29 April 2004 Internal T.I. 2003-0048331I7 - Dealer's equipment rental

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues:

Whether the leased equipment of a dealer in heavy equipment is classified as inventory or depreciable property?

Position:

Probably classified as inventory.

Reasons:

Based on the particular facts and the jurisprudence

April 29, 2004

	XXXXXXXXXX  TAX SERVICES OFFICE	HEADQUARTERS
	Technical Services	L. J. Roy, CGA
(613) 957-8968
	Attention:  XXXXXXXXXX
		2003-004833

XXXXXXXXXX (hereinafter "ABC")

This is in reply to your memorandum of November 5, 2003, wherein you requested our opinion concerning the classification of rental equipment as depreciable property or inventory. Our understanding of the facts is as follows.

Facts

1. ABC is a Canadian-controlled private corporation, as defined in subsection 125(7) of the Income Tax Act (the "Act"), that was founded in XXXXXXXXXX.

2. ABC is an authorized XXXXXXXXXX.

3. The company sells, rents and services the full line of XXXXXXXXXX heavy equipment, XXXXXXXXXX. It also sells, rents and services some XXXXXXXXXX equipment, but this is a minor portion of the company's revenues and does not impact the rental equipment.

4. ABC has one sales force that is responsible for all of ABC's machines. Also, it has XXXXXXXXXX fully dedicated to the rental equipment.

5. ABC is organized into XXXXXXXXXX major divisions namely: XXXXXXXXXX.

6. The taxpayer's audited financial statements shows separately as current assets, the "inventories of machines, parts and work-in-progress" and the "rental equipment". The capital assets are presented as long-term assets.

7. A note to the audited financial statements discloses the original cost and the accumulated amortization of the rental equipment. Another note discloses the cost and the accumulated amortization of the capital assets.

8. Note 2 of the audited financial statements with respect to ABC's accounting policies indicates, among others, the following:

"XXXXXXXXXX".

9. In its audited statement of earnings, the taxpayer reports revenues from all sources as one item and reports separately the "amortization of rental equipment" and "amortization for capital assets".

10. In its internal income statement, ABC reports separately the revenues from sales of machines, parts and revenues for services. The cost of goods sold reflects the same disclosures with respect to these same elements. In addition, both the sales and the cost of goods sold of each section disclose separately the revenues from sales of new and used machines and those relating to the rental equipment.

11. Machines that are rented do not only include machines shown on the balance sheet as rental equipment but also include new and used machines held in ABC's inventory. ABC was obligated to lease those machines on a temporary basis due to a shortage of machines in the rental equipment. Such machines never become part of the rental equipment, but are transferred to the inventory of used machines (if they were originally part of the new machines inventory) once the lease term expires. The rental machines included in inventories varies from year to year and depend solely on market demand and the rental equipment availability.

12. The accounting amortization of the rental equipment is determined on an individual basis for each machine included in the rental equipment and is computed as XXXXXXXXXX% of the rental revenue generated by the particular machine.

13. The accounting firm that prepared the audited financial statement is of the view that the accounting amortization of the rental equipment is recorded in accordance with the principles of revenue recognition prescribed by the CICA Handbook.

14. When a machine included in the rental equipment is sold, its sales revenue is included in the total sales revenues of the company (like all other sales), the cost and accumulated amortization of the machine sold are removed and flow through the cost of goods sold. The difference, the accounting profit, is included in revenues.

15. From a tax perspective, the accounting amortization is added back on Schedule 1 and capital cost allowance ("CCA") is claimed with respect to the rental equipment. ABC uses a separate Schedule 8 from the one used for long-term capital assets to compute the CCA relating to the rental equipment.

16. CCA of the rental equipment is computed as the maximum amount permitted under the Act and the Income Tax Regulations (the "Regulations") for the given class with the following peculiarities:

a) The taxpayer computes the half-year rule on the cost of acquisitions for the year rather than the cost of acquisitions in the year in excess of the net proceeds of disposition (or capital cost if less) in that year as required pursuant to subsection 1100(2) of the Regulations.

b) Additions to machines included in the rental equipment are added to the undepreciated capital cost ("UCC") and are not subjected to the half-year rule. These additions are a rare event and are not significant. Additions to machines included in the rental equipment occur solely when ABC is convinced that the lease contract will result in the sale of the machines by the end of the lease or when the customer exercises the purchase option included in the lease contract. These are very special circumstances, as ABC's policy is to rent machines on an "as is basis" without any modifications. Any other policy would render the business less profitable given the short-term nature of the lease contracts.

c) When a machine from the rental equipment is sold, ABC reduces the UCC by the UCC of the machine at that time rather than by the lesser of the net proceeds of disposition and capital cost as required under the definition of UCC in subsection 13(21) of the Act.

d) The taxpayer computes the CCA of machines included in the rental equipment on a machine by machine basis, as though each machine were included in a separate class.

17. The total sales realized by ABC for some of the taxation years under audit are as follows:

	    (XXXXXXXXXX )
	    XXXXXXXX 	XXXXXXXX 

Revenues for machines	XXXXXXXXXX 	XXXXXXXXXX
Revenues for parts	XXXXXXXXXX 	XXXXXXXXXX
Revenues for services	XXXXXXXXXX 	XXXXXXXXXX 

Total per financial statements	XXXXXXXXXX 	XXXXXXXXXX 

The total rental income
included in the total revenues 	XXXXXXXXXX 	XXXXXXXXXX 

18. ABC's audited financial statements shows the following amounts with respect to the rental equipment and inventories of machines, parts and work in progress.

(XXXXXXXXXX )

	XXXXXXXX 	XXXXXXXX 	XXXXXXXX 	XXXXXXXX 

	Rental equipment	XXXXXXXX 	XXXXXXXX 	XXXXXXXX XXXXXXXX 

	Inventories of machines,
	parts and work in progress	XXXXXXXX 	XXXXXXXX 	XXXXXXXX 	XXXXXXXX  	

Your position

19. You are of the view that the rental equipment should be classified as inventory for the following reasons:

(a) The financial statements consider them as such.

(b) Note 2 to the financial statements states that those assets are rented on a short-term basis with the intent to sell them.

(c) Like inventories, machines included in the rental equipment are evaluated at the lower of cost less accumulated amortization and net realizable value.

(d) ABC reports sales of machines included in the rental equipment as income rather than capital gain.

(e) As per paragraph 4 of Interpretation Bulletin IT-102R2, ABC both sells and leases property of the same kind. Consequently, all proceeds from the sale of properties that were leased constitute income of ABC from the sale of inventory since it does not met conditions in (a) to (c) of paragraph 4 of Interpretation Bulletin IT-102R2.

(f) Based on your sampling, machines included in the rental equipment are often sold at a price that exceeds the acquisition cost of the machine. Therefore, it is your view that paragraph 6 of Interpretation Bulletin IT-102R2 does not apply.

20. Alternatively, if the rental equipment is not inventory, you believe that those machines would be subject to the specified leasing rules.

Representative's Position

21. The representative is of the view that if a machine is included in the rental equipment at the end of a given taxation year and is used to earn rental income, it does not meet the definition of inventory in subsection 248(1) of the Act, as its cost does not enter into the computation of ABC's income for that taxation year. This is also supported by the taxpayer's business experience, which has demonstrated that, on average, a machine included in the rental equipment generates rental income for a period ranging between XXXXXXXXXX months.

22. Although ABC's ultimate intention is to sell the machine in the short term, the well established commercial practice is to use the machine to earn income during the initial period that follows its acquisition. It is their intention to sell the machines leased within a XXXXXXXXXX month period. Hence, they do not sign rental contracts for a period exceeding XXXXXXXXXX months. Consequently, during the period referred in paragraph 21, the machine is rented to different customers for periods not exceeding XXXXXXXXXX months.

23. The tax treatment used by the taxpayer is similar to the accounting treatment. The rental equipment is presented as a current asset because machines are leased on a short-term basis. In the minority of cases, this classification is also due to the inclusion of a purchase option in the lease agreements. As a result, the short-term sale of machines is always a possibility and ultimately the intent of the taxpayer. Nevertheless, it is not inventory because the assets are amortized for accounting purposes and the amortization expense is separately disclosed in the Income Statement, as required by generally accepted accounting principles. This separate disclosure is not required for obsolescence provisions.

