Self Supply Tax and Rebate for residential rental construction

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We reach out to banks regularly to finance construction of rental building. Due to the high turnover as well as fast growth at the banks, there is a new analyst doing the grunt work financial and credit analysis of our construction proforma number. Whereas all other cost figures are pretty straight forward to understand, I have found analysts to be flummoxed by the self-supply HST number. Initially they reach out to their seniors in the banks who explain it to them as best as they could. Then the analysts reach out to me to confirm their understanding and I tell them that they have understood it wrong. So here I try to explain the concept of self-supply HST when it comes to construction of rental building.

What is Self Supply HST ?

From the Canada Revenue Agency website,

If a builder constructs or substantially renovates a residential complex that is:

  • a single-unit residential complex,
  • a residential condominium unit, or
  • a multiple-unit residential complex,

and subsequently supplies

  • the single-unit residential complex,
  • the residential condominium unit, or
  • a residential unit in the multiple-unit residential complex

by way of lease, licence or similar arrangement for use by an individual as a place of residence, the builder is deemed to have sold and repurchased (i.e., self-supplied) the residential complex at its fair market value generally

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when the unit is first rented. In the case of a multiple-unit residential complex, such as an apartment building, the builder is treated as having sold and repurchased the whole of the residential complex, i.e., the whole apartment building, at its fair market value generally when the first unit is first rented.

Why Self Supply HST ?

From the same website

The self-supply rules … apply only to “builders” and their purpose is to remove the potential tax advantage a builder would have in constructing or substantially renovating a residential complex and then offering the residential complex for rent or appropriating it for the builder’s personal use. A person who is not a builder who wanted to do the same would have to purchase the new or substantially renovated residential complex in a completed state from a builder and would have to pay GST/HST on the purchase. In the absence of the self-supply rules, the builder who constructs or substantially renovates a residential complex would generally experience a competitive advantage through tax savings on the non-taxable value that is added to the residential complex, such as the value of employed labour, financing costs and profit which would otherwise be realized through the sale price established by a builder who sells the residential complex.

Let’s take a simplified example

Say a builder constructs a residential rental complex at a cost of $100 Million and its market value is $200 Million. The builder would have paid $13 Million (at the rate of 13% comprising of 8% of Ontario provincial tax and 5% federal tax) as tax on the costs. Now if a REIT buys this from the builder, the REIT will have to pay $26 Million as tax.

From tax perspective, building a residential complex gives substantial tax advantages compared to buying a ready built residential complex. The purpose of self supply rules is to eliminate this tax advantage.

Note that the self-supply rules that apply to a supply of a residential complex are triggered only if the supply is by way of lease, licence or similar arrangement. The self-supply rules are not triggered if the supply of the residential complex is made under an agreement of purchase and sale.

In simple words, self supply tax is only triggered if the builder is renting out the newly constructed/renovated units.

When to Pay Self Supply HST ?

In the case of a newly constructed or substantially renovated multiple-unit residential complex or addition to a multiple-unit residential complex, the builder must generally self-assess GST/HST on the fair market value of the whole of the substantially completed multiple-unit residential complex or addition when possession of the first unit is given under a lease, licence or similar arrangement as a place of residence of an individual.

So in our proforma modeling, using the aforementioned example, $26 Million self supply tax is paid on the day building is completed and first unit is rented out.

What is the Fair Market Value ?

the fair market value represents the highest price, expressed in terms of money or money’s worth, obtainable in an open and unrestricted market between knowledgeable, informed and prudent parties acting at arm’s length, neither party being under any compulsion to transact.

So how does one estimate the fair market value of the building yet to be constructed in the proforma. One way is to ask an appraiser to provide us with a fair market value or the building “as completed” or “as stabilized” and use that to arrive at the HST value.

Alternatively, this is how I estimate the fair market value

  • In the rental proforma, calculate the stabilized NOI which is the annual NOI for Year 2.
  • Discount it by 2% rate (for inflation, turn over and rent increases during the year) to bring the NOI value one year.
  • Divide it by prevailing cap rate of 4.5% to arrive at the Fair Market Value.
  • HST is calculated by multiplying Fair Market Value by 13%.
  • The FMV is usually divide by Net Saleable Area (NSA) or Net Rentable Area (NRA) of residential units to arrive at FMV of each unit which is required to calculate NRRP rebate (as explained in following section).

New Residential Rental Property (NRRP) Rebate

At the same time, we also apply for the rebate under NRRP rebate program. One can consult with their tax advisor or visit the CRA website GST/HST new residential rental property rebate to find out more about how the rebate is calculated. To summarize,

Builders in Ontario are charged 13% HST on their self supply, which consists of a 5% federal tax and 8% provincial tax. The NRRP rebate in Ontario essentially kicks back 75% of the Ontario portion of the HST, which maxes out at unit value of $400,000. This results in a maximum rebate at a provincial level of $24,000 ($400,000 x 0.08 x 0.75) per unit. Federal rebate pays back 36% of the Federal portion of the rebate for units with a maximum rebate of $6,300. However, if the unit is valued at more than $450,000 no rebate is available. Based on the type of units constructed it can be substantial amount up to 50% of the self supply HST amount. For example, in our above example where $26 Million cheque was written to CRA, depending on the type of units build, the rebate could be as substantial as $11 Million. Thus the net HST to the builder would have been $15 Million ($26MM self supply – $11MM NRRP rebate).

As to timing of receiving the rebate, it varies. Builders usually apply for the rebate as soon as they file the payment. I generally model that the rebate is received at the end of lease up period. In reality, it could be later or earlier.

Proforma Modeling Consideration

From construction financing as well as cash flow perspective, it is imperative that the timing difference between payment of HST and receipt of rebate is understood. I have seen many a loan documents as well as proformas wherein the builder has modeled the net HST amount. This leads to a cash flow squeeze right around the time when the building is complete, all the credit limits are fully utilized because the bank approved a $15MM amount for the net HST amount whereas the builder ended up writing a cheque to $26MM to CRA and it will be some time before the rebate cheque is received from CRA.