Wang Canada Ltd. v. MNR, 91 DTC 1279, [1991] 2 CTC 2773 (TCC)

Bonner, T.C.J.:—At issue in this case is the method of computation of the income of a taxpayer whose business it is to buy, sell, lease and service products in cases in which that taxpayer sells such products after having leased or used them and after having claimed capital cost allowance in respect of them.

The parties to the appeals filed the following agreed statement of facts and issues as follows:

1. The Appellant is a corporation incorporated under the laws of Ontario having its head office in Toronto, Ontario.

2. During its 1981 and 1982 taxation years the Appellant carried on one business, that of selling, leasing and servicing computer equipment.

3. In carrying on its business, the Appellant from time to time acquired computer equipment for the purpose of leasing such equipment and thereby earning rental income.

4. In some cases upon the expiration of the lease, the particular equipment was sold by the Appellant or used by the Appellant in its business.

5. In carrying on its business the Appellant was required to maintain certain computer equipment to perform necessary administrative and sales support functions. The administrative functions included maintenance and data processing of the Appellant's financial and accounting records, business communications and customer correspondence, compilation of the Appellant's statistics and customer information, and other general administrative functions. In supporting its sales function the Appellant required this computer equipment to familiarize employees with its products utilized in its sales, leasing and servicing business, to service other computer equipment and to provide temporary customer loans. Such computer equipment was acquired by the Appellant specifically for its own use. Such equipment was generally not available for sale or lease to customers of its business while it was needed for the Appellant's internal use.

6. In computing its income for the 1981 and 1982 taxation years, the Appellant treated its computer equipment acquired and used for the purpose of leasing as depreciable capital property within Class 10 of Schedule Il to the Regulations for purposes of the Income Tax Act (Canada) (the 'Act").

7. In computing its income for such years, the Appellant treated its computer equipment acquired and used for its internal administration and general office use, for sales support or for service and repair, as Class 10 depreciable capital property for purposes of the Act.

8. While the Appellant owned the equipment referred to in paragraphs 6 and 7 hereof, it claimed capital cost allowance in respect thereof pursuant to paragraph 20(1)(a) of the Act. Upon a subsequent disposition of any such equipment, the Appellant accounted for the proceeds of disposition by reducing the undepreciated capital cost of property of Class 10 by an amount equal to the lesser of the proceeds of disposition (net of any outlays or expenses associated therewith) and the capital cost of the equipment, and treated any proceeds in excess of the capital cost of the equipment as a capital gain. The Respondent does not agree that the Appellant correctly accounted for the proceeds of sale under the Act.

9. Under the Reassessments, the Respondent inter alia disallowed the Appellant's treatment of dispositions of equipment as described in paragraph 8 hereof. Rather, the Respondent in so reassessing the Appellant reduced the undepreciated capital cost of Class 10 property by the net book value of the property sold. The Respondent included in the Appellant's income an amount equal to the difference between the net book value of the equipment in question and the Appellant's proceeds of disposition thereof. The Appellant does not agree that the Respondent correctly treated the proceeds of disposition in computing the Appellant's income.

10. The Appellant concedes that all proceeds from the sale of leased equipment in excess of the original cost of such equipment should be treated as ordinary income and not as capital gains.

11. The Respondent concedes that, in respect of property purchased by the Appellant and disposed of within the same taxation year, the undepreciated capital cost of Class 10 property should be reduced by the original cost of such property or the Appellant's proceeds of disposition, whichever is less. The parties agree that this would have the following effect on the assessments in issue:

	1981	1982
reduction in profit on sale of inventory:	$191,809.00	$227,011.00
less decrease in capital cost allowance:	57,543.00	84,029.00
net decrease to income:	$134,266.00	$142,982.00

Issues

1. The sole remaining issue for determination by this Court is the quantum of reduction in the undepreciated capital cost of Class 10 in respect of property purchased in one year and disposed of in a subsequent year. The Appellant contends that the reduction in undepreciated capital cost of Class 10 should be in an amount equal to the lesser of proceeds of disposition (net of any outlays or expenses associated therewith) and the capital cost of the property sold. The Respondent contends that the reduction in undepreciated capital cost of Class 10 should be equal to the net book value of the property sold. The parties are agreed that the excess, if any, of the proceeds of disposition over the amount by which the undepreciated capital cost of Class 10 is reduced will be included in computing the income of the Appellant for the year of sale.

