Federal Court Decisions

     T-3480-90

     IN RE: THE INCOME TAX ACT

BETWEEN:

     PARDEE EQUIPMENT LIMITED,

     Plaintiff,

     - and -

     HER MAJESTY THE QUEEN,

     Defendant.

     REASONS FOR JUDGMENT

REED J.

     The issue in this case is whether the plaintiff is entitled to claim inventory allowances with respect to certain goods for the years 1978 - 86 and investment tax credits for the years 1983 - 1987. The relevant legislative provisions are paragraph 20(1)(gg) and section 127 of the Income Tax Act, R.S.C. 1952, c. 148, as amended (the "Act").

     On January 19, 1990, the plaintiff filed a statement of claim, T-156-90, claiming inventory allowances for the 1978 - 1982 taxation years. On December 31, 1990, the plaintiff filed a statement of claim, T-3480-90, claiming inventory allowances for the 1983 - 1986 taxation years and investment tax credits for the years 1983 - 1987. On November 22, 1991, the two actions were consolidated under court file T-3480-90. The issue underlying all claims is the same: the nature of the plaintiff's interest in the goods at the relevant times.

     Counsel for the defendant agrees that if the taxpayer "held" the goods for sale for the purposes of paragraph 20(1)(gg), then it is entitled to both the inventory allowance deductions and the investment tax credits that are claimed. The relevant legislative provisions are:

20.(1) ... 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:

(gg) an amount in respect of any business carried on by the taxpayer in the year, equal to that portion of 3% of the cost amount to the taxpayer, at the commencement of the year, of the tangible property (other than real property or an interest therein) that was

(i)      described in the taxpayer's inventory in respect of the business, and

(ii)      held by him for sale or for the purposes of being processed, fabricated, manufactured, incorporated into, attached to, or otherwise converted into or used in the packaging of, property for sale in the ordinary course of the business

that the number of days in the year is 365.

     (underlining added)

Subsection 248(1) of the Act sets out certain definitions:

"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 ...

"cost amount" to a taxpayer of any property at any time means, except as expressly otherwise provided in this Act:

(c)      where the property was property described in an inventory of the taxpayer, its value at that time as determined for the purpose of computing his income,

Facts

     The goods with respect to which inventory allowances are claimed are heavy industrial machines such as excavators, bulldozers and log skidders. The average value of the machines is $150,000.00 to $200,000.00 with some being worth as much as $350,000.00. The taxpayer was and is in the business of selling, servicing and renting such equipment at several locations in Alberta. The plaintiff primarily deals in equipment manufactured by Deere & Co. in the United States ("Deere U.S."). The equipment is distributed to dealers in Canada through John Deere Limited ("Deere Canada"). The plaintiff has been a John Deere equipment dealer since 1956.

     From time to time, the plaintiff signed dealer agreements with Deere Canada for each location in Alberta at which it carried on business. The plaintiff did not sell agricultural equipment. The dealer agreements provide that the equipment (referred to in the evidence as "complete machines") would be ordered and sent to the dealer as "consigned goods". Other equipment, below a certain value was sold to the dealer on a different basis. They are described in the dealer agreements as "sold goods" purchased by the dealer.

     As noted, the agreements between the plaintiff and Deere Canada describe the machines in question as being held by the plaintiff on consignment. The agreements provide that title remains with Deere Canada until completely sold by the dealer. Various documents, for instance the invoices sent to the plaintiff for the machines, repeatedly refer to the goods as having been sent and received on consignment. These are all documents originating with Deere Canada. If the plaintiff had not signed them the plaintiff would not be a dealer in Deere equipment.

     Mr. Pardee, the principal shareholder of the plaintiff company, determined the types of machines and how many of each were required from time to time for his business. These were ordered directly from the Deere U.S. factory although the paper work goes through Deere Canada. The machines were shipped directly from the Deere U.S. factory to the plaintiff. A few Deere machines or parts were manufactured offshore and in that case would be received directly from the offshore manufacturing facility. Once the plaintiff had ordered a machine and it had been "sourced into production" the order could not be cancelled although some changes in specifications and requested shipping date could be made up until what is called the freeze date. The machines were sent f.o.b. the factory gate. This designation indicates that the party to whom the goods are being shipped has legal possession of the goods and, of course, bears the risk of damage or loss after the goods leave the plant gate. Deere Canada carries an insurance policy, however, which covered the goods in transit and for some period thereafter (presumably until the wholesale price had been completely paid). The plaintiff was charged by Deere Canada for the cost of this insurance.

     The plaintiff was invoiced for what was called the wholesale price of the machines. The wholesale price consisted of the dealer price (set by Deere and by reference to which the plaintiff had ordered the goods) and the charges for freight, handling, surcharge duty, sales and similar taxes arising from the transfer of the equipment to the dealer.

     The dealer, the plaintiff, pays the wholesale price to Deere Canada in accordance with terms that vary depending upon the basis on which the particular machine was ordered and the type of machine in question (e.g., those exceeding 100 horsepower have more lenient terms than those having less than 100 horsepower). Typically there is a period of time after delivery, 2 months in some cases, 6 to 9 months in others, during which no amount need be paid. After that "original selling period" has expired, the dealer is required to pay a percentage of the wholesale price, 15% - 25%, to Deere Canada. A second period is then identified (a further 6 months) and after that period the dealer must pay 25% of the wholesale price that then remains outstanding. These periodic payments are called "carry over deposits" ("c.o.d.s"). The process continues with the outstanding balance being diminished in percentage increments at the end of each defined period. This payment schedule only operates so long as the machine is not sold. If the machine is sold by the dealer the total wholesale price, or whatever part thereof remains outstanding, becomes immediately due and payable. Deere Canada does not account for the sale of the machine on its books until it is sold by the dealer. The c.o.d.s are treated for its accounting purposes as deposits. When a dealer pays off the total amount of the wholesale price owing, Deere Canada records the transaction as being a return of the deposits to the dealer and the receipt of the full purchase price by Deere Canada. In fact, what happens is that the dealer only remits to Deere Canada the amount of the outstanding liability owed by the dealer for the machine.

     It is important to note that in the ordinary course of business the plaintiff has no right to return a machine to Deere Canada and has never done so; nor has Deere Canada reclaimed a machine from the plaintiff. There is provision for a transfer of machines between dealers with Deere Canada's approval. When this occurs, Deere Canada records on its books a refund of the c.o.d.s to the transferring dealer and a receipt from the transferee of the exact same amount, as c.o.d. payments. As between the dealers, the machine may be transferred at either a profit or loss depending upon the terms that have been negotiated between them. The plaintiff produced records showing some of the occasions on which he had transferred machines to another dealer at a loss. If the plaintiff's dealership arrangement should be terminated, Deere Canada has the right to direct the dealer to ship the machines to a destination of Deere's choice or to repossess them itself. Termination might occur for example if the plaintiff should become bankrupt or decide to cease doing business or Deere Canada should decide that it no longer wanted the plaintiff as a dealer.

     In addition to the wholesale price, the plaintiff incurs other costs relating to the machines before they are sold. When a machine arrives at the plaintiff's premises set up and testing costs to ready it for sale are incurred. The plaintiff might and did alter some of the machines by adding attachments to convert them to special uses: use in the oil field, use in the forestry industry. The attachments used to make the modifications were not of Deere's manufacture although the engineering department of Deere U.S. approved the modifications. If they were not approved the Deere warranty on the machine was voided. Some of these modifications were of a substantial value as a percentage of the total cost of the machine.

     The plaintiff was obligated to repay Deere Canada the wholesale price regardless of the price at which the plaintiff sold the machine. The plaintiff could sell the machine at a profit and this had no effect on the amount paid to Deere Canada. The plaintiff could sell the machine at a loss and this had no effect on the amount owed to Deere Canada. The plaintiff produced evidence to show sales at a loss. Deere Canada did monthly inspections to ensure that the number of machines that had not been completely paid for (or were "consigned"), were at the respective dealer locations to which they had been delivered, or there was an acceptable reason for their absence. If no such explanation would be given the total amount owing for the machine became immediately due and payable. Any damage or depreciation that occurred was charged to the dealer and had to be paid for immediately to pay down the wholesale price. A dealer could not use a machine for more than a certain number of hours for demonstration purpose without paying Deere Canada "depreciation" charges. These were credited against the wholesale price owed by the dealer. A dealer could not rent a machine to a customer for more than a few months without the total amount owing for the machine becoming immediately due and payable. The rental payments during the limited rental period were paid to Deere Canada to pay down the outstanding balance owed on the wholesale price.

