25 November 1987 Income Tax Severed Letter 8-0109 - Investment Tax Credit

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.

DATE NOV 25 1987

R.A. D'Avignon Director General Appeals Branch

B.A. Chisholm Specialty Rulings Directorate Chris Higgins 957-2097

Investment Tax Credit

This is in reply to your memorandum dated June 15.1987 in which you requested our opinion on certain matters relating to XXXXXX are have addressed the requests under three areas as covered in your memorandurn.

A. CATEGORIZATION OF INDIVIDUAL ASSETS VS OPERATION AS A WHOLE

Your memorandum indicated some concerns as to whether the comments in our August 19, 1985 memorandum had been interpreted too strictly in reassessing the above taxpayer. You referred to specific items in our research files that appeared to imply that we should consider individual assets rather than the entire pulp and paper process when distinguishing capital expenditures from repairs and maintenance. You indicated that this impression was based on comments made in the British Columbia Forest Products case (71 DTC 5178). This case did not specifically address the issue of whether individual assets are considered capital or instead part of an entire operation process. Instead it dealt with the issue and meaning of "structure" and what was considered to be included in Class 3 rather than Class 8. The issue of what constitutes a structure is not necessarily relevant in determining whether individual assets form part of an entire asset.

As previously noted in your June 15, 1987 memorandum, the central issue in this appeal is determining the nature of the expenditures in question and whether they are on account of capital or income. A number of Canadian court case decisions (many of which were discussed in our August 19, 1985 memo) on whether the expense was capital or income were based on what the court said was the "capital asset" in question.

In the Vancouver Tugboat case (DTC 1126 1957) where the issue was whether the cost of replacing an engine in one of the company's tugboats was an outlay on account of capital, it was held that the capital asset was the engine itself and not the tugboat so that the replacement of it was in substance the replacement of a particular capital asset and not the repair of a larger capital asset.

A similar conclusion was reached by the Supreme Court of Canada in the Haddon Hall Realty Inc. case (DTC 1001 1962). There, the Exchequer Court had decided costs of replacing appliances in an apartment complex were expenditures of an income nature because the equipment was not to be regarded as a capital asset separate from the apartment building. However, the Supreme Court of Canada reversed this decision on the basis that the expenditure in question was made once and for all with a view to bringing into existence an asset or an advantage for the enduring benefit of the trade. That is, the appliances were capital assets separate from the apartment building.

In a 1966 case (DTC 5205) Canada Steamship Lines v. M.N.R. similar application of the above principles was considered. The expenditures in this case fell into two classes:

(a) expenses of replacing floors and walls of cargo-carrying holds in certain ships as a result of the wear and tear arising out of the loading, carrying and unloading of cargoes,

(b) expenses incurred on the replacement of boilers in one of the ships.

With respect to the first class, Mr. Justice Jackett said he had little difficulty in reaching the conclusion that the expenditures were deductible. Jackett commented, "So long as the ship services as a ship and damaged plates are replaced by sound plates, I have no doubt that the ship is being repaired and it is a deductible current expense. I cannot accept the view that the cost of repairs ceases to be current expenses merely because the repairs required are very extensive or because their cost is substantial." Addressing the replacement of boilers, Jackett said their replacement could be regarded as an expenditure for the repair of the ship by replacing a worn out part, or as the acquisition of a new piece of plant or machinery to replace an old asset separate and distinct from the ship.

Jackett indicated that in the case of ordinary plant and machinery in a factory or shop, he would have thought there was no doubt that each engine and machine was a capital asset distinct from the building in which it was installed and used and the acquisition of such assets was a capital matter. However, "On the other hand, in the case of a ship, the function of which involves movement, I should have thought that it was a tenable or arguable view that the equipment or machinery required to effect such movement is an integral part of the ship as a capital asset." On this basis he felt replacement of the boiler should be an expense. However, based on two previous decisions, (Thompson Constr'n & Vancouver Tug Boat) he felt constrained as a matter of consistency to treat boiler costs as capital. Whether Jackett could have distinguished the facts of this case from the other two was not addressed. Jacketts' comments relating to machines and engines in a factory are very interesting and perhaps relevant as far as XXX concerned.

