Income Tax Folio S3-F3-C1, Replacement Property

Discussion and interpretation

General overview of the replacement property rules

1.1 Where a capital property, other than a share of the capital stock of a corporation, is disposed of, whether voluntarily or involuntarily, and a replacement property is acquired within specified time limits, subsection 44(1) may provide for the deferral of all or part of the capital gain on the disposition.

1.2 Similarly, all or part of the recapture of CCA on the disposition of a property described in ¶1.3 that is depreciable property of a prescribed class may be deferred by virtue of subsection 13(4) where a replacement property is acquired within the specified time limits.

1.3 Unless otherwise specified, a reference in this Chapter to a former property applies to any property disposed of in either of the situations described below:

• when subject of an involuntary disposition: a property where the proceeds of disposition (POD) received by the taxpayer consist of compensation for property unlawfully taken (for example, stolen), compensation for property destroyed including any amount of insurance proceeds payable in respect of that loss or destruction, compensation for property taken under statutory authority (for example, expropriated) or the sale price of property sold to a person by whom notice of an intention to take it under statutory authority was given. These types of POD are as described in paragraphs (b), (c), or (d) of the respective definitions of POD in subsection 13(21) or in section 54; or
• when subject of a voluntary disposition: a property that was, immediately before the disposition, a former business property of the taxpayer. This expression former business property is discussed in ¶1.27 to 1.32.

The rules will generally be referred to as the replacement property rules.

Requirements of the replacement property rules

1.4 In order for the replacement property rules to apply, several requirements must be met. These requirements are discussed in ¶1.5 to 1.14.

Timing of acquisition of replacement property

1.5 In general, a replacement property can either be acquired before or after the disposition of a former property as long as it otherwise meets the conditions for being a replacement property as set out in ¶1.33.

1.6 For involuntary dispositions, the replacement property must be acquired before the later of:

• the end of the second tax year following the initial year; and
• 24 months after the end of the initial year.

1.7 For voluntary dispositions of a former business property, the replacement property must be acquired before the later of:

• the end of the first tax year following the initial year; and
• 12 months after the end of the initial year.

1.8 For purposes of the replacement property rules, the initial year is the tax year in which an amount has become receivable as POD for the former property.

1.9  Often, POD will be receivable in the same tax year in which the actual disposition of the former property occurs. However, for involuntary dispositions, subsection 44(2) may deem the disposition of the former property to occur and the POD to be receivable in a later tax year. In this case, the initial year for that involuntary disposition will essentially be the year in which the earliest of the events described in ¶1.10 takes place.

1.10 For all involuntary dispositions, the disposition is deemed to have occurred and the POD are deemed to have become receivable on the earliest of:

• The day the taxpayer agrees on the full amount of compensation for the property;
• The day the tribunals or courts make the final determination of compensation for the property;
• The day that is two years after the loss, destruction, or taking of the property if no proceeding before a tribunal or court has been taken before that time;
• The day the taxpayer dies or ceases to be a resident in Canada which results in the deemed disposition of the property; and
• If the taxpayer is a corporation being wound up (other than a taxable Canadian corporation that is wound up into a second taxable Canadian corporation), the time immediately before the winding up.

1.11 Where such a former property was taken under statutory authority, the replacement property can be acquired at any time after a taxpayer receives notice of an intention to take the property under statutory authority and before the time noted in ¶1.6.

Timing of the disposition of replacement property

1.12  The replacement property cannot be disposed of prior to the date of disposition of the former property.

Use of the former property

1.13  For a voluntary disposition, the former property must be a former business property.

Requirement to file an election

1.14  A taxpayer must make a valid election to use the replacement property rules.

Reporting requirements

1.15  A taxpayer is required to report any recaptured CCA or taxable capital gain arising from the disposition of a former property in the year of disposition. However, where a replacement property is acquired in a subsequent tax year and within specified time limits, the taxpayer may request a reassessment of the income tax return for the year of disposition of the former property. This will generate a refund in respect of the income tax paid on income arising on the disposition.

1.16  Having to pay tax that will be refunded when a replacement property is acquired could create a financial burden. To alleviate this financial burden, acceptable security may be provided in lieu of the payment of taxes owing until the time the final determination of taxes is made or the time period for acquiring the replacement property has expired. Where this practice is followed, the full cost of providing such security is borne by the taxpayer. The interest on the unpaid taxes will continue to accrue at the prescribed rate subject to being reduced by interest credited on any subsequent reassessment confirming the deferral. The arrangements to provide security must be acceptable to the taxpayer’s tax services office. For more information on how arrangements to provide security are to be made see Information Circular IC98-1R7, Tax Collections Policies.

Reallocation of proceeds of disposition between land and building

1.17  Where more than one capital property has been disposed of in circumstances where subsection 44(1) applies, the provisions of that subsection apply to each such property and its replacement property individually. In the case of land and buildings thereon, the capital gain on each of these properties should be calculated separately.

1.18  However, under subsection 44(6), a taxpayer may be permitted to reallocate the POD of a former business propertycomposed of land and one or more buildings between the land component and the building component. For this purpose, subsection 44(6) provides that land is, “the land (or an interest, or for civil law a right, therein) subjacent to, or immediately contiguous to and necessary for the use of, the building.”

1.19  The amount eligible for reallocation is limited to the excess of POD otherwise determined of one or the other of the components over its ACB. If, for instance, the POD of land determined without reference to subsection 44(6) exceed its ACB, a taxpayer can elect to treat all or a portion of the excess as being POD of the building component of the former business property. This will defer recognition of all or a portion of the accrued capital gain with respect to the land.

1.20  The election to change the allocation of the POD between land and building must be filed in an income tax return of the taxpayer for the year in which the replacement property is acquired.

Reserves

1.21 A taxpayer who calculates a capital gain under subsection 44(1) for a particular tax year may not also claim a reserve under subparagraph 40(1)(a)(iii). However, subparagraph 44(1)(e)(iii) provides that a reasonable reserve in respect of POD that are payable after the end of the year is available in most instances, based on the capital gain as reduced under subsection 44(1).

1.22 Pursuant to subsection 44(7), no such reserve is allowed where:

• the taxpayer was not resident in Canada at the end of the year or at any time in the immediately following year,
• the taxpayer was exempt from tax under Part I of the Act at the end of the year or at any time in the immediately following year,
• the person that acquires the former property of the taxpayer was immediately after the disposition a controlled or controlling corporation as described in paragraph 44(7)(b), or
• the former property of the taxpayer was disposed of to a partnership in which the taxpayer was, immediately after the disposition, a majority-interest partner.

1.23  Subparagraph 44(1)(e)(iii) provides other restrictions on allowable reserves. These restrictions limit reserves so that at least one fifth of a gain is recognized in the year of disposition of the property and in each of the four following years. Gains in respect of certain transfers to children are eligible for a deferral extending over a ten-year period rather than the five-year period referred to above. This exception is provided in subsection 44(1.1) and applies only to dispositions from a parent to a child of family farm or fishing land and buildings where the rules in subsection 73(3) and 73(3.1) also apply. An individual (other than a trust) who is claiming a reserve under subparagraph 44(1)(e)(iii) should use the prescribed form, T1030, Election to Claim a Capital Gains Reserve for Individuals (other than trusts) When Calculating the Amount of a Capital Gain Using the Replacement Property Rules. Other taxpayers may claim the reserve in their income tax returns.

Election to use the replacement property rules

1.24  A taxpayer must elect to have the replacement property rules apply. The election should be made as follows:

• If the disposition and replacement take place in the same year, the taxpayer’s calculation (in the income tax return for that year) of the recaptured CCA or the capital gain by virtue of subsection 44(1) will be considered to constitute an election.
• If the property is not replaced until a subsequent year, the election should take the form of a letter attached to the income tax return for the year the replacement property is acquired. The letter should include a description of the replacement property and the former property, a request for an adjustment to the recapture of capital cost or the taxable capital gain reported, and a calculation of the revised recapture or taxable capital gain.
• If the replacement property is acquired prior to the year of disposition of the property, the election should take the form of a letter attached to the income tax return for the year in which the replacement property is acquired. The letter should include descriptions of the replacement property and the property that is to be replaced. If the taxpayer late-files such an election, it will be accepted if it is filed in the income tax return for the year in which the former property is disposed of, provided it is evident that the new property qualifies as a replacement property.

