Plaza Pontiac Buick Limited v. Minister of National Revenue, [1983] CTC 2371, 83 DTC 316

D E Taylor:—This is an appeal heard in Toronto, Ontario, on April 12, 1983 against income tax assessments for the years 1977 and 1978 in which the Minister of National Revenue disallowed deductions of $44,833 and $45,566 respectively, claimed by the appellant as “inventory allowance” pursuant to paragraph 20(1 )(gg) of the Income Tax Act.

The appellant is incorporated under the laws of the Province of Ontario, with its fiscal year ending December 31. During its 1977 and 1978 taxation years, it carried on the business of selling and servicing new and used vehicles and related activities in Toronto. In computing its income for the said years, Plaza determined that the cost amounts of its inventories and the relevant deductions were as follows:

The appellant submitted that its leased vehicles are tangible property, are described in its inventory in respect of its business and are held by the appellant for sale.

The position of the respondent was that the leased vehicles were not held by the appellant for sale and, accordingly, no allowance could be taken in respect of their cost amount, which allowance in this case would be $44,833 and $45,556 in respect of said years, respectively, in accordance with paragraph 20(1 )(gg) of the Income Tax Act.

At the commencement of the hearing, some discussion was held between the parties and the presiding member relative to the proper general interpretation and application of paragraph 20(1 )(gg) of the Act. It was noted that the total “inventory allowance” had been claimed by the appellant by way of an adjustment to “net income” per the financial statements of the corporation to reduce that amount to “net taxable income” for purposes of preparing the corporation tax returns, and the details were provided on a supplementary sheet attached to the corporation income tax returns. In effect, there had been no accounting entries recorded (e.g. Dr Inventory Allowance Expenses $117,536, Cr Inventory or Cr Reserve for Inventory Allowance $117,536), such as might be found in applying other somewhat similar sections of the Act, perhaps paragraph 20(1 )(l) or 20(1 )(n), or the regulations dealing with “capital cost allowance”. The stated position of counsel for the appellant regarding the proper application of paragraph 20(1)(gg) was that it was totally outside the general treatment to be accorded to other deductions noted in section 20 of the Act, and formed a kind of “inflation recognition factor” provided by Parliament. It was further asserted by counsel for the appellant that this provision was not a “one-shot” affair, but could and should continue to be available to taxpayers year after year. The presiding member expressed serious reservations that using paragraph 20(1 )(gg) to produce “net taxable income” as contrasted with “net income” fulfilled the requirements of subsection 20(1) of the Act “in computing a taxpayer’s income for a taxation year . . as this was portrayed under subsection 9(1) of the Act. He also noted that the decision in this matter was not to be taken as any form of confirmation or endorsement by the Board that even the “inventory allowance” on the new and used car inventory permitted by the Minister was necessarily an appropriate deduction in the manner in which it was taken by the appellant. Counsel for the Minister also stated that the portion of the deduction claimed which was allowed by the Minister should not be taken as general acceptance by the Minister of the method used by the tax- payer in claiming such a deduction in this case. Counsel for the Minister agreed that the Board’s decision would only relate to whether or not the alleged “inventory” of leased cars fitted the requirements of the Act on a basis equivalent to the inventory of new and used cars, as portrayed in this case, and this case only.

lt was common ground between the parties that no funds of the company relative to the deduction sought had been laid out, nor had any obligation in connection with it been taken on by the company, other than the original purchases of automobiles which would be accounted for in the normal course of events.

Reference was made to the concluding paragraph of the case of T Bar B Cattle Co Ltd v MNR, [1983] CTC 2168; 83 DTC 165, which I quote:

As I see the whole matter, the provision with the 3% allowance is strictly a bonus or allowance to a taxpayer, but has no de facto effect on his inventory. It allows him 3% of a figure, which figure is of his choosing — it can be based on full inventory or on an amount just above zero. It has no direct relationship to de facto inventory. Therefore, I conclude the assessments have been properly made and the appeals should be dismissed.

Clearly the comment had a singular application in that case, the late learned Assistant Chairman of the Tax Review Board noting quite specifically that paragraph 20(1 )(gg) could not be called upon to create an inventory for income tax purposes where none actually existed. The comment might also imply that properly applied, the section had no final or lasting effect on inventory, but the relevance of “bonus or allowance to a taxpayer” was not amplified in the decision.

