30 March 2006 Internal T.I. 2005-0156181I7 - Conversion of inventory to capital property

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: An automobile dealership acquires vehicles for sale and places them in inventory. Clients may also select vehicles from this inventory for lease. No separate division for leased assets is kept by the auto dealership. Is there a conversion of the leased asset from inventory to capital asset?

Position: Previous position in IT-102R2 and other Rulings interpretations

Reasons: See paragraphs 4 and 6 of IT-102R2

 							March 30, 2006

	XXXXXXXXXX  TSO				HEADQUARTERS
							Income Tax Rulings
	Attention:  XXXXXXXXXX 			  Directorate
G. Moore
(613) 957-9232

							2005-015618

Conversion of Property to or from Inventory

This is in response to your memorandum of October 25, 2005, regarding the conversion of capital property to inventory. We apologize for the delay in replying.

As we understand it, the taxpayer is a large automobile dealership which sells and leases vehicles. The taxpayer does not maintain separate records for the leasing operation. Unless a vehicle is purchased specifically for leasing, all vehicles purchased are put into inventory. Vehicles specifically purchased for lease are classified as leasing assets for capital cost allowance ("CCA") purposes. When customers choose vehicles from the lot that they wish to lease, the vehicles are reclassified from inventory to leasing assets at their cost and CCA is claimed. Therefore, the leased vehicle class is made up of vehicles transferred from inventory as well as those specifically acquired for leasing. Vehicles are removed from the class of leasing assets after the expiration of their leases when they are sold to their third parties or transferred to used car inventory. You are asking our views on how the sales of the leased vehicles should be recorded. You have also asked for our views about whether Rulings interpretation 2000-0035017 contradicts the positions in IT-102R2, Conversion of property, other than real property, from or to inventory.

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 general rule is that a taxpayer that both sells and leases assets of the same kind would not be able to claim CCA on its leased assets and all of the properties must be treated as inventory from the date of acquisition, if the three conditions outlined in paragraph 4 of IT-102R2 are not met. The only exception to the general rule in paragraph 4 is found in paragraph 6 of IT-102R2. Paragraph 6 of IT-102R2 states that notwithstanding paragraph 4, a leased property may be a capital property rather than inventory if it falls within the circumstances described therein. While the facts seems to be clear that the taxpayer in your case does not satisfy the conditions in paragraphs 4(a), (b) and (c) of IT-102R2, they are not sufficient for us to conclude whether the leased automobiles fall within the circumstances in paragraph 6 of IT-102R2. For instance, it is unclear whether your reference to vehicles specifically acquired for leasing is simply meant as a reference to the fact that the vehicles are equipped with features normally demanded by renters in general or whether the said vehicles are also intended for long-term lease arrangements of the type referred to in paragraph 6 of IT-102R2. However, it is our view that, if you determine that the conditions described in paragraph 6 of IT-102R2 are not satisfied in the situation you described, treating the automobiles as depreciable property would not be appropriate.

As mentioned in paragraph 7 of IT-102R2, the facts of each case will determine whether or not a conversion of property, such as a car dealer's vehicle, from inventory to capital property or from capital property to inventory has occurred. It is the Agency's general view that a conversion is not considered to have taken place where a property that was purchased primarily for resale is temporarily leased in a business to earn income and the intention of the taxpayer is always to sell the property in the near future.

Where a property, such as a vehicle, is subject to a lease, a review of all the relevant facts and the lease agreement is necessary to reach a conclusion as to whether or not a conversion occurs when the property is first leased or when it will be withdrawn from leasing and will be disposed of. However, our general position is that a property that is subject to a long-term lease that meets the conditions indicated in paragraph 6 of IT-102R2 may be considered as capital property. Consequently, in a situation where a taxpayer acquires a property, such as a vehicle, with the intention of selling it but later on decides to permanently use it as a capital property to earn income from it, and the conditions in paragraph 6 of IT-102R2 are met, there will be a conversion of the property from inventory to capital property. Furthermore, as indicated in paragraph 3 of IT-102R2, while capital property that is used in a business or to earn income from it is not, as a general rule, converted to inventory simply because it is put on the market for sale, there are exceptions. For example, a franchise car rental agency would generally not be seen as having converted capital property to inventory where the leased cars are being replaced only when worn out or obsolete. However, where the leased cars are withdrawn from leasing prior to that time and are sold as an integral part of the agency's normal business operations a conversion of the cars to inventory may be considered to occur prior to their sale. In other words, although the prime activity of the agency is rental, such conversion might be considered to occur if the active sale of used cars (e.g., an active, ongoing sales campaign; a willingness to sell any car that are a few months old; regular advertising and an offer of a used car warranty) is essential to the profitability and efficient operation of the business.

With regards to Rulings' memo 2000-0035017, we believe that it is not in conflict with IT-102R2. The comments in that document relate to the conversion of capital property to inventory, and as such the comments in paragraph 8 of IT-102R2 are applicable. We would point out that the comments in the Rulings memo are applicable to a particular fact situation and it would not be reasonable nor correct to treat the memo as requiring the conversion of capital property to inventory whenever a taxpayer's main business is leasing. Based on the specific facts under review in the Rulings memo, it was concluded that a conversion of the trucks from capital property to inventory had occurred because the leased vehicles were withdrawn from leasing prior to the time when they would have been considered worn out or obsolete and were sold as an integral part of the taxpayer's normal business operations, the active sales of the used trucks being essential to the efficient operation of the business.

You have also asked for the legislative authority for the conversion of inventory to capital assets and vice versa. Although the Income Tax Act ("Act") contains provisions dealing with a change in use of a property from income-use to non-income use and vice versa (i.e., section 45 and subsection 13(7)) and paragraphs 39(1)(a) and (b) of the Act would generally require that a capital gain or a capital loss, respectively, should exclude the portion thereof that is on income account, the Act does not specifically address a conversion of income-use property from inventory to capital property and vice versa. However, the bulletin is based on legal principles gleaned from court cases. A review of our records for IT-102 indicates that the court cases considered in drafting the bulletin included the following: Sharkey v. Wernher (1955) 36 TC 275 (British House of Lords); Pinehill Investments Limited, 67 DTC 204 TAB; J. Bert Mac Donald, 70 DTC 6032 (Exchequer Court); Canadian Kodak Sales Ltd. 54 DTC 1194 (Exch); and Dorothy May Hughes v. The Queen 84 DTC 6110. In the Pinehill case, the Board found that at a certain point in time, property ceased to be capital and became inventory and the cost for inventory purposes was the market value of the property at the time of conversion to inventory. In the Hughes case, the taxpayer purchased an apartment building. About 6 months after the purchase, the taxpayer got approval for and converted the apartment building to strata title. The taxpayer then sold the units individually. The Court was satisfied that the taxpayer purchased the property as an investment but that she changed her intention when she applied for strata title approval six months after the purchase. The increase in value prior to her application for approval was found to be on capital account while the balance of the taxpayer's profit was on account of income.

The action of conversion does not constitute a disposition within the meaning of subsection 248(1) of the Act. It is, however, recognized that the ultimate disposition of a property that was so converted may give rise to a gain or loss on capital account, a gain or loss on income account or a gain or loss that is partly capital and partly income. Accordingly, with respect to capital property that has been converted to inventory, taxpayers may calculate capital gains or losses, if any, on the basis that a notional disposition of such property occurred on the date of conversion. The amount of such a notionally determined capital gain or loss in respect of a property will be the difference between its adjusted cost base, as defined in section 54 of the Act, and its fair market value on the date of conversion. These notionally determined capital gains or losses will be considered to give rise to taxable capital gains or allowable capital losses for the taxation year during which the actual disposition of the relevant property occurs and will be required to be so reported in that same year. The amount of any income gain or loss arising on actual disposition of the converted property will be determined in accordance with generally accepted accounting principles on the basis that its initial inventory value is its fair market value on the date of conversion.

For your information, some of the cases dealing with the subject of inventory versus capital assets include: Canadian Kodak Sales Ltd. 54 DTC 1194 (Exch); Anthes Equipment Ltd. 87 DTC 59 (TCC); Les Enterprises de Pipe-line Universel Ltee. 88 DTC 1384 Wang Canada Ltd. 91 DTC 1279 (TCC); Jake Friesen v. The Queen, 95 DTC 5551 (SCC); Plaza Pontiac Buick Limited v. The Queen, 94 DTC 6058 (FCA), Canadian Imperial Bank of Commerce v. The Queen, 2000 DTC 6207 (FCA); and Daybo Rentals Inc v. Her Majesty the Queen, (1994) 2 GTC 1019.

In conclusion, based on the limited facts available to us, the taxpayer in your audit does not appear to meet the exception described in paragraph 4 of IT-102R2. Accordingly, it must treat its leased vehicles as inventory from the date of acquisition for purposes of the Act, unless you determine that all of the conditions in paragraph 6 of IT-102R2 apply.

We trust that these comments will be of assistance.

For your information 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, they can be provided with the electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. You should make requests for this latter version to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

Bob Skulski
Manager
Business Incentives and Capital Transactions Section
Business and Partnerships Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch