PUBLIC VERSION
Citation: 2011 TCC 354
Date: 20110812
Docket: 2008-1944(IT)G
BETWEEN:
CAE INC.,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
[OFFICIAL ENGLISH
TRANSLATION]
REASONS FOR JUDGMENT
Jorré J.
Introduction
[1]
The appellant, CAE Inc.,
is the leading manufacturer of civil aviation flight simulators. It also provides
flight training services.
[2]
The appellant is also involved
in other activities, such as manufacturing military simulators and providing
military training services, but this case involves civil aviation simulators
and training only.
[3]
The appellant is
appealing reassessments for the taxation years ended March 31, 2000,
2001 and 2002.
[4]
The dispute pertains to
seven simulators and five different situations.
[5]
In some cases, the
respondent disallowed capital cost allowance claimed by the appellant. In other
cases, the appellant sold simulators and the respondent considered those sales as
giving rise to business income, while the appellant considers the sales as
giving rise to capital gains.
[6]
The facts are not
really in dispute.
[7]
For the reasons set out
below, I find that the appellant's position concerning the capital cost
allowance is correct, but that the respondent's position concerning the nature
of the sales is correct.
[8]
The witnesses in these
proceedings were as follows: Derek Burney, the appellant's former president; Alain Raquepas, CA, the appellant's chief financial officer; Sylvie Brossard,
CA, a tax specialist and the appellant's tax director; and Ginette Phisel, CA, large business auditor with the Canada Revenue
Agency. All the exhibits, including the transcripts of the examinations for
discovery, were filed in evidence on mutual consent.
The nature of the appellant's business and
the evolution of its business model
[9]
Flight simulators are
large. They include a full flight deck, a visual system that generates very
realistic images simulating what pilots would see from the flight deck, a
motion system, the electronic equipment necessary for the simulation, and
software. Flight simulators cost roughly $10 million to $20 million each.
[10]
The realism of
simulators enables airlines to reduce their costs because they can do a
significant amount of their pilot training on a simulator. They can thus reduce
the number of flight training hours aboard an aircraft. Moreover, simulators
make it possible to simulate difficult flight conditions and equipment failures
for training purposes.
[11]
Simulators generally
operate 20-22 hours a day, 365 days a year.
[12]
In the past, the
appellant sold flight simulators that were built to order.
[13]
The civil aviation
industry experiences significant cyclical highs and lows, so the simulator
market is also very cyclical. The appellant built anywhere from a dozen or so to
roughly 30 simulators per year.
[14]
The appellant set out to
do two things. One was to increase sales, which was very difficult because it was
already the largest supplier of flight simulators for the civil aviation sector.
The other was to achieve a more stable income stream.
[15]
In order to achieve its
objectives, the appellant
expanded its offering.
[16]
The appellant broadened
its use of its simulator design and construction expertise by offering a more
complete range of services to its customers. In addition to simply selling
simulators, it began to offer
(a) simulator
leasing (full-time or hourly) with or without maintenance services, and
(b) complete
flight training services with an instructor, in which case the appellant took
care of maintenance.
[17]
The appellant also
created flight training centres.
[18]
Since the costs of building
simulators are very high, and simulators are specific to aircraft type, the
appellant does not build simulators without having
(a) a
purchaser, or
(b) a
lease or training customer, an "anchor tenant", who will lease the
simulator for a sufficient number of hours or purchase a sufficient amount of
training hours to justify building that particular simulator.
Transactions
Simulators for Canadair Regional Jet CL-65 and
Airbus A330/A340 aircraft (Air Canada)
[19]
Although there are
differences between the facts concerning the CL-65 simulator and the facts
concerning the A330/A340 simulator,
the differences are not important for the purposes of this case. Therefore, I
will only discuss the situation involving the CL-65 simulator, noting, however certain
differences pertaining to the A330/A340 simulator.
[20]
In April 1997, the
appellant and Air Canada signed a contract concerning a CL-65 simulator. The essential
elements of the contract were as follows:
(a) The
appellant would build a CL-65 simulator that Air Canada could use.
(b) The
simulator would be built, installed, tested and ready to use for training in
July 1998.
(c) The
simulator would be located on the appellant's premises in Montreal.
(d) The
appellant would maintain the simulator while it was located on its premises. If
the simulator was moved elsewhere, Air Canada
would have to maintain it. In either case, Air Canada was responsible for
maintaining the avionics.
(e) The
appellant would not provide the services of an instructor while the simulator
was being used.
(f) Air
Canada agreed to use the simulator for [CONFIDENTIAL] years ([CONFIDENTIAL] years
in the case of the A330/A340 simulator) in consideration of (i) certain fixed
monthly payments
and (ii) other payments that varied depending on the number of hours of
simulator use.
(g) [CONFIDENTIAL]
(h) The
[CONFIDENTIAL] –year term could be shortened by the appellant if its
annual revenue was below a certain target; in such a case, the appellant could
terminate the contract on 15 months' notice. The appellant also had the option
to terminate the contract if Air Canada sold all or substantially
all of its CL-65 aircraft.
(i) Third
parties could use the simulator; if they did, the income from the third parties
[CONFIDENTIAL]. [CONFIDENTIAL] would be split between the appellant and Air
Canada, with certain adjustments.
(j) Air
Canada would schedule the simulator use and undertook to
make reasonable efforts to sell other airlines the simulator time that it was
not using. The appellant could also sell simulator time not used by Air Canada,
provided it made sure the hours of use were established jointly with Air Canada.
(k) [CONFIDENTIAL]
(l) There
was a purchase option clause entitling Air Canada
to purchase the simulator on three months' notice, subject to agreement between
the parties on the terms, particularly with respect to price.
[21]
[CONFIDENTIAL]
[22]
Air Canada began to use the simulator during the 1999 taxation
year, and the appellant claimed capital cost allowance in computing its income
for tax purposes.
Sale and
leaseback contracts
[23]
On December 22, 1999, the
appellant signed five contracts concerning the CL‑65 simulator: The first contract
sold the simulator to the Bank of America Canada Leasing VIII Company ("Bank
of America"). In the second, Bank of America leased the simulator to the
appellant. The third was a contract between the appellant and Air Canada for the supply of services involving use of the
simulator; this contract replaced the April 1997 contract with Air Canada. The fourth was between the appellant, Air Canada
and Bank of America. The fifth, entitled "Participation Agreement 1999‑1",
was between the appellant and Bank of America.
[24]
These contracts clearly
form a whole. The lease of the simulator to the appellant depended on it having
been sold to the bank.
[25]
The new contract with
Air Canada contains the main elements of the first contract, though there are a
few differences (such as the fact that the new contract states that the
simulator is to be moved to the Air Canada training centre in Toronto). There is no change that is relevant to this matter.
[26]
The lease contract with
Bank of America provides for a lease term of [CONFIDENTIAL] years. According to
the lease contract, the appellant must, at its expense, make all
necessary repairs and any changes or updates required by the country's laws. The appellant
must insure the simulator at its expense and is responsible for any risks related to the
simulator.
[27]
At the end of the
lease, the appellant must return a simulator [CONFIDENTIAL] to the bank.
[28]
The lease contract also
states that the appellant guarantees the bank that the simulator will have a
minimum residual value.
[29]
Further provisions of
the lease contract enable the appellant to purchase the simulator before the expiry
of the lease, notably if Air Canada wishes to exercise the purchase option granted
in the contract for the supply of services, or on a fixed date that is approximately
six months prior to the end of the contract for the supply of services entered
into with Air Canada.
[30]
The contract contains
financial terms and conditions governing each of the cases in which the
appellant can terminate the lease before its expiry. Although those terms and
conditions vary depending on the different termination clauses, the appellant
must always [CONFIDENTIAL].
[31]
From the appellant's
standpoint, these sale and leaseback transactions are a financing method, a way
to "monetize" the value of the simulators.According to Mr. Raquepas,
the result of the sale and leaseback is similar to the result that would have
been achieved if there had been a loan and the appellant had given the
simulator as security. In the course of the lease, the bank receives payments
in excess of the purchase price and therefore receives a return on its
investment, that is, imputed interest; the rent, including imputed interest,
was similar to a repayment of loan principal plus interest.
[32]
Mr. Raquepas testified
that the bank was not a customer; in his view, the profit from the simulators
is derived from the lease to Air Canada, not the sale to Bank of America.
The accounting treatment of these transactions
[33]
Mr. Raquepas testified
that, from an accounting standpoint, the transactions of December 22, 1999,
were not recorded as a sale to a customer, but, rather, as a disposition of
assets, because the company's auditors would not have permitted the company to
"crystallize" the profit from the transactions during the year in
which the transactions occurred.
[34]
The accounting
treatment of these transactions was as follows: the gain on the disposition of
each simulator to the bank —
that is to say, the selling price to the bank minus the cost of the simulator — was treated as a "deferred
gain." This gain [CONFIDENTIAL] is realized gradually as a reduction of
rent paid during each year of the lease.
As for the balance of the gain [CONFIDENTIAL], this balance, minus any payment
made under the [CONFIDENTIAL], will be realized at the end of the lease.
[35]
This is illustrated by
the following example:
|
Selling
price
|
$100
|
|
Less
cost
|
($80)
|
|
Deferred
gain
|
$20
|
|
[CONFIDENTIAL]
|
___
|
|
Gain over term of lease
|
$12
|
|
|
|
|
Gain realized at end of lease
|
$8 (less any
payments pursuant to [CONFIDENTIAL])
|
In this example, part of the gain, $12, is
realized over time as a reduction of the rent during the lease. The $8 balance [CONFIDENTIAL]
will be included in the appellant's income at the end of the lease. [CONFIDENTIAL]
[36]
With respect to the two
simulators, there are two points in issue:
(a) Prior
to the sale and leaseback arrangement with Bank of America, could the appellant
claim capital cost allowance?
(b) Did
the sale to Bank of America give rise to income or to a capital gain?
Airbus
A320 and A330/A340 simulators (Toronto training centre)
[37]
The appellant decided
to open a flight training centre in Toronto and to build an
A320 simulator and an A330/340 simulator for that centre. These two simulators
were the first ones installed at the Toronto training
centre. Their construction began on December 1, 2000, and
September 4, 2000, respectively.
[38]
The appellant had major
customers (anchor tenants) for the A320 simulator (Skyservice Airlines and Canada 3000) and the A330/A340 simulator (Skyservice Airlines)
(contract dated September 29, 2000, with Skyservice, and contract dated
December 6, 2000, with Canada 3000).Each
of these airlines undertook to lease the simulator for at least a certain
number of hours per year. In both cases, the appellant performed the
maintenance but did not provide an instructor.
[39]
The guaranteed minimum
number of rental hours per simulator in the case of Skyservice Airlines was less
than half the rental hours contemplated [CONFIDENTIAL] in the aforementioned
two contracts with Air Canada. However, upon reading the contract, one can
see that there is an expectation that the use will exceed these guaranteed
hours because, for one thing, the customer, Skyservice, agrees to do all of
its training for A320 and A330/A340 aircraft on the appellant's simulators,
subject to certain conditions, and for another, the appellant reserves the
right to cancel the contract if, during each of the first three years of the
contract, the customer does not increase the number of crews undergoing Airbus
training by [CONFIDENTIAL] crews per year.
In the case of the contract with Canada 3000, the evidence does not reveal the
details.
[40]
The term of the contract
with Skyservice is three years.
The term of the contract with Canada 3000 is six years.
[41]
Both contracts provide
that the lease will begin before the two simulators in question for the Toronto training centre are built, installed and certified.
Consequently, the lease began with the appellant’s simulators in Montreal, and continued
in Toronto once the Toronto
training centre and its simulators were operational.
[42]
As it did with the two aforementioned
simulators for Air Canada, the appellant decided to “monetize” the two
simulators built for the Toronto training centre. Consequently, sale
and leaseback contracts for these two simulators were entered into between the BAL
Simulator Leasing 2001 Company (another Bank of America subsidiary) and the
appellant.
