1 May 1990 Income Tax Severed Letter AC74708 - Grain Swap and Inventory Allowance

R.A. Davis                                   Head Office
Director General                             Specialty Rulings
Compliance Research and                       Directorate
 Investigations Directorate                  F. Fontaine
                                             (613) 957-2094
Cord Ellis

                                             7-4708

Subject:   24(1)
         Grain Swap and Inventory Allowance

We are writing in reply to your memorandum of February 6, 1990, concerning transactions involving grain swaps between companies and the resulting inventory allowance claimed under section 20(1) (gg) of the Income Tax Act (the "Act").

In your memorandum you stated that officers of the Winnipeg District Office have requested our opinion related to the possible disallowance of the addition to the memorandum you provided the following information related to inventory allowance in situations where grain swaps have occurred. In addition to the memorandum you provided the following information related to the grain swaps.

- The taxpayers involved have inflated the value of their year-end inventory of grain by using swap agreements.

- A swap agreement is a written agreement between too grain companies which have different fiscal year-ends. The swap agreement details the terms of purchase and repayment of grain temporarily sold by one company to the other company. The effect of an agreement is to allow one company to acquire grain from the other prior to its year-end and thus inflate its year-end inventory above normal inventory levels required to carry on its normal business operations. The company acquiring the grain agrees to return it to the other company at the prearranged date after the year-end and at a prearranged price. The acquisition usually occurs a fern days prior to the year-end, and the return date is usually early in the month following the year-end.

- The primary purpose of the swap agreement appears to be to inflate the year-end inventory in order to claim a larger inventory allowance than would be allowed based on normal inventory levels of the business.

2. Subparagraph 20(1)(gg)(ii) also requires that the inventory on which the taxpayer calculates his inventory allowance be "held by him for sale". Paragraph IS of Interpretation Bulletin IT-435R states that the Department considers that inventory is "held for sale" by a taxpayer if:

a) he has title to or all the incidents of title, such as possession, use, and risk, even though legal title remains in the vendor as security for the purchase price,

b) it is described in his inventory, and

c) it is being offered for sale.

The argument exists that in a swap situation the inventory does fulfil requirement c) above. The inventory is offered for sale as it is held to fulfil an agreement for the return of specifically identifiable goods to their original owner. A similar argument was advanced by the Department in Bastion Management Limited v. 88 DTC 2344. In the Bastion case the taxpayer carried on the business of managing funds for third parties and also traded securities or commodities on its own behalf. The company purchased gold and silver bullion 5 days prior Co its year-end and covered any risk of loss by using futures contracts. The bullion was then sold 3 days after its obligations under the futures contracts. The taxpayer's deduction has been allowed at the Tax Court level on the basis that the futures contracts did not refer to specific or identifiable bullion and could not therefore be said to be rights to the billion in question The Department is currently appealing this case 21(1)(b)

                                         24(1)
3.   It is also our opinion that the Act requires that a taxpayer 
be the  beneficial owner of an inventory in order to qualify for
the inventory allowance.  Therefore, consideration could be given
to the possibility that the purchasing taxpayer is not the
beneficial owner of the grain. It could be argued that the grain
was loaned to a taxpayer prior to his year-end as opposed to
having been sold to him.

4. Consideration should be given to the reassessment of the companies which provided the grain to the taxpayers which have claimed the inventory allowances. Subsection 20(17) of the Act provides for a reduction of a taxpayer's inventory allowance where the taxpayer has disposed of a portion of its inventory in a "specified transaction" to a person with whom it was not dealing at arm's length. Paragraph 20(18)(b) of the act defines a "specified transaction" as:

a) a distribution by a corporation of qualifying inventory on or in the course of its winding up,

b) a disposition by a taxpayer of all or a substantial part of his qualifying inventory, or

c) a disposition at a particular time of qualifying inventory by a taxpayer one of the principal purposes of which was to permit a person with whom he does not deal at arm's length to obtain a deduction in respect thereof under paragraph 20(1)(gg) of the Act for that person's first taxation year commencing after the particular time, but does not include any such distribution or disposition by a taxpayer to another person during a taxation year of that other person that ends at least 11 months after the commencement of the taxation year of the taxpayer during which the distribution or disposition occurs.

The purposes of subsection 20(17) of the Act was to prevent a multiplication of the inventory allowance when non-arm's length parties engaged in transactions with a view to increasing their inventory allowances. Although it is a question of fact whether the companies involved were dealing at arm's length, it is our opinion based on the cases of Millward 86 DTC 6538, Chamberlain

82 DTC 1781 and Sayers 81 DTC 790, that the companies were not dealing at arm's length and therefore subsection 20(17) of the Act will generally apply to a company which provides grain for a swap transactions. Paragraphs 2, 6, 7 and 8 of Interpretation Bulletin IT-435R discuss the reduction in the inventory allowance deduction and illustrate its application.

                      21(1)(b)

5.                               24(1)

Subsection (iv) of the definItion of "disposition of property contained in paragraph 54(c) of the Act states that for greater certainty a disposition does include any transfer of property for the purpose only of securing a debt or a loan. Although this definition applies only to subdivision c, it indicates that subsection 20(17) of the act would not apply to a borrower as the borrower would not be considered to have disposed of the inventory. In addition, the transfer of grain as collateral would not cause it to be beneficially owned by the taxpayer and no inventory allowance could be claimed.

We trust our comments will be of assistance.

B.W. Dath Director Business and General Division Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch