Tri-Star Leasing (London) Inc. v. MNR, 92 DTC 1786, [1992] 2 CTC 2099 (TCC)

Sarchuk, T.C.CJ.:—This is the appeal of Tri-Star Leasing (London) Inc. (TriStar) from assessments to tax with respect to its 1986, 1987 and 1988 taxation years.

Tri-Star is a leasing company whose business consisted of the leasing of photocopiers and multi facsimile machines during the years under appeal. In computing its income for the 1986, 1987 and 1988 taxation years Tri-Star, by way of “lease inventory write-down” sought to deduct a portion of the cost of equipment acquired by it in each year for the purpose of leasing to its customers. The amount so deducted by Tri-Star was $27,457 in 1986, $152,400 in 1987 and $233,495 in 1988.

By reassessment the respondent disallowed the deductions claimed and reclassified the inventory as depreciable assets within Class 8 of the Income Tax Regulations, C.R.C. 1978, c. 945 as amended (the Regulations). The respondent allowed the maximum amount of capital cost allowance to be deducted by Tri- Star for each year in respect of those assets in accordance with Tri-Star's instructions in that regard. The respondent also included in Tri-Star's income for 1987 an amount of $918 which amount represented the excess of proceeds of disposition over the fair market value of an asset that was disposed of by Tri- Star in 1987, the inclusion of which in Tri-Star's income is not disputed by the appellant.

The issue before me is whether the leases entered into by the appellant are in law a true lease or whether they are a financial lease or conditional sales agreement. Counsel agree that if they are a true lease then the assets in issue are Capital assets and the only depreciation that could be claimed against those assets is capital cost allowance. If, on the other hand, they constitute a financial lease or a conditional sales agreement, then the assets may be considered part of the inventory of the appellant and since there is loss of value, depreciation of such loss of value could be claimed each year by Tri-Star in the computation of its income.

Evidence was adduced on behalf of the appellant from Mr. Rickland R. Cooper, the President and Manager of Tri-Star; Mr. Peter Schultz, a chartered accountant and Mr. John M. Savel, also a chartered accountant.

Mr. Cooper has been in the photocopier business since 1973. In 1978 he became co-owner of London Photocopy Ltd. which was the authorized Sharp office equipment dealer of facsimiles and photocopiers in the London region. Approximately 75 per cent of the equipment that London Photocopy sold went to leasing companies who in turn leased it to their customers. In 1986 Cooper and his partner in London Photocopy incorporated Tri-Star. Mr. Cooper testified that the decision was taken primarily because from a retail standpoint sales of equipment by London Photocopy only produced a margin of $200 to $300 per unit. On the other hand the leasing company which purchased the product earned from $1,200 to $1,500 over the course of a three or four-year lease "by financing it and charging interest above what the retail price of the equipment is worth”. They concluded that rather than have London Photocopy deal with an unrelated leasing company a more productive arrangement should be considered, henceforth Tri-Star. There is no dispute that Tri-Star is related to London Photocopy, it operated from the same place of business, both companies had the same clerical staff and Mr. Cooper indicated that he is the manager of London Photocopy as well as of Tri-Star.

Mr. Cooper asserted that the lease payments made by Tri-Star's customers are based on the capital cost of the equipment to the appellant plus what he called an"interest portion” reflecting the customer's cost of borrowing money. He alleged that the rate of interest charged is substantial and results in significant income over the course of a lease. The system utilized by Tri-Star is, according to him, consistent with that of all of the other leasing companies involved in the photocopy business.

Once Tri-Star was incorporated the process was as follows. When a customer required a piece of photocopy equipment Tri-Star would arrange to purchase it from London Photocopy (e.g. Exhibit A-1). Tri-Star would then enter into a lease with the customer for that equipment. A standard lease form was used in all instances (Exhibit A-22), and several examples of completed leases were tendered in evidence (Exhibits A-2, A-8, A-11, A-14). Mr. Cooper indicated that all Tri-Star leases were registered. Included as part of each lease on the advice of Tri-Star's solicitors is a document from the Minister of Consumer and Commercial Relations (Ontario) captioned Financing Statement". Mr. Cooper explained that this was to retain ownership and the entitlement to seize goods in the event of non-payment (Exhibit A-3).

The cost upon which the lessees payments were based was the cost of the equipment to Tri-Star. For example, the lease with the Corporation of the City of Woodstock dated June 29, 1988 (Exhibit A-2) was for a period of 42 months. It disclosed the cost of the new equipment as $4,295 and called for monthly payments of $1,420 for a total lease cost to Woodstock of $5,964.

On May 17, 1991 Tri-Star sent what Mr. Cooper called a "buy out letter” to Woodstock (Exhibit A-4). This letter advised Woodstock that on June 29, 1991 a "purchase option" for the leased equipment was available and that for an amount which represented 20 per cent of the original purchase price Wood- stock was at liberty to buy the equipment. Woodstock was also advised that upon failure to exercise the "option" the lease would run to expiry at which time the lessees would be able to purchase equipment at fair market value; to upgrade; to renew the present lease; or to return the equipment to Tri-Star.

