The Capital Cost Allowance System

[Pages:20]The Capital Cost Allowance System

Israel Mida and Kathleen Stewart*

PR?CIS Cet article comporte un historique et une analyse du r?gime canadien de d?duction pour amortissement, qui sert de base pour l'?tablissement de l'amortissement d'immobilisations ? l'?gard de l'imp?t. Les auteurs r?sument les ?l?ments cl?s du r?gime actuel, y compris les genres de biens admissibles ? la d?duction pour amortissement, la m?thode de calcul des demandes de d?duction pour amortissement et les principales dispositions qui ont ?t? adopt?es au fil des ans afin de restreindre les demandes de d?duction pour amortissement. Les auteurs ?value ensuite l'?quit?, la simplicit?, l'?-propos et la comp?titivit? du r?gime, et ils examinent les facteurs qui influenceront les modifications qui y seront apport?es.

ABSTRACT This article presents a review and analysis of the Canadian capital cost allowance system, which establishes the basis for the depreciation of capital property for tax purposes. The authors summarize the key elements of the current system, including the types of property that are eligible for capital cost allowance, the method of calculating capital cost allowance claims, and the major provisions that have been introduced over the years to restrict capital cost allowance claims. The authors then assess the fairness, simplicity, adequacy, and competitiveness of the system and consider the factors that will influence future changes to it.

INTRODUCTION This article presents a review and analysis of the Canadian capital cost allowance (CCA) system. For many taxpayers, capital expenditures represent the most significant cost of doing business. Paragraph 18(1)(b) of the Income Tax Act1 prohibits the deduction of capital expenditures; however, paragraph 20(1)(a) allows a taxpayer to deduct an amount with respect to the capital cost of property to the extent allowed by the Income Tax Regulations. The regulations contain a multitude of detailed rules that make up the CCA system.

* Of Coopers & Lybrand, Toronto. 1 RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as "the Act"). Unless otherwise stated, statutory references in this article are to the Act.

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The first section of the article summarizes the depreciation system under the Income War Tax Act of 1917 (IWTA) and then the basic CCA system. As the current CCA system has evolved over a period of nearly 50 years, the article deals with only the highlights of the amendments made during that time. Table 1 provides a chronological summary of the key amendments, excluding rate changes. The second section of this article provides an assessment of the CCA system. The final section considers the future of the system.

BACKGROUND: THE SYSTEM BEFORE 19492 The CCA system was designed, in large part, to address the many concerns that taxpayers had with its predecessor, the depreciation system introduced as part of the IWTA. The IWTA gave the minister of national revenue absolute discretion in determining how much depreciation, if any, would be allowed to a particular taxpayer for tax purposes.3 Over time, an informal set of rules developed as the maximum rates that were generally allowed by the minister for various types of assets became known within the business community. However, since rates for particular taxpayers could still be negotiated, there was no assurance that the minister would always be consistent and treat taxpayers equally.

Once depreciation rates were set for a taxpayer, they had to be strictly adhered to unless otherwise allowed by the minister. Even in a loss year, the minister required that a taxpayer claim a minimum of 50 percent of its usual tax depreciation allowance. If a taxpayer claimed a low rate of depreciation in a given year owing to poor profitability, there was no opportunity to amend the claim subsequently if profitability was higher in a later year.

The system was designed to recognize the wear and tear of property used to earn income. Depreciation was generally calculated on a straightline basis over what the minister estimated to be the useful life of the property. The effect of obsolescence on the loss in value of the property was not recognized in the setting of the rates. If property was sold or scrapped before it was fully depreciated, no further depreciation was allowed, and any resulting loss was considered capital in nature and thus not recognized for tax purposes. (Capital gains and losses were "nothings" until 1972.)

In 1940, the legislation was amended to provide that tax depreciation could not be claimed in excess of the depreciation that was booked for accounting purposes. The result was that taxpayers established accounting policies for depreciation that would allow for the maximum tax

2 For further discussion of the predecessor system, see Canada, Department of Finance, 1976 Budget, Budget Paper C, "Capital Cost Allowances," May 25, 1976; Robert W. Davis, Capital Cost Allowance, Studies of the Royal Commission on Taxation no. 21 (Ottawa: Queen's Printer, 1966); and Lancelot J. Smith, "Twelve Years of Capital Cost Allowances," in Corporate Management Conference 1961, Canadian Tax Paper no. 24 (Toronto: Canadian Tax Foundation, 1961), 15-32.

3 The Income War Tax Act, RSC 1927, c. 97, section 5(a).

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Table 1 Canadian Tax Depreciation Systems: Summary of Milestones

Year

Milestone

1917 . . . . . . 1940 . . . . . .