For e-filers, see the Paper documentation discussion on the webpage File returns.

1.25  If a former property is depreciable property, subsection 44(4) provides that a taxpayer who elects on that property under subsection 44(1) is deemed to have also elected on that property under subsection 13(4). Similarly, if the taxpayer elects under subsection 13(4), the taxpayer is deemed to have elected under subsection 44(1) as well.

1.26  Under the combined provisions of subsection 220(3.2) and Part VI of the Regulations, depending on the circumstances, a late or amended election under subsection 13(4), 44(1), or 44(6) or a request to revoke such an election may be accepted. For more information, see Information Circular IC07-1, Taxpayer Relief Provisions.

Former business property – general

1.27  Subsection 248(1) defines a former business property as capital property that is:

• real or immovable property;
• an interest in real property;
• a right in an immovable; or
• a property that is the subject of an election under subsection 13(4.2).

The property must be used by the taxpayer or a person related to the taxpayer primarily for the purpose of gaining or producing income from a business but generally does not include rental property.

1.28  For the replacement property rules to apply to former business property, paragraph 44(1)(b) requires that it qualify as such immediately before its disposition. This means that the words “used…primarily” in the definition of former business property refer to the use made of the property during the tax year of disposition. Accordingly, the property must have been used primarily to earn income from a business (not rent) during the year of disposition. Where no use was made of the property during that year, the use made of the property in the previous tax year will be considered.

Rental property

1.29 The definition of former business property excludes rental property. For purposes of this definition, rental property is defined to mean real or immovable property owned by the taxpayer and used in the particular year principally for the purpose of gaining or producing gross revenue that is rent. Accordingly, even though a property is used to earn qualified business income, it would be disqualified as a former business property if, in the tax year of disposition, it was used principally for the purpose of producing rent. However, if a property is leased by the taxpayer to a person related to the taxpayer and is used by that related person principally for any purpose other than gaining or producing gross revenue that is rent, it is not included in the definition of rental property.

1.30  Where property is used in part to earn gross revenue that is rental income and in part to earn income from a business other than rental income, the principal use of the property is determined by the facts in the particular case. The word principally signifies mainly or chiefly and means more than 50%. Accordingly, one should look to the main or chief purpose or intent for which the owner uses the property. Although a pure quantum measurement may not necessarily be conclusive in every case, one of the prime factors to consider is the actual or physical proportion of the property used in the two income-earning processes. In addition, it may be necessary to consider other factors that are both relative and subjective. These may include:

• income or gross revenue from each operation;
• profits realized from each operation;
• capital employed in and rate of return from each operation;
• time, attention, and effort expended in each operation;
• the motivation or intent of the taxpayer in making the investment together with the ultimate utilization of the property.

Delays in the disposition of former business property

1.31  If a property that would otherwise qualify as a former business property is rented for a short period prior to its disposition, it is a question of fact as to whether the renting was simply an interim measure while bona fide attempts were being made to sell the property. If so, the CRA may accept that the property maintained its status as a former business property, subject to the rule described in ¶1.29.

1.32  Likewise, if the property remained idle for a period of time while attempts were made to sell it, the CRA would consider that the property was, immediately before the disposition, a former business property provided the property otherwise qualifies.

What is replacement property?

1.33  A particular depreciable or capital property acquired by a taxpayer will qualify as a replacement property for the former property owned by the taxpayer if it meets each of the following conditions that is applicable:

• it must be reasonable to conclude that the property was acquired by the taxpayer to replace the former property;
• it must be acquired by the taxpayer and used by the taxpayer or a person related to the taxpayer for a use that is the same as or similar to the use to which the taxpayer or a person related to the taxpayer put the former property;
• where the former property was used by the taxpayer or a person related to the taxpayer for the purpose of gaining or producing income from a business, it must be acquired for the purpose of gaining or producing income from that or a similar business or for the use by a person related to the taxpayer for such a purpose;
• where the former property was taxable Canadian property, the particular property must also be a taxable Canadian property of the taxpayer; and
• where the former property was a taxable Canadian property of the taxpayer that is not a treaty-protected property, the particular property must also be a taxable Canadian property of the taxpayer that is not a treaty-protected property.

1.34  A taxpayer is considered to have acquired replacement property at the time the acquisition would ordinarily be considered to have been made under the provisions of the Act and the general principles of law. See Income Tax Folio S3-F4-C1, General Discussion of Capital Cost Allowance, for a discussion of the time of acquisition of depreciable property.

1.35 In some situations, it may be necessary to purchase more than one property to replace another property. Conversely, two or more properties may be replaced with one property. However, in such situations, the specific facts must be considered to determine whether the particular property or properties purchased will be considered as a replacement property for the original property or properties.

Acquired to replace the former property

1.36  To satisfy the requirement described in ¶1.33(a), it must be reasonable to conclude that the property was acquired to replace the former property. In this regard, there must be some correlation or direct substitution, that is, a causal relationship between the disposition of a former property and the acquisition of the new property or properties. Where it cannot readily be determined whether one property is actually being replaced by another, the newly acquired property will not be considered a replacement property for the former property. For example, consider the situation where a taxpayer has a number of retail locations, some of which are in the process of commencing operations while others are scheduled for closing. A building at a new location probably would not be considered a replacement property for a building at an old location if the business operations at the two locations are carried on simultaneously (other than for a brief transitional period, for example, while the inventory at the old location is liquidated). Generally, the geographical location of the replacement property is not determinative when considering whether one property is a replacement for another.

Acquired for the same or a similar use

1.37  For an involuntary disposition, where a former property was not used for the purpose of gaining or producing income from a business, the following comments apply in determining whether a replacement property is acquired for the same or a similar use as required by the condition described in ¶1.33(b).

• This condition is met where the use of the property is the same or similar to the use to which the taxpayer or a person related to the taxpayer put the former property. Since the former property must have been used, land that has never been used by the taxpayer or a related person cannot qualify as a former property. Land or any other capital property that has been used for non-income earning purposes can qualify as a former property (for example, a personal-use cottage that is expropriated). Land that is acquired for resale cannot qualify because it is not a capital property.
• Although the replacement property generally will bear the same physical description as the former property, for example, land replaced by land or a building by a building, there may be cases where a different type of property provides the same use or function as the former property. For example, where shares of a cooperative corporation which carry rights to accommodation in an office building are acquired to replace an expropriated office building of the taxpayer, the shares could constitute a replacement property.

1.38  Where the former property was used for the purpose of gaining or producing income from a business, another property will usually be considered to be a property acquired for the same or a similar use if it is acquired to gain or produce income from the same or a similar business and if it generally bears the same physical description as the former property.

1.39  It must be kept in mind, however, that the same or a similar use test is still a separate test from, and is not overridden by, the same or a similar business test discussed in ¶1.41 to 1.44. So, for example, a residential property used to house a company’s employees would generally not be considered to have the same or a similar use as a building used to carry on the company’s day-to-day operations. This would be the case even though both properties are real property and are used in the same business.

1.40  Further, a property normally will not be a replacement property acquired for the same or a similar use when it is acquired to replace a former property and at the same time provide substantial other uses. An insignificant secondary use of a new replacement property is not a concern. A former business property cannot be replaced with a rental property.

Acquired to gain or produce income from the same or a similar business

1.41  The term similar business as used in the phrase “the same or a similar business” or “from that or a similar business” in ¶1.33(c) is generally interpreted in a reasonably broad manner. In this respect, two businesses will be considered to be similar if they both fall within the same one of the following categories:

• merchandising – retailing and wholesaling;
• farming;
• fishing;
• forestry and forest products;
• extractive industries, including refining;
• financial services;
• communications;
• transportation;
• construction, including subcontracting; and
• manufacturing and processing.

1.42  With regard to the categories referred to in ¶1.41, where a business falls into more than one, a similar business will be one that falls into any one of these categories in which the business operates.

1.43  A taxpayer who changes from one business category to another but continues to deal in the same product will normally be considered to be in a similar business. On the other hand, where a taxpayer carries on a number of separate businesses and the same products are not involved, these businesses will normally not be considered to be similar businesses.

1.44  Service industries, such as hotels, restaurants, repairs, professional services, barber and hairdressing shops, funeral parlours, laundries, real estate agencies, tourism, and entertainment, are not included in the general business categories referred to in ¶1.41, because most of these industries are too varied and different to permit categorization. Where there is a question of whether two businesses in a service industry or in any other industry not included in the categories in ¶1.41 are similar businesses, the determination will have to be made on the facts of the case. For such cases, similar business will generally be interpreted in a reasonably broad manner.

Other considerations relevant to the replacement property rules

Class 14.1

1.45  Effective January 1, 2017, the eligible capital property rules were repealed and were replaced by Class 14.1 of depreciable property under the CCA regulations. As a consequence, property that was eligible capital property on December 31, 2016, and expenditures and receipts occurring after that date that would have formerly been accounted for under the eligible capital property rules are accounted for under the rules for depreciable property and included in Class 14.1.

1.46  In the case of a voluntary disposition, the replacement property rules will only apply if, immediately before the disposition, the former property was a former business property. One of the characteristics of a former business property is that the property is real or immovable property or an interest therein. Property included in Class 14.1 (such as a farm quota) is generally considered to be intangible property and, as such, will generally not be former business property. Consequently, a voluntary disposition of such property will not be eligible for the replacement property rules.

Limited period franchises, concessions or licences

1.47  The term former business property includes a property that is the subject of an election under subsection 13(4.2). This means that the replacement property rules may apply where a taxpayer has disposed of or terminated a limited-period franchise, concession or licence. A taxpayer can defer any recapture or capital gain on the disposition or termination of such a property where the conditions in subsection 13(4.2) are met.

Subsection 85(1) election

1.48  In some cases, where a taxpayer disposes of a former business property to a taxable Canadian corporation and a subsection 85(1) election is made, a capital gain may result. In such case, a deferral of this gain is available pursuant to section 44 provided that the requirements of that section are otherwise met.

Amalgamations and wind-ups

1.49  Paragraph 87(2)(l.3) prevents the deferral rules in sections 13 and 44 from being lost in a situation where, before a section 87 amalgamation occurs, property of a predecessor corporation:

• has been unlawfully taken, lost, destroyed or taken under statutory authority, or
• was a former business property of the predecessor corporation.

Very generally, paragraph 87(2)(l.3) does this by deeming that the new corporation is the same corporation as, and is a continuation of, the predecessor corporation.

1.50  Similarly, paragraph 88(1)(e.2) prevents the loss of a section 13 or section 44 deferral in a winding-up to which subsection 88(1) applies. Properties distributed to a parent by a subsidiary in a winding-up are deemed by paragraph 88(1)(a) to have been disposed of by the subsidiary and are thus considered to have been acquired by the parent. As such, a property acquired upon winding up may serve as a replacement property for purposes of subsections 13(4.1) and 44(5) in respect of the disposition of a former property by the parent corporation if all of the other requirements of the relevant subsection are satisfied.

1.51  While paragraphs 87(2)(l.3) and 88(1)(e.2) prevent the deferral from being lost, it may not be reasonable to conclude that the property was acquired to replace a former property. Each situation must be considered on its facts to make this determination.

Amalgamation – rental property

1.52  Real or immovable property owned by one corporation and rented to another corporation becomes the property of the amalgamated corporation following the amalgamation of the two corporations. In this situation, if the amalgamated corporation uses the property primarily for the purpose of gaining or producing income from a business, it could qualify as former business property of the amalgamated corporation. This will be the case provided the property otherwise satisfies the requirements of the definition of former business property.