[43]
These sales and leasebacks
took place when the simulators became operational (late September 2001)
but before the appellant used them. The simulators always remained in the
appellant's possession. The essential terms and conditions of these contracts are
very similar to the essential terms and conditions of the sale and leaseback
agreements involving the aforementioned simulators used by Air Canada. The duration
of the leaseback by the appellant from the bank is [CONFIDENTIAL] years.
[44]
For accounting purposes,
these two sale and leaseback arrangements were treated the same way as those
involving the two simulators subleased to Air Canada
discussed above.
[45]
The issue concerning
the simulators being presently considered is whether the sale to BAL gave rise
to income or to a capital gain.
Airbus A320
simulator [CONFIDENTIAL]
[46]
In June 1997, the
appellant and Airbus Industrie signed an agreement. Under the agreement,
the appellant was to build and install, on Airbus's premises in Toulouse, an A320 simulator that would be operational on June
30, 1998. [CONFIDENTIAL].
[47]
The agreement provided
that, after the [CONFIDENTIAL] -year period, Airbus could either lease the
simulator and pay on that basis, or purchase it. Fixed prices were provided for
should Airbus exercise either of these options. In addition, the agreement
provided for the possibility of leasing or purchasing after the third year, at
fixed prices.
[48]
[CONFIDENTIAL].
[49]
[CONFIDENTIAL].
[50]
Airbus exercised the
option to lease, and rented the simulator for one year following the loan
period. At the end of the lease, the simulator was not used for a while. It was
sold to Khalifa Airways in 2003, which is beyond the period relevant to this
litigation.
[51]
The issue with respect
to this simulator is whether the appellant was entitled to claim capital cost
allowance.
Airbus A320
simulator (built for US Airways)
[52]
US Airways ordered an
A320 simulator and cancelled its order in June 2000. The appellant
had completed nearly 60% of the simulator's construction, and decided to finish
it. The simulator became operational around November 2000.
[53]
[CONFIDENTIAL].
[54]
The simulator was then
used for training purposes on the appellant's premises in Montreal. Apparently, under the contracts discussed above, Skyservice
and Canada 3000 were the first users of this
simulator, or among the first. It is not certain how the simulator was used
from December 2001 to June 2002.
[55]
In August 2001, the
appellant signed a five-year lease of the simulator with Frontier Airlines,
commencing on the simulator's anticipated commissioning date in Denver, Colorado.
That date was June 30, 2002.
[56]
Under the agreement,
the appellant would not provide any instructors and, subject to certain
exceptions, Frontier agreed to do all its A320 training on this simulator located
in Denver, though it did not guarantee a minimum
number of hours. The agreement offered Frontier two choices: it could (i) lease
by the hour; or (ii) have "exclusive" use of the simulator for a
fixed annual price.
[57]
The agreement could be
terminated under certain circumstances, notably if Frontier used less than a specified
number of hours annually.
[58]
If Frontier made choice
(ii), but was not using all the simulator hours, the appellant retained
the right to sell the unused hours to other airlines, in which case the revenues
would be shared.
[59]
Civil Aviation Training
Services (CATS) is a Denver-based subsidiary of the appellant that operated a
flight training centre.
[60]
In September 2002, the
appellant sold the simulator to CATS. The simulator became operational in
Denver on October 5, 2002.
[61]
The issue is whether
the simulator was depreciable.
Boeing
747-400 simulator
[62]
In April 1997, the
appellant purchased a Boeing 747-400 simulator from Singapore Airways. The
simulator was to be delivered to the appellant in Singapore within 90 days. The appellant
spent more than $1,000,000 to renovate and update this simulator, which it had
originally built, and to get it recertified.
[63]
At the time of the
purchase, the appellant had United Airlines in mind as a customer for the
simulator, but the appellant and United only signed an agreement in March 1999. At the time of
signing, the simulator had already been delivered to the premises of United in
Denver.
[64]
The agreement provided
(a) that
United
- would
use the equipment to train pilots,
- would
maintain the simulator,
- would
be the simulator's operator,
- would
make reasonable efforts to sell and market training services using the
simulator,
- would
have the option to purchase the simulator in accordance with a predetermined
price calculation method, and
- [CONFIDENTIAL];
(b) that
unless United exercised the purchase option,
-
either party could terminate the agreement after 15 months, on six months'
notice,
-
either party could terminate the agreement after 15 months, on 30 days' notice,
if the use of the simulator was below a certain minimum;
(c) that
the revenues would be shared between United and the appellant (the percentage
of revenues attributed to each party would be calculated using a scale in which
the percentage attributed to United increased as certain thresholds were
exceeded);
(d) that
United had to insure the simulator and the parts, while the appellant had to
obtain liability insurance; and
(e) that
unless United purchased the simulator, the appellant would remain its owner.
[65]
After just over two
years, United terminated the agreement, after which the simulator was
transferred to the appellant's training centre in Toronto.
[66]
The issue is whether
the Boeing 747-400 simulator was depreciable.
Analysis
General considerations
Nature of the business
[67]
It is important to bear
in mind the nature of the appellant's business in the field of civil aviation.
[68]
The appellant creates simulators.
It also provides flight training services. Drawing on its employees' knowledge and
exploiting intellectual property rights, it designs, builds, verifies and
installs civil aviation flight simulators using its employees' labour and purchased
parts and materials. After building the simulators, it turns them to account by
selling them, leasing them out, or using them to sell flight training services.
[69]
The appellant built
roughly 12 to 30 simulators per year.
[70]
The evidence shows a
great deal of flexibility with regard to clients; this is reflected in the
many options available to satisfy their needs for simulators, simulator time,
or training. In addition, the appellant's contracts and its actions show
flexibility in terms of the possibilities in relation to a given simulator.
[71]
There is a single civil
aviation simulator business. The evidence does not establish the existence of a
distinct simulator leasing or training business.
The word "capital" can have various
meanings
[72]
It is helpful to point
out that the word "capital" can have different meanings. For example,
a capital expenditure might be made to acquire property that will procure
benefits over several fiscal years; in this sense, it is the opposite of a
current expenditure. In some cases, a capital expenditure in this sense results
in the acquisition of "depreciable property" within the meaning of
the Income Tax Act (the Act).