In Thompson Construction (57 DTC 1114) a new engine costing a net amount of $6000 was installed in a power shovel with an original cost of $27,000. The Court was "influenced" in part by the magnitude of the outlay when related to the value of the power shovel as a whole in deciding that the expenditure was on account of capital. The engine was characterized as a "separate capital asset." The engine clearly was a marketable entity, readily detachable from the power shovel by the removal of a few bolts and capable of being used for other purposes. However, the amount of a repair expenditure is relevant only when it is unclear whether the item being replaced is an integral part of a larger asset or a distinct capital asset. As indicated in our August 19, 1985 memo and as indicated above, a part of a larger asset can be considered to be a separate capital property.

Your June 15, 1987 memorandum also cited the 1987 Federal Court case of Gold Bar Developments Ltd. v. the Queen. This case relates to a taxpayer who was reassessed and disallowed deductions for expenditures made to improve unsound walls of an apartment building. The court decided that Gold Bar should be allowed to deduct expenditures as repairs on the basis. that the expenditures were incurred as a result of a "genuine repair crisis". The court did not overrule any of the traditional tests that have evolved in determining whether an expenditure is a deductible repair or on account of capital. They only indicated that no single test was determinative and whether this "genuine repair crisis" test becomes an additional criteria in assessing future cases on "repairs v. capital" remains to be seen.

Based on the above, we feel that the above principles as well as those outlined in IT-128R should be applied in determining whether expenditures relating to the pulp and paper mill previously capitalized by the taxpayer and expensed on reassessment should in fact be capitalized. Discretion should be used to the extent possible. An all or nothing approach would, in our view, be inappropriate in this instance and machines and equipment within the plant should be considered as components separate and distinct from the building.

CONSTRUCTION OF NEW MILL COMPLEX

As indicated in your memo, this issue relates to the denial of I.T.C.'s on expenditures incurred to build the new XXX complex. Included in these expenditures are acquisitions of mobile equipment, trucks, temporary construction buildings, various tools used to build the new mill, and modification and relocation costs incurred to connect the old mill to the new one. I.T.C.'s have been disallowed on the basis that the above expenditures either relate to the old mill or were for the purpose of construction which was an ineligible activity at the time these expenditures were made. The taxpayer has taken the position that if an outside contractor was hired, the price paid for the new mill would have included an allowance for the disallowed costs and as a result feel the new mill is presently undervalued for tax purposes.

A reveiw of the District Office audit files indicate there were four G/L accounts relating to the Remove/Modity Costs. A summary of costs allocated to these accounts is as follows:

XXX

comments in IT-174R (Paragraph 4), although no ITC's were claimed relating to these costs. Approximately 15% of the old mill was ultimately retained after the new XXX mills were built around it.

Although the term "capital cost" is not defined in the Act, paragraph 1 of IT-174R states that the term "capital cost of property" generally means the full cost to the taxpayer of acquiring the property. Paragraph 2 states that the capital cost of depreciable property a taxpayer manufactures for his own use includes material, labour and overhead costs reasonably attributable to the property.

These comments are consistent with Generally Accepted Accounting Principles which require that "the recorded cost of a tangible capital asset should include all costs necessary to put the asset in a position to be used". This principle should be used in determining the "capital cost" of depreciable property for tax purposes unless there are specific provisions in the Act which override this principle. For example, depreciable assets that relate to the cost of constructing a building would not be included in the building's capital cost for tax purposes where these assets are included in another C.C.A. class as prescribed by the Income Tax Regulations. Therefore, assets that were used by 124(1) XXXX the construction of the building (eg. pickup trucks) which are required by reg Cation to be included in a C.C.A. class separate from the building must be included in that other class and will only qualify for investment tax credits if they satisfy the definition of "qualified property" as defined in subsection 127(9) (subsection 127(10) for taxation years ending prior to 1985).

With respect to costs incurred on the demolition of a major portion of the old mill, paragraph 4 of IT-174R states that when an old building is demolished to build a new one, the cost of demolition is not considered to be part of the capital cost of the new building (unless the taxpayer so desires) but may be deducted as an expense in the year. This has been the Department's position for a number of years. Paragraph 6 of IT-12 SR indicates that where a taxpayer acquires real estate including a building, and the building is torn down within a relatively short time after purchase, the question arises as to whether the building should be classified as depreciable property. If the building is demolished by the purchaser without having been used to earn income, the building cannot be regarded as depreciable property. Also, where the building is used to earn income for only a short time prior to demolition, it is not regarded as depreciable property unless the taxpayer can clearly establish that the price intention on acquiring the building was for the purpose of gaining or producing income. Determining whether the old mill acquired by XXX for the purpose of gaining or producing income will depend upon their intentions at the time of acquisition. That is, court cases have determined It is possible for a property that is acquired for the purpose of earning income and which is subsequently demolished, to be considered depreciable property in which the taxpayer will have the right to depreciate the purchase price. However, the taxpayer would have to provide support that at the time of purchase of the building his intention was not to demolish it to obtaina site forthe construction of another building. In this sitution, XXX acquired a building which they operated for approximately three'years. Also, the building was not entirely demolished as a new mill was built around the old mill and included certain components of the old mill.

Based on the above, we feel that some of the costs disallowed on reassessment may in fact form part of the capital cost of the XXX complex and/or machinery and may be eligible for investment tax credits. The t that certain property has been used in construction may not be relevant if it is considered to form part of the capital cost of a qualified property as defined in subsection 127(9) of the Act and Section 4600 of the Income Tax Regulations. Demolition costs which are included for tax purposes in the capital cost of the constructed building, should be eligible for investment tax credits provided the building satisfies the definition of "qualified property" in subsection 127(9) of the Act.

CAPITAL SPARES

Your memorandum indicated that it was your understanding that the policy of treating capital spares as an inventory of Darts has beer consistently applied. Your reference to this point was the Mining Information Session" (Sept. 26/83) Our review of this document indicates gnat to ere war ah inconsistency in the tax reporting of capital spares as it relates to the mining Industry. At that, time there was also an inconsistency in tax reporting between taxpayers, as well as District Tax Office. This inconsistency probably reflects the fact that each situation is different and must be considered individually XXX argument for capitalizing their spare parts is that they are essential to have on hand to prevent major shutdowns in operations and that they are essentially large components which are usually interchangeable with the original part. Also, their policy of capitalizing these components has not changed with the introduction of the investment tax credit and has been accepted by the Department in the past. Paragraph 7 of our memo of August 19, 1985 states that capital spares should not qualify for investment tax credits but should be accounted for in inventory until used. Our position has not changed in this respect. Replacement of a machine part as a result of wear and tear which does not significantly improve the quality, value or performance of the machine cannot be considered a capital expenditure. The fact that the spare parts are on hand at the time of the required replacement, in our view, has no bearing on the tax treatment of this expenditure. We question the difference between the taxpayer buying the identical part in advance as opposed to discontinuing operations and repairing the spare part. The costs of discontinuing operations would probably not be capitalized by the taxpayer. The spare parts were not acquired to improve the larger capital asset but rather to prevent or avoid the costs of a plant shutdown.

In ordinary circumstances, numerous costs comprise two elements:

1. a replacement element which merely fills a hole in productive capability, caused by breakdown, emergency, accident, etc. This type of cost relates to past revenues generated by the assets repaired.

2. an improvement or extension of capability which creates some measure of betterment or enlargement.

When something is restored or renewed, decline in past usefulness that is now made good respesents an expense and not a future benefit. The restoration of something to its original condition should be as lasting and durable as practicable but this long-lasting quality does not make the repair an addition of something new and improved.

Other arguments for capital spares not being considered as capital expenditures include the following:

- critical spare parts are replacements for component parts in larger machinery and systems. The value of these parts in relation to the value of the whole machine does not appear to be material;

- a new independent asset has not been created but merely used to restore a larger asset to its original condition;

- replacements do riot extend the useful life or improve the efficiency of the original piece of machinery to which they are attached. In any event, as was found in Gold Bar Developments Ltd. (87 DTC 5152), the improvement test alone is not determinative. In every case "it is expected that repairs to a capital asset should improve it."

In fact, the Gold Bar case appears to have added a qualification to the improvement test. If the capital asset in question was improved to preserve that asset as a result of an emergency situation, the court will lay less significance on the fact that the asset was improved and they will lean towards treating the expenditure as an expense.

Based on the above, we consider "spare parts" as constituting inventory or prepaid expenses as provided in subsections 10(5) and 18(9) of the Income Tax Act. The parts cannot be considered depreciable property by virtue of paragraphs 1102(1)(a) and (b) of the Regulations and the taxpayer should not be allowed to treat them as Class 29 assets. No investment tax credits will be earned on these parts by virtue of paragraphs 127(9) and 127(10) of the Act.

We hope these comments will be of assistance.

ORIGINAL SIGNED BY ORIGINAL SIGNED PAR R J. L. READ

Director General Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch