| 19(1) | File No. 5-8540 |
| J. Chan | |
| (613) 952-9019 |
September 26, 1989
Re: Classification of Core Bits and Drilling Bits
We are writing in response to your letter dated August 15, 1989, wherein you requested our interpretation of the classification of core bits and Steel Body drilling bits used in drilling for petroleum and natural gas.
QUESTION 1 - Core bits
Whether core bits would be classified as inventory or depreciable property in any particular situation is a question of fact that can only be resolved by examination of all of the relevant facts of the particular situation. However, regarding the specific situation involving Company A which you described, we offer the following general comments which may be of assistance to you.
FACTS
Our understanding of the salient points in Company A's situation is as follows:
(i) Company A manufactures core barrels and core bits for two main purposes:
(a) rental of core barrels; and
(b) providing coring services wherein the primary equipment used is the core barrel.
(ii) During our telephone conversation of September 19, 1989 19(1) ,J. Chan) you advised that the core bits are not rented per se but are provided with the core barrel for use in the operation of the core barrel.
(iii) The core barrel generally lasts for four to five years.
(iv) The core bits are not repairable and are generally consumed within one year, depending on the number and type of jobs performed.
COMMENTARY
There seems little doubt that the core barrel would be depreciable property as there is an enduring benefit of four to five years. The operation of the core barrel requires a core bit, notwithstanding that the bit is not an integral part of the core barrel. The bit is an accessory to the core barrel.
You stated that the bits could be compared to the tires on a rental car.
In this case, the initial tires on a rental car would be classified as depreciable property and capitalized as a part of the acquisition cost thereof. After all, the tires are essential to the locomotion of the car which is designed to be used with wheels and must be evident in order for the car to be rented. In Mac Millan Bloedel (Alberni) Limited vs R., 73 DTC 5264 (F.C.T.D.) and Mac Millan Bloedel Industries Limited vs R., 73 DTC 5267 (F.C.T.D.), it was held that
"the initial cost of the tires was not a deductible expense. The trucks were capital assets and obviously could not function without tires. It was pointed out that there was other equipment or materials which required replacement or repair within the first year (such as fan belts and lubricating oil), but the appellant did not try to deduct these expenses presumably because the cost of such minor items was small in respect to the overall cost of the unit. The Court felt that segregating the tires from the rest of the unit was an arbitrary procedure with no rational basis in law.
Similarly, since the core bit is essential to the operation of the core barrel, the initial bit should be classified as depreciable property in the same manner as the core barrel.
After the usefulness of the initial bit has expired, which may be within a relatively short period of time, replacement would be similar to replacing the initial tires on a rental car. The costs associated with such replacement (including the replacement cost of the bit or tires) would be expended as being incurred in respect of the maintenance or repair of a property. In this regard, the comments in paragraph 4 of IT Bulletin l28R would be relevant.
OPINION
In our view, the initial bit provided with the core barrel should be classified as depreciable property.
Regarding the replacement bits on hand at year-end, treatment as inventory for tax purposes may be appropriate provided that the guidelines in paragraph 4 of IT Bulletin l28R have been met for treating these bits as items of repairs and maintenance. In this case, valuation at year-end would be subject to the provisions of section 10 of the Income Tax Act. Under these provisions, your suggested valuation at the lower of cost or market would be acceptable.
Question 2 - Steel Body drill bits
Your question regarding Steel Body drill bits (the "bits") is in relation to bits which you state "are held by the company primarily for rental purposes and therefore are considered to be a capital asset."
You suggest possible inclusion of the bits in class l2 or class l0 of Schedule II to the Income Tax Regulations (the "Regulations") and class 41 of the Draft Income Tax Regulations issued on December l6, 1987 (the "Draft Regulations") but advise that in your opinion they should be classified as class 12 property.
OPINION
We do not share your view entirely.
Based on the information provided, we would be inclined to concur with your interpretation that the bits would otherwise be classified as class 12 property by virtue of paragraph thereof i.e., the cutting or shaping part in a machine. However, Class 10 provides after paragraph (f.l) for
"property that would otherwise be included in another class in this Schedule that is... (t) a property acquired after May 22, 1979 that is designed principally for the purpose of
(i) determining the existence, location, extent or quality of accumulations of petroleum or natural gas,
(ii) drilling oil or gas wells,..."(underlining added)
That the bits would otherwise be included in another class (class 12) seems apparent. Whether or not the bits are designed principally for the purposes in subparagraphs (i) or (ii) above is a question of fact. However, the information provided - that the bits are used in the drilling for petroleum or natural gas - seems to satisfy the purposes described above and as such they would be classified as class 10(t) property.
As class 10(t) property, the bits would fall within the ambit of class 41 of the draft Regulations by virtue of subparagraph (b)(i) thereof.
The above comments are only expressions of opinion and as such should not be construed as advance income tax rulings, nor are they binding on the Department.
Yours truly,
Section ChiefResource Industries SectionBilingual Services and ResourceIndustries Division Rulings Directorate