In C.A.E. Inc. v. The Queen, 2013 FCA 92, the Federal Court of Appeal (FCA) sets the Tax Court of Canada (TCC) straight on some fundamentally important tax principles: the interplay between inventory and depreciable property. The facts provide useful context. The company’s business was building and exploiting commercial airline flight simulators in one of three ways: selling them, leasing them, or using them to sell training services. The company had leased certain simulators in prior years, and sold some of these in subsequent years to a financial institution in sale-leaseback arrangements. The company claimed capital cost allowance (CCA) on all the leased simulators in the prior years, and reported capital gains on the sale portion of the sale-leaseback arrangements. The Canada Revenue Agency (CRA) reassessed by disallowing the CCA and treating the gain on the sales as ordinary income. The Tax Court allowed the CCA but said the gain in the sale-leaseback arrangements was ordinary income. The FCA reversed the TCC. The FCA held that the gain in the sale-leaseback arrangements was a capital gain, and that CCA was available for all but two of the leased simulators. In the course of its judgment, the FCA clarified the following fundamental tax principles.
- Ordinarily, where a property is held for sale, any ultimate sale of that property is ordinary income. This remains so notwithstanding that the property may be used to earn income (rental or leasing income) in the interim.
- Here, however, the sale of the particular simulators to the financial institutions could be distinguished. The properties were indeed sold, but the leasing component of the composite sale-and-leaseback arrangements extended over a period of 20 to 21 years. The arrangement allowed the company to carry on its leasing/service activities with respect to the applicable simulators throughout this period. This meant the simulators did not lose their character as capital property at any time. Accordingly, the sale to the financial institutions as part of sale-leaseback arrangements did not generate ordinary income, but rather a capital gain. In addition, the company was entitled to claim CCA in respect of all but two of these (leased) simulators because fundamentally they were not held for sale.
- The remaining two simulators were leased out by the company under a lease agreement that included “a firm purchase option” at a fixed price. This option could be exercised during the term of the agreement. If these options were exercised, the company would have no choice but to cease using the simulators and sell them. As a result, the FCA concluded that these simulators were being “held for sale” and (as such) constituted inventory. No CCA could be claimed for these simulators simply because inventory is specifically excluded from the definition of depreciable property (see Regulation 1102(1)(b)). These two simulators were not in fact sold (to anyone). It seems clear the FCA would have found that any gain on the sale of these two simulators would have been ordinary income.
- Finally, although not directly relevant to its decision, the FCA expressly stated that the statutory change-of-use rules in s. 13(7) and s. 45(1) are engaged when a property is converted from depreciable property to inventory, and vice versa.