Partnerships

1.53  The replacement property rules apply to a partnership if the requirements outlined in ¶1.5 to 1.14 are met. The replacement property rules would also apply to a member of a partnership who acquires a replacement property for a personally owned former business property which is or was being used in the partnership business. However, these provisions would not apply to a situation where the partnership disposes of a former business property and a partner (or partners) acquires the replacement property. This is because pursuant to paragraph 96(1)(a), the partnership is considered to be a person separate from its partners for purposes of income and loss computations under subdivision j.

Partnerships – rental property

1.54  A building owned by a taxpayer and rented to a partnership in which the taxpayer is a partner would normally qualify as a former business property if it is used by the partnership to earn business income as opposed to earning rent. While the income received from the partnership for leasing the property is classified as rent, the owner is also considered to be using the property for business purposes as a member of the partnership. Where the rental income exceeds the owner’s share of the partnership’s business profits attributable to that building’s operations in a year, the comments in ¶1.29 and 1.30 apply.

Partnerships – wind-ups

1.55  Where a partnership is wound up, the partners may elect under subsection 98(3) to take an undivided interest, or for civil law an undivided right, in each property of the partnership. The undivided interests or the undivided rights may then be exchanged between the partners in order to permit a particular partner to become the sole owner of a particular property. This allows that partner to continue operating the business separately. Provided that the properties disposed of are interests in real property or rights in immovables that were used in the former partnership primarily to earn income from a business other than rent, they will qualify as former business properties.

Non-residents and deceased taxpayers

1.56  The replacement property rules can apply to a non-resident who has disposed of taxable Canadian property and who acquires a qualifying replacement property that is also taxable Canadian property as discussed in ¶1.33(e).

1.57  Where a taxpayer dies or ceases to be resident in Canada and is deemed pursuant to section 70 or paragraph 128.1(4)(b) to have disposed of a capital property, the replacement property rules do not apply. However, where a taxpayer dies, subsection 72(2) will, in certain circumstances, permit an election so that a reserve under subsection 44(1) may be claimed in respect of the deceased person.

Application

This Chapter, which may be referenced as S3-F3-C1, is effective April 8, 2019 and replaces and cancels Interpretation Bulletin IT-259R4, Exchange of Property and Interpretation Bulletin IT-491, Former Business Property, together with its special release, IT-491SR.
Any technical updates from the cancelled interpretation bulletin(s) can be viewed in the Chapter History page.

Except as otherwise noted, all statutory references herein are references to the provisions of the Income Tax Act, R.S.C., 1985, c.1 (5th Supp.), as amended and all references to a Regulation are to the Income Tax Regulations, C.R.C., c. 945, as amended.

Links to jurisprudence are provided through CanLII.

Income tax folios are available in electronic format only.

Reference

Sections 44, 70, 87, and the definition of proceeds of disposition in section 54; subsections 13(4), 13(4.1), 13(4.2), 13(4.3), 13(35), 13(37), 44(1), 44(1.1), 44(2), 44(4), 44(5), 44(6), 44(7), 72(2), 73(3), 85(1), 88(1), 98(3), 220(3.2), and the definitions of proceeds of disposition and undepreciated capital cost in subsection 13(21) and former business property in subsection 248(1); paragraphs 13(4)(c), 13(4)(d), 13(4.1)(a), 13(4.1)(a.1), 13(4.1)(b), 13(4.3)(a), 13(4.3)(b), 20(16.1)(b), 44(1)(b), 44(1)(e), 44(1)(f), 44(5)(a), 44(5)(a.1), 44(5)(b), 44(7)(b), 87(2)(l.3), 87(2)(l.4), 88(1)(a), 88(1)(e.2), 96(1)(a) and 128.1(4)(b); subparagraphs 13(4)(c)(i), 40(1)(a)(iii), 44(1)(e)(i) and 44(1)(e)(iii); clauses 44(1)(e)(i)(A) and 44(1)(e)(i)(B) and Part VI of the Regulations.

Note, all references to section 14 have been removed throughout the Folio.

Link to Source:https://www.canada.ca/en/revenue-agency/services/tax/technical-information/income-tax/income-tax-folios-index/series-3-property-investments-savings-plans/folio-3-capital-transactions/income-tax-folio-s3-f3-c1-replacement-property.html