Kamsel Leasing Inc. v. MNR, 93 DTC 250, [1993] 1 CTC 2279 (TCC)

Sarchuk, T.C.C.J.:—Kamsel Leasing Inc. (Kamsel) is incorporated pursuant to the laws of the Province of Ontario and carries on the business of leasing chattels and equipment. It appeals from reassessments to tax with respect to its 1984, 1985 and 1986 taxation years by virtue of which the Minister of National Revenue increased its income by $831,447 in 1984; $921,442 in 1985; and $998,002 in 1986.

The reassessments arose as follows. With respect to its business Kamsel considered itself as the holder of intangible assets represented by a portfolio of leases, and not as owner of capital property represented by the underlying chattels or equipment which were the subject matter of the leases. These leases were treated for accounting purposes as direct financing leases pursuant to which the cost of a lease to Kamsel, representing its outlay to secure and enter into the particular lease, was amortized over the term of the particular lease. Kamsel accounted for its leasing income by crediting to income the entire amount of the leasing charge. Leased assets were carried at cost, less amortization, which was based on writing off the applicable value of the lease in equal monthly amounts, over the life of the lease. [1] In the preparation and filing of its returns of income for the taxation years in issue Kamsel reported its income on this basis and took deductions based on its amortization of lease costs.

The respondent disallowed the deductions as claimed and reclassified the chattels as depreciable assets within Class 8 of the Schedule as set out in the Income Tax Regulations (Regulations). In so doing the Minister of National Revenue treated the property as depreciable property within the meaning of the Income Tax Act (the Act), the cost of which was capital and not deductible by virtue of paragraph 18(1)(b). The Minister therefore limited the deductions available to the extent provided by paragraph 20(1)(a) and Part 1100 of the Regulations and allowed the deductions to that extent only.

The issue before me is whether the lease utilized by Kamsel is a direct financing lease as asserted by the appellant or a true or operating lease as asserted by the respondent.

Five witnesses testified on behalf of the appellant, Ruth Ann Adams, the manager of Kamsel; Jeffrey L. White, a sales representative with K.E.L. Communications; Larry D. Dibbley, a chartered accountant, and two expert witnesses, Ralph Fraser Selby, a chartered accountant and Martin Leo O’Brien, a solicitor. What is relevant in their testimony follows.

Ms. Adams has been associated with Kamsel since 1980 and is responsible for approving credit and attending to collections. She described its business as the leasing of equipment with emphasis on what is known in the industry as "small ticket" items such as office equipment and furniture, communications and computer systems, photocopiers, word processors and cellular telephone systems. Kamsel carried no inventory or stock of equipment for leasing, did not maintain any storage facilities and had no staff to provide maintenance, service or repairs. Adams considered the business of the appellant to be essentially the provision of a financing service to both the suppliers and purchasers of such equipment. It did not advertise but relied on referrals and repeat customers for the bulk of its business and had developed a reputation as a reliable provider of such services. Both Dibbley and Adams stated that the profits of Kamsel were substantially derived from the margin between its cost of funds and the yield provided by the payments from the lessees to it under the leases. The balance of profit if any was derived from the payment received from the lessee for the buy-out of the equipment on the expiration of the lease.

As a general rule Kamsel did not participate directly in the negotiations with suppliers. This was done by the prospective lessees who, in discussions with the supplier, determined the specific equipment they required and its cost. When the terms and conditions of the sale were arranged to the satisfaction of both, the prospective lessee (or on some occasions the supplier) would approach Kamsel. A credit review of the prospective lessee was conducted and if satisfactory Kamsel advised the supplier that it would be purchasing the particular equipment on the basis of the arranged terms. Kamsel then calculated the appropriate leasing cost and the aggregate amount so determined was amortized over a lease term settled in consultation with the particular lessee, which, in the usual case was 36 months.

Once these arrangements were completed Kamsel provided the supplier with the prepared lease agreement. It was executed by the prospective lessee in the presence of the suppliers' sales person and was returned to Kamsel for execution. Then payment for the equipment was remitted by Kamsel to the supplier, who in turn delivered the equipment to the lessee. All leases were net leases and all maintenance, service, repairs and insurance were the responsibility of the lessee. Title was retained by Kamsel which registered its interest in the equipment pursuant to the provisions of the Personal Property Security Act of Ontario.