1949 . . . . . . 1954 . . . . . . 1972 . . . . . . 1976 . . . . . . 1981 . . . . . . 1987 . . . . . .

1989 . . . . . . 1995 . . . . . .

Introduction of depreciation system in Income War Tax Act Introduction of requirement that tax depreciation not exceed accounting depreciation Introduction of accelerated depreciation and a limited form of recapture of accelerated depreciation Introduction of capital cost allowance system Repeal of requirement that tax depreciation not exceed accounting depreciation Restrictions on CCA claims for rental properties Restrictions on CCA claims for leasing properties Introduction of half-year rule Available-for-use rules Restrictions of CCA for passenger vehicles Specified leasing property rules Revision of rules governing non-arm's-length transfers of assets

writeoff, whether or not the method was appropriate for accounting purposes. When the government abandoned this limitation in 1954, a number of taxpayers restated their accounting depreciation for financial statement purposes for prior years.4

Beginning in 1940, accelerated depreciation was permitted in order to encourage the expansion of wartime production facilities. A limited form of recapture also was introduced in that year. In 1944, a further legislative amendment provided for double depreciation on up to 80 percent of the cost of new investment. This change was designed to facilitate the transition to peace and to stimulate the economy. These measures appear to be the first attempts by the federal government to use depreciation as a fiscal tool.

Although the system from 1917 to 1948 permitted an allowance that closely approximated that provided by business in financial statements, concerns of business about the proper exercise of ministerial discretion and the lack of recognition of obsolescence made changes necessary.5 These concerns ultimately led to the introduction of the CCA system.

CAPITAL COST ALLOWANCE SYSTEM Overview

The CCA system became effective January 1, 1949. It was designed to be simpler and more equitable than its predecessor. Although many modifications have been made over the years, the basic structure of the original CCA system remains intact today. The system gives taxpayers the statutory right to make a discretionary claim in respect of an eligible capital acquisition equal to any amount up to the maximum allowed under the

4 Davis, supra footnote 2, at 61. 5 Ibid., at 1.

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regulations. CCA is generally calculated on a declining balance basis at the prescribed rate on the undepreciated capital cost (UCC) of depreciable property grouped in prescribed classes. The myriad of factors to be considered in determining a CCA claim are discussed below under three major headings:

1) eligibility for inclusion in CCA classes,

2) calculation of CCA, and

3) restrictions on CCA claims.

Eligibility for Inclusion in CCA Classes As noted above, the CCA system applies to capital expenditures. Jurisprudence has established a number of criteria that may be considered in determining whether an expenditure is capital in nature. For example, capital expenditures generally produce an enduring benefit, while expenditures of a current nature produce an immediate benefit but have little or no long-term effect.6

Property must be included in the regulations in order to be eligible for CCA.7 The regulations apply to tangible depreciable assets such as buildings, equipment, and furniture and fixtures, and to intangibles such as patents, franchises, and leasehold improvements.8 No depreciation is allowed for land.9 Goodwill and other intangibles are entitled to a tax writeoff as eligible capital expenditures.10 This tax writeoff is not discussed here but has been covered thoroughly elsewhere.11

Regulation 1102 specifically excludes from the CCA classes certain property including the cost of property that is deductible in computing income, inventory, property that was not acquired for the purpose of gaining or producing income, property acquired that qualifies for a deduction under section 37 of the Act, land, and property owned by a non-resident person that is situated outside Canada. In addition, class 8 provides a number of other exclusions.12

6 British Insulated and Helsby Cables v. Atherton, [1926] AC 205 (HL). Other criteria that may be considered in determining whether an expenditure is of a current or capital nature are summarized in Interpretation Bulletin IT-128R, "Capital Cost Allowance-- Depreciable Property," May 21, 1985.

7 Paragraph 20(1)(a). 8 Assets included in CCA classes are summarized in regulation schedules II to VI. 9 Regulation 1102(2). 10 Defined in subsection 14(5). 11 See, for example, Ronald W. Larter, "Capital Cost Allowance and Eligible Capital Property: Tax Reform Implications," in Report of Proceedings of the Fortieth Tax Conference, 1988 Conference Report (Toronto: Canadian Tax Foundation, 1989), 27:1-27; and Joseph A. Stainsby, "Recent Developments in Capital Cost Allowance and Eligible Capital Expenditures," in Current Developments in Measuring Business Income for Tax Purposes, 1981 Corporate Management Tax Conference (Toronto: Canadian Tax Foundation, 1982), 167-207. 12 Regulation schedule II, class 8.

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Ownership An asset can generally be included in a CCA class only when the taxpayer has acquired a capital property or a leasehold interest in capital property for the purpose of gaining or producing income.13 The taxpayer will generally be considered to have acquired a depreciable property at the earlier of the day on which the taxpayer obtains title to it and the date on which the taxpayer has all the incidents of title, such as possession, use, and risk. A number of court cases have considered the issue of ownership, particularly in the context of lease arrangements.14

Available-for-Use Rules The timing of the inclusion of an asset in the UCC of a class is also affected by the "available-for-use rules," which were introduced as part of the 1987 tax reform. These rules, contained in subsections 13(26) to (32), prevent the taxpayer from claiming CCA until the time the property is "available for use." The time at which property is available for use is defined in subsection 13(27) for property other than buildings and in subsection 13(28) for buildings. Each of these provisions includes a two-year rolling start rule, providing that property that has not otherwise become available for use is deemed to be available for use in the second taxation year following the year in which the cost was incurred by the taxpayer.

The application of the available-for-use rules may be limited in the third and subsequent years of a long-term project if the taxpayer elects under subsection 13(29) to use the "long-term project rule." The taxpayer may make the election in the first taxation year that begins more than 357 days after the end of the taxation year in which the taxpayer first incurred expenditures in respect of the project. When this election is made, only expenditures in excess of certain threshold amounts in the third and subsequent years will be subject to the available-for-use rules.15

Calculation of CCA For purposes of calculating CCA, assets are grouped in prescribed classes. CCA is generally calculated by applying the prescribed CCA rate to the UCC of each class at the end of a taxation year.16 Table 2 lists the classes

13 See the definitions of "depreciable property" and "undepreciated capital cost" in subsection 13(21).

14 See, for example, MNR v. Wardean Drilling Ltd., 69 DTC 5194 (Ex. Ct.); and The Queen v. Henuset Bros. Ltd. [No. 1], 77 DTC 5169 (FCTD). Additional cases are summarized in Thomas S. Gillespie, "Lease Financing," in Income Tax and Goods and Services Tax Considerations in Corporate Financing, 1992 Corporate Management Tax Conference (Toronto: Canadian Tax Foundation, 1993), 7:1-43.

15 An example of the long-term project rule is provided in the technical notes to Bill C-18: Canada, Department of Finance, Explanatory Notes to Legislation Relating to Income Tax (Ottawa: the department, May 1991), 186-89. For further discussion of the available-for-use rules, see Bruce R. Sinclair, "Depreciable Property: A Review of Recent Legislative Developments," in Report of Proceedings of the Forty-Third Tax Conference, 1991 Conference Report (Toronto: Canadian Tax Foundation, 1992), 26:1-20.

16 Regulation 1100(1)(a).

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Table 2 Canadian CCA Rates as of 1995

Asset category

Class for tax purposes

Method and rate applied

Building . . . . . . . . . . . . . . . . . . . . .

1

Manufacturing machinery

and equipment . . . . . . . . . . . . . . .

43

Passenger vehicles . . . . . . . . . . . . .

10.l

Automobiles and trucks . . . . . . . . .

10

R & D assets . . . . . . . . . . . . . . . . . .

na

Furniture and fixtures . . . . . . . . . . .

8

Computer hardware . . . . . . . . . . . .

10

Computer software . . . . . . . . . . . . .

10

12

Leasehold improvements . . . . . . . .

13

Patents . . . . . . . . . . . . . . . . . . . . . .

14

44

4% DB

30% DB 30% DB 30% DB 100%a 20% DB 30% DB 30% DB 100% SL over longer of 5 years and lease term plus first renewal term SL over life 25% DB

DB: declining balance SL: straightline a 100% deductible in the year incurred pursuant to paragraph 37(1)(b).

and the current prescribed rates that apply to the most common depreciable property.17 Although CCA is calculated on a declining balance basis for most classes, the straightline method is prescribed for some classes.18 As noted above, CCA is a discretionary deduction, and the taxpayer may claim any amount up to the maximum prescribed by the regulations. Importantly, Revenue Canada does permit the revision of previous CCA claims in some circumstances.19

UCC, on which the CCA for a particular class is calculated at any time, is determined in accordance with a formula set out in subsection 13(21) of the Act. The issues relevant to the calculation of UCC are discussed below under the following headings:

? additions to UCC,

? deductions from UCC,

? adjustments to capital cost,

17 Schedules II to VI contain detailed lists of the asset classifications and the applicable rates.

18 For example, regulation 1100(1)(c) provides that class 14 assets (licences or franchises) are calculated on a straightline basis over the life of the asset. A straightline formula is provided in schedule III of the regulations for class 13 assets (leasehold improvements).

19 Revisions to claims in taxable years are generally permitted only where the revisions cause no change to assessed tax for taxable years unless the period for filing a notice of objection has not expired. Revisions to claims in non-taxable years are generally permitted provided that there is no change to the tax payable for the year or any other year filed. Revenue Canada's policy is summarized in Information Circular 84-1, "Revision of Capital Cost Allowance Claims and Other Permissive Deductions," July 9, 1984.