Counsel for the appellant argued that the respondent had improperly failed to apply subparagraph 13(21)(f)(iv) of the Income Tax Act, R.S.C. 1952 c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") in making the assessments in issue. He pointed out that "net book value” is a term which has no significance for purposes of the Act. He reviewed the provisions of the Act which in his submission were relevant. He noted that although for purposes of section 9 of the Act, profit must be determined in accordance with ordinary commercial principles [1] that rule is subject to any applicable overriding statutory direction. He pointed to paragraph 18(1)(b) of the Act as one such direction. It prohibits deductions in respect of ”... an outlay, loss or replacement of capital except as expressly permitted by . . .” Part I of the Act and thus prohibits the deduction of accounting depreciation. Paragraph 20(1)(a) of the Act permits the deduction of an ”. . . amount in respect of the capital cost to the taxpayer of property . . .” as permitted by the Regulations. Counsel referred to subsection 13(1) which makes provision for recapture where proceeds of disposition of depreciable property described in a class plus capital cost allowance claimed exceed the undepreciated capital cost of property of that class. He turned then to the definition of undepreciated capital cost of depreciable property of a prescribed class to be found in paragraph 13(21)(f) of the Act and noted that term has absolutely nothing to do with accounting depreciation. It requires, generally speaking, that undepreciated capital cost be calculated by deducting from the capital cost of property of the class total depreciation (as defined by paragraph 13(21)(e)) and, in respect of each disposition of property of that class, an amount calculated in accordance with subparagraph 13(21)(f)(iv). The respondent, he submitted, erred in failing to use an amount so calculated in respect of the disposition of computer equipment which the appellant sold after having either leased it or used it for its own purposes. In summary it was his position that the undepreciated capital cost of the appellant's property of Class 10 should, when such property is sold, be reduced in accordance with the statutory formula in subparagraph 13(21)(f)(iv) of the Act by the lesser of proceeds of disposition or cost of the property sold. That amount, he said, will usually be proceeds of disposition. Profit would then be computed based on the formula of excess of proceeds over lesser of proceeds or cost.

Counsel for the respondent argued that the computer equipment in issue was not, when sold, depreciable capital property. He said that at that time it was inventory. He reasoned that the appellant, by admitting that the profit on the sale of the equipment was income, admitted as well that the equipment was inventory when sold. There was, he said, a notional conversion from depreciable capital property to inventory at some time prior to the sale and such conversion is to be regarded as a disposition the proceeds of which are equal to undepreciated capital cost. If the proceeds were taken to be any different figure and conversion were to occur in a year prior to actual sale a terminal loss or recapture might result. Such a result was not, in counsel's submission, contemplated by the Act.

Counsel for the respondent argued that the use in making the assessment of the net book value of the property sold does not have any bearing on the outcome. There was, he said, no material difference between the net book value of the property sold and its undepreciated capital cost. In this regard he referred to the respondent's reply to the notice of appeal which asserted that in making the assessment in issue, the respondent proceeded on the basis of a finding or assumption that:

. . . the net book value of the relevant equipment was used in calculating this income since it was impossible for the respondent to calculate the undepreciated capital cost of every piece of equipment sold, since there was no material difference between the net book value and the undepreciated capital cost of the property sold and since the appellant used the net book value in the calculation of its profit for accounting purposes.

He pointed out that the appellant did not challenge the correctness of that assumption.

In my view the position of the respondent is correct. When the appellant ceased to hold and use the computer equipment for the purpose of gaining or producing rental income or for use in the operation of its business, that equipment was in effect converted from capital property to inventory. It ceased to be depreciable property of a prescribed class within the meaning of paragraph 13(21)(f) of the Act. The rule in subparagraph 13(21)(f)(iv) of the Act upon which the appellant relied has application by its very terms only where there has been a disposition of such property.

In my view, the decision of the Exchequer Court in Canadian Kodak Sales Ltd. v. M.N.R., [1954] C.T.C. 375 ; 54 D.T.C. 1194 is determinative. There the taxpayer carried on the business of the distributor of photographic equipment. It took over from a sister company the business of distributing and servicing microfilm machines known as recordaks. For some time the machines were not sold by the taxpayer but rather were rented by it to the public for a monthly fee. They were carried on the taxpayer's books during that period as capital assets and, in computing income, capital cost allowance was deducted in respect of them. The taxpayer then decided to sell the recordaks. It succeeded in doing so at prices in excess of book value and it contended on appeal that the profit realized on the sale of the machines was not a profit from its business. It was submitted that the recordaks had always been regarded by it as capital assets and that the Minister had accepted that classification. It was further submitted that the recordaks had never become inventory. At page 379 (D.T.C. 1196) Thorson, P., rejected that contention and stated that the appellant's recordaks

. . . were not fundamentally different in principle from the wide range of cameras and photographic equipment and supplies sold by it, that the decision to sell the recordaks was a business decision made for business reasons to increase the appellant's sales and to increase its profits, that from the time of this decision the appellant was in the business of selling recordaks and that its profit therefrom was a profit from its business and taxable income within the meaning of the Act.

At page 383 (D.T.C. 1198) Thorson, P. rejected a submission that the provisions of subsection 20(1) of the former Act [2] relating to recapture applied to the disposition of the recordaks. His Lordship said:

There, is I think, a brief answer to counsel's submission. While the purpose of section 20(1) seems to be to ensure that under the circumstances specified in it some of the proceeds of the disposition of depreciable property, which, apart from the section, would not be income within the meaning of the Act, is included in income because of the fact that depreciation or capital cost allowances have been granted in respect of it, it seems to me that there is no need of resorting to the section for such purpose in a case such as this where the disposition of the property has been made in the course of the taxpayer's business as the result of a change of business policy in dealing with it and all of the proceeds of the disposition have been taken into account as income from the business and all the profit made on the disposition of the property is profit from a business.

Accordingly I am of the opinion that the rule in paragraph 13(21)(f) does not apply to the computation of the profit from the sale of the property in question. The appeals will be allowed and the assessments will be referred back to the respondent for reassessment in the manner set forth in paragraph 11 of the agreed statement of facts. There will be no order as to costs. The appellant will be entitled to no further relief.

Appeal allowed.