[73]
The term "capital
expenditure" can also be mean an expenditure for the purpose of acquiring
property the disposition of which would give rise to a capital gain or loss for
the taxpayer.
[74]
Would a capital
expenditure in the first sense of the term automatically be a capital
expenditure in the second sense? In other words, does a capital expenditure in
the first sense necessarily result in the acquisition of property which, if
sold, will give rise to a capital gain or capital loss? We will come back to
this question.
Difficulties
in distinguishing between a capital gain and income in certain cases
[75]
It is also worth noting
that it is often difficult to determine whether the sale of certain property
produces income or a capital gain.
[76]
In some cases, the
distinction is easy to make. The classic example is the distinction between a
fruit tree and the fruit it produces. A farmer who buys an orchard and sells
the fruit from its trees receives income from the fruit. Upon selling the
orchard when he retires 40 years later, he is clearly realizing a capital gain.
[77]
However, things can get
complicated very quickly. If a person purchases the orchard with the intention
of reselling it at a profit because the person believes that a builder will
purchase it for a new suburban residential development, but the person is happy
to receive in the meantime the income from the sale of the fruit, the proceeds
of the sale are not a capital gain, but income, because there was at least
a secondary intention to resell. One might also call this a dual intention.
[78]
In the instant case,
the situation is even more complicated because the appellant
"created" the simulators.
[79]
At the moment that a simulator
is ready to be used, the difference between the fair market value of the
simulator and its cost (all costs, namely salaries, materials, parts,
depreciation, etc.) — that is
to say, the value created —
is a product of the efforts made by the appellant and by its business. This created
value is not merely a change in the value of an investment.
[80]
Consequently, getting
back to the fruit tree analogy, what is the nature of a tree that has been
created by its owner, whose calling is to plant and grow trees (i.e. to be
a "tree creator") and to sell the trees (or the orchard) when they
have grown sufficiently to bear fruit? The tree is the fruit of the owner's
work. Obviously, if the tree is simply sold, it is part of inventory, and the sale is
income.
[81]
Similarly, the building
and then selling of a simulator produces income.
[82]
But what if this
"tree creator" (or, here, creator of simulators) leases out or uses
one of the trees (or simulators) and sells it later? We will come back to this.
[83]
The question whether
depreciable machines or equipment used by a business give rise to a capital
gain or to income upon their disposition is of limited importance if they are
sold at a price lower than their cost.
In such a case, the Act's provisions concerning recapture and terminal loss will render any
loss or recapture completely deductible or taxable, even if the sale, in the
absence of those provisions, gives rise to a capital gain or loss.
[84]
However, if the machine
or equipment is sold for more than its cost, the distinction is of major
importance.
[85]
It is surprising that
the question whether the sale of depreciable property gives rise to income or a
capital gain has not come up more often in the case law. Perhaps the scarcity
of case law reflects the fact that the owner of depreciable property is rarely
able to sell it for an amount that exceeds its cost.
[86]
I will come back,
further on, to the issue of whether the sale of depreciable property can give
rise to income.
The sales
[87]
I will analyze the nature
of the gain from the disposition of the simulators in two stages:
(a) If
the simulators had been sold to an airline or a flying school unconnected with
the appellant, what would the nature of the gain have been?
(b) Does
a sale to a financial institution alter that nature?
If the
sales had been made to an airline
[88]
One approach is to
examine the appellant's use of the property and the nature of the revenues generated
by that use. One must also consider the four criteria from Friesen v. Canada:
17 IT-218R, which replaced IT-218 in
1986, lists a number of factors which have been used by the courts to determine
whether a transaction involving real estate is an adventure in the nature of
trade creating business income or a capital transaction involving the sale of an
investment. Particular attention is paid to:
(i) The taxpayer's
intention with respect to the real estate at the time of purchase and the
feasibility of that intention and the extent to which it was carried out. An
intention to sell the property for a profit will make it more likely to be
characterized as an adventure in the nature of trade.
(ii) The nature of
the business, profession, calling or trade of the taxpayer and
associates. The more closely a taxpayer's business or occupation is
related to real estate transactions, the more likely it is that the income will
be considered business income rather than capital gain.
(iii) The nature of
the property and the use made of it by the taxpayer.
(iv) The extent to
which borrowed money was used to finance the transaction and the length of time
that the real estate was held by the taxpayer. Transactions involving
borrowed money and rapid resale are more likely to be adventures in the nature
of trade.
[89]
If, after using this
approach, one concludes that the primary object of the transaction does not
constitute an adventure in the nature of a trade, then the following question
must be asked: Was there also a secondary intention to sell, or a dual
intention? In this approach, one must bear in mind that in order for
there to be a secondary intention, it is not sufficient that the business be
prepared, if offered a high enough price, to sell what it intended to keep for
its own use.
[90]
Although the criteria
in Friesen are articulated in the context of real estate transactions,
they are, subject to the necessary adjustments, generally accepted.
However, it must be borne in mind that they do not constitute a complete
list of potentially relevant factors.
[91]
It is important to note
that these criteria are for determining whether there is an "adventure or
concern in the nature of a trade", this being an addition to the concept
of business.
[92]
The other approach, as
I understand it, places more emphasis on the nature of the business and the
question whether the transaction is integral to the operation of the business. The
decision of the House of Lords in Gloucester Railway Carriage and Wagon Co.,
Ltd. v. Commissioners of Inland Revenue
is at the heart of this approach.
[93]
Another way to describe
this second approach is that it is one which determines that a
"business" exist without resorting to the concept of "adventure or
concern in the nature of a trade."
[94]
Before examining Gloucester,
it would be helpful to recall the decision in California Copper Syndicate v.
Harris,
which the House of Lords followed in Commissioner of Taxes v. The
Melbourne Trust Ltd.,
a decision which was, in turn, followed by the Supreme Court of Canada in Anderson
Logging Co. v. The King,
where that court stated:
The principle of these
decisions can best be stated for our present purpose in the language of Lord
Dunedin in his judgment delivered on behalf of the Judicial Committee, in Commissioner
of Taxes v. The Melbourne Trust, Ltd.,
It is common ground that a company, if a
trading company and making profit, is assessable to income tax for that profit.
*** The principle is correctly stated in the Scottish case quoted, California
Copper Syndicate v. Harris. It is quite a well settled principle in dealing
with questions of income tax that where the owner of an ordinary investment
chooses to realize it, and obtains a greater price for it than he originally
acquired it at, the enhanced price is not profit in the sense of schedule D of
the Income Tax Act of 1842 assessable to income tax. But it is equally
well established that enhanced values obtained from realization or conversion
of securities may be so assessable where what is done is not merely a
realization or change of investment, but an act done in what is truly the
carrying on, or carrying out, of a business;
or, in the language of the judgment from
which this quotation is made, which follows in sequence after the passage
cited:
What is the line which separates the two
classes of cases may be difficult to define and each case must be considered
according to its facts; the question to be determined being — Is the sum of
gain that has been made a mere enhancement of value by realizing a security, or
is it a gain made in an operation of business in carrying out a scheme for
profit-making?
or, in the form adopted by Sankey J. — in Beynon
v. Ogg — from the argument of the Attorney General — was the profit in
question
a profit made in the operation of the
appellant company’s business?
[Emphasis added.]
[95]
The decision in Gloucester
was cited in Anderson.
Gloucester Railway Carriage and Wagon Co. built, sold and leased railway wagons,
and purchased wagons built by others. Gloucester was followed by Thorson
P. of the Exchequer Court in Canadian Kodak Sales Ltd. v. M.N.R., where he
summarized Gloucester as follows:
Moreover, I am unable
to distinguish this case in principle from the case of Gloucester Railway
Carriage and Wagon Co. v. Inland Revenue Commissioners, (1925) A.C. 467 and
12 T.C. 720. In that case the Company was formed to manufacture, buy, sell,
hire and let on hire wagons and other rolling stock, and for many years it
manufactured railway wagons, either selling them outright or on the
hire-purchase system or letting them on simple hire. In the books of the
Company the wagons built to be let on hire were capitalized at a sum which
included an amount added as profit on manufacture, and year by year an amount
was written off the value of the wagons for depreciation. In 1920 the Company
decided to cease letting wagons on hire and to sell them. It then sold the
entire stock of wagons used in that branch of its business for a sum in excess
of the value of the wagons in the Company's books. The surplus was included in
an assessment to corporation profits tax on the Company in respect of the
profits of its business, and the Company appealed contending that the surplus
arose from the realization of capital assets used in its hiring business. The
Special Commissioners disagreed with the contention of the Company that the
profit on the sales was an accretion of capital. They found as follows, at page
734 of 12 T.C.:
We are unable to take this view. In our
opinion we must have regard to the main object of the Company which is to make
a profit in one way or another out of making wagons and rolling stock. We are
unable to draw the very sharp line which we are asked to draw between wagons
sold, wagons let on hire purchase and wagons let on simple hire, nor do we
consider that this very sharp division in fact exists. 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 the 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 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.
The decision of the Commissioners was affirmed
by Rowlatt J. of the King's Bench Division. An appeal from his decision to the
Court of Appeal was dismissed, Pollock M.R. dissenting. The judgment of
the majority of the Court was clearly to the effect that the profit made by the
Company was profit arising from the business. On an appeal being taken to the
House of Lords it was unanimously dismissed. I need quote only the last
paragraph of Lord Dunedin's speech, reported at page 474 of (1925) A.C.:
The appellants argue that this is really a
capital increment; and to say so they call these wagons plant of the hiring
business. I am of the opinion that in calling them plant they really beg the
whole question. The Commissioners have found -- and I think it is the fact --
that there was here one business. A wagon is none the less sold as an incident
of the business of buying and selling because in the meantime before sold it
has been utilized by being hired out. There is no similarity whatever between
these wagons and plant in the proper sense, e.g. machinery, or between them and
investments the sale of which plant or investments at a price greater than that
at which they had been acquired would be a capital increment and not an item of
income. I think that the appeal fails.
The principles applied in the Gloucester
Railway Carriage and Wagon Company case (supra) are
applicable in this one. Counsel for the appellant sought to distinguish it from
the present case on several grounds one of which was that in the case cited
there was only one business whereas in the appellant's case there had always
been a sharp separation between its Recordak Division and its other business so
that the former was really a separate business, but the fact is that in each
case there was only one business. The appellant's Recordak Division was not a
separate business. The manner in which the appellant kept its accounts proves
this beyond dispute. Moreover, just as in the case cited the Commissioners
did not regard themselves as precluded by the fact that as long as the wagons
were let they were treated as plant and machinery from deciding that they were
stock in trade when they were sold, and Lord Dunedin considered that "a
wagon is none the less sold as an incident of the business of buying and
selling because in the meantime before sold it has been utilized by being hired
out", so 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.
[96]
Gloucester Railway
Carriage and Wagon Co. was a firm that manufactured railway wagons that it sold
or leased. Sometimes it purchased wagons made by others and then leased them
or, less frequently, resold them right away.
[97]
The decision in Gloucester applies to the
case at bar. There, as here, a manufacturer sold and leased its products. There,
as here, there is only one business. The appellant does not have a separate
leasing business. Having a separate leasing business would in fact be contrary
to its strategy of offering a full range of options to airlines, with a great
deal of flexibility as to options for each customer. The activities involved
are at the very heart of the appellant's business.
[98]
The fundamental
principle on which Gloucester is based is this: A profit constitutes
income if it is derived from systematic efforts rather than from a mere
investment. This principle is clearly expressed by Justice Noël in Dansereau v. Canada:
12 A line must be drawn under the Act
between a mere investment in property and an activity or activities that
constitute a business. The expansive definition of the term
"business" in section 248 is not exhaustive. It extends to any
endeavour that occupies time, labour and attention with a view to profit. To
the extent that income is derived from human activity rather than from the
passive ownership of property, its source can be properly described as
business. The distinction must be made in light of the facts and circumstances
surrounding each particular case (compare The Queen v.
Rockmore Investments Ltd., 76 D.T.C. 6156, per Jackett C.J. at 6157).
[99]
Consequently, if there
were sales to airlines, the profit from those sales of the A320 and A330/A340 simulators
(used at the Toronto training centre), at the time that they were first put to
use, would be income, not a capital gain.
[100] As for the CL-65 and A330/A340 simulators (used
by Air Canada), even with a long-term lease, by virtue of the application of Gloucester
the profit is income for the simple reason that it is derived from the
appellant's work and initiative in designing and manufacturing the simulators. The
profit represents the value created by the appellant. It is not derived from a
mere investment by the appellant.
Does the sale to a financial institution
change the result?
[101] The appellant submits that, in determining
the nature of these four simulator sales, one must take into account the fact
that from both a commercial and practical standpoint they constitute a
financing method. The financial institutions are not customers.
[102] I agree that the financial institutions which
purchased the simulators are not simulator customers, and that the sales to
them are a financing method for the appellant.
[103] That said, they are sales, not loans, and we
must bear in mind that profit —
that is to say, the value created by a business — is a financing method, since businesses
often finance themselves using the profits that they realize.
[104] It must also be borne in mind that this
financing was not for the purchase or construction of the four simulators in
question.
The four simulators had already been built; the financing was for other
activities, including new civil aviation flight simulators.
[105] I do not see how the fact that the sale was
made for financing purposes could exclude the application of the principle in Gloucester
and thereby change the nature of the sales.
[106] First of all, the appellant still realized
the value created by its work in manufacturing each simulator.
[107] Moreover, in "monetizing" the simulator's
value, the appellant was not doing anything fundamentally different from what
it does in a traditional sale to a customer. In either case, the appellant
recovers the capital invested in the simulator's construction (its costs) and
realizes the value that this capital created, namely its profit, which can be
used to finance the business.
[108] Consequently, the fact that the purpose is
financing does not change the nature of the gain made upon selling the simulators
to the financial institutions. It is income.
Depreciation
and capital cost allowance
[109] It is useful to begin by examining the
applicable provisions of the Act and the Income Tax Regulations (the
Regulations).
Depreciable
property
[110] The Act defines "depreciable
property" as follows in subsection 248(1):
"depreciable property" has the
meaning assigned by subsection 13(21).
[111] Subsection 13(21) of the Act provides the
following definition:
"depreciable
property" of a taxpayer as of any time in a taxation year means property
acquired by the taxpayer in respect of which the taxpayer has been allowed, or
would, if the taxpayer owned the property at the end of the year and this Act
were read without reference to subsection 13(26), be entitled to, a deduction
under paragraph 20(1)(a) in computing income for that year or a
preceding taxation year.
[112] Paragraph 20(1)(a) of the Act
provides:
20(1) Deductions permitted in computing
income from business or property ― Notwithstanding
paragraphs 18(1)(a), (b) and (h), in computing a taxpayer's
income for a taxation year from a business or property, there may be deducted
such of the following amounts as are wholly applicable to that source or such
part of the following amounts as may reasonably be regarded as applicable
thereto
(a) Capital cost of property ― such part of the capital cost to the taxpayer of property, or such
amount in respect of the capital cost to the taxpayer of property, if any, as
is allowed by regulation;
. . .
[113] Next, we must look at Parts XI and XVII and
Schedules II to VI of the Regulations to determine when a taxpayer is entitled
to claim part of the capital cost, that is to say, capital cost allowance.
[114] There are numerous rules. The property in
question must come within one of the classes of depreciable property. The
parties agree that the simulators do come within one of those classes.
[115] The exclusions set out in subsection 1102(1)
of the Regulations are a part of these rules. Among other things, paragraph 1102(1)(a)
excludes property the cost of which is otherwise deductible, and paragraph
1102(1)(b) excludes property "that is described in the taxpayer's
inventory."
[116] One consequence of paragraph 1102(1)(a)
is that any property the cost of which can be deducted as a current expense
cannot be depreciable property.
[117] Furthermore, the property must be
depreciable at the end of the taxation year.
[118] Nothing in the Regulations requires that
depreciable property be property that would give rise to a capital gain at the
time of its sale.
[119] This may seem surprising given that
paragraph (a) of the definition of "capital property"[76]
in section 54
of the Act includes "any depreciable property of the taxpayer", but
only paragraph (b) of the definition includes property
"any gain or loss from the disposition of which would, if the
property were disposed of, be a capital gain or a capital loss . . . ."
[120] It is important to remember that, in this
context, the Act is using the term "capital property" in a
limited sense.
[121] In particular, capital gains are not
derived from the disposition of capital property. Paragraph 39(1)(a)
of the Act provides that a capital gain is a gain from any disposition, except
for certain exclusions in subparagraphs 39(1)(a)(i) through (v) and
amounts already included in income.
[122] The fact that paragraph (b) of the
definition of the term "capital property" in section 54 excludes
"depreciable property" does not mean that, under the Act, the sale of
depreciable property necessarily gives rise to a capital gain. The Act leaves
open the possibility that the sale of an item of depreciable property will give
rise to income or a capital gain, depending on the circumstances. In other words,
the Act leaves open the possibility that depreciable property will be part of
inventory at the time of its sale.
[123] In the case at bar, the only possible
reason to disallow depreciation with respect to the simulators in question is
that, during the period in issue, the simulators were "described in
the . . . inventory" of the appellant. The simulators clearly met all the
other conditions in order for them to be depreciable property.
[124] The term "inventory" is defined
as follows in subsection 248(1):
"inventory" means 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 or would have been so relevant if
the income from the business had not been computed in accordance with the cash
method and, with respect to a farming business, includes all of the livestock
held in the course of carrying on the business.
[125] This definition leaves many unanswered
questions, and so we must consider the case law as well as accounting concepts.
The concept of inventory is relevant in determining the profit or loss of a
business for the purposes of section 9 of the Act.
[126] Were the simulators in question part of inventory
during the period in issue? Are they "property the cost or value of which
is relevant in computing a taxpayer's income from a business for a
taxation year"?
[127] Since the appellant sells many simulators, since
its business model is very flexible and since it offers airlines range of
options ― sale, lease or training ― and considering the flexibility seen in
the situations that we have studied, the only possible conclusion is that the
appellant is a business that seeks to derive profit from its knowledge and
skill in creating simulators, whether by selling or by leasing them. This model incorporates
a dual or secondary intention in that the leased simulators (or, in the case of
Airbus, the loaned simulators) are for lease and for sale.
[128] To the extent that a simulator is for sale,
it is inventory, because its price will be relevant in computing the
appellant's income.
[129] However, to the extent that the property is
leased, even if the possibility of a sale always exists (and a simulator might
be used as rental property for its entire useful life), it is not inventory
but, rather, property used as depreciable property, that is to say, property
which is used in a business, but the cost of which is not a current expense or
an expense from which all the benefit is used up over the course of a year.
[130] Thus, there are indicia supporting both
possible characterizations of the simulators in question: inventory, or
depreciable property.
[131] The appellant submits that in order to
determine whether a simulator is inventory or capital property, one must take
into account (i) the use of the property and (ii) the nature of the income
derived from the property. I agree that this is the correct approach, but I
arrive at this conclusion somewhat differently from the appellant. I would
add that the second criterion—the nature of the income—is, to a great extent,
an indicator of the use of the property.
[132] In such a situation, since the Act applies on
a year-by-year basis, I do not see how the issue of the simulators' nature can
be resolved other than by an examination of their current use in each taxation
year and of all the indicia in each taxation year. This characterization
can evolve from year to year.
[133] It is therefore necessary to examine the
use of each simulator and all the indicia and to do so for each year in order
to determine whether the primary nature of the property was inventory or
depreciable property at the end of each taxation year.
[134] Before undertaking this analysis, I must
examine the decision of the Supreme Court of Canada in Friesen, where the majority
of the Court held that a person who participated in an adventure in the nature
of trade involving a parcel of raw land could avail himself of subsection 10(1)
of the Act.
[135] The judgment of the majority, written by
Justice Major, states the following at paragraph 28:
28 The second problem with the
interpretation proposed by the respondent is that it is inconsistent with the
basic division in the Income Tax Act between business income and
capital gain. As discussed above, subdivision b of Division B of the Act
deals with business and property income and subdivision c of Division B deals
with capital gains. The Act defines two types of property, one of which
applies to each of these sources of revenue. Capital property (as defined
in s. 54(b)) creates a capital gain or loss upon
disposition. Inventory is property the cost or value of which is relevant
to the computation of business income. The Act thus 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.
In addition, the decision of the majority
rules out the possibility that the property can be inventory during the year of
its sale but not during another year.
[136] In his dissenting opinion, Justice
Iacobucci disagrees with this point of view; see paragraph 136 of Friesen,
which states, in part:
136 . . . I fail to understand how
property that has received a particular characterization in one year ipso
facto receives that characterization in another, or all other, years.
[137] On an initial reading, this decision of the
Supreme Court implies that the approach that I have just described is impossible,
because a simulator would have to be either inventory or capital property.
Moreover, the nature of the property could not change from one year to another,
thus if the sale of the simulators generated income, that would mean they were inventory,
which, under the Regulations, is not depreciable.
[138] It would also mean that if, for example, a
taxpayer purchased a building with a view to leasing it, but with a secondary—or
dual—intention to sell it, the taxpayer could never claim capital cost
allowance, even if many years elapsed before the sale occurred.
[139] Does the excerpt from Friesen that I
have just quoted, apply? We are no longer in the era where Lord Halsbury stated
that a judgment is authoritative solely for the issue it decides and nothing
more. Ever since the Supreme Court's decision in Sellars v. The Queen, it has been
clear that the Supreme Court's decisions have broader scope than they would
under Lord Halsbury's classic approach.
[140] The current situation is summed up by the
Supreme Court in R. v. Henry,
at paragraphs 53 to 57. At paragraph 57, that court summarizes the applicable principles:
57 The issue in each case, to return
to the Halsbury question, is what did the case decide? Beyond the ratio
decidendi which, as the Earl of Halsbury L.C. pointed out, is
generally rooted in the facts, the legal point decided by this Court may be as
narrow as the jury instruction at issue in Sellars or as broad
as the Oakes test. All obiter do not
have, and are not intended to have, the same weight. The weight decreases as
one moves from the dispositive ratio decidendi to a wider circle of
analysis which is obviously intended for guidance and which should be accepted
as authoritative. Beyond that, there will be commentary, examples or
exposition that are intended to be helpful and may be found to be persuasive,
but are certainly not "binding" in the sense the Sellars principle
in its most exaggerated form would have it. The objective of the exercise
is to promote certainty in the law, not to stifle its growth and
creativity. The notion that each phrase in a judgment of this Court should
be treated as if enacted in a statute is not supported by the cases and is
inconsistent with the basic fundamental principle that the common law develops
by experience.
[141] In order to apply paragraph 57 of Henry
in the present context, we must examine the decision of the majority in Friesen.
[142] In Friesen, vacant land was involved
and therefore there could have been no question of its being depreciable property.
Thus, there was no issue as to (i) whether depreciable property could constitute
another category or subcategory which could, depending on the circumstances,
give rise either to income or to a capital gain upon its disposition; or (ii) whether,
alternatively, depreciable property could become inventory in a subsequent
year.
[143] In Friesen, supra, at
paragraph 28,
the majority states, among other things:
28 . . . The Act defines two types of
property, one of which applies to each of these sources of
revenue. Capital property (as defined in s. 54(b)) creates a
capital gain or loss upon disposition. Inventory is property the cost or
value of which is relevant to the computation of business income. The Act
thus creates a simple system which recognizes only two broad categories of
property. . . .
[Emphasis added.]
[144] The capital assets defined in paragraph (b)
of the definition "capital property" in section 54 exclude
"depreciable property", and since depreciable property cannot, under
the Regulations, constitute inventory, it appears that "depreciable
property" belongs to neither of the two categories.
[145] Since the majority's decision in Friesen
leaves depreciable property outside both categories, I conclude, applying the
approach set out in paragraph 57 of the decision in Henry, that in the
context of the instant case, I am not bound by the assertion that all assets
are either inventory or property giving rise to a capital gain and that the
category cannot change from one year to another.
[146] Consequently, I can follow the approach
that I have described above and look at the current use of each simulator year
by year, whatever the nature of the income might have been at the time that the
simulator was sold.
[147] I would add that, in following this
approach, I am in agreement with Justice Bowie, who states the following
in Good Equipment Limited v. The Queen,
at paragraph 8:
8 The respondent contends that the
leased items of equipment do not qualify as capital assets. In my view,
however, the appellant correctly so classified these units during the term of
each lease. The characterization of an asset as inventory or depreciable
capital asset may change from time to time depending on the circumstances, and
in particular, the use to which the unit is being put at a given time:
see Plaza Pontiac-Buick Ltd. v. The Queen; Canadian Kodak Sales Ltd. v.
M.N.R. . . .
I would clarify that what is involved is
"depreciable property", the term used in the Act, not a
"depreciable capital asset", and that, as I have explained above,
depreciable property does not necessarily give rise to a capital gain upon its
disposition.
Simulators
for Canadair Regional Jet CL-65 and Airbus A330/A340 (Air Canada)
[148] These two simulators were leased to Air Canada on a long-term basis ([CONFIDENTIAL: The leases were
longer than five years.]). There was no question of sales to the bank at the
time that the leases were entered into.
[149] These leases began in July 1998 and January
1999 and were renewed on a sublease basis at the time of the simulator sale-and-leaseback
arrangement involving the bank.
[150] These were not short-term leases. Nothing
in the evidence suggests that a sale could be anticipated in the short term.
The option clause was just a possibility; it is always possible for an owner
and lessee to agree to the sale of property that is being leased. Moreover,
nothing in the evidence suggests that the circumstances which led the customer
to choose a leasing arrangement would change in the short term.
[151] Similarly, as a consequence of the lease
contract the appellant could not sell the simulators to another airline. The
appellant received rental income during the lease.
[152] Given these circumstances, the simulators were
not inventory between the time of their commissioning and, at the earliest, the
beginning of the taxation year in which the sale to Bank of America took place. Thus, the
appellant was entitled to claim capital cost allowance for income tax purposes
under paragraph 20(1)(a) of the Act.
Airbus
A320 simulator (Airbus)
[153] I do not see how this simulator could
constitute inventory during the period commencing with its commissioning in
late June 1998 and ending in late June 2001, following the two-year loan and
one-year lease.
[154] [CONFIDENTIAL]
[155] However, during the three years in
question, this simulator could not be sold to another airline, and during the
first two years, it could not be sold to anyone, including Airbus. [CONFIDENTIAL]
[156] [CONFIDENTIAL]. [CONFIDENTIAL]
[157] During the three years in question, the
current use of the simulator was to earn rental income.
[158] The simulator was not inventory during those
three years. By its primary nature the simulator was depreciable property.
[159] Given the sale to Khalifa Airways in 2003, the
simulator became inventory no later than 2003, when the sale took place.
[160] There is no evidence regarding the use of
the simulator after the end of the lease to Airbus and for the rest of the
fiscal year ended March 31, 2002. Consequently, there are no
facts on which it could be found that the use of the simulator changed prior to
March 31, 2002.
[161] In light of the foregoing, the appellant was
entitled to claim capital cost allowance with respect to this simulator for the
three years at issue.
Boeing
747-400 simulator
[162] The appellant and United signed a lease
contract of indeterminate duration for this simulator. The contract could be
terminated after 15 months. There was a significant sharing of risks between
the parties, and United had the option to purchase the simulator at a price predetermined
according to a formula. United ended the lease after a bit more than two years.
[163] Nothing in the evidence points to
circumstances that made it probable that United would exercise its option in
the short term.
[164] After two years, the appellant moved the
simulator to Toronto, where it used it in its training centre. The respondent
agrees that this simulator was depreciable once it was in Toronto. The dispute
is about the two years during which it was leased to United.
[165] The use during that period was under a lease
for an indeterminate term. The income was rental income. This simulator could
not have been sold to another airline before United terminated the lease.
[166] Given the circumstances, by its primary
nature the simulator was depreciable property, and I do not see how one could
consider it inventory during the years in question.
[167] I agree that it was depreciable property.
Airbus
A320 simulator (built for US Airways)
[168] I will limit my analysis to the 2002
taxation year (April 1, 2001 to March 31, 2002) because no capital
cost allowance was claimed for the two preceding years.
[169] The simulator was used to conduct training
on the appellant's premises in Montreal from the fall of 2000 until December 2001
(at least).
[170] In August 2001, the appellant signed a
five-year lease that commenced on June 30, 2002. Although there were clauses allowing
the appellant to terminate the contract earlier, nothing in the evidence
suggests that a premature termination of the lease could be anticipated.
[171] Given the agreement with Frontier, the simulator
could not be sold during the 2002 taxation year. It could not be sold to another
airline while the agreement with Frontier was in place.
[172] Although the simulator was not yet
operational in Denver on March 31, 2002, it had been used
during the year to earn income, and it was expected that it would be leased to
Frontier during the five years of the agreement. By its primary
nature, it was depreciable property.
[173] Therefore, it constituted depreciable
property during the 2002 taxation year.
Conclusion
[174] The appeal is allowed, and the entire
matter is referred back to the Minister of National Revenue for reconsideration
and reassessment in accordance with these reasons, on the following basis:
(a) The
profit from the sale of the A320 and A330/A340 simulators (used at the Toronto training centre) and the CL-65 and A330/A340 simulators
(used by Air Canada) was income.
(b) The appellant was entitled to claim capital cost
allowance in respect of the CL-65 and A330/A340 simulators (used by Air Canada), the
A320 simulator (Airbus), the Boeing 747‑400
simulator, and the A320 simulator (originally built for US Airways).
Signed at Toronto,
Ontario, this 12th day of August 2011.
"Gaston Jorré"
Translation certified true
on this 28th day of October 2011.
Erich Klein, Revisor
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