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? recapture, ? terminal losses, and ? separate classes.

Additions to UCC The following amounts must be added to UCC:

? The capital cost to the taxpayer of depreciable property of a class acquired by the taxpayer. Capital cost of a property is generally the purchase price plus any other related costs that must be incurred in order to make the asset operational (for example, installation and delivery charges).20 There are a number of provisions that may affect the amount included in respect of the capital cost of a property. These are discussed below under the heading "Adjustments to Capital Cost."

? All amounts included in income as recapture of CCA claimed in a previous taxation year. The recapture provisions are discussed below.

? Repayments of assistance, inducements, or reimbursements received in respect of depreciable property of the class occurring after the disposition of the asset.

Deductions from UCC The calculation of UCC includes the following deductions:

? Total depreciation previously allowed to the taxpayer for property of the class. Total depreciation is defined to be all CCA claimed plus any terminal losses previously allowed under subsection 20(16).21 Terminal losses are discussed in detail below.

? The lesser of proceeds of disposition and the original capital cost of the disposed of property. The terms "disposition of property" and "proceeds of disposition" are defined in subsection 13(21). A disposition of property includes any transaction or event that entitles a taxpayer to proceeds of disposition of property. Proceeds of disposition include the sale price of property that has been sold, compensation for property unlawfully taken, and compensation for property damaged or destroyed.

? Investment tax credits claimed after the related property is sold. ? Certain assistance received in respect of a property subsequent to the disposition of that property.

Adjustments to Capital Cost The Act provides for the following adjustments to the capital cost otherwise included in a UCC pool of property:

20 The term "capital cost" is not defined in the Act. Revenue Canada has summarized its definition in paragraph 8 of Interpretation Bulletin IT-285R2, "Capital Cost Allowance--General Comments," March 31, 1994.

21 Subsection 13(21).

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? Where a property has been acquired pursuant to a section 85 election, the capital cost of the property will be the "elected amount."22

? Where a depreciable property has been acquired from a non-arm'slength party, subsection 85(5.1) applies to override subsection 85(1) if the transferor has an inherent terminal loss with respect to the property. It deems the capital cost of the property to the transferee to be the lesser of the transferor's cost and the UCC attributed to the particular property. Subsection 85(5.1) is to be repealed with effect after April 26, 1995 as a result of the introduction of proposed subsection 13(21.2),23 which limits the capital cost to the transferee to the FMV of the asset. Proposed subsection 13(21.2) is discussed further below under the heading "Terminal Losses."

? Where a property has been acquired from a non-arm's-length transferee, paragraph 13(7)(e) may apply to reduce its capital cost where the transferor has recognized a capital gain on the disposition.

? Where a taxpayer has acquired anything from a person with whom the taxpayer was not dealing at arm's length for an amount in excess of FMV, the taxpayer is deemed by paragraph 69(1)(a) to have acquired it at FMV.

? Where an amount has been paid in respect of the acquisition of property or services, section 68 permits the minister to reallocate the proceeds between the various assets or services if some or all of the values specified are considered unreasonable.24

? Immediately before an acquisition of control, a taxpayer may elect to have a deemed disposition and reacquisition of each capital property at an amount between the adjusted cost base and the FMV of the property.25 For purposes of calculating CCA, the capital cost of the reacquired property is deemed by paragraph 13(7)(f) to equal the original capital cost plus three-quarters of the realized gain.

? Where government assistance (such as a grant, subsidy, or forgivable loan) or an investment tax credit has been received in respect of the

22 There are a number of provisions that apply to limit the "elected amount." Paragraph 85(1)(e) provides that the elected amount cannot be less than the least of the UCC of the class, the cost to the taxpayer of the property, and the fair market value (FMV) of the property. Paragraph 85(1)(b) deems the elected amount to equal the FMV of non-share consideration where the agreed amount is less than the FMV of non-share consideration. Paragraph 85(1)(c) restricts the elected amount to an amount no greater than the FMV of the property disposed of.

23 Included in Canada, Department of Finance, Draft Amendments to the Income Tax Act, the Income Tax Application Rules, the Canada Pension Plan, the Children's Special Allowances Act, the Customs Act, the Old Age Security Act, the Unemployment Insurance Act and a Related Act, April 26, 1995.

24 For a discussion of the application of section 68, see David Forster, "The Purchase and Sale of Assets of a Business: Selected Tax Aspects," in Selected Income Tax and Goods and Services Tax Aspects of the Purchase and Sale of a Business, 1990 Corporate Management Tax Conference (Toronto: Canadian Tax Foundation, 1991), 2:1-36.

25 Paragraph 111(4)(e).

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