24. The representative referred to paragraphs 10 and 11 of the Interpretation Bulletin IT-102R dated May 16, 1977 which stated:

"10. Where a taxpayer is a dealer in certain type of property (normally automobiles or machinery and equipment), no capital gain is recognized when such property that was acquired for leasing purposes rather than as stock in trade is transferred to inventory to be sold. Such property would initially be treated as depreciable property subject to capital cost allowance at the appropriate rate. When the property is transferred to inventory, the cost for purposes of computing the trading gain or loss is either the undepreciated capital cost of property or the price that would have been paid at that time if the property had been purchased in an arm's length transaction, depending on the costing procedure consistently followed by the taxpayer. ...

11. As an alternative to the procedure described in 10 above, a dealer may choose not to classify as depreciable property automobiles or items of machinery and equipment acquired for leasing purposes but instead to carry such property in his inventory from the date of acquisition to the date of disposition. For purposes of valuing such property in an inventory, it is normally an acceptable practice to value the property at the amount that would have been its undepreciated capital cost if the property had been classified as depreciable property."

25. In their view, the treatment described in paragraph 10 and 11 of IT-102R is consistent with GST/HST Policy Statement P-133 - Transitional relief for lease/rental assets dated April 22, 1994 which states:

"It is possible, although rare, that assets may not have a primary business purpose (i.e., either for sale or for lease/rental). Specifically, past business practices may not indicate that particular vehicles are ordinarily held for one purpose or the other. In this case, the registrant would have an option of treating the goods as inventory or capital. ..."

26. They contend that machines included in the rental equipment are available for sale or lease and that according to the industry practice, and based on management's past experience, XXXXXXXXXX% to XXXXXXXXXX% of those machines will have to be rented in order to meet customers' demands. The percentage varies from year to year. Accordingly, they are of the view that ABC was justified and continues to be justified in taking the position that a machine included in the rental equipment constitutes capital property for income tax purposes.

27. While Interpretation Bulletin IT-102R2 does not specifically deal with this issue, they submit that there has been no indication that the position set in Interpretation Bulletin IT-102R and the approach taken by the taxpayer is not consistent with both administrative policy and the Act.

28. They are of the view that many companies in the sale and leasing business treat goods offered for sale as inventory and items and goods being leased as capital assets. This is especially true in the automobile industry, which is comparable to ABC's business.

29. Jurisprudence has well established that in circumstances such as ABC, it is appropriate to treat temporarily leased property as depreciable property which is then converted back to inventory at the time of sale. Their position is based on the following cases:

Plaza Pontiac Buick Ltd.v. M.N.R, 83 DTC 316

Sako Auto Leasing v. M.N.R. [1993] G.S.T.C.17, Canadian International Trade Tribunal

Our comments

Depreciable property of a taxpayer is defined under subsection 13(21) the Act as property acquired by the taxpayer in respect of which the taxpayer has been allowed, or would, if the taxpayer owned the property at the end of the year and the Act were read without reference to the available for use restriction, be entitled to a deduction under paragraph 20(1)(a) of the Act in computing income for that year or a preceding taxation year. Paragraph 20(1)(a) of the Act allows a deduction in respect of the capital cost of the property as allowed by regulation.

Subsection 1100(1) of the Regulations prescribes the amount of capital cost allowance that can be deducted under paragraph 20(1)(a) of the Act as a specified percentage of the UCC as of the end of the taxation year of property of the class. Element A of the definition of UCC in subsection 13(21) of the Act adds the capital cost of a "depreciable property". Paragraph 1102(1)(b) of the Regulations provides that a property will not be included in a prescribed class if it "is described in the taxpayer's inventory".

The term "inventory" is defined in subsection 248(1) of the Act as "a description of property the cost or value of which is relevant in computing the taxpayer's income from a business for the taxation year..."

It is our view that dealers who both sell and lease property of the same kind, will normally be considered to acquire, hold and sell such property as inventory. More specifically, the rental property should be treated as inventory from the date of its acquisition where it was acquired to be used in the same company or business. This position was one of the reasons for the deletion of paragraph 10 of IT-102R which the representative uses to support the taxpayer's position. That Interpretation Bulletin was replaced by Interpretation Bulletin IT-102R2 which applies to taxation years commencing after July 22, 1985. Consequently, the taxpayer cannot rely on the comments in paragraph 10 of IT-102R.

However, where a dealer can establish that he is carrying on a separate leasing business and can identify specific property which has been acquired for use in the leasing business and that the lease properties are normally sold for an amount that is less than their cost, such leased property will be considered to be acquired, held and sold as capital property. Based on the facts provided, we are not able to conclude that this exception applies to ABC.

In the case of Jake Friesen v. The Queen, 95 DTC 5551 (S.C.C.), the Supreme Court of Canada concluded that it was not required that a property contributes directly to income in a taxation year in order to qualify as inventory. In this respect, Justice Major made the following statements:

24. The plain meaning of the definition in s. 248(1) is that an item of property need only be relevant to business income in a single year to qualify as inventory: "relevant in computing a taxpayer's income from a business for a taxation year". In this respect the definition of "inventory" in the Income Tax Act is consistent with the ordinary meaning of the word. In the normal sense, inventory is property which a business holds for sale and this term applies to that property both in the year of sale and in years where the property remains as yet unsold by a business.

27. The respondent is asking this Court to interpret the definition of "inventory" as though it read:

"inventory" [for a taxation year ] means a description of property the cost or value of which is relevant in computing a taxpayer's income from a business for [the ] taxation year;

The principal problem with the respondent's interpretation is that the bracketed words do not appear in the definition in the Income Tax Act. The addition of these words to the definition effects a significant change to the sense of the definition. It is a basic principle of statutory interpretation that the court should not accept an interpretation which requires the insertion of extra wording where there is another acceptable interpretation which does not require any additional wording. Reading extra words into a statutory definition is even less acceptable when the phrases which must be read in appear in several other definitions in the same statute. If Parliament had intended to require that property must be relevant to the computation of income in a particular year in order to be inventory in that year, it would have added the necessary phraseology to make that clear.

28. The second problem with the interpretation proposed by the respondent is that it is inconsistent with the basic division in the Income Tax Act between business income and capital gain. As discussed above, subdivision b of Division B of the Act deals with business and property income and subdivision c of Division B deals with capital gains. The Act defines two types of property, one of which applies to each of these sources of revenue. Capital property (as defined in s. 54(b)) creates a capital gain or loss upon disposition. Inventory is property the cost or value of which is relevant to the computation of business income. The Act thus creates a simple system which recognizes only two broad categories of property. The characterization of an item of property as inventory or capital property is based primarily on the type of income that the property will produce.

33. Thirdly, the interpretation proposed by the respondent is inconsistent with the commonly understood definition of the term. In the ordinary sense of the term, an item of property which a business keeps for the purpose of offering it for sale constitutes inventory at any time prior to the sale of that item. The ordinary sense of the word also reflects the definition of inventory which is accepted according to ordinary principles of commercial accounting and of business. The Canadian Institute of Chartered Accountants has defined "inventory" as including, inter alia "[i]tems of tangible property which are held for sale in the ordinary course of business": Terminology for Accountants (3rd ed. 1983), at p. 81. In the specific context of real estate the Canadian Institute of Public Real Estate Companies states that land held for sale and land held for future development and sale is inventory: Canadian Institute of Public Real Estate Companies Recommended Accounting Practices for Real Estate Companies (November 1985), at p. 204-1.

Based on those comments, we do not agree with the representative's view that if the machine is included in the rental equipment at the end of a given taxation year and is used to earn rental income, it does not meet the definition of inventory in subsection 248(1) of the Act, as its cost does not enter into the computation of ABC's income for the particular taxation year. In our view, it is clear from the facts that the cost of such a machine will be relevant in computing the taxpayer's income in a year.

From an accounting perspective, ABC treats the rental equipment as current assets separate from its regular inventory and capital assets. Therefore, we have to determine if that fact is sufficient to conclude that the rental equipment is inventory as defined under subsection 248(1) of the Act.

On this issue, we believe that the following comment in Friesen is relevant:

34. ....I agree with my colleague that the express wording of the Income Tax Act is capable of overruling accounting and commercial principles where it is sufficiently explicit. Nevertheless, the Court should be cautious to adopt a[n] interpretation which is clearly inconsistent with the commonly accepted usage of a technical term particularly where an interpretation consistent with common usage is more natural on a plain reading of the definition.

In the Canadian Imperial Bank of Commerce v. the Queen, 2000 DTC 6207, (F.C.A.), on the issue of whether the bullion was described in inventory, the judge made the following statement:

Property is "described in" a taxpayer's inventory if it is inventory as a matter of fact and law. Inventory in its ordinary sense is simply stock in trade, or property held for sale in the ordinary course of a business. For income tax purposes inventory generally is any property the cost or value of which is relevant in determining income: Friesen v. Canada, [1995] 3 S.C.R. 103.

