Principal Issues: [TaxInterpretations translation]
The corporation buys XXXXXXXXXX for restoration or to build up an inventory of parts. It also rents them. When purchasing those XXXXXXXXXX, whether for parts or for restoration, what tax treatment should be applied to them? Inventory or capital assets? When disposing of those XXXXXXXXXX, should the profit generated be treated as a capital gain or as business income?
Position:
We are of the view that XXXXXXXXXX acquired for the purpose of restoration or for the purpose of supplying spare parts are inventory. Therefore, their disposal generates business income.
Reasons:
Our interpretation is based on the facts presented by the auditor and our analysis of the case law.
September 25, 2007
XXXXXXXXXX Tax Services Office Headquarters Income Tax Rulings Directorate Attention: XXXXXXXXXX Nancy Turgeon, CGA
2007-022675
Capital gain versus business income
This is further to your letter of March 8, 2007, concerning taxpayer XXXXXXXXXX ("Corporation"). You wish to know whether its XXXXXXXXXX sales should be recognized as business income or capital gain in the following situation.
Unless otherwise indicated, all statutory references herein are to provisions of the Income Tax Act (the "Act").
Our understanding of the facts of the situation you have presented to us is as follows:
- The corporation was incorporated on XXXXXXXXXX. It continues the activities of another corporation that had been operating since XXXXXXXXXX;
- XXXXXXXXXX;
- The corporation seeks out and purchases damaged and/or out-of-use XXXXXXXXXX in order to restore them. It then rents them out for a period often ranging from XXXXXXXXXX and sells them for a profit afterwards. XXXXXXXXXX were sold without even having been rented previously;
- The corporation leases its XXXXXXXXXX to other corporations, XXXXXXXXXX;
- The lessee XXXXXXXXXX is responsible for the routine maintenance and ensuring that it is returned to the corporation in the same condition as when it was first rented;
- No XXXXXXXXXX were leased over a long period of time in the audited years;
- The corporation also purchases XXXXXXXXXX for parts only. Once XXXXXXXXXX is disassembled, the parts are used to assemble and refurbish other XXXXXXXXXX;
- When the shareholder evaluates the damaged XXXXXXXXXX for restoration, he takes into account its acquisition cost and the costs he will have to incur to restore it to XXXXXXXXXX condition. His aim is to make a profit of approximately US$ XXXXXXXXXX per XXXXXXXXXX on resale;
- XXXXXXXXXX. He therefore knows that he will sell them quickly and get a good price;
- On the corporation's website (XXXXXXXXXX) it is stated that the corporation restores, rents and sells XXXXXXXXXX. There are no details about the rental, while the whole restoration process is described from dismantling to rebuilding XXXXXXXXXX, with photos. The site lists XXXXXXXXXX for sale. XXXXXXXXXX;
- During the visit to the place of business, the auditor saw XXXXXXXXXX and a room full of filing cabinets in which are stored parts (XXXXXXXXXX.) that will be used for future XXXXXXXXXX that will be restored;
- The representative states that the sale of XXXXXXXXXX is strictly for the cash flow needs of the corporation;
- The corporation is still in the process of restoring XXXXXXXXXX at a time. The time required to restore XXXXXXXXXX is approximately XXXXXXXXXX;
- You have noted that there is repetition of XXXXXXXXXX buy and sell transactions. The corporation appears to be moving towards XXXXXXXXXX machining. Direct costs are incurred to complete these steps. It appears that all XXXXXXXXXX are sold at a profit;
- You stated that in the corporation's books, the only two long-term loans finance the purchase of two wheeled vehicles. The remaining short-term financing at XXXXXXXXXX consists of a line of credit of $XXXXXXXXXX, a bank overdraft of $XXXXXXXXXX, a note payable of $XXXXXXXXXX and an advance from a corporation under common control of $XXXXXXXXXX;
- The corporation is currently dealing with a subcontractor accredited by XXXXXXXXXX to carry out the reconstruction of XXXXXXXXXX directly on the corporation's premises;
- XXXXXXXXXX;
- The taxpayer's representative is of the opinion that the principal activity of the corporation is the XXXXXXXXXX rental, and therefore treats the XXXXXXXXXX dispositions as generating a capital gain;
- From an accounting standpoint, the corporation does not start depreciating its XXXXXXXXXX until it starts renting them. For tax purposes, all XXXXXXXXXX acquisitions (for parts or for rebuilding) are added to Class XXXXXXXXXX and depreciated at a rate of XXXXXXXXXX% from the time of purchase;
- XXXXXXXXXX;
- A review of the latest financial statements shows that the corporation's XXXXXXXXXX generated rental income of $XXXXXXXXXX while its resales generated profits of $XXXXXXXXXX.
Your Questions
1. Should the sale of XXXXXXXXXX by the corporation be treated as generating a capital gain or business income?
2. For capital cost allowance purposes, can the corporation capitalize and depreciate all XXXXXXXXXX purchases including those purchased strictly for parts and those not in use?
Your Position
You are of the opinion that the numerous acquisitions XXXXXXXXXX, year after year, are for the purpose of building up a large inventory of parts necessary for the reconstruction XXXXXXXXXX. They show that the corporation's activities are mainly focused on restoring XXXXXXXXXX for resale. In your view, the rental income is only incidental.
You point out that by selling XXXXXXXXXX, the corporation recovers a lot of cash. Thus, the corporation appears to operate under a continuous process of acquiring parts and XXXXXXXXXX for the purpose of rebuilding others and reselling them. This is demonstrated by the operations of the last few years.