Mr. Cooper stated that all lessees were entitled to “purchase options” similar to that utilized in the Woodstock transaction. These "options" were not written into the leases but, he said, the information was contained in Tri-Star's rate card. He later added that the option is discussed with the lessees when the lease is negotiated but the customer is not provided with the rate card nor is it disclosed to him. It is my understanding that the rate card referred to is merely an aid to Tri-Star's sales staff. Using the 42-month lease as an example, Mr. Cooper explained that the prospective lessees would know only that they could, at the 36-month point, purchase the equipment at a cost equivalent to 20 per cent of the total lease cost or at the termination of the lease (42 months) at fair market value.

These "options" were not available to the purchaser at any time other than that set by Tri-Star. On the other hand if a lessee wished to purchase the equipment during the currency of the lease separate arrangements could be made. Mr. Cooper indicated that a small but not insubstantial percentage of Tri-Star’s customers did so. He also advised the Court that the early purchase price was arrived at essentially by way of negotiation and by considering the length of time, into the lease, the rate of interest and so forth. From the price so reached Tri-Star deducted the payments already made by the lessee.

An examination of the leases introduced into evidence disclosed, with one exception, that all transactions followed the same general pattern. The exception is the lease entered into between Tri-Star and Lon Real Group Inc. In this case a handwritten note records in some abbreviated form the discussions between the lessor and the lessee. It indicates the existence of a form of buy out by lessee in the amount of $1 after 24 payments. Mr. Cooper specifically noted that such information was not normally provided to the lessee. He described this as an unusual case and reiterated that the lessees would only be told that an option" to buy would be available at "fair market value”.

Evidence was also given as to the usable life of the equipment at the end of the lease. Mr. Cooper said this would range from no further usable life to one or two years depending on the use (or abuse) by the customer. He indicated that it was very individualistic but that for reasons of redundancy and obsolescence most customers were desirous of trading in the equipment at the three and a half or four year mark.

It was his evidence as well that fair market value at the four year point of time was, generally speaking, very low. For Tri-Star, once a piece of equipment has been rented for that period of time it was worth nothing. Tri-Star was not interested in retention and resale since it was not practical and there was no real second hand market. The general consensus in the industry was that fair market value at the four year point of time ranged between two and one half per cent and ten per cent. These factors, of course, made it particularly important and advantageous to treat the equipment as inventory.

Appellant's position

The appellants position is two-fold. The primary submission is that the only appropriate characterization of the agreements the appellant entered into during the years under appeal is that they constitute a financial lease or a conditional sale. At trial counsel advanced an alternative argument not previously pleaded. He submitted that in the event the Court were to find that the equipment constitutes a capital asset rather than inventory, then each lease agreement would correspondingly constitute a disposition of a capital asset. In this context he relies on paragraphs 13(21)(c) and 13(21)(d) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the"Act").

Respondent's position

Counsel for the respondent argued that Tri-Star was in the leasing business and that the agreements it entered into were true leases. This results in a conclusion that the equipment in issue is a capital asset and the only depreciation that can be claimed against those assets is capital cost allowance. With respect to the alternative argument counsel submitted that if the Court concludes that the lease agreements were true leases, (with the result that the assets leased were capital assets) it would not be possible to find on the same facts that the leases entered into by Tri-Star and its customers were sales agreements which constituted a disposition of a capital asset in the taxation years in issue.

Conclusions

In essence the appellant is asserting that the lease it enters into with its clients does not reflect the totality of the agreement and that there was in each case a specific and certain collateral agreement with respect to the so-called purchase option. Parol evidence may, in certain circumstances, be adduced to establish such an agreement. However such evidence must unequivocally establish the facts asserted, i.e. the existence of a separate contractual arrangement. The evidence adduced falls short of establishing that there was, in each case a collateral agreement. It is difficult to understand how counsel for the appellant can argue that, notwithstanding the customer's refusal to execute a lease agreement containing an option clause, there was nonetheless a meeting of the minds. I would be most surprised if any lessee dealing with Tri-Star would be prepared to accept the proposition advanced. In any event it was open to the appellant's counsel to have adduced evidence to establish this point. There is in my view no adequate evidence of a collateral agreement specific in its terms and enforceable.

There are other reasons for rejecting the appellant's position. The so-called options to purchase of which the lessees were advised during the currency of the lease term were based on amounts which on the evidence adduced were either higher than or at least equal to the fair market value of the asset at the time the option could be exercised. Mr. Cooper conceded that in each case whether the transaction ultimately ended in an early purchase by the customer, or a purchase at the 36-month "option" stage or was purchased at the end of the lease, the equipment is not sold at an amount less than fair market value. He conceded that at 42 months the value would generally be marginal but stated that at the 36-month point of time the 20 per cent of cost charged represented either fair market value or better, although that would depend on the specific piece and the user. There was, as I see it, no enforceable right during or at the expiration of the lease, to acquire the property at a price which at the inception of the lease is substantially less than the probable fair market value of the property at the time of permitted acquisition by the lessee. Nor can it be said that the lessee had the right, and by this I mean enforceable right, during the lease or at its expiration to acquire the property at a price which the lessee knew at the inception of the lease was such that no reasonable person would refuse.