     The plaintiff both sold and rented machines to customers. The plaintiff had two rental programs: one was a straight rental; the other was a rent to purchase arrangement. Under the first the machines were, in general, part of the plaintiff's rental fleet and there is no dispute they were owned by the plaintiff. Their purchase by the plaintiff could have been financed under a Deere Finance Plan available to dealers. Under the second a customer could rent a machine with the option of having the rental payments applied against the purchase price should the customer eventually decide to purchase the machine. Since Deere Canada would not allow more than a few months rental period, the plaintiff would pay the outstanding balance owing on the machine after the allowed rental period in order to continue the rental by the customer.

     Deere Canada also had a lease program pursuant to which machines in a dealer's hands could be rented to customers. Under that agreement (DRV Lease/Finance Agreement) the dealer assigned the leases entered into with the customer to Deere Canada and the proceeds received from the rental were paid to Deere Canada to be credited against the amount of the wholesale price outstanding. The dealer agreement with Deere Canada for this program states that "the function of such Assignment is to acknowledge your [i.e., Deere Canada's] ownership of the consigned goods". Although the plaintiff signed the DRV Lease/Finance Agreement because as a Deere dealer he was required to do so, the plaintiff did not use this program. Mr. Pardee's evidence was that he did not like the program because of the residual value terms that operated at the end of the lease period.

     Deere Canada did not pay the plaintiff interest on the c.o.d. amounts paid by it, nor did it charge interest on the outstanding wholesale balance amount. Interest was charged if a scheduled c.o.d. payment was missed. Rebates or other promotional discounts were paid or offered by Deere Canada to encourage the ordering of machines and to aid in the sales of such machines to retail customers. On at least one occasion Deere credited the dealers with a bonus for all machines of a certain model, a machine that was referred to in the evidence as a 3lemon3. The plaintiff's sales of these machines despite the bonuses were still sales at a loss.

     The dealer agreements did not require the plaintiff to maintain a trust account for the proceeds from the sale of the machines nor segregate the machines from other industrial equipment in the plaintiff's inventory. On June 4, 1980, at the request of Deere Canada, the plaintiff executed a demand debenture on the principle amount of $1,000,000.00 in accordance with terms stipulated by Deere. The principals of the plaintiff were required by Deere Canada to execute personal guarantees of any liability the plaintiff owed to Deere Canada. Throughout the material time there was an agreement in effect between the plaintiff and Deere Canada whereby the plaintiff waived the protection granted by what was then the Conditional Sales Act of Alberta.

     For the years 1978 to 1983 inclusive the plaintiff accounted for its "equity" in the complete machines in notes to its financial statement which it then listed as an "Asset" on the Balance Sheet. As an example "Note 2" of the 1980 Financial Statements stated:

2. Inventories

Details as follows:

1980          1979

New Equipment owned or

held on consignment          $11,894,000.00      $7,586,000.00

Less consignment liability      10,712,000.00      6,860,000.00

New Equipment owned and

equity in consignment

equipment              1,182,000.00      726,000.00

Used Equipment          3,014,000.00      2,053,000.00

4,196,000.00      2,779,000.00

Part and supplies          1,805,000.00      1,686,000.00

$6,001,000.00      $4,465,000.00

Thus the sum of $6,001,000 was entered as a "Current" asset on the balance sheet.

     For the 1984 to 1986 years inclusive the plaintiff changed the accounting presentation used for its financial statements. It accounted for the machines it had on hand by showing the total amount outstanding to Deere Canada on the machines as a "Liability" on the balance sheet and showing the total value of the machines it had on hand at the less of cost or market value as an "Asset" on the balance sheet.

     Accounting evidence was given that the presentation used for the 1984 - 1986 years was preferable since it gave more consideration to the substance of the transactions rather than the form in which they appeared from the dealer agreements and documents. On a closer analysis of the substance of the transactions, the plaintiff's accountant concluded the risks and rewards associated with ownership vested with the plaintiff and not Deere Canada and the financial statements should be presented to more clearly reflect that reality.

     I was referred to portions of the CICA Handbook that discuss the transfer of goods from a seller to a buyer as having been effected when there is a transfer of the significant risks and rewards of ownership and the seller retains no continuing managerial involvement or effective control over the goods to the degree usually associated with ownership. The Handbook notes that the transfer of legal title may occur at a different time from the passing of possession or the risks and rewards of ownership.

Applicable Law and Analysis

     The defendant's position is that the arrangements between the plaintiff and Deere Canada are the same as those adjudicated upon in The Queen v. Dresden Farm Equipment, 89 D.T.C. 5019 (F.C.A.), overruling 86 D.T.C. 6167 (F.C.T.D.) and 82 D.T.C. 1388 (T.C.C.), and that the machines are not part of the taxpayer's inventory.

     Counsel for the plaintiff quotes the comments in Quinn v. Leathem, [1901] A.C. 495 at 506 (H.L.):

... every judgment must be read as applicable to the particular facts proved, or assumed to be proved, since the generality of the expressions which may be found there are not intended to be expositions of the whole law, but governed and qualified by the particular facts of the case in which such expressions are to be found.

     Counsel for the plaintiff argues that the facts proven in this case differ from those set out and relied upon by the Court in the Dresden decision. He argues as well that some doubt has been cast on the correctness of the Dresden decision as a result of the Supreme Court decision in Friesen v. Her Majesty the Queen (1995), 95 D.T.C. 5551 (S.C.C.).

     I am not persuaded that the Friesen decision cast doubt on the correctness of the Dresden decision. The decisions deal with different issues: the Friesen decision dealt with an evaluation issue; the Dresden decision with whether or not the equipment was "held" by the taxpayer as inventory. In Dresden the Court of Appeal found that the equipment was held on consignment, it was not owned by the taxpayer and that there was no 3cost3 to the taxpayer until the sale of the consigned goods was effected. Thus a 3value3 could not be assigned to the goods as inventory for the purposes of computing the taxpayer's taxable income.

     While dicta from Dresden was not adopted in Friesen, the central finding in the Dresden case was not disavowed. The Friesen case, however, made it plain that the term 3inventory3, as defined in subsection 248(1), should be interpreted by reference to the plain meaning of that word consistent with its commonly understood meaning in accordance with ordinary principles of commercial accounting and business.

     It is trite law that the terminology used in agreements does not control the legal characterization of those arguments. One looks at the substance of the agreement. In the present case, although the dealer agreements and other documentation characterize the machines in question as "consigned goods", the indicia of the transactions are more properly characterized as a sale subject to a secured interest being held by Deere Canada until the purchase price is fully paid. The control that Deere Canada continues to exercise over the machines is more consistent with the control a secured creditor would exercise rather than that of an owner. Of primary importance for the characterization is the fact that the machines are not and cannot be returned to Deere. This is in consistent with a consignment. While the goods can be transferred to another dealer with Deere Canada's consent, this is not equivalent to a return of the machines to Deere since it only occurs when the other dealer consents and the transfer is not cost neutral for the plaintiff. It may involve either a profit or a loss for the plaintiff.

     While the Federal Court of Appeal in Dresden stated that in order to be inventory, goods have to be owned by the taxpayer, there was no analysis in that case of the type of ownership interest that was required. There was no analysis of the situation in which the indicia of ownership are divided with someone other than the taxpayer holding the legal title until the point of sale. In addition, in this case the evidence establishes that treating the machines as inventory in the plaintiff's hands is consistent with ordinary commercial accounting and business practices because the risks and rewards associated with ownership rest with the plaintiff not Deere Canada. The facts in this case differ from those in the Dresden case. The facts in this case show that the plaintiff "held" the machines for sale as that term is used in paragraph 20(1)(gg) of the Act.

OTTAWA, Ontario.

May 6, 1997.

    

                                 Judge