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CAE – FCA Overturns Hybrid Capital/Inventory Asset Classification 

Canadian Tax Adviser

 

April 23, 2013

 

Benoit Lacoste-Bienvenue
National Leader, Canadian Corporate Tax

 

The Federal Court of Appeal (FCA) recently made a decision in favour of the taxpayer in CAE Inc. v. The Queen (2013 FCA 92). The FCA overturned the Tax Court of Canada's (TCC) decision, finding that the taxpayer realized a capital gain (not income as the TCC found) when it sold assets that were part of a sale-leaseback arrangement on the basis that the sale from the sale-leaseback transactions were not entered into the normal course of the taxpayer's business. Further, the FCA found that the taxpayer could claim capital cost allowance (CCA) deductions on most of these assets because they were not inventory to the taxpayer.

Facts

The taxpayer's (Opco) main business is building and selling airplane flight simulators. However, it also builds flight simulators to be leased on a short-term or long-term basis, or to be provided in its flight training services. The dispute in this case results from the multiple uses of the simulators.

 

In one of the uses addressed, Opco entered into a long-term lease with an airline. As part of this long-term lease, it undertook a monetization financing operation whereby it entered into a sale-leaseback arrangement with the leasing arm of a bank. In particular, Opco sold the simulators to the bank and then leased them back for a twenty-year term. Opco then leased the simulators back to the airline on the same terms as the original long-term lease. In this situation, the sale of the flight simulators to the bank resulted in a $15 million gain.

 

Opco claimed CCA on these leased simulators prior to the sale-leaseback and declared the gain on the sale on capital account.

 

Opco also entered into other sale-leaseback transactions with the simulators it built for its training centre.

 

The CRA reassessed the taxpayer for its 2000-2002 taxation years on the basis that the simulators were inventory to Opco, such that no CCA was permitted and a gain of $27 million from simulators sold during the relevant period was on income account.

 

Background — TCC's decision
In its decision in CAE Inc. v. The Queen (2011 TCC 354), the TCC addressed the issue of characterizing property (i.e., airplane flight simulators) that was leased out (with the possibility of a sale) as depreciable property or inventory. In this situation, the leasing property was characterized as depreciable property and the TCC allowed the CCA. However, the TCC also concluded that, on the sale of the property for an amount in excess of its cost, the gain was on income account. In effect, the court seems to have treated the assets in question as a type of hybrid capital/inventory asset.

 

The TCC concluded that property may be depreciable capital property at one point and inventory at another point. As a result, the use of the property and the revenue generated from the property must be examined annually.

 

Gain from sale-leaseback is capital not income
The FCA noted that the dispute in this case arises because of the multiple uses to which Opco put its simulators during the relevant period.

 

The FCA began its analysis by citing Friesen, noting that it is the nature of the property sold that determines the resulting tax treatment.

 

The FCA noted that the sales that were part of the sale-leaseback arrangements were made for financing purposes and from an operational level nothing changed.

 

The FCA also found in reviewing the sale-leaseback as a whole that it was it significant that the sale-leaseback sales were not profitable on their own. It was only with the income generated from the ongoing use of the simulators over the period of the lease "that the sale-and-leaseback transactions make business sense". This fact explains the accounting treatment whereby the sales were not recorded as profit but instead were recorded as a reduction of rental expense over the term of the contract.

 

The simulators sold under the sale-leaseback contracts were long-term assets capable of allowing Opco to generate rental or service income for twenty years.

 

As a result, the FCA found that the gain from the sale-leaseback transactions was not realized in the normal course of Opco's business activities and therefore the gain was on account of capital.

 

CCA allowed on asset in sale-leaseback arrangement
The FCA found that the TCC failed to consider that the Income Tax Act contains a mechanism that recognizes and accounts for changes in an asset's use, i.e., subsection 45(1) provides for a deemed disposition at fair market value on a change in use of non-depreciable capital property to or from income-earning, and subsection 13(7) provides the equivalent rule for depreciable property. By failing to consider these provisions, the TCC "felt the need to decree the existence of a new class of property" (i.e., hybrid capital/inventory asset). The FCA disagreed that an asset can be both depreciable property and inventory.

 

The FCA noted that the purpose of the change in use rules in subsections 45(1) and 13(7) is to recognize changes in the use of property which have the effect of changing the tax treatment that applies, to allow a "fair and equitable transition based on set valuations, while preserving the integrity of the tax system".

 

The FCA noted that under paragraph 1100 (1)(a) of the Income Tax Regulations, if at the end of a taxpayer's taxation year the taxpayer holds property that is part of a prescribed class and was used in the year to earn income, then in general the taxpayer is entitled to CCA for that year. However, property that is inventory is excluded from the definition of "depreciable property" under paragraph 1102(1)(b) of the Regulations. Thus, property held for sale is not depreciable property, even if it is used in the meantime to earn income.

 

The FCA found that most of the simulators sold by Opco under the sale-leaseback arrangement were not inventory and thus Opco was entitled to claim CCA deductions on those simulators prior to the sale-leaseback.

 

CCA not allowed on assets where option to purchase exists during lease term
The FCA disagreed with the TCC and did not allow Opco to claim CCA on simulators that gave an airline an option to purchase the simulator during the lease term rather than at the expiration of the lease. The FCA noted that if the options were exercised, Opco had "no choice but to cease using the simulators and sell. Given this, [Opco] cannot maintain that these simulators were not being held for sale and therefore part of its inventory."

 

For more information, contact your KPMG adviser.

 

 

 

 

 

Information is current to April 23, 2013. The information contained in this publication is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG's National Tax Centre at 416.777.8500

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