Ms. Adams also stated that at the time the lease was executed each lessee understood that it had several options upon its expiry. These included the right to purchase the equipment at ten per cent of its actual cost; to renew the lease at an annual renewal equal to the quarterly payment; or to return the equipment. [2] She conceded that with a few exceptions [3] the lease agreement itself did not make reference to the buy-out option but maintained that the lessee was invariably advised of its right to do so. She was certain of this fact because all suppliers who dealt with Kamsel were provided with a document captioned "Leasing Factors" (Exhibit A-1) containing information which enabled the supplier to demonstrate how the ultimate lease payment would be calculated and which also specifically set out the options available to the lessee at expiry of the lease. Ms. Adams stated that all suppliers were aware of the options and to the best of her knowledge drew them to the attention of the lessee.

Shortly before the expiration of a lease Kamsel sent a notice advising the lessee of its right to acquire the equipment at the option price. Her evidence and that of Dibbley was that a substantial majority of Kamsel's customers exercised the option. This was expected since the residual value of the equipment as a general rule exceeded the ten per cent option price.

Appellant's position

It is asserted that Kamsel's business was the provision of financial accommodation to suppliers and purchasers of certain equipment. This was done on the basis that Kamsel would act as lessor in a transaction where the lessee acquired a chattel or equipment from a supplier with the expectation that it would generate profit from financing these transactions rather than realizing any form of gross profit from the sale of the chattel itself. The lease agreements used were full pay-out leases and the lessee had an option of acquiring the chattel at the conclusion of the term of the lease for ten per cent of the original price paid to the supplier for the chattel, which amount was referred to in the trade as a "bargain purchase”. Counsel noted that at the time a lease agreement was executed the lessee was advised, generally by the supplier, but on occasion by Kamsel, of its option rights. He noted that the residual fair market value of the chattel at the conclusion of the lease had been established to be in excess of the option price, and that in most instances the lessee exercised the option. From all of this it was apparent that the leases in issue effectively transferred substantially all of the benefits and risks of ownership. This, counsel submitted, is consistent with Kamsel's position that they were direct financing leases.

Furthermore counsel argued that at all relevant times Kamsel correctly followed generally accepted accounting principles in accounting for them as direct financing leases. He referred to a handbook prepared by the Canadian Institute of Chartered Accountants and to the testimony of Selby as to the appropriate accounting principles. [4] He further submitted that the transactions also qualified as a direct financing lease in that they met the criteria as set out by Revenue Canada in Interpretation Bulletin 11-233R. These criteria were established to assist in determining whether a transaction was to be treated as a sale and financing or as an operating lease and whether payments made pursuant to those agreements were in substance payments of rent or payments on account of the purchase price of property. The appellants position is that the transactions in issue satisfy those criteria and are consistent with the position of Revenue Canada as to what constitutes, in the appellants terminology, a direct financing lease.

In support counsel for the appellant cited the following decisions: Front & Simcoe Ltd. v. M.N.R., [1960] C.T.C. 123, 60 D.T.C. 1081 (Ex. Ct.); Chibougamau Lumber Ltée v. M.N.R., [1973] C.T.C. 2174, 73 D.T.C. 134 (T.R.B.); The Queen v. Lagueux & Freres Inc., [1974] C.T.C. 687, 74 D.T.C. 6569 (F.C.T.D.); The Queen v. Moore, [1986] 2 C.T.C. 22, 86 D.T.C. 6325 (F.C.T.D.); Feinstein v. M.N.R., [1978] C.T.C. 2219, 78 D.T.C. 1171 (T.R.B.); and Tri-Star Leasing (London) Inc. v. M.N.R., [1992] 2 C.T.C. 2099, 92 D.T.C. 1786.

Respondent's position

Counsel argues that the facts do not support the conclusion sought by the appellant. He contends that the leases in issue (with the exception of those relating to cellular phones) make no mention of the lessee's option and that the evidence as to any collateral oral agreement with respect to the option was nebulous and not adequately supported. He argued that ownership remained at all times with the appellant and suggested that the evidence respecting the value of the chattels at the time of the exercise of the option was insufficient to enable the Court to reach the conclusion urged by counsel for the appellant. The respondent relies principally on this Court's decision in Tri-Star Leasing and suggested that there was no distinction between the cases on the facts.

Conclusions

There is no special provision in the Income Tax Act dealing with agreements such as the leases in question. Accordingly a determination as to their true nature must be made in consideration of both the terms of the agreement and the factual circumstances relevant to both the making and execution of the lease agreement. I have concluded that the evidence adduced supports the position taken by the appellant.

I am satisfied that the majority of the lessees were aware of their option rights at the time of the execution of the lease. In this context I note Kamsel's practice of providing its suppliers with the document describing the options and the testimony of Ms. Adams and Jeffrey White that in the normal course the suppliers informed the prospective lessees thereof. There is also independent evidence of this fact, such as instances where the lessee, prior to the commencement of the lease, requested confirmation in writing from Kamsel of the option to purchase the equipment at lease termination at a specified amount, being ten per cent of its cost (Exhibit A-2, page 8). [5] Reference can also be made to the Windsor Welding lease (Exhibit A-7, page 4) in which the purchase option was incorporated into the lease at the request of the lessee. While such occurrences appear to be the exception rather than the rule, they are confirmatory of the testimony of Adams and White. Adams also testified that occasionally Kamsel staff prepared lease documents for execution by the lessee. She was involved in a number of such transactions and her usual practice was to review the lease with the lessee and to specifically advise it of the purchase option.

The evidence also satisfies me that as a general rule the residual fair market value of the chattel at the expiration of the lease exceeded the ten per cent option price. Adams's testimony in this regard was not seriously challenged in cross-examination. Her assertion that in almost every case the lessees exercised their option to acquire the chattel is supported by a random analysis of leases for years ended August 31, 1984, 1985 and 1986 prepared by Dibbley. This analysis (Exhibit A-9), while far from exhaustive, was reasonably conducted and is of some probative value.

The respondent's reliance on this Court's decision in Tri-Star Leasing is misplaced since in that case there was no evidence of any enforceable option to purchase being granted to the lessee. In the present appeal there is sufficient evidence upon which I can conclude that a lessee had the right at the expiration of the lease to acquire the property at a price which at the inception of the lease could be said to be substantially less than the probable fair market value of the property at the time of permitted acquisition. It is equally fair to state that the option permitted a lessee to acquire the property at a price which at the inception of the lease was such that no reasonable person would fail to exercise, and indeed the evidence was that a substantial percentage of the lessees exercised the option. These two findings I am constrained to note mirror the circumstances under which, according to IT-233R, Revenue Canada would consider a transaction to be a sale rather than a lease.

I have reached my conclusions with little reference to the testimony of the two expert witnesses. Mr. Selby has been associated with the Equipment Lessors Association (the Association) since its founding. He is the chairman of the accounting committee of the Association and as such has been involved in discussions with Revenue Canada with specific reference to its position regarding the tax treatment of direct financing leases. Mr. O'Brien has been an advisor to the Association since 1973. He had substantial discussions with officials of the Department prior to the release of Interpretation Bulletin IT-233 in 1975. It is fair to say that both are proponents of the Association's position with respect to direct financing leases and hold strong views regarding Revenue Canada's intractability on the issue.

The role of expert witnesses is to provide impartial assistance to a court, particularly when complex issues of a scientific or technical nature are involved. [6] Thus that portion of the testimony given by Selby relating to generally accepted accounting principles was appropriate and of probative value. However I have reservations as to the weight to be given to the balance of their testimony. Each was presented with a hypothetical fact situation (approximating the facts being asserted by the appellant) and from each counsel elicited the opinion that such facts described a direct financial lease. These responses amounted to an opinion on a mixed question of fact and law which requires the application of a legal standard. It has been said that such opinions are superfluous (The Queen v. Fisher, [1961] S.C.R. 535, [1961] O.W.N. 94, at page 535 (O.W.N. 95), Aylesworth, J.A.), and in this case they were just that.

The appeals are allowed, with costs.

Appeals allowed.