Minister of National Revenue v. Shofar Investment Corporation, 79 DTC 5347, [1979] CTC 433, [1980] 1 SCR 350

Martland, J:—The question in issue in this appeal is as to whether or not subsection (3) of section 12 of the Income Tax Act, RSC 1952, c 148, has any application in the assessment of income tax payable by the respondent (“Shofar”) in respect of Shofar’s 1960, 1961 and 1962 taxation years.

The facts are not in dispute, an agreed statement of facts having been filed before trial. The agreed facts are as follows.

Shofar was incorporated on June 11, 1958. On April 20,1959, it purchased a parcel of land from Lanber Investment Corporation. At the time of the purchase, Shofar was not dealing at arm’s length with Lanber Investment Corporation.

The purchase price of the parcel of land was $110,000 of which $1,000 was paid in cash and the balance of $109,000 was payable in nine annual instalments of $11,000 each, with a final payment of $10,000 due in 1970.

On June 15,1960, Shofar sold the parcel of land for $250,000, with a cash payment of $35,000 and payments due on June 15 each year in varying amounts from 1961 to 1966. At the time of this sale, Shofar was not dealing at arm’s length with Lanber Investment Corporation.

Shofar followed an accrual system of accounting for tax purposes.

Subsection 12(3) of the Income Tax Act, in effect at the time relevant in these proceedings, provided as follows:

12.(3) In computing a taxpayer’s income for a taxation year, no deduction shall be made in respect of an otherwise deductible outlay or expense payable by the taxpayer to a person with whom he was not dealing at arm’s length if the amount thereof has not been paid before the day one year after the end of the taxation year; but, if an amount that was not deductible in computing the income of one taxation year by virtue of this subsection was subsequently paid, it may be deducted in computing the taxpayer’s income for the taxation year in which it was paid.

There is no issue about taxability or otherwise in respect of its gain on the sale of the parcel of land. The sole question for determination is whether Shofar which bought the parcel of land at $110,000 and resold it at $250,000 should proceed on the basis of calculating its income in relationship thereto (subject to any other relevant deductions or reserves) at $140,000, being the difference between the cost price and the resale, as contended by Shofar, or at $238,000 gross profit as contended by the appellant (“Minister”). The position taken by the Minister is that, applying subsection 12(3), out of a total cost of $110,000 for the land, only the $1,000 paid in 1960 and the $11,000 paid in 1961 should be allowed in the assessment for 1960 tax purposes and the remaining $98,000 out of the total land cost should be disallowed because it was payable to a person with whom Shofar was not dealing at arm’s length and was not paid before the day one year after the end of the taxation year.

An appeal by Shofar from the Minister’s assessment was dismissed by the Tax Appeal Board, whose decision was sustained on appeal to the Trial Division of the Federal Court. Shofar’s appeal from that decision to the Federal Court of Appeal was allowed, from which judgment the present appeal to this Court is brought.

The judgment of the Federal Court of Appeal was “that subsection 12(3) of the Income Tax Act has no application in respect of the cost of the land that was subject of the sale that gave rise to the profit that is the subject matter of the assessment”.

This conclusion was obviously reached on the basis of an earlier judgment of the Federal Court of Appeal in Oryx Realty Corporation v MNR, [1974] 2 FC 44; [1974] CTC 430; 74 DTC 6352. The Oryx case had been tried at the same time and by the same judge as the Shofar case. The judgment of the majority in the Oryx case was delivered by Chief Justice Jackett. Pratt, J expressed no opinion on the point now in issue, but concurred in allowing the Oryx appeal on a second ground, also adopted by the majority, which does not arise in the present case.

The reasons of Chief Justice Jackett for deciding that subsection 12(3) was not applicable in this case are contained in the following passage from his judgment, commencing at 47 [433, 6354]:

What we are concerned with here is “gross profit”. “The law is clear. . . that for income tax purposes gross profit, in the case of a business which consists of ac- quiring property and re-selling it, is the excess of price over cost . . (see MNA v Irwin, [1964] SCR 662, per Abbott J, delivering the judgment of the Court, at pages 664-65). Gross trading profit for a taxation year may be obtained by adding together the profits of the various transactions completed in the year or by adding together the prices at which sales were effected in the year and deducting the aggregate of the costs of the various things sold. Either of such methods would be suitable for a business consisting of relatively few transactions. In the ordinary trading business, however, the practice, which has hardened into a rule of law, is that profit for a year must be computed by deducting from the aggregate “proceeds” of all sales the “cost of sales” computed by adding a value placed on inventory at the beginning of the year to the cost of acquisitions in the year and deducting a value placed on inventory at the end of the year.

In considering what application section 12(3) has, there can be no doubt that “gross profit” must be computed before income can be determined and that, at least in the second method of computing “gross profit” indicated above, the price for which the property was bought is “deductible” in its computation. If, on the other hand, the computation of “income” for a taxation year is thought of as commencing with “gross profit” then the “cost” of the property bought is not an amount that is “deductible” in its computation. When, moreover, on thinks of applying section 12(3) to a trader whose transactions are so numerous or of such a character as to dictate the use of the proceeds of sales less cost of sales formula, then, in the “computation” of the “taxpayer’s income for a taxation year” there is no deduction, at least as such, of the cost of the goods that were sold in the year. Presumably, however, section 12(3) is to have the same effect in relation to the computation of a taxpayer’s income for a year regardless of the method that has to be used to compute “gross profit”. With considerable hesitation, I have come to the conclusion that section 12(3) should be interpreted, in the case of business income, as referring to the computation of “income” or “profit” for a year from the “gross profit” for the year; and was not, therefore, applicable in the circumstances of this case. In reaching that conclusion, I am conscious that, in other contexts, for more than a century the general statements in the leading cases concerning business profits have treated the computation of profit as including the computation of gross profit. What has brought me to the opposite conclusion in the interpretation of section 12(3) is the necessity of giving such meaning to that subsection as will operate with consistency in the different circumstances to be encountered in the normal course of events.

I am in agreement with his conclusions.

Subsection (3) of section 12 is concerned with an outlay or expense payable by a taxpayer to a person with whom the taxpayer is not dealing at arm’s length, which would be “deductible” from his income except for the application of the subsection. A payment to be made by a trading corporation for an item of inventory is not, per se, deductible from income. As Chief Justice Jackett points out, the practice “hardened into a rule of law” in the computation of the profit of a trading business is to deduct from the aggregate proceeds of all sales the cost of sales computed by adding the value placed on inventory at the beginning of the year to the cost of acquisitions to inventory during the year, less the value of inventory at the end of the year.

The Act, in subsections (2) and (3) of section 14, contains mandatory provisions as to inventory valuation:

(2) For the purpose of computing income, the property described in an inventory shall be valued at its cost to the taxpayer or its fair market value, whichever is lower, or in such other manner as may be permitted by regulation.

(3) Notwithstanding subsection (2), for the purpose of computing income for a taxation year the property described in an inventory at the commencement of the year shall be valued at the same amount as the amount at which it was valued at the end of the immediately perceding year for the purpose of computing income for that preceding year.

The value of inventory, which is used in determining profit, is determined on the basis of cost or fair market value, whichever is lower, or in such other manner as may be permitted by regulation. By virtue of subsection 14(2), therefore, the cost of an inventory item is a factor which has relevance in determining inventory value. To that extent it can affect the ascertainment of the gross profit of the business, but it is not, in itself, deductible from the taxpayer’s income. It is not, in itself, a “deductible outlay or expense” and is not within the provisions of subsection 12(3).

The standard accounting approach is illustrated in Gilmour Income Tax Handbook 1967-1968 at pp 205-208 (and corresponding provisions in earlier volumes). As stated at p 207 in commenting on subsection 12(3):

It would seem that the provisions of this Section can have reference only to unpaid amounts of expenses incurred for services, such as salaries, rents, interest and the like, and can have no application to unpaid amounts arising out of the purchase of assets, whether these be assets such as stock-in-trade, whose cost is eventually absorbed against income on resale, or depreciable assets whose cost is absorbed against income by capital cost allowances.

The provisions of this Section only apply “where an amount in respect of a deductible outlay or expense that was owing by a taxpayer. . . is unpaid at the end of that second year”. The word “outlay’ normally refers to an amount which is laid out or which is paid, and it is difficult to conceive of an unpaid outlay. Accordingly, it appears that the Section applies only to an unpaid expense and few accountants would concede that the cost price of an asset, such as inventory, can be applied against revenues until the asset has been resold in normal trading operations.

I am in agreement with this approach to the application of subsection 12(3).

I would dismiss the appeal with costs.