Anthes Equipment Limited v. Minister of National Revenue, [1987] 1 CTC 2117, 87 DTC 59

Christie, A.C.J.T.C.:—It is the position of the respondent that in respect of the appellant's 1979 taxation year $134,022 shall be added to its reported income as an “income gain on sale of rental equipment" and that $31,942 shall be deducted from its income, this amount being the taxable capital gain on the sale of rental equipment reported* [1] by it. The respondent further contends that he was correct in making similar changes in reassessing regarding the appellant’s 1980 taxation year. The respective amounts involved in this taxation year being $1,010,807 and $505,404.

Three testified at the hearing. All were called on behalf of the appellant. They are: Mr. Robert P. Curl, who was managing director and chief executive officer of the appellant from the time it was purchased from Molson's on 9 December 1978 until early 1983 when he departed for other employment; Mr. Paul A. Gillespie, who was employed by the appellant as a vice president in December of 1979 and has been chief operating officer for the past two and one-half years and Mr. Muhammad Saleh who, during the time relevant to this appeal, was in the employment of the appellant as a senior accountant. He is now the senior accountant with the title Accounting Supervisor. What is pertinent in their testimony comes to this. The appellant has 14 branch offices plus independent distributors across Canada. It also has subsidiaries in the United States. Its business is concerned with scaffolding and shoring. Scaffolding is equipment used in construction and renovation projects that is designed to provide access to the builders to what is being constructed or renovated. Shoring is designed to "withstand a load-bearing situation". The equipment is used to support forms into which concrete is poured. After it sets the shoring is removed. Both undertakings require considerable engineering expertise. On occasion the equipment can be used interchangeably. Both kinds of equipment are used in projects ranging from the small to the immense.

The appellant’s business comprises, inter alia, the sale of new products. They include products that are rented and some that not for rent, e.g. heaters for use at construction sites. No question arises on this appeal regarding the gains on these sales. They are treated as business income by the appellant in calculating its tax liability and in filling its returns of income.

The primary emphasis of the appellant’s business is on the renting of scaffolding and shoring equipment. It is also its principal source of revenue. Additionally it disposes of used rental equipment. For example, in the year ended March 31, 1980 the relativities in this regard are: rentals $10,647,000 (58.33 per cent); sales of new equipment $4, 398,000 (24.33 per cent); disposal of rental assets $2,430,000 (13.33 per cent) and intercompany sales $763,000 (4 per cent). The dispute to be settled relates to the gains on the disposal of assets that had been used in relation to that component of the appellant’s business concerned with renting equipment. These dispositions are the origin of the $134,022 and $1,010,807 mentioned in the first paragraph of these reasons. The question is: are they capital gains or business income?

The appellant’s “rental pool” contains literally many thousands of items of scaffolding and shoring equipment of varying kinds and sizes. The disposition of assets from it falls into three basic categories: first, when the usefulness of equipment is exhausted by reason of wear and tear or when it becomes technically obsolete it is sold, usually as scrap; second, sales to rental customers and others and third, equipment that is not returned by lessees who have lost it or is returned damaged beyond repair and is no longer serviceable.

The first category requires no explication. Sales described in the second category are unsolicited and made reluctantly. This is because it is far more lucrative for the appellant to continue to rent equipment in the rental pool than to sell it. A piece of equipment several years old, yet serviceable, that has regularly produced rental income over that period continues to command the same rental as new or relatively new equipment of the same kind. Also when serviceable equipment is sold out of the rental pool it must be replaced with new equipment. As the relativities cited indicate, renting in contrast to selling was unquestionably greater and the more important to the appellant’s business. Generally speaking, because of the large variety of equipment and engineering configurations thereof required for different construction and renovation projects, it is not economical for contractors to invest their capital in this equipment. Too much of it might be left idle for too long. For them it pays to rent. When to make unsolicited sales and, if so, on what terms depends to a considerable extent on the importance that the appellant attaches to its business relationship with the customer. The only concrete example of that kind of sale given at the hearing involved Ontario Hydro. It required considerable amounts of equipment for a nuclear power project and it insisted that the agreement to rent with the appellant include an option to Ontario Hydro to purchase the equipment at a fixed price and, further, if the option were exercised a rebate of 90 per cent of the rent paid would be applied to that price. Having regard to the importance of Ontario Hydro to the appellant as a customer, the latter agreed to these terms. Dispositions in this category are predictable and repetitive. Furthermore they generate significant revenue.