Mr Herbert Stein, President of the appellant corporation and Mr Frank Sammeroff, a chartered accountant of the firm of Wm Eisenberg & Co, Chartered Accountants, testified regarding the business and accounting practices of the appellant leading up to the amounts at issue. Plaza had been in business for more than 25 years and the years under appeal were typical of that activity. The “leasing business” had developed largely as a convenience to a segment of the customers who preferred that method as opposed to outright purchase, and it was conceded by Mr Stein that without that service, Plaza would probably lose that particular clientele. It was not regarded by him as profitable, and he did not make a practice of buying from General Motors Corporation (GM) certain cars for lease and others for sale. In effect, all the cars on his lot at any time were available for either lease or sale, and they would be shown as inventory for sale since he stressed sale if possible. The normal lease period was for three years, but certain exceptions were made for two, or even one-year leases. At the end of the lease period, the cars were always sold. From the regular “disposition reports” GM was made aware of which particular automobile had been leased by Plaza or sold to a customer. Only a small part of the staff was involved with the leasing operation, the majority was occupied with the business of selling cars. In round numbers Plaza sold about 2,400 automobiles per year; kept a “stock on hand” of approximately 500 cars; had about 400 automobiles out on lease at any one time and, of the leases, about 150 would expire each year and the cars sold — and included in the total of 2,400 noted above. The leases normally did not provide an “option to purchase” clause, and they were cancellable on 30 days’ notice, without cause, by Plaza. Mr Stein agreed that such cancellation — at the option of Plaza — would be very rare indeed and that, in practice, the lessee had the use of the vehicle without interruption throughout the life of the lease. However, the cars when purchased were all purchased for sale, and they were ultimately sold. That between such purchase and sale some of them might have served another auxiliary business function did not change that situation in his mind. It was always the intention of Plaza, at purchase, to sell each vehicle so acquired eventually.

Mr Sammeroff explained that his firm determined, after considerable review, that the leased cars should be carried on the financial statements as current assets — inventory — as opposed to fixed assets — equipment used in a business. However, in examining the question of how to value this leased car inventory for statement purposes, it was decided that a system such as examining each one at the fiscal year end and placing a value on it was not only unbusinesslike, but it was impractical from a customer viewpoint. A procedure was adopted of estimating the residual value of each leased car at the end of the lease, and apportioning the difference between that amount and the cost at the start of the lease over the period of the lease month by month. This called for a process of “depreciating” the vehicles at rates ranging from 1 /2 to 3% per month for statement purposes. Since this “depreciation” was not a deductible tax expense, at the year end accounting entries were made reversing it and charging an amount against income as “capital cost allowance”, based on considering the “leased car inventory” as a class 10 asset. In the audited financial statements the firm had included the following note:

Inventory of leased vehicles

The leased vehicles and related deferred finance charges, notes payable and deferred income taxes have been shown as current items as this treatment more accurately indicates their nature. This will have the effect of increasing the accounting cycle to a period exceeding one year.

When questioned by counsel for the respondent on the apparent dichotomy of “depreciating” inventory and also showing it as a current asset, Mr Sammeroff agreed that this “leased car’ inventory was not regularly and immediately available for sale in the current year and noted that the system adopted resulted from the view that the leased automobiles were “inventory — held for sale in the normal course of business”, if not specifically “available for sale in the current year”. It was essentially the best and most practical administrative course of dealing with a complex and somewhat unusual business problem. The cars when purchased were all purchased for sale, and they were ultimately all sold. That between such purchase and sale some of them might have served another ancillary business function did not change that situation.

Counsel for the appellant provided the Board with Revenue Canada Interpretation Bulletin 128 as well as the following case law:

Dartmouth Developments Ltd v MNR, [1979] CTC 2611; 79 DTC 545;

Gloucester Railway Carriage and Wagon Company Limited v CIR [1925] AC 469;

Canadian Kodak Sales Limited v MNR, [1955] Ex CR 40; [1954] CTC 375, 54; DTC 1194;

MNR v JT T Labadie Limited, [1954] Ex CR 260; [1954] CTC 90; 54 DTC 1053;

MNR v British and American Motors Toronto Limited, [1954] Ex CR 153; [1953] CTC 177; 53 DTC 1113;

Gene A Nowegijick v The Queen, [1983] CTC 20, 83 DTC 5041.

Counsel for the appellant provided a concise, detailed and well- researched argument and, in my view, it rested almost exclusively on the question of “intention” at purchase — and that, in his opinion, was for sale, not lease. Counsel noted that there did not appear to be any bar to the appellant’s claim based on the fact “depreciation” (or capital cost allo- wance) had been charged, and cited passages from the above jurisprudence in support of that view. It also appeared from the same jurisprudence that the taxpayers in those cases had been singularly unsuccessful in attempts to establish that the leased assets in question had been capital assets, and the jurisprudence upheld the assessments which had treated them as current assets (inventory) available for sale, even if that objective had been slightly marred or delayed by the leasing processes. The conclusion he reached was that since his client had acquired the automobiles in question in the appeal for sale, and they ultimately were sold, the same jurisprudence which had worked to the Minister’s advantage in the cited jurisprudence should apply to uphold this appeal which worked to the taxpayer’s advantage in this instance. The taxing circumstances were simply reversed as far as the application of 20(1 )(gg) was concerned. Counsel also noted that the principal, in fact, only business of this taxpayer was to make a profit out of selling automobiles and that the convenience of leasing, which was provided to Plaza’s customers, only contributed to that end objective, it did not form a separate business in itself.

The Minister also referred to Canadian Kodak (supra) but noted the following cases:

Boehringer Ingelheim (Canada) Ltd v MNR, [1982] CTC 2850; 82 DTC 1859;

Dresden Farm Equipment Ltd v MNR, [1982] CTC 2377; 82 DTC 1388.

The respondent made essentially three points:

(1) that even if bought for sale and thereby inventory, when the automobiles in question were leased, their character and purpose changed and they became capital assets in the leasing business. The appellant’s regular depreciation of these supported this opinion.

(2) that there was a real question whether the amounts at issue were based on the appropriate “cost” of the leased automobiles.

(3) that is seemed to be stretching a point unusually far to indicate that all the automobiles had been bought for sale — leasing was a regular part of the appellant’s business.

Looking at the arguments raised by the respondent, I would comment that the jurisprudence cited by counsel for the appellant would tend to thwart the “utilization” issue raised as the main argument in support of the assessments. It would appear to me that when and if acquired as a current asset (inventory) for sale, later temporary or intermittent use as a capital asset for the production of income does not alter the original characteristics of the asset for income tax purposes. I would rely for that conclusion on Gloucester Railway Carriage (supra) and Dartmouth Developments Ltd (supra). It has not been shown by the respondent that /f the leased automobiles in this appeal were originally acquired for sale (and that is the proposition of the appellant), a conversion decision was made by Plaza after such acquisition to use certain of them in a separate business, or a distinct part of the total business — the leasing of automobiles, in such a way that they should be considered as capital rather than inventory assets. And even if so shown, the jurisprudence would support the appellant’s view that such use did not change the income or tax treatment thereof.

With regard to the second point raised by the respondent, while there was little in the way of detail provided to the Board to support the calculation of the “cost amount” of the leased automobile inventory upon which the 3% allowance at issue was taken, the Minister did not seriously challenge the mathematics during the hearing, and I doubt there is any basis for the Board to do so now.

Turning to the third point by counsel for the respondent — the intention at acquisition — the respondent then runs directly into the main thrust of the appellant’s argument that the automobiles leased were actually purchased for sale. The respondent provided limited assistance to the Board in reviewing these contrasting positions but, in my view, it is the area that must be thoroughly examined. The appellant is saying that, on an average, the corporation purchased 2,400 automobiles each year for sale, and on an average sold that many. I do not accept that contention for the years under appeal. The fact is that by 1977 and 1978, leasing of automobiles was an established, integral part of the appellant’s business. Whether it was in itself profitable is irrelevant. The requirement for a supply of automobiles destined for leasing had become a consideration of a dimension to be taken into account as well as those destined for direct sale. This was no temporary or intermittent activity or short term commitment of resources. Whether it was started, and perhaps even maintained, as a convenience to customers is irrelevant. A certain segment of customers — the leasing clientele — would not have done business at Plaza unless they could have leased automobiles. It was their choice, not the choice of Plaza. Plaza had done, and continued to do, all in its power to persuade customers to buy, not to lease. Having leased, however, I am sure that Plaza provided good and faithful service to that particular clientèle, as it undoubtedly did to all its customers. Nevertheless, some 400 automobiles were on lease all the time, of which there was an annual turnover of about 150 cars which were sold.

The only conclusion I can reach is that 150 automobiles were purchased each year for the purpose of leasing. Management may not have known at the time of purchase whether a certain car would be leased or sold, but management did know that, of the total of 2,400 units purchased, 150 would be leased. Without that obligation, only some 2,250 automobiles would have been needed to maintain an adequate inventory for sale. It cannot be said from the evidence provided to the Board that the 150 vehicles sold each year from the leased stock were purchased for the primary purpose of sale. That they would be sold ultimately is beyond question, but to contend that such eventual sale was the main purpose for their acquisition has not been supported. As I see it, if they were not purchased for sale, they could not possibly have been “held for sale” during the tenure of the leases. I would quote from British and American Motors (supra) at 158,181 and 1116 respectively.

It is my opinion that where it is clearly established that a motor vehicle has been bought for use as a capital asset in the necessary service of the taxpayer, has been used in the same manner and to the same extent as a Capital asset would normally be used, and has always been treated and recognized as a capital asset, the profit which may arise upon its disposition is a capital profit.

It is not necessary for the Board, for the purpose of this decision, to determine whether the leasing business was a “separate business” from an inventory viewpoint, or whether it remained a part of the total of appellant’s basic operation. Neither is it necessary to determine whether the appellant’s method of accounting for the leasing operation, the “inventory” and the “depreciation” associated therewith is proper or not. Indeed, as both a practical and professional approach, it has a great deal to commend it, and I make this point strongly. It may well be that for the purpose of accounting for the income of the appellant, treating the leased car stock as a current asset (inventory) is correct. It may be the only realistic way to do it, and indeed Mr. Sammeroff indicated that to be the approach generally used in the industry, and accepted by Revenue Canada in similar circumstances for purposes determining of net income. Interpretation Bulletin IT-128 (supra) recognizes the great difficulties of providing an iron-clad set of rules to apply to inventory calculation and reconciliation. The calculation of the profit of the company, according to the financial statements — if that were used for income tax determination purposes — apparently would not be in issue before the Board. The question is whether the method of doing that accounting calculation — by treating the leased cars as inventory — meets the provisions of paragraph 20(1 )(gg) of the Act for a subsidiary deduction sought by the appellant.

Finally, it is not necessary for the Board to consider whether any gain on leased automobile sales was on “capital” or “income” account. It is only necessary for the Board to determine if it can be said that the leased automobiles were “held for sale” to permit the allowance claimed under paragraph 20(1 )(gg) and, in my view, it cannot be said that they were so held. I do not see that a subsidiary argument from counsel for the appellant that the only business of Plaza was the buying and selling of cars serves to alter that contention in the circumstances of this case. I have reviewed Gloucester Railway Carriage, (Supra), particularly at 472:

. . . We do not regard ourselves as precluded by the fact that as long as the wagons were let, they were treated “as plant and machinery” subject to wear and tear, from deciding that they are stock in trade when they are sold, even though let under tenancy agreements, for they seem to us to have in fact the one or other aspect according as they are regarded from the point of view of the users or the company. In our view shortly it makes no difference that one way of making a profit out of the wagons was given up, for the very giving up itself involved the making of a profit in another way out of the same wagons, and the purpose of the company’s trade is to make a profit out of wagons.

I am unable to reach the conclusion that the only commercial activity encompassed by the business of Plaza was the buying and selling of cars.

It might well be argued that utilizing paragraph 20(1 )(gg) as one would deal with any other calculated allowance in connection with a reserve — deducting it from income one year and bringing it back in the next, if necessary — would support the contention of counsel for the appellant that the allowance is permissible year after year, and it could be in accord with the decision in T Bar B (supra). However, when applied, as in this appeal, outside the accounting for net income framework, that conclusion would inevitably lead to a de facto total write-off in a period of 33 / years out of taxes, not income, of the inventory held for sale, if that inventory remained stable. That, indeed, may have been the deliberate intention of the legislators or it may be the result of referencing the section as an “inventory allowance” rather than an “inventory reserve”.

Perhaps this appeal serves to highlight the unusual questions which arise from the perceived prospect of utilizing paragraph 20(1 )(gg) outside the regular accounting system. Such write-off would in fact even continue beyond that point, while retaining the inventory itself for sale at a profit, according to the. contention of counsel for the appellant. As noted earlier, that general problem of paragraph 20(1 )(gg) was not posed to the Board, and the Board has not had the benefit of the specific respective views of counsel on it, only general observations related to it within which the prospect of the difficulty related in this paragraph is inherent.

The appeal is dismissed.

Appeal dismissed.