Consequently, it is our view that the ordinary sense of the term inventory must be taken into consideration in order to determine if the rental equipment is inventory. As stated in Friesen, the ordinary sense of the term inventory is an item of property which a business keeps for the purpose of offering it for sale constitutes inventory at any time prior to the sale of that item. Also, judge Major quoted The Canadian Institute of Chartered Accountants definition of inventory as including, inter alia items of tangible property which are held for sale in the ordinary course of business. The " Dictionnaire de la comptabilité et de la gestion financière " defines inventory as follow:

Articles qu'une entité détient à un moment donnée et qu'elle a l'intention de vendre ou d'utiliser pour fabriquer un produit ou rendre un services; valeur totale attribuée à l'ensemble de ces biens.

Based on the comments of the Courts mentioned above and the ordinary sense of inventory, we are of the view that the fact that the rental equipment is reported as current assets is not sufficient in itself to conclude that it is not inventory. Moreover, we believe that the position that the rental equipment of dealers who both sell and lease property of the same kind is inventory from the date of acquisition, is consistent with the common usage of the term inventory.

The taxpayer relies on the case Plaza Pontiac Buick Ltd v. M.N.R., 83 DTC 316 (Tax Review Board) to support his view that the rental equipment is not inventory before the time of sale and he quotes:

Neither is it necessary to determine whether the appellant's method of accounting for the leasing operation, the "inventory" and the "depreciation" associated therewith is proper or not. Indeed, as both a practical and professional approach, it has a great deal to commend it, and I make this point strongly. It may well be that for the purpose of accounting for the income of the appellant, treating the leased car stock as a current asset (inventory) is correct. It may be the only realistic way to do it, and indeed Mr. Sammeroff indicated that to be the approach generally used in the industry,...

This case was dealing with the inventory allowance deduction pursuant to paragraph 20(1)(gg) of the Act. Paragraph 20(1)(gg) permitted a deduction of an amount equal to 3% of the opening cost amount of tangible property (other than real property) that was described in the taxpayer's inventory and held by the taxpayer for sale in the ordinary course of its business.

It must be emphasized that this case, being a decision under paragraph 20(1)(gg) of the Act, was expressly concerned with the question of whether the assets were acquired for resale and not just a general definition of inventory which may or may not also require the asset to be acquired for resale. The Federal Court -Trial Division, 94 DTC 6058, dismissed the appeal since it made no sense to apply the paragraph in issue to the taxpayer's inventory of leased vehicles which were not sold, but were in fact out under lease generating revenue for the taxpayer. In this regard, the judge made the following statement:

"in our view, in order for the taxpayer to qualify for a deduction under the provisions, they had to be held for sale at every point of time during this period, which was clearly not the case, since they were leased to customers and were never repossessed for sale during this period. Their status could not be taken as mere use for leasing purposes; it was a contrary use, contrary to the notion of "held for sale".

We believe that this case cannot be relied on to conclude that the rental equipment is not described in inventory. This judgment, which was decided prior to the Supreme Court decision in Friesen, did not deal with the issue of whether leased vehicles were described in inventory, it only dealt with the condition that the property had to be "held for sale" under subparagraph 20(1)(g)(ii) of the Act.

In conclusion, it is our view that the accounting treatment of the rental equipment is not determinative of their nature for the purposes of the Act. Also, we are of the view that the facts submitted show that the taxpayer's intent is to sell the machines included in the rental equipment and that the fact they leased for short terms demonstrate that intention.

As a consequence, it is our view that unless the taxpayer can demonstrate that classifying the rental equipment as inventory goes against the commonly understood definition of inventory, we are of the view that the rental equipment constitutes inventory as that term is defined in subsection 248(1) of the Act.

However, we suggest that you discuss this issue with Mr. Tony Dibartolomeo, Automotive Specialist. He will be able to tell you how automobile dealerships treat their leased automobiles for tax purposes. Mr. Dibartolomeo can be reached at (519) 257-6621.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the CRA's mainframe computer. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the LAD version or they may request a copy severed using the Privacy Act criteria which does not remove client identity. Requests for this latter version should be made by you to Jackie Page at (819) 994-2898. The severed copy will be sent to you for delivery to the client.

We trust the above comments will be of assistance to you.

Ghislain Martineau
For Director
Financial Industries Division
Income Tax Rulings Directorate