This is the context of dispositions described in the third category. The appellant normally uses a common type of invoice whether the transaction is for rent or sale of equipment. There are boxes in the upper right-hand corner which provide for identifying whether a transaction is one of rental, sale of new equipment or sale from the rental inventory. The usual things follow relating to date, terms, shipping, price, etc. This appears at the foot of the document:

The above material has been shipped subject to the terms & conditions on the reverse and in accordance with your order shown above. Your signature below acknowledges receipt of above material in good condition except for damages noted.

Lines for the customer's signature and signature on behalf of the appellant follow. On the reverse side of the invoice there is a heading: “Terms and Conditions — General”. Thereunder are six paragraphs of terms and conditions which can apply to both sales and leases. Then comes this heading: “Conditions of Lease". Again there are six paragraphs. Only the second need be reproduced for present purposes. It reads:

MAINTENANCE AND OPERATION. The Lessee shall see that the equipment is not subjected to careless or needlessly rough usage; and he shall at his own expense maintain the equipment and its apurtenances in good repair and operative condition, and return it in such condition to the Lessor.

When a customer fails to return lost equipment or returns it in a damaged condition that has rendered it of no further use as a rental asset the appellant demands payment by the customer of its current list price for the equipment. This price is twice what the equipment costs the appellant. Some meet the demand, but many do not. Negotiations ensue. They can become difficult. Gillespie said: “There is usually a tremendous amount of haggling". Initially the salesmen are involved. The issue may move to the sales manager, then to the branch manager and on to the credit manager. Negotiations can result in a reduction of the amount claimed. The strength of the economic muscle that a customer can flex in relation to the appellant is relevant in determining the amount of the reduction. Reference was made to some settlements based on replacement cost to the appellant plus two per cent to five per cent coupled with the contractor's undertaking to rent from the appellant whatever equipment is necessary for his next project. The import of the evidence is that with few exceptions, if any, the settlement figure exceeded replacement cost to the appellant. Instances of failure to return equipment, in contrast to returning damaged equipment, are decidedly preponderant.

In these proceedings these transactions have been variously referred to as “penal sales”, “forced sales”, “involuntary sales”, “loss or damage sales” and “shortage sales”. This multiplicity of characterizations probably arises because they are not sales of any kind. In Black’s Law Dictionary, 5th (1979) ed., there is a good definition of the word “Sale" and the transactions do not fall within it. It reads:

A contract between two parties, called, respectively, the “seller” (or vendor) and the “buyer” (or purchaser), by which the former, in consideration of the payment or promise of payment of a certain price in money, transfers to the latter the title and the possession of property. Transfer of property for consideration either in money or its equivalent.

As I see it, the relationship that exists between the appellant and those who lease its equipment is that of bailor and bailee. Hire of chattels is a class of bailment. Under the general law of bailment the duty of care imposed on a lessee of chattel is that which a prudent person would exercise in relation to his own property of a similar kind. This duty can, however, be made more stringent by a specified term in the contract of bailment. In the absence of an express undertaking it is an implied term of the bailment that at the expiration of the lease the bailee must return the property: paras. 42 & 43 "Bailment” vol. 2, 3rd ed., Canadian Encyclopedic Digest (Ontario).

In my opinion on the basis of the evidence before me these transactions, on their true construction, are negotiated settlements for the breach of the second condition of the contracts of bailment previously cited or, in those few cases where there may have been a special contract other than the standard invoice that did not specifically deal with standard of care or return of the equipment, for breach of the implied terms in this regard.

Payments received in settlement of a breach of contract may be either a capital or an income receipt. If payment is made to compensate for loss of anticipated profits from a taxpayer's business, what is received is business income: Fleck Manufacturing (1959) Limited v. M.N.R., 30 Tax A.B.C. 265; 62 D.T.C. 580; M.N.R. v. Bonaventure Investment Co. Ltd., [1962] C.T.C. 160; 62 D.T.C. 1083 and Brussels Steel Corp. v. The Queen, [1986] 1 C.T.C. 180; 86 D.T.C. 6077. If payment is made to compensate for the loss of a capital asset, what is received is capital in nature.

The payments received by the appellant in respect of the third category of dispositions are capital receipts. In support of his contention that the payments are trading receipts, counsel for the respondent stressed, and the evidence supports him, that revenues from these dispositions were predictable and significant from year to year. He also underscored the fact that what the appellant initially sought to recover was much in excess of the cost to it of replacing the lost or damaged equipment and that what was in fact recovered normally, if not invariably, exceeded that cost. I do not regard these things as leading to the conclusion that what would otherwise be regarded as capital receipts should be labelled business income. Up to the time of loss or damage rendering it unfit for rent, the equipment was clearly capital assets in relation to the appellant’s business of renting scaffolding and shoring material. The appellant claimed and was allowed capital cost allowance in respect of it while it constituted part of the rental pool. The existence of this course of action was discussed at the hearing, but its correctness was not called into question. Further, where there is a bona fide negotiated settlement of a claim for breach of contract the amount paid and received is compensation for breach of contract. It does not become something else simply because it exceeds or is less than the actual loss suffered by the breach. The appellant is entitled to succeed on this aspect of the appeal.

Turning now to dispositions in the second category, i.e. sales of equipment from the rental pool albeit allegedly reluctantly. It is well settled that a capital asset in the hands of a taxpayer can be converted to an income or trading asset if at some time after the capital asset is acquired he takes steps which can properly be described as engaging in business using or intending to use what had been a capital asset as a trading asset: Canadian Kodak Sales Limited v. M.N.R., [1954] C.T.C. 375; 54 D.T.C. 1194; Moluch v. M.N.R., [1966] C.T.C. 712; 66 D.T.C. 5463 and Magilb Development Corporation Ltd. v. M.N.R., [1982] C.T.C. 2278; 82 D.T.C. 1249 — reversed, but not on this point: F.C.T.D. McNair J [reported at [1987] 1 C.T.C. 66].

Regarding judicial authority on this facet of the appeal I do not believe it necessary to do more than expound the reasons for judgment in Canadian Kodak because to my mind they offer a complete answer. It involved appeals regarding the appellant's 1951 and 1952 taxation years. The appellant was concerned with sales in Canada of all the products of Canadian Kodak Company Limited which was a manufacturer of a wide range of photographic supplies. In addition the appellant engaged in renting on a monthly basis “recordaks”, which was micofilming equipment. Prior to 1951 this equipment was never sold. Recordaks were retained as capital assets and replaced when they became unserviceable or obsolete. In January 1951 the appellant changed its policy and made a business decision to sell recordaks in the hands of its rental customers on terms which were spelled out in correspondence. In 1951, 40 per cent of the machines which users had rented were purchased by them. In 1952 an additional five per cent were purchased. They were sold at prices well above the book value. Those units which were not sold continued to be leased and the appellant went on acquiring recordaks and offering them for sale or lease. In reporting its income for the taxation years previously mentioned the appellant took the position that the sale of the previously leased recordaks was the sale of capital assets and consequently the gains therefrom were capital gains. In reassessing, the respondent treated the gains as business income.

Thorson, P. held that the gains were business income and taxable as such. He said at 381-82 (D.T.C. 1197):

... the fact that the appellant’s recordaks were formerly leased and treated as Capital assets subject to depreciation does not prevent the profit from their sale being profit from the appellant’s business once it had made the business decision to sell them and sold them in the course of its ordinary business of selling photographic equipment and supplies. It was in exactly the same position in which it would have been in if it had acquired the recordaks for resale. There was nothing of a capital nature in the sale of its recordaks and it is fanciful to say that they were realizations of investments. There was no difference in principle between its sales of recordaks and its sales of other photographic equipment. They were all sales in the course of the appellant’s business.

I have no difficulty in finding that the gains from the dispositions in the second category are business income. As noted earlier the appellant was in the business of selling new equipment. Also the sale of equipment from the rental pool was a predictable, recurring and ongoing thing. I am prepared to accept that the appellant would have preferred not to make these sales but this, in my opinion, changes nothing. The decision to make sales of this kind was adopted as a business policy because it was considered to be in the best overall commercial interests of the appellant. When a decision was made to sell a particular piece of equipment from the rental inventory which was followed by a sale, that equipment ceased to be a capital asset in respect of that part of the appellant’s business that is devoted to renting scaffolding and shoring equipment and became part of its business inventory. This aspect of the appeal cannot succeed.

Little need be said regarding dispositions in the first category. This equipment ab initio forms part of the rental pool and it remains there until it becomes unserviceable by reason of wear and tear in the course of being rented or until it becomes obsolete, whereupon it is disposed of. This is clearly the disposition of the remnants of capital assets and the revenue therefrom is a capital receipt. Indeed, if I understood him correctly, counsel for the respondent conceded this during argument. The appellant succeeds on this issue.

The appeal is allowed to the extent indicated in these reasons for judgment and the matter is referred back to the respondent for reconsideration and reassessment in accordance with these reasons. The appellant is awarded party and party costs.

Appeal allowed in part.