4 March 1999 Internal T.I. 9901417 - WHETHER SHARES INVENTORY?

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:

Whether an investment in preferred shares, losses from the disposition of which the taxpayer and the TSO have agreed to treat as an income loss, is inventory of the taxpayer. The investment is made by the taxpayer in order to help finance businesses which purchase the taxpayer’s products for resale.

Position: No.

Reasons:

It is our view that inventory is property held for resale in the ordinary course of a business.

		March 4, 1999

	Toronto Centre Tax	HEADQUARTERS
	   Services Office	J. Gibbons
	Business Enquiries Group	(613)957-8953
	Audit Division

	Attention: Paul Leblanc
		7-990141

XXXXXXXXXX (the “taxpayer”)

This is in response to your letter of January 12, 1999, concerning the proposed filing position of the taxpayer. The taxpayer is proposing to treat certain temporary preferred share investments as inventory, which will be valued at the lower of cost or fair market value, in accordance with subsection 10(1) of the Act.

Briefly, the relevant facts, as we understand them, are as follows:

1. The taxpayer sells and manufactures XXXXXXXXXX.

2. The taxpayer’s products are sold throughout Canada in XXXXXXXXXX, which can be categorized as either independent dealers or “Temporary Co-Ownerships” (“TCO’s”).

3. TCO’s are corporations, 100% of the common shares of which are owned by an individual who is also the active manager of the corporation.

4. A typical TCO costs $200,000 to $400,000 to set up. The funds are required to purchase equipment, leasehold improvements, provide working capital and fund potential operating losses during the start-up phase.

5. The taxpayer provides financing to TCO’s by way of extended credit terms on its inventory purchases and by investing in the preferred shares of the TCO’s.

6. The taxpayer does not charge interest on the outstanding accounts receivable balances from the TCO’s nor does it receive dividends on the preferred shares. Instead, the taxpayer seeks to earn a sufficient return on its investment by way of gross profit on product sales to the TCO’s.

7. The taxpayer sells its products to the TCO’s at the same prices and terms used in transactions with other customers.

8. The taxpayer’s goal is to have its preferred shares redeemed within five years once a TCO is profitable and generating sufficient cash flow.

9. When the investment in preferred shares has been established to be unrecoverable due to a TCO ceasing operations, the winding-up of a TCO or the bankruptcy of a TCO, the loss incurred is deducted for income tax purposes as an income loss.

Taxpayer’s views

According to the taxpayer, its filing position with respect to the preferred share investment was confirmed by Revenue Canada auditors a number of years ago. (As discussed in our telephone conversation, neither you nor the taxpayer has anything in writing that substantiates or explains this agreement.) At that time, the taxpayer’s TCO program was likely not as significant. It has grown quite rapidly over the past couple of years. This has prompted the taxpayer’s management to review the appropriateness of its historical filing position.

The taxpayer’s proposed filing position for the 1998 taxation year is to treat the temporary preferred share investment in the TCO’s as inventory used in the taxpayer’s business of manufacturing and selling XXXXXXXXXX. Accordingly, the taxpayer proposes that the investment of preferred shares be valued annually at the lower of cost or fair market value pursuant to subsection 10(1) of the Act. The new income tax filing position will be applied on a retroactive basis.

Subsection 248(1) defines inventory as “a description of property the cost or value of which is relevant in computing a taxpayer’s income from a business for a taxation year ...” Typically, inventory is considered to consist of the stock of goods that a business holds for resale. However, in the taxpayer’s view, the definition of the term “inventory” is broad enough to include other property and, in particular, the preferred shares investment in TCO’s. The taxpayer refers to Friesen (95 DTC 5551) to support this view, specifically the following comments of Major, J. at 5556:

The Act creates a simple system which recognizes only two broad categories of property. The characterization of an item of property as inventory or capital property is based primarily on the type of income that the property will produce.

And at 5557:

I endorse the approach taken in these cases of considering the definition of “inventory” in the context of the basic distinction between business income and capital gain.