The lease agreements did not refer to the lease payments as being comprised partly of a capital payment and partly of an interest payment as suggested by the appellant. While an interest factor may be part of the basis upon which the appellant calculated its leasing charges, the leasing agreements themselves provided for fixed payments regardless of the term with no adjustments for fluctuating rates of interest. It seems to me that the manner in which Tri-Star calculates the price at which it is prepared to lease any particular piece of equipment is virtually irrelevant in this case for the purposes of determining whether the agreement in issue is a lease, conditional sales agreement or a financial lease.

With respect to his primary argument counsel for the appellant relied upon the following decisions: Marcotte (B.) v. M.N.R. (1960), 25 Tax A.B.C. 129, 60 D.T.C. 519 (T.A.B.); Chibougamau Lumber Ltée v. M.N.R., [1973] C.T.C. 2174, 73 D.T.C. 134 (T.R.B.); The Queen v. Lagueux & Frères Inc., [1974] C.T.C. 687, 74 D.T.C. 6569 (F.C.T.D.); The Queen v. Moore (H.N.), [1986] 2 C.T.C. 22, 86 D.T.C. 6325 (F.C.T.D.); and C.R. Stewart Equipment Ltd. v. M.N.R., [1977] C.T.C. 2232, 77 D.T.C. 176 (T.R.B.). Counsel also referred to Interpretation Bulletin IT-233R.

In Marcotte the document at issue was described as a "Lease with Promise of Sale". It granted to the "lessee" the right to purchase the property at the expiry of the lease at a fixed price. The Board found that it was the intention of Marcotte to sell the property and not to rent it. It also found that the clauses of the agreement were all provisions normally found in contracts of sale but not in leases, and that the clause in the agreement setting forth the consideration clearly established that it was a selling price payment rather than annual rent. The Board, not surprisingly, held that the agreement, while taking on the form of a lease, was in substance a contract of sale.

In Chibougamau Lumber the question before the chairman was whether the agreements in issue were true rental agreements or whether in fact they represented the purchase on time of the equipment mentioned in each respective contract. Additionally, the second part of the agreement was an "Option to Purchase: Supplement to Lease of Personal Property" which gave Chibougamau Lumber the right to purchase the property after all payments had been made under the lease agreement for the sum of $1. This option could be exercised at any time, but if exercised before the end of the instalment period, all instalments had to be paid. If exercised after the end of the instalment payment period, it was to be exercised within 30 days. The Board concluded that in each instance the contracts represented no more than a purchase on a time-payment plan and were not"by any stretch of the imagination leases in the true legal sense of that term".

In Lagueux & Frères the contract in issue gave the "lessee" an option to purchase the equipment at a nominal price at the end of the lease. It was also a fact that except for interest and administrative costs which were added to the monthly payment the actual cost of the equipment was the same whether it was bought or leased. The Board held that the provisions of the agreements before it conferred on the parties the rights and liabilities of a conditional vendor and a conditional purchaser, and that the purpose of the contracts was to allow the taxpayer company to purchase equipment on the instalment plan.

The decision in Moore includes a lengthy review of certain propositions found in the handbook of the Canadian Institute of Chartered Accountants designed to assist their practitioners in determining whether a lease is to be classed as a capital outlay or an operating lease. These propositions were reviewed by the Court and while they are of some interest they must be read in the context of that particular case. In Moore the lease related to land was, for a period of 60 years, granted an option in respect of which the Court found there was reasonable assurance that the investors would exercise the option in view of the fact that they were to construct a 33-unit apartment on the site. For rather obvious reasons the Court concluded that the lease exhibited all of the characteristics of a capital lease and so found.

These cases provide little assistance to the appellant since each is markedly distinguishable on its facts. In order to determine the nature of the agreement before me it is necessary to look at the language of the contract itself, its purpose and the circumstances surrounding the conclusion of the contract. To that extent it is appropriate to look to the common intent of the parties in addition to looking at the manner in which the contract is framed. In the appeal before me the appellants basic proposition is premised on the existence of a collateral agreement beyond that found in the agreements filed as Exhibits A-2, A-8, A-11 and A-14.

The fact that distinguishes the agreements before me from those found in the cases cited by the appellant is the absence of any enforceable option to purchase being granted thereby to the lessee. Not only is an option not found in the agreement itself, its absence is deliberate, Mr. Cooper said, and I quote:

. . . Our understanding from our lawyers was basically if you provide, whether it be Tri-Star Leasing or London Photocopy, the agent of Tri-Star Leasing, if you provide documentation to potential clients that they have a specific dollar value purchase option then it becomes a conditional sales contract, which from a client standpoint of view meant they could not write the lease payments off, they had to capitalize it, and by doing so people did not want anything, they put the trust in us of what we were telling them is this is your purchase option, you will be notified of it 20% at the end of 42 months it will be fair market value.

I agree with the comments advanced on behalf of the respondent by his counsel that the leases in issue did not constitute a sale or disposition of the assets, either as inventory or capital.

On balance I am not satisfied that the appellant has established that the assessments were in error. The appeals are dismissed.

Appeals dismissed.