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Landmark Ruling Favours Commercial Taxpayers Toronto, MPAC Appeal Decision on Assessment Approach
October, 2008
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FULL EDUCATION TAX DISCOUNT KICKS IN FOR NEW CONSTRUCTION
New commercial and industrial buildings will be immediately eligible for the reduced business education tax (BET) rate the Ontario government pledged in its 2007 budget, provided the building permits were issued after March 22, 2007. Ontario Regulation 315/08 recently established five new property tax classes for new construction to facilitate this lower tax rate, which will not exceed 1.6%. Meanwhile, the business education tax rate for existing commercial/industrial properties will be gradually reduced to 1.6% over a seven-year period ending in 2014.
The 2007 budget promise addressed commercial and industrial property owners' longstanding complaint about the patchwork of differing education tax rates across Ontario, which were based on the pre-1998 period when individual school boards levied taxes for their own purposes. Although the government did not implement a single equalized education tax rate - as is the case for all residential properties in Ontario - it introduced the plan for a seven-year phased reduction in tax rates.
Alternatively, some municipalities already have business education tax rates lower than 1.6% and these will not be increased.
The phase-in will translate into an annual $540-million tax cut across Ontario by 2014, with ratepayers in the Greater Toronto Area eventually realizing about $225 million in annual savings. For example, commercial ratepayers in the City of Toronto can expect a 19% tax decrease over the seven years.
Property tax classes have now been created for new construction in the commercial, shopping centre, office building, industrial and large industrial tax classes, but not all classes will necessarily be invoked in every municipality. The number of new construction tax classes will depend on whether the municipality has instituted any of the sub-classes that are currently allowed in the commercial and industrial property classes.
"These new classes will exactly mirror the choices that municipalities have already made," says Chris Broughton, Manager of the Property Tax Analysis Unit in the Ministry of Finance.
The new Regulation also requires that any new construction on a commercial or industrial property must increase the assessed value of that property by at least 50% before the new business education tax rate would apply. This guards against a property owner potentially erecting an inconsequential structure just to secure the tax reduction.
"Obviously, land values do vary quite substantially across Ontario," Broughton notes. "A 50% increase in some areas where land isn't very expensive could mean they wouldn't have to put up very much, but in a city like Toronto, it would have to be a fairly significant investment."
The new construction property tax classes should become redundant once the tax rate reduction is completely phased in. "At this point, it is hard to say whether the [separate] tax classes would continue after 2014 because once all properties are taxed at the same rate there wouldn't seem to be a legitimate point in keeping those classes, unless other factors come into play in the interim," Broughton says.
Until then, new construction will receive a tax benefit compared to existing properties. "From a policy point of view, when you are giving a lower rate to new construction, it is almost an economic development tool. However, this is only advisable if there is a plan in place to reduce all existing businesses down to the new lower rate over time - as the Province has done," reflects Dana Howes, Senior Economic Analyst in Durham Region. "Otherwise, such a policy for new construction is inadvisable because it creates another inequity in the taxation system."
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By Jeff Cowan
The Ontario Assessment Review Board (ARB) decision involving six office tower complexes in downtown Toronto represented the culmination of one of the most lengthy and complex assessment appeals ever determined by the Board or its predecessors. It took testimony from nine experts, weeks of hearings and a review of hundreds of exhibits leading up to the February 2008 decision on how income producing properties should be assessed for municipal taxation in Ontario
The resulting decision - which sided predominately with the taxpayers' interpretation of how business property should be valued - could result in a loss of millions of dollars in assessed taxes for the City of Toronto. The City of Toronto and the Municipal Property Assessment Corporation (MPAC) have sought leave to appeal the decision to the Divisional Court so a final determination of this case has not yet been made, but the findings of the Board are of interest to municipalities throughout the province.
At issue in this case was a 1998 amendment to the Assessment Act that required land, including buildings, to be valued at current value. This is defined as: "the amount of money the fee simple, if unencumbered, would realize if sold at arms-length by a willing seller to a willing buyer."
MPAC argued that it's not enough to value land by reference only to the owner's interest where that land is subject to a lease that creates a tenant's interest of substantial value. It should be the totality of the interests in the title that are used to determine an assessment value.
The Assessment Review Board disagreed. It noted that the 1998 amendments removed the former requirement that land be assessed against tenants to the extent of their occupancy as the basis for business taxes - and it contrasted the Assessment Act definition of land (a physical description including buildings and structures) with that of the Expropriation Act, which specifically defines the interests in land to be valued, including those of tenants.
The ARB further found that leases were legal encumbrances on an owner's fee simple interest, in that they limit an owner's ability to deal with its fee simple estate. The Board also noted that a tenant's lease interest in a lease was personal property, which was not subject to assessment.
In the end, the Board found that "fee simple, if unencumbered" did not express a legislative intent to assess all interests, including tenants' market interest or value (positive or negative) of its lease contract.
VALUATION ISSUES
Having determined the legal meaning of the statute, the Assessment Review Board had to decide which of the two competing valuation methodologies presented at the hearing best met this statutory definition. MPAC proposed a method that replaced current contract rents with current market rents, with standard allowances for vacancy and management expenses and a capitalization rate determined from market sales of comparable properties.
The taxpayers also advocated a method that replaced current contract rents with current market rent. However, the capitalization rate would be adjusted slightly upwards (from 8% to 8.75%) to reflect the added costs and risk of acquiring full current market rents for all leaseable areas for the entire property.
The Board accepted the taxpayers' methodology, noting that MPAC's own valuation guidelines provided that the unencumbered fee simple was to be valued "as if the subject space was vacant and available for let".
The Board also settled a number of corollary but important valuation issues, based on the extensive evidence given at the hearing:
• Market Rents: The Board found that market rents were to be determined for that of a typical tenant and a typical unit - in this case, a tenant occupying one full floor or more. MPAC had used all market rents available in the relevant timeframe, including less than full floor leases.
• Renewal Rents: While the taxpayers proposed assessing the value based on new leases of full floor tenants and not renewal rents, the Board found that renewals, expansions and "blend and extends" for a full floor or more were part of the market, and should be included in the assessment process.
• Adjustments to Face Rent: The Board also determined that face rents should be adjusted to reflect cash inducements, lease takeovers, rent-free periods and lease commissions. It also found that the standardized vacancy allowance should reflect the actual revenue loss incurred and be applied to the estimated potential gross revenue of the property, not the revenue after deduction for non-recoverable operating costs.
• Parking Income: The Board determined that parking revenue should reflect monthly charges for unreserved parking spaces only, and that income from transient (daily and hourly) use was not subject to assessment.
• Tenant Improvements: There was extensive non-contradicted evidence that new typical tenants attributed no value in exchange to the existing improvements, and the Assessment Review Board determined that the fair market rent was not to be adjusted upwards to reflect any value of tenant improvements. The Board clearly noted however that this finding was restricted to the facts of this case, and that the assessed value in other cases could include the value of tenant improvement.
Based on these established ground rules, the Board asked the parties to determine the appropriate market rents and resultant changed assessments. Both the results of the final assessments - and the status of the leave to appeal application - remain to be determined. Ironically, if the decision stands, the impact on assessment practice should not be significant given fluctuations, capitalization rates and traditional use of full floor leases.
Jeff Cowan is a Partner at WeirFoulds LLP in Toronto.
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