The taxpayer’s line of reasoning is that, since the redemption of preferred shares by the TCO’s is on account of income, and since there are only two types of property - capital and inventory, the preferred shares must be inventory. The taxpayer also makes the assertion that the inclusion of the cost of the TCO program in the computation of income accords with the goal of obtaining the most accurate picture of profit, one of the principles of profit determination espoused by J. Iacobucci in Canderel (98 DTC 6100).

Our views

We do not agree that Friesen stands for the proposition that inventory is other than what is commonly understood, i.e., items of property which a business holds for sale in the ordinary course of business. In this regard, we also refer to comments made by J. Major in Friesen at 5557:

In the ordinary sense of the term, an item of property which a business keeps for the purpose of offering it for sale constitutes inventory at any time prior to the sale of that item. The ordinary sense of the word also reflects the definition of inventory which is accepted according to ordinary principles of commercial accounting and of business.

Further, as regards J. Major’s comments about there only being two types of property, it is important to understand the context in which they were made. In Friesen, the issue involved the determination of whether real estate held for sale in an adventure or concern in the nature of trade could be written down pursuant to subsection 10(1). In opposing such a write-down, the Department argued that the definition of “inventory” in subsection 248(1) should be read as “inventory for a taxation year.” On this basis, the Department argued that real estate held in an adventure or concern in the nature of trade was not inventory until the year in which it is sold. It was in refuting this argument that J. Major made his statement about there being only two types of property. Accordingly, in our view, it would be wrong to apply J. Major’s comments beyond the contextual situation in Friesen. This is supported by the following comments of Bonner, T.C.C.J., in T. Eaton Company Limited (96 DTC 1846 at 1848), in which he addresses the appellant’s reference to the comments in Friesen that there are only two types of property:

In my view the decision of the Supreme Court of Canada in Friesen is not of assistance in deciding whether the contractual right surrendered by the appellant was a capital asset. At issue in that case was the timing of recognition of gains and losses from an adventure in the nature of trade. It was in that context that Major, J. made the remark on which the appellant relies. Such remarks cannot be viewed as rules of universal application intended to be applied mechanically in the analysis of totally different questions.

The taxpayer’s preferred share investments in the TCO’s are not held for resale. Rather, they are held for about five years with the hope of generating a sufficient return in the way of product sales to the TCO’s. Accordingly, in our view, the preferred share investments in the TCO’s cannot be categorized as “inventory,” i.e., property held for resale in the ordinary course of business. In fact, the taxpayer’s description of its investment in preferred shares appears to fit squarely within the concept of a capital asset. That is, an asset which produces income from holding or using it. Therefore, in our view, losses from the redemption of preferred shares in the TCO’s are likely capital losses or allowable business investment losses.

Since we are of the view that the investment in preferred shares is probably on account of capital, losses should be recognized only when the shares are disposed of. Accordingly, we have some concerns with the taxpayer’s practice of recognizing income losses on preferred shares when the “temporary preferred share investment has been established to be unrecoverable due to the TCO ceasing operations, the winding-up of the TCO or the bankruptcy of the TCO.” Section 54 of the Act defines a disposition to include any transaction or event by which shares are redeemed in whole or in part or are cancelled. In addition, where a taxpayer files an election pursuant to subsection 50(1) in respect of shares which are described in that provision, a disposition of those shares will be deemed to have occurred. Paragraph 50(1)(b) describes those shares for which an election may be filed. Accordingly, unless shares are cancelled or redeemed, a disposition of shares will only be recognized if the shares are of the type described in paragraph 50(1)(b) and an election is filed. It is not clear from the taxpayer’s submission that this is in fact the case.

In conclusion, although the evidence suggests that losses on preferred share investments in the TCO’s should be treated on account of capital, there may be other factors, which we are not aware of, which led previous Revenue Canada Auditors to accept the taxpayer’s practice of treating these losses on account of income. However, we do not believe that there is anything to support the taxpayer’s proposal to treat the preferred share investment in TCO’s as inventory.

J.F. Oulton, CA
for Director
Business and Publications Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch

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