in the course of a GST/HST audit.
How RSM Canada’s Indirect Tax Team may assist
RSM Canada’s indirect tax team has the knowledge and experience in the real estate sector to assist our clients reduce GST/HST and QST compliance risks and related costs.
The real estate sector is an area where GST/HST and QST auditors are very active. Our indirect tax professionals can assist our clients by proactively conducting GST/HST and QST diagnostic reviews. These reviews are intended to identify significant compliance issues and recommend solutions. In addition, the reviews are intended to identify potential recovery of past GST/HST and QST overpayments or missed ITCs, ITRs and rebates as well as opportunities to reduce future GST/HST and QST related costs.
In addition, RSM’s indirect tax team can advise our clients on proposed transactions, organization changes and participate in due diligence reviews.
If a client is contacted by CRA or Revenue Quebec for audit, RSM can advise the client on best practices for managing the audit as well as assisting directly in responding to the auditor’s questions. We are also experienced in dispute resolution, including responding to proposed assessments and notices of assessment on behalf of our clients.
Our approach is integrated and collaborative, as we work with the client and our colleagues in assurance and income tax to ensure that our conclusions and recommendations take into account other accounting, systems and tax issues.