Furthermore, in your view, the issue of financing is an important criterion in the case law. Typically, income-producing properties are encumbered by long-term debt with a view to generating ongoing income over a long period of time. Typically, short-term financing is used for quick purchase and sale transactions.
Our Comments
Section 248(1) defines the term "business" as follows:
business includes a profession, calling, trade, manufacture or undertaking of any kind whatever and, except for the purposes of paragraph 18(2)(c), section 54.2, subsection 95(1) and paragraph 110.6(14)(f), an adventure or concern in the nature of trade but does not include an office or employment.
The courts have repeatedly considered the question of what constitutes a "business". In this regard, they have often used the definition of "business" as formulated by Jessel M.R. in Smith v. Anderson (1880), 15 Ch. D. 247 (C.A.), see inter alia, Canadian Marconi Corporation v. The Queen, 84 DTC 6267 (F.C.A.) and Louis Schultz and Thomas M.G. Schultz v. The Queen, 95 DTC 5657 (F.C.A.). Jessel M.R. defined a "business" in these terms:
"...anything which occupies the time and attention and labour of a man for the purpose of profit is business."
As stated in paragraph 8 of Interpretation Bulletin IT-73R5, Small Business Deduction, the CRA considers that if a corporation is incorporated to earn income by doing business, there is a general presumption that profits arising from its activities are derived from a business.
It should be noted that the presumption that income earned by a corporation in the course of an activity carried on in accordance with its constating documents is business income was raised in Canadian Marconi Corporation referred to above. The Court concluded that this presumption is logical but that the issue remains a question of fact in all cases.
In the present situation, we are of the view that the corporation carried on a XXXXXXXXXX sales and rental business.
The question is therefore whether the XXXXXXXXXX purchased for restoration purposes constitute inventory or capital property. Section 248(1) defines "inventory" as follows:
inventory means a description of property the cost or value of which is relevant in computing a taxpayer’s income from a business for a taxation year or would have been so relevant if the income from the business had not been computed in accordance with the cash method and, with respect to a farming business, includes all of the livestock held in the course of carrying on the business.
In Canadian Imperial Bank of Commerce v. The Queen, 2000 DTC 6207 (F.C.A.) on the issue of whether bullion was "described in the inventory", the judge stated at paragraph 25:
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.
In Bastion Management Ltd v. The Queen, 94 DTC 6272 (F.C.T.D.), the judge made the following comment on the definition of inventory:
This is a very broad definition. On its face it seems to include all property owned by a taxpayer which is relevant to its business. I accept counsel for the plaintiff's argument that such a broad definition is not proper. What constitutes inventory must be interpreted in the commercial and accounting contexts within which that term is normally used. Inventory is usually acquired for the purpose of selling it to make a profit thereon. There is usually an opening inventory and closing inventory by reference to which a taxpayer's income for a taxation year is calculated.
Finally, Major J. in Friesen v. The Queen, 95 DTC 5551 (S.C.C.) stated at paragraphs 33 and 34:
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. …
… 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 an 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 addition, Interpretation Bulletin IT-102R2 (Conversion of property, other than real property, from or to inventory) sets out, in paragraph 4, the CRA's position where a taxpayer sells and leases the same type of property. The paragraph reads as follows:
Where a taxpayer both sells and either rents or leases property of the same kind, it is the Department's position that all proceeds from the sale of property that has been rented or leased constitutes income of the taxpayer from the sale of inventory unless
(a) the taxpayer operates a separate and clearly distinguishable leasing division, including the keeping of separate records,
(b) specific property is set aside by the taxpayer for either renting or leasing and is factually so used, and
(c) properties that are so rented or leased are normally sold for an amount that is less than their cost to the taxpayer.
Where the conditions in (a) to (c) above are satisfied, the ultimate disposition of property used for short-term or long-term rental should be treated as a disposition of capital property.
The information you have submitted to us shows that the taxpayer does not satisfy at least one of the three essential criteria for treating its purchases as capital property. Indeed, condition (c) is not satisfied since the taxpayer sells for profit XXXXXXXXXX which it was leasing.
Furthermore, paragraph 1102(1)(b) of the Income Tax Regulations, provides that classes of property described in Part XI and in Schedule II shall be deemed not to include property that is described in the taxpayer’s inventory. We are of the view that the XXXXXXXXXX is not depreciable property. Based on the facts you have submitted to us, we are satisfied that the XXXXXXXXXX acquired for restoration are inventory. Consequently, the proceeds from the sale of the XXXXXXXXXX would be business income and not capital gain. With respect to the XXXXXXXXXX purchases for the parts, based on our previous comments, it appears that they should be treated as inventory and not depreciable property. Therefore, they should not be depreciated but rather treated as the cost of goods sold. Furthermore, the accounting treatment established by the taxpayer confirms this position notwithstanding the tax treatment it applied.
In conclusion, we are of the view that the corporation is engaged in the business of selling XXXXXXXXXX which it restores. The rental income appears to us to be incidental income. Consequently, the XXXXXXXXXX restored or acquired for parts are inventory goods to be taken into account in computing the cost of goods sold.
Access to Information
For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. 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, the electronic library version can be provided. Alternatively, the client may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Ms. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
We hope that these comments are of assistance.
Louise J. Roy, CGA
Interim Manager
Business and Partnerships Section
Business and Partnerships Division
Income Tax Rulings Directorate.