10 July 2002 Internal T.I. 2001-0115657 - FINANCING LEASE

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 a particular agreement would be considered a lease such that the payments made under the terms of the said agreement would be deductible in computing income for purposes of both the Income Tax Act and the Excise Tax Act.

Position: Yes

Reasons:

A sale at law has not incurred and the legal relationship created by the agreement is that of a lessor/lessee.

									July 10, 2002

	EDMONTON TSO		HEADQUARTERS
	Verification and Enforcement		Income Tax Rulings
				  Directorate
	Attention:  Donald Boyce		N.L. Storry
(613) 957-3499

			2001-011565

XXXXXXXXXX

We are writing in response to your correspondence of December 12, 2001, wherein you requested our views regarding the characterization of an arrangement whereby miscellaneous equipment is acquired then leased to a prospective Lessee under the terms of a standard agreement which includes an option to purchase at the expiration of the agreement for a nominal price.

You have described a situation in which a purchaser (the "Lessee") wishes to acquire property from a vendor (the "Vendor") and arranges financing of the asset with a third party (the "Lessor"). The Lessor acquires the property and then leases the property to the Lessee pursuant to a Lease Agreement (the "Agreement").

Issues

You requested our comments on the following issues:

Issue 1: Whether ownership of the property has been legally transferred to the Lessor or do the documents represent lease agreements.

Issue 2: Whether the documentation supports the premise that the transaction for purposes of the Excise Tax Act (the "ETA") is a financial transaction or a lease.

Issue 3: Whether for purposes of the Income Tax Act (the "ITA") the transactions are financing transactions, as filed by the taxpayer, or leasing income.

Issue 4: Does the proper interpretation of the ITA and the ETA support the position that assessing positions may vary due to the differences in the wording of the legislation.

Our Comments

Interpretation Bulletin IT-233R sets out criteria to be used in determining if a lease is in substance payments of rent or payments on account of the purchase price of property. The recent Supreme Court decisions (see The Queen v. Singleton 2001 SCC 61, Shell Canada 99 DTC 5669, Continental Bank 98 DTC 5700, Canderel 98 DTC 6100, Hickman Motors Ltd. 97 DTC 5363) favour legal relationship between parties in applying the Act. In Shell, the SCC stated

"...this court has never held that the economic realities of a situation can be used to recharacterize a taxpayer's bona fide relationship. To the contrary, we have held that, absent a specific provision of the Act to the contrary or a finding that they are a sham, the taxpayer's legal relationship must be respected in tax cases. Recharacterization is only permissible if the label attached by the taxpayer to the particular transaction does not properly reflect its actual legal effect..."

As a result, the Canada Customs and Revenue Agency ("CCRA") announced in Income Tax Technical News No. 21 (ITTN No. 21) dated June 13, 2001 that it has cancelled Interpretation Bulletin IT-233R dated February 11, 1983 entitled "Lease-option Agreements and Sale-leaseback Agreements," which described circumstances where the substance of a transaction was allowed to dictate its treatment for tax purposes rather than its legal form. As stated in ITTN No. 21, it is now CCRA's view that the determination of whether a contract is a lease or a sale is based on the legal relationships created by the terms of the particular agreement, rather than on any attempt to ascertain the underlying economic reality. Therefore, in the absence of a sham, it is our view that a lease is a lease and a sale is a sale.

Issue 1:

To determine whether a lease is a lease at law for purposes of both the ITA and the ETA, we must determine whether there has been a sale at law. The meaning of disposition of property has been interpreted broadly in Olympia & York 80 DTC 6185 (FCA) and Robert Bédard 85 DTC 643 (TCC) to include transactions or events that are not sales. These cases dealt with sales transactions where the date of sale was the issue and where the characterization of the transactions was not an issue.

In Wardean Drilling 69 DTC 5194 (Ex.Ct.), the issue was the date of acquisition with respect to a conditional sale. The taxpayer claimed to have acquired the subject asset when it signed a purchase contract for the asset. The Court rejected this claim stating that the taxpayer must have title or the incidents of title and must have rights in the asset, not just rights in a contract relating to the asset. In the case of a lease, the lessee will usually be regarded as only having rights in a contract relating to the leased property and not rights in the leased property. Thus it might be argued that the incidents of title approach is only appropriate to determine when a person becomes an owner of an asset for income tax purposes in circumstances where it is known that the taxpayer has or will become the owner.

The Agreements you have provided state that the equipment is and shall at all times remain the sole and exclusive property of the Lessor, and the customer shall have no right, title or interest in the equipment except as expressly provided in the Agreement.

In addition, the Agreements provided indicate that at no time prior to exercising the purchase option is it known whether or not the Lessee will become the owner of the property.

The documents provided also indicate that it was the intent of the Lessee and Lessor to create a lease arrangement and the relationship created is, in fact, that of a lessee/lessor. Title to the assets remains with the Lessor at all times and the only disposition of property occurs between the Vendor and the Lessor. Although in substance the lease may transfer all the incidents of ownership to the Lessee, the legal relationship created by the Agreement is that of Lessee/Lessor. It is our opinion that a sale at "law" has not occurred and that the form of the agreements described herein reflects the true intentions of the parties to enter into a lease.

Issue 2:

Based on the following interpretation, for purposes of the ETA the financing lease will receive the same GST treatment as an operating lease.

April 18, 2000, Document No: 6302, File No: 11715-6 - Technical Interpretation

The Canada Customs and Revenue Agency has indicated that virtually all transactions structured as leases will be treated as such for GST/HST purposes, regardless of their accounting for financial statement and income tax purposes. A financing lease (such as a bargain option purchase lease), where the agreement is considered to be a lease at law (i[.]e., the agreement is in form and substance a lease), will be treated the same as an operating lease for GST/HST purposes.

On the basis of our examination of the terms and conditions of the Lease Agreement, as well as the surrounding circumstances, it is our opinion that the Agreement should be categorized as a lease for the purposes of the Act. The circumstances are such that it does not meet the definition of "sale" in section 123 of the Act. It is not a transfer of the ownership of the property, nor is it a transfer of possession of the equipment under an agreement to transfer ownership of the equipment (the second component of the definition of "sale").

A financing lease, which is considered to be a lease at law in terms of its form and substance, will receive the same GST treatment as an operating lease. These agreements should not be seen as a conditional sales contract, which provide for the automatic transfer of ownership upon fulfillment of the terms of the agreement.

Based on the definition of "sale" under section 123 of the ETA, a sale of personal property will generally be considered to occur where ownership of the property is transferred or possession of the property is transferred pursuant to an agreement to transfer ownership of the property. In the second instance, the agreement between the parties is the basis on which ownership of the property is intended to be subsequently transferred. Alternatively, if possession of the property is given under an agreement which does not directly result in the current or intended transfer of ownership of the property, the agreement should be considered to be a lease, license or similar arrangement.

The Lease Agreement does contain an option to purchase and there is evidence that in some instances, at the conclusion of the term, customers have exercised the purchase option. This, on its own, should not be taken as clear evidence that the parties intended that ownership of the goods would eventually be transferred at the time that the agreement was entered into. There is no obligation on the part of the Customer to assume ownership of the equipment at the expiration of the Lease Agreement.

Issue 3:

Although we concur that in the case of a typical financial lease the lessee, at the inception of the lease, assumes the normal incidents of title including possession, use and risk, the ITA recognizes financing leases as leases and has specific provisions, which have been implemented to curtail the after-tax financing aspects of leasing. A review of the specified leasing rules (1100(1.1)) and other sections of the Act such as 13(5.2), 16.1, 127(9) and 181.2(3)(f) reveals that the Department of Finance intended that financial leases be considered leases for tax purposes. If we are to follow the legal form of a typical financial lease, then for purposes of the ITA such leases are leases and will be treated as such.

Issue 4:

As stated in Issue #3 above, it is our opinion that the leases described herein are considered to be financing leases. Since a financing lease is considered to be a lease at law for purposes of both the ITA and the ETA, the assessing position of the CCRA will be consistent under both Acts.

We trust these comments will be of assistance.

Steve Tevlin
for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch