19 September 1995 Administrative Letter 952402A - IDENTICAL PROPERTIES HELD AS INVENTORY - ESCROW

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 Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

Where shares of the capital stock of corporations are held by a taxpayer as inventory rather than as capital property, how are the costs of identical properties averaged if some of the previously-acquired shares are subject to an escrow arrangement?

Position TAKEN and REASONS THEREFOR:

Since the shares are not capital property, subsection 47(1) does not apply to calculate the average cost. Instead, one must look to general principles. Initially, it appeared that (as in the case of capital property) all identical shares, whether free shares or escrowed shares, should be averaged together. However, under the circumstances, accounting principles would seem to require the nominal-value escrowed shares to be reported separately as noncurrent assets, distinct from the normal inventory in current assets. That being so, it would be appropriate to calculate the cost of the noncurrent assets separately from the current assets -- in effect, two pools.

September 19, 1995
Mr. Dennis Luciuk HEADQUARTERS
Director J.D. Brooks
Vancouver Tax Services Office 957-8953
Attention: Thea Kruger
Technical Advisor
Appeals
952402

Sections 10 and 47 of the Income Tax Act

This is in reply to XXXXXXXXXX submission of August 28, 1995 and is further to our memorandum of August 8, 1995 concerning the determination of the cost of shares sold which were held on income account. Her submission provided more details of the taxpayer's representative's views on this matter as well as on other matters which we have not been asked to address.

The representative's previous argument, as we understood it, was that the escrowed shares were not similar to the free shares and thus it would not be appropriate under GAAP to average their costs. Since it is the Department's view that escrowed shares are identical to free shares of the same class, we stated that it would be appropriate to average the cost of all shares on hand. The basis for this was that, although subsection 47(1) of the Income Tax Act would have no application to shares held on income account, the use of average costs would yield the truer picture of the individual's income.

Although we do not depart from the views we expressed, we acknowledge that the representative may have a defensible argument that, under GAAP, the inventory of shares that are not available for sale within the next year should be reported separately from the inventory of shares that are available for sale within the next year. At section 1510.01 in the CICA Handbook, it defines current assets as assets that are realizable with the next year or cycle. At section 12.7 in the Accountants' Handbook, it states that inventories are ordinarily classified as current assets; however, where inventory will not be consumed within a year or normal business operating cycle, there are good reasons to segregate it and present it as a noncurrent asset. It is reasonable that the cost of goods in inventory that are current assets should be kept separate from the cost of goods in inventory that are noncurrent assets, even where the goods are otherwise considered to be identical. Otherwise, in the facts of the case at hand, the cost of inventory that is a current asset would be understated and the cost of inventory that is a noncurrent asset would be overstated. Such would not seem to present a truer picture of the owner's financial situation.

Thus we maintain our view that generally the use of average costs would yield the truer picture of an individual's income, although we would qualify this thought with the view that it appears there may be sound reason for maintaining two separate pools -- one consisting of current assets and one consisting of noncurrent assets -- on the basis that it appears that GAAP would require separate pools and separate costing with respect thereto. There is no specific provision in the Income Tax Act that would negate a determination of the individual's income under GAAP. Rather, one must rely on the guidance provided by the Federal Court of Appeal in West Kootenay Power and Light Company (92 DTC 6023), that the principle of using accounting methods which give the "truer picture" of the revenue is valid. In the fact situation, the escrowed shares were issued for nominal consideration and were held in escrow pursuant to requirements of an arm's length governing body (the Vancouver Stock Exchange). The escrowed shares were required to be held until certain performance criteria were met, and were subject to cancellation if the criteria were not met.

One difference in dealing with shares held on capital account and shares held on income account is that, in the former instance, subsection 47(1) requires the cost of newly-acquired shares to be averaged with the adjusted cost base of previously-acquired shares. This is a provision of the Income Tax Act that applies by virtue of the escrowed shares being identical to the free shares. However, in the latter instance, there is no similar provision in the Income Tax Act and thus GAAP plays a more significant role.

We have not sought a GAAP opinion from an accounting firm on this matter, and we leave it to your discretion as to whether you feel that such is warranted.

for Director
Business and General Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch