Many of my legal colleagues choose not to practice income tax law. According to them, “real lawyers” don’t do tax – tax is something accountants do, not lawyers. I usually choose not to challenge them on this; it’s enough to smile quietly and remain silent. Like other died-in-the-wool tax practitioners (both lawyers and accountants), I love tax practice because it gives me the opportunity to explore the more interesting aspects of both the legal and accounting worlds. For all of the frustration involved in trying to stay on top of the constantly changing legislative rules, judicial rulings, and administrative pronouncements, I wouldn’t switch to a more conventional legal practice for anything.
I found myself musing on this recently, after reading a recent CRA technical interpretation (TI 2012-0442831I7) concerning the appropriate tax treatment of payments made under certain long term leases. Payments in the early years were higher than those in the later ones, a feature common to so-called step-down leases. As a matter of commercial law, the lessee was obligated to pay the rent under a schedule of laddered payments rather than by a series of equal annual amounts. So how should the lessee treat the higher payments for tax purposes? Rent is usually regarded as a period cost for accounting purposes, and period costs are usually deductible in full in the year incurred. Applying commercial law to the lease, the full amount of each rent payment is a cost incurred each year, and as such it ought to be deducted as it is made. But the Tax Act restricts the deduction of certain payments if they relate in whole or in part to a future period. In that event, only the portion attributable to the current period is deductible. (See subsection 18(9)). So here we have an apparent conflict between the commercial obligation to pay an amount as rent, and the tax law which may require a more sophisticated analysis of what period the rent payment relates to.
Enter the accounting treatment. Could the tax treatment turn on how the lessee sets up the rent expense for financial statement purposes? This question was the focus of the recent technical interpretation. In an earlier period, the lessee deducted the full amount of the higher payment for financial statement as well as for tax purposes. But then in a subsequent year the accounting treatment changed. For accounting purposes, the annual deduction was limited to the amount determined by treating the rent expense as accruing in equal yearly amounts over the life of the lease. However, in computing income for tax purposes, the lessee continued to deduct the full amount of the higher annual payment. In the TI, the CRA considered whether the tax treatment should be governed by the revised accounting presentation.
In the TI, CRA said there was insufficient information on which to base a decision. The Agency did agree, though, that GAAPs did not necessarily govern the computation of income for tax purposes, citing the well-known decision of the Supreme Court of Canada in the Canderel case. The nub of the issue was whether on a proper interpretation of the lease, any portion of an annual payment related to a future year, or not. In regard to the accounting treatment, CRA said, “it is necessary to understand the business and legal relationship between the lessor and the lessee.” The accounting treatment was not determinative, although the accounting treatment did provide a useful guide to understanding the nature of the expenses.
I confess that the ‘accountant’ in me sometimes wonders why GAAPs are not determinative of these issues. After all, as the SCC said in the Canderel case, what we are looking for here is a “true picture” of the taxpayer’s income. As a lawyer, though I appreciate the fact that the liability for tax continues to be based primarily on the legal consequences of the contractual relations between the parties, not a gloss on them adopted for financial statement purposes. There are times (frankly, most of the time) when the accounting treatment will reflect the “true picture” and the correct tax result will follow the accounting. The fun part for me is when there is an apparent disconnect between the two, and I get to play part lawyer, part accountant, in helping resolve the proper tax filing. The TI reinforces the fact that when there is an issue regarding the proper treatment of an item for tax purposes, it is essential to understand the business context, the legal relationships between the relevant parties, and the basis for the applicable accounting rules in determining the proper application of the tax provisions.