NO: IT-102R2
DATE : July 22, 1985
SUBJECT : INCOME TAX ACT
Conversion of Property, Other than Real Property, from or to Inventory
Section 9 (also section 45, subsections 13(7) and 248(1), and paragraphs 13(21)(c) and 54(a), (b) and (c))
The comments in this bulletin apply for taxation years commencing after its issue date. IT-102R will continue to apply for taxation years commencing before that date. Proposals contained in the Notices of Ways and Means Motions of May 9 and May 23, 1985 are not considered in this release.
1. This bulletin deals with conversions of business property, other than real property either from inventory to capital property or from capital property to inventory, without a change in ownership thereof. The bulletin does not deal with the rules in section 45 concerning the determination of capital gains or losses or with the rules in subsection 13(7) concerning capital cost allowance and its recapture. See IT-218 for the Department’s views on profit on the sale of real property other than a principal residence.
2. Inventory is defined in subsection 248(1) as being “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”. Capital property is defined in paragraph 54(b) as being “any depreciable property of the taxpayer, and any property (other than depreciable property), any gain or loss from the disposition of which would, if the property were disposed of, be a capital gain or a capital loss, as the case may be, of the taxpayer”.
3. Capital property, whether or not depreciable property of a prescribed class, that is used for the purpose of earning income from a business or property is not, as a general rule, converted to inventory simply because it is put on the market for sale. Accordingly, where capital property is sold, the sales proceeds will ordinarily be treated as proceeds of disposition of capital property for all purposes of the Act. It is, however, the Department’s position that exceptions to this general rule will occur.
4. Where a taxpayer both sells and either rents or leases property of the same kind, it is the Department’s position that all proceeds from the sale of property that has been rented or leased constitutes income of the taxpayer from the sale of inventory unless
(a) the taxpayer operates a separate and clearly distinguishable leasing division, including the keeping of separate records,
(b) specific property is set aside by the taxpayer for either renting or leasing and is factually so used, and
(c) properties that are so rented or leased are normally sold for an amount that is less than their cost to the taxpayer.
Where the conditions in (a) to (c) above are complied with, the ultimate disposal of property used for renting or leasing will be treated as the disposal of capital property.
5. It is recognized that a taxpayer whose business consists only of the renting or leasing of property is, from time to time, required to renew such property by selling it after it has been rented or leased for a period of time, and purchasing new property. In these circumstances, where the proceeds from the disposal of each individual property normally exceed the taxpayer’s cost thereof, the proceeds from the sale of all of the taxpayer’s property that has been rented or leased will be considered to be received by the taxpayer on account of income rather than capital.
6. Notwithstanding 4 and 5 above, where, at any time, a particular property is leased
(a) without option to purchase,
(b) for a sufficiently long period of time so that the anticipated sales price of the particular property at the time of expiry of the lease will not ordinarily exceed its cost to the lessor, and
(c) the particular property is not ordinarily replaced by other property during the currency of the lease, the lessor may, from that time, treat the particular property as capital property rather than inventory for all purposes of the Act.
7. The facts of each case will determine whether or not a conversion of property, as described in 1 above has occurred. For example, a conversion is generally not considered to have taken place where
(a) property that was purchased primarily for resale is temporarily withdrawn from inventory and used in a business to earn income, for example demonstrator or courtesy vehicles by a car dealer, salesmen’s samples or the use of equipment by employees in carrying out their business responsibilities, or
(b) the cost of property was incorrectly classified in the accounts of a business and has been reclassified to reflect the use made of the property, as capital property or inventory, as the case may be, since it was acquired.
Capital Property Converted to Inventory
8. Where capital property is converted to inventory, the action of conversion does not constitute a disposition within the meaning of paragraphs 13(21)(c) and 54(c). It is, however, recognized that the ultimate disposition of a property that was so converted may give rise to a gain or loss on capital account, a gain or loss on income account or a gain or loss that is partly capital and partly income. Accordingly, with respect to capital property that has been converted to inventory, taxpayers may calculate capital gains or losses, if any, on the basis that a notional disposition of such property occurred on the date of conversion. The amount of such a notionally determined capital gain or loss in respect of a property will be the difference between its adjusted cost base, as defined in paragraph 54(a), (subject to the ITAR rules for property held on December 31, 1971) and its fair market value on the date of conversion. These notionally determined capital gains or losses will be considered to give rise to taxable capital gains or allowable capital losses for the taxation year during which the actual disposition of the relevant property occurs and will be required to be so reported in that same year. The amount of any income gain or loss arising on actual disposition of the converted property will be determined in accordance with generally accepted accounting principles on the basis that its initial inventory value is its fair market value on the date of conversion.
Inventory Converted to Capital Property
9. Where at any time a taxpayer finds it necessary to convert a particular property from inventory to capital property, its capital cost for all purposes of the Act will be its inventory value at that time. Such a conversion might occur, for example, where a particular property in inventory
(a) is required for lease in the leasing division of a taxpayer described in 4 above,
(b) has been leased by any taxpayer under the conditions described in 6 above, or
(c) is otherwise used by the taxpayer as a fixed asset of the business.
10. The conversion of a unit of merchandise from inventory to capital property, as envisaged by 9 above, is not considered to be either a disposition or an acquisition. Therefore, on such a conversion,the application of the half-rate capital cost allowance rules in the first year of ownership will be based on the actual date of acquisition rather than the date of conversion.