Capital Cost Struggles

June 1, 2012

The struggle between landlords and tenants regarding capital costs is not a new one.  Commercial leases address this issue in a variety of ways.  A very recent decision of the Ontario Superior Court of Justice in RioCan Holdings Inc. v. Metro Ontario Real Estate Limited [2012] ONSC 1819 provides an in-depth analysis of language in a retail shopping centre lease that excluded from additional rent charges “expenditures which by accepted accounting practice are of a capital nature . . .”

The facts of the case are straightforward.  In 2002, RioCan (the landlord) rehabilitated the parking lot pavement of a shopping mall in Windsor, Ontario.  Rehabilitation is a process that involves pulverizing the asphalt and some of the granular base, compacting the pulverized asphalt and granular base and adding a layer of hot asphalt mix on top.  The total cost was $431,000 which RioCan (although not required to do so under the terms of the lease) amortized over twenty years.  Metro’s monthly instalment of this cost was $858 which it paid initially until it reviewed the matter in 2007/2008.  At that time, Metro disputed this cost, refused to make any further payments with respect to this cost and set-off the monthly instalments already paid from its future rent instalments.  The lease does not define what is meant by “accepted accounting practice”.

RioCan argued that this should include not only GAAP but also tax accounting practices.  It argued that “for there to be a finding that the new asphalt layer was capital in nature, there must be a future economic benefit to RioCan by way of increased rental income…”  The repaving of the parking lot did not result in any increased rent to RioCan.  It did not receive any direct revenues with respect to the parking lot.  Metro, on the other hand, successfully contended that it is not necessary to “engage in an exercise of trying to match particular revenues with the improved asset.”  The extension of the parking lot’s life and the significant reduction in on-going operating costs were more than sufficient for the repaving of the parking lot to be treated as a capital cost.  The fact that RioCan amortized the cost over twenty years suggests, by itself, that the cost is a capital one.

The court dismissed RioCan’s application and ruled in favour of Metro.  The rehabilitation of the parking lot was a capital expenditure and therefore, under the terms of the lease, could not be included as an additional rent charge.  RioCan was caught in a difficult situation.  It could not simply continue to patch and repair the parking lot each year as it had done before 2002 and charge the full cost to its tenants in the year they were incurred.  At some point, however, patching and repairing becomes ineffective and a rehabilitation strategy must be adopted.  By addressing the parking lot issue in a comprehensive and cost effective manner, RioCan was acting in a commercially responsible manner.  Unfortunately, this is not relevant when interpreting the lease.  As a matter of fact, the decision indicated quite clearly that “it would be odd for the internal accounting policies or decisions of the landlord to be a relevant consideration.  Otherwise the tenant’s rights may change if the lease is assigned to a different landlord that had different internal accounting policies.”  It should come as no surprise, therefore, that it is the lease that governs regardless of the landlords’ cost efficiencies or best practices.

What lessons can landlords learn from this decision other than to include capital expenditures in the definition of operating costs?  If there is tenant resistance to broadly worded capital expenditure provisions, the capital expenditure could be limited to those capital expenditures intended to reduce operating costs.  Set out the specific accounting standard to follow.  GAAP may not always be appropriate.  Include a provision to preclude tenants from objecting after the expiry of a certain period.

Counsel for RioCan has indicated that this case will be appealed.  Stay tuned.

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In our Leasing Times article entitled Capital Cost Struggles (June 1, 2012), we advised that the landlord had appealed the Ontario Superior Court of Justice decision in RioCan Holdings Inc. v. Metro Ontario Real Estate Limited 2012 ONSC 1819.  The Ontario Court of Appeal dismissed the appeal with costs to the tenant stating in its reasons that it was “not inclined to interfere with the application judge’s analysis or conclusion. Neither the words ‘repair’ nor ‘capital’ are defined in the lease. In that context, the application judge engaged in a careful and comprehensive review of all of the relevant factual circumstances surrounding this major project. His ultimate conclusions, including that the work significantly extended the life of the parking lot and significantly reduced the operating costs associated with parking lot, were entirely open to him. Importantly, even if these conclusions constitute a finding of mixed fact and law, they fall at the far end of the fact spectrum and deserve, therefore, substantial deference.”

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