Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.
Principal Issues: Whether activities qualify for M&P deduction.
Position: No.
Reasons: Goods are provided through contracts for service, not sale.
August 25, 2003
XXXXXXXXXX Tax Services Office HEADQUARTERS
Basic Files/Large Case B.G. Dodd
(613) 957-8954
Attention: XXXXXXXXXX
2003-001591
XXXXXXXXXX
Manufacturing and Processing Profits Deduction
We are writing in reply to your April 30, 2003 memorandum requesting our comments on XXXXXXXXXX claim for the manufacturing and processing profits deduction under section 125.1 of the Income Tax Act (the "Act"), a matter that you presently have under audit. We also acknowledge receipt of a copy of XXXXXXXXXX letter to you dated May 30, 2003 setting out arguments in support of their claim.
Facts
Our understanding of the facts is as follows.
XXXXXXXXXX.
Issue
The area of concern involves the activities described in paragraph 6 above, wherein the customer sends the engine to XXXXXXXXXX to be overhauled and whether such activities constitute manufacturing or processing of goods for sale or lease for the purpose of section 125.1 of the Act.
As we understand it, you agree with XXXXXXXXXX that activities described in paragraph 5 above, in which it remanufactures parts and sells them to other entities would be eligible for the manufacturing and processing profits deduction, provided the 10% de minimus rule in paragraph (l) of the definition of "manufacturing and processing" in subsection 125.1(3) of the Act is met.
TSO's View
In your view, based on the decision in Rolls-Royce (Canada) Ltd. v. The Queen, 93 DTC 5031 (F.C.A.), in the case of an overhaul, the parts that XXXXXXXXXX remanufactures are transferred by way of accession, not by way of sale or lease. You are also of the view, based on the decision in The Queen v. Coopers & Lybrand Ltd. (Trustee in Bankruptcy of Hawboldt Hydraulics (Canada) Inc.), 94 DTC 6541 (F.C.A.), that the remanufacture of parts for use in an overhaul does not qualify as manufacturing and processing of goods for sale or lease.
XXXXXXXXXX View
XXXXXXXXXX notes that it is aware of the Rolls-Royce case but states in their May 30, 2003 letter:
XXXXXXXXXX.
The letter goes on to quote another letter written by XXXXXXXXXX.
"XXXXXXXXXX."
You advise that XXXXXXXXXX also argues that although only one engine is overhauled, each part has a serial number and they, in fact, obtain separate permission from the customer for repair or replacement of each part or component. Therefore, XXXXXXXXXX argues they are selling each part or component separately and as such, the parts or components meet the definition of "for sale or lease" in Canada.
To qualify for the manufacturing and processing profits deduction under section 125.1 of the Act, a taxpayer must have, among other things, income from an active business of manufacturing or processing in Canada of goods for sale or lease. There had developed over the years two divergent interpretations of the activities that constitute manufacturing and processing of goods for sale or lease. On one hand were the decisions in Crown Tire Service Ltd. v. The Queen, 83 DTC 5426 (F.C.T.D.) and the above-noted Hawboldt Hydraulics, wherein the Court referred to common law and provincial sale of goods law in defining the scope of the manufacturing and processing provisions of the Act. A second line of authority evolved as a result of the decisions in Halliburton Services Ltd. v. The Queen, 85 DTC 5336 (F.C.T.D.), aff'd 90 DTC 6320 (F.C.A.), and The Queen v. Nowsco Well Service Ltd., 90 DTC 6312 (F.C.A.). This second line of authority declined to apply statutory and common law sale of goods rules, but advocated a literal construction of the word "sale". Under this broader interpretation of sale, the provision of a service incidental to the supply of a manufactured or processed good would not preclude a taxpayer from receiving the benefit of the manufacturing and processing incentives.
The divergence between the two lines of authority was settled by the majority decision of the Supreme Court of Canada in Will-Kare Paving & Contracting Ltd. v. The Queen, 2000 DTC 6467. In that case, the Supreme Court of Canada ruled that the principles set out in the Crown Tire and Hawboldt cases are to be followed. Mr. Justice Major (L'Heureux - Dubé, Iacobucci and Bastarache, J. J. concurring) stated in Will-Kare at 6473 and 6474:
[29] Notwithstanding this absence of direction, the concepts of a sale or a lease have settled legal definitions. As noted in Crown Tire and Hawboldt Hydraulics, Parliament was cognizant of these meanings and the implication of using such language. It follows that the availability of the manufacturing and processing incentives at issue must be restricted to property utilized in the supply of goods for sale and not extended to property primarily utilized in the supply of goods through contracts from work and materials.
...
[33] The technical nature of the Act does not lend itself to broadening the principle of plain meaning to embrace popular meaning. The word sale has an established and accepted legal meaning.
[34] Will-Kare's submissions essentially advocate the application of an economic realities test to the interpretation of what constitutes a sale for the purpose of the manufacturing and processing incentives. However, as noted above, in the absence of express legislative direction to the contrary, I view the incentives' reference to the concepts of sale and lease as importing private law distinctions. As such, the provisions at issue are clear and unambiguous and reference to economic realities is not warranted. See Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622, at para. 40.
[35] It would be open to Parliament to provide for a broadened definition of sale for the purpose of applying the incentives with clear language to that effect. Given, however, the provisions merely refer to sale, it cannot be concluded that a definition other than that which follows from common law and sale of goods legislation was envisioned.
[36] For the taxation years in issue, approximately 75 per cent of the asphalt produced by the Will-Kare's plant was supplied in connection with Will-Kare's paving services. Thus the plant was used primarily in the manufacturing or processing of goods supplied through contracts for work and materials, not through sale. Property in the asphalt transferred to Will-Kare's customers as a fixture to real property.
[37] The principles enunciated in Crown Tire and Hawboldt Hydraulics, to the extent they dictate reference to a common law and statutory definition of sale, offer a guide preferable to the broader interpretation of sale described in Halliburton and Nowsco.
[underlining added]
The Supreme Court of Canada has thus confirmed that, in determining if there is manufacturing and processing of goods for sale or lease for purposes of the Act, reference is to be made to the common law and statutory definition of "sale" and further that manufactured or processed goods supplied through contracts for work and materials are not sold to the customer. More specifically, the Court cited Crown Tire's approach at 6471:
[21] The Crown Tire case related to whether the application of treads manufactured by the taxpayer to tires brought in by customers for repair constituted the manufacture or processing of goods for sale. Strayer, J. (later J.A.) disallowed the taxpayer's claim to the s. 125.1 manufacturing and processing profits deduction as the manufactured tread was supplied through a contract for work and materials, a characterization based upon the method through which property transferred to the buyer. See p. 223:
In Benjamin's Sale of Goods (London, 1974), in considering the distinction between a contract of sale of goods and a contract for work and materials, it is stated:
Where work is to be done on the land of the employer or on a chattel belonging to him, which involves the use or affixing of materials belonging to the person employed, the contract will ordinarily be one intended for work and materials, the property in the latter passing to the employer by accession and not under and contract of sale.
While XXXXXXXXXX were not involved in Hawboldt Hydraulics, that case nevertheless seems particularly useful given the otherwise marked similarities with XXXXXXXXXX activities. In Hawboldt, the Federal Court of Appeal set out the facts at 6542-43:
The facts are not in dispute. At the material times, the taxpayer (Maritime Hydraulic Repair Centre Limited) carried on the business of manufacturing, selling, "repairing and re-manufacturing" hydraulic and pneumatic components for equipment used in industry. The business included the following categories of activities:
a) selling hydraulic parts and accessories manufactured by others;
b) replacing defective parts in hydraulic systems with parts manufactured by others;
c) manufacturing, with its own raw materials and machinery, hydraulic components or systems and selling them to customers by sample or according to their specifications (custom-made); and
d) repairing and "re-manufacturing" hydraulic systems for customers. The activities in this category included the replacement of a part or parts of a customer's hydraulic system with a part or parts manufactured by the taxpayer.
In his reasons, the Trial Judge described the category d) activities as follows (Appeal Book Vol. VIII, page 1505):
In the category of its work that the taxpayer described as "repair and re-manufacture" the evidence is that a customer would bring to the taxpayer and leave for repair equipment with hydraulic components, or the components themselves. The hydraulic component would be taken apart or "disassembled" and some part of it, either the cylinder, or a piston or a rod, or some other part, would be replaced with a corresponding part manufactured to fit the component from raw materials held in inventory or acquired by the taxpayer. In the manufacture of the required parts the equipment in question was used, as it was in the manufacture of hydraulic components to meet customers' specifications (category c above), which is not here in issue. When the new part was manufactured, the component or the customer's equipment was reassembled and tested.
In finding that the activities described in d) did not constitute manufacturing or processing goods for sale, the Federal Court of Appeal stated at 6548:
[w]e are dealing with a commercial statute and in commerce the words have a meaning that is well understood. In the common law, "for sale" does not mean "for use in a repair process". And I doubt that any informed commercial person would seriously say that the manufacture of parts to be used to repair a customer's defective equipment was a manufacture of those parts for sale.
Conclusion
If the parts or components remanufactured by XXXXXXXXXX are transferred to the customer under a contract for work and materials, the remanufacturing activity will not constitute manufacturing or processing of goods for sale or lease within the meaning of section 125.1 of the Act.
While XXXXXXXXXX distinguishes its situation from that in Rolls-Royce, based on our appreciation of the facts, it would seem to us that the two are fundamentally similar. The fact that the XXXXXXXXXX which XXXXXXXXXX overhauls are smaller and more component-based than those in Rolls-Royce, or that in its overhaul activities XXXXXXXXXX uses parts or components which it has remanufactured whereas Roll-Royce used new parts, does not, in our view, suggest that Rolls-Royce is not applicable here.
Based on the information available to us, we agree that XXXXXXXXXX has not established that its engine overhaul activities result in a sale of goods rather than the provisions of work and materials. Accordingly, we are of the view that you would be justified in denying a deduction under section 125.1 of the Act in respect of these activities.
For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Customs and Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you from Mrs. Jackie Page at (819) 994-2898, who will send the severed copy to you for delivery to the client.
We hope this will be of assistance.
Daryl Boychuk, LL.B
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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