Friday, May 2, 2014
What Common Area Expenses Can the Landlord Pass On to the Net Lease Tenant?
Although there are certain standard practices that are common to most commercial leases, the landlord and tenant may negotiate terms that derogate from them.
A frequent concern is the tenant’s proportionate share of the common area maintenance ("CAM"). Usually, expenses of a capital nature that are incurred are considered to be the sole responsibility of the landlord and are excluded. Frequently, the lease may refer to accepted accounting practice for the definition of a capital expense. According to the Canadian Institute of Chartered Accountants (CICA) Handbook, whether an expense can be considered as a capital expense is dependent upon whether the service potential of the asset was enhanced and not simply maintained. An interesting discussion of the issue is found in the Ontario Superior Court of Justice decision in RioCan Holdings Inc. v. Metro Ontario Real Estate Limited, 2012 ONSC 1819.
In 2002, RioCan resurfaced the pavement of the parking lot at its shopping centre in order to correct some cracking and distress created by wear and tear of traffic and the elements. It then charged the tenant its proportionate share of the cost, amortized over 20 years, as part of the additional rent. From 2003 to 2006, the tenant’s predecessor paid the charges without complaint. However, in 2007/2008, the tenant decided that it would no longer be responsible for such costs because it considered them be capital in nature.
In 2002, the parking lot was "rehabilitated" by a process that involved pulverizing the asphalt and underlying granular base, compacting it, and adding a new layer of hot mix. RioCan amortized the cost ($431,000) over 20 years with the intention of passing it on to the tenants as additional rent.
In addition to engaging expert pavement and asphalt engineers to explain the nature of the "rehabilitation" and its consequences, the parties also retained accountants to assist the Court in deciding whether the cost ought to be capitalized in accordance with Generally Accepted Accounting Principles ("GAAP") or whether it was also appropriate to apply or seek inspiration from income tax accounting principles. Both accountants agreed that GAAP does not encompass tax accounting practices but the latter could nevertheless be useful because it uses the term "capital" while GAAP uses different terms such as "betterment".
According to RioCan, if an expenditure resulted in an enhancement of the expected future economic benefit to the owner, then such an expense would be a capital or betterment expense. To word it differently, RioCan would ask the question: Will the expenditure lead directly or indirectly to increased future net cash flows, i.e. an increase to rental income? If so then it should be treated as a capital expense. On the other hand, if the expenditure has the limited effect of maintaining an asset in operational condition, then such expenditure should properly be considered a repair which could be recovered from the tenants.
The tenant argued that the life span of the parking lot pavement was significantly extended by the expenditure thereby resulting in "enhanced service potential" of the parking lot.
RioCan argued that the relevant asset is not the parking lot but the shopping centre as a whole and there was no future economic benefit to RioCan resulting from the expenditure, i.e. the rents that were required to be paid were not affected and since the centre was fully leased at the time, there was no reasonable expectation of increased rent as a result of the expenditure.
The tenant’s engineer was of the opinion that the process used by RioCan, which consisted of breaking up the asphalt, mixing it and reusing it with the existing base, significantly extended the life span of the pavement by as much as 18 years. The tenant’s engineer described the process as "major rehabilitation" and not a "repair". The process used by RioCan and known in the industry as "IPP" is a relatively recent technique, i.e. subsequent to the 1980’s. The IPP process involves grading and compacting the mixture of asphalt and underlying granular material to form a new superior foundation.
The Court found that the expenditure caused the parking lot to be "as good as new", significantly extended its life and significantly decreased the operating costs of the parking lot. The Court noted that these are factors considered in the CICA Handbook for the determination as to whether the service potential of an asset has been enhanced and should be treated as a "betterment".
The Court accepted the tenant’s argument that although RioCan unilaterally amortized the expenditure over 20 years, there was nothing in the lease that required it to do so. Ordinarily, only capital costs are amortized not maintenance costs. Consequently, the tenant successfully argued that for RioCan to succeed, it must persuade the Court that it was permitted to charge its tenants the entire amount of the expenditure as a lump sum in the year that it was incurred. In other words, RioCan by unilaterally amortizing the expenditure, implicitly acknowledged that it was capital in nature.
The Court noted that although the engineering expert evidence submitted by the parties was reasonably consistent, the accountants differed in their conclusions as to whether the expenditure was capital or maintenance, mainly as a result of their disagreement regarding whether the shopping centre or the parking lot should be considered the relevant asset.
The Court found on the evidence that the rehabilitation of the parking lot was a significant capital project and not mundane, such as fixing potholes or painting lines, and which had the effect of reducing operating expenses and extending the life of the parking lot.
The Court rejected RioCan’s argument that the expenditure had no impact on the estimated life of the shopping centre taken as a whole. The Court found the argument to be illogical since otherwise, any capital expenditure for the parking lot, even a full demolition and rebuild, would never extend the life of the shopping centre as a whole.
The Court preferred the approach of the tenant that the parking lot is a component of the overall property and where an expenditure is incurred that results in a significant increase in the useful life of a component of the leased property, there is also an increase in the useful life of the leased property as a whole and of its service potential. The Court also agreed that there are economic benefits resulting from the expenditure on a parking lot that will extend its useful life as compared with a deteriorated parking lot.
In addition, the Court concluded that in determining whether an expenditure is capital in nature, it is not necessary to attempt to match a particular revenue with the improved assets and that indirect relationships are sufficient.
Examples of such indirect relationships that the Court gave include:
(a) Complying with the landlord’s lease obligations and thereby avoiding claims by its tenants;
(b) Retaining existing tenants;
(c) Attracting new tenants;
(d) Obtaining additional rent to the extent the landlord is entitled to rent as a percentage of the tenants’ sales and sales increase because of the quality of the property;
(e) Enhancing the economic value of the property, and
(f) Avoidance of possible claims from visitors to the property relating to injuries sustained in the parking lot.
Finally, the Court noted that expenses of a capital nature are not clearly defined in the case law and will depend on the particular facts of each case.
Legal counsel are continually being challenged by the acceleration of innovation in our society. While this is arguably more pronounced in the intellectual property domain, this case illustrates that the same is true in a more traditional “bricks and mortar” area of the law.
New technology is testing common definitions that are generally used but have not been updated in a timely manner. The definitions and interpretation of terms such as capital or maintenance are being challenged with the potential of having significant financial impact on the parties to a commercial lease.
Legal counsel should not overlook the importance of drafting clear definitions for important terms in commercial leases that risk being the potential source of costly litigation.