Rudolph Furniture Ltd. v. The Queen, 82 DTC 6196, [1982] CTC 211 (FCTD)

Mahoney, J:—The issue here is the difference in the value of the plaintiff’s inventory as at the beginning and end of its fiscal year ended September 30, 1976. It involves consistency in the valuation of the opening and closing inventories and the acceptability of the said method by which the plaintiff arrived at its valuation in the previous year. That method involves the valuation of new stock at cost and the assumption that the market value of items in stock over six months is less than cost. Percentages applied in reduction of the value vary as particular items age in inventory, eg, 10% for six months to a year; 90% for over four years. This method was accepted by the Minister for income tax purposes for the years prior to 1976 but, I understand, has been rejected by him for the subsequent years. I further understand that the assessments for 1977 and later remain open to both reassessment and appeal. However, it is only the 1976 assessment that is in issue here.

The plaintiff simply did not take inventory at all at the end of its 1976 fiscal year. It was in the process of changing its stock and pricing records system. Instead, in late December, 1976, or early January, 1977, the plaintiff’s principal, an experienced furniture dealer, estimated that the inventory at year end had been about 10% greater than the opening inventory for the year. The opening inventory had been $142,477; the closing inventory was reported at $154,500, an increase of less than 8.5%.

The Minister audited the return. The actual audit of the inventory began in late September or early October, 1977. At the time the only information the plaintiff was able to produce as to its actual inventory as at September 30, 1976, was an adding machine tape, totalling $515,612.35, which was represented and accepted as being the aggregate of the tagged prices of the September 30 inventory. It had been derived from the price tags removed in the process of the system change. The Minister ascertained that the cost of the plaintiff’s opening 1976 inventory had been 41.5% of its tagged price. He also concluded that, notwithstanding exceptions, perhaps fairly numerous, as to individual items, the cost of the entire inventory was clearly less than its market value. Both of those conclusions are confirmed by the evidence at trial. Applying 41.5% to $515,612.35, and adding $900 inventory admitted by the plaintiff to have been overlooked in its return, the Minister valued the plaintiff’s 1976 closing inventory at $214,879.

The Act provides:

10. (1) For the purpose of computing income from a business, 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.

The plaintiff’s calculation is based on an opening inventory value that was neither the lower of its cost nor market value. It was a mixture. New stock was valued at cost which, on the evidence, was clearly lower than its market value while stock over six months old was globally assumed, contrary to the evidence, to have a market value less than cost. Whatever its validity as an acceptable commercial approach to inventory valuation, it is unacceptable for tax purposes in view of subsection 10(1).

The Minister’s approach does attempt to arrive at an inventory valuation acceptable under subsection 10(1). It was a fair approach in the circumstances. The plaintiff is entirely the author of those circumstances. The plaintiff has led evidence in support of a factor lower than 41.5% but I am not persuaded by it. I confirm the valuation of the closing inventory at $214,879.

The Act further provides:

10. (3) Where the property described in the inventory of a business at the commencement of a taxation year has, according to the method adopted by the taxpayer for computing income from the business for that year, not been valued as required by subsection (1), the property described therein at the commencement of that year shall, if the Minister so directs, be deemed to have been valued as required by that subsection.

The opening 1976 inventory had not, as stated, been valued in a manner consistent with the closing inventory and it was not so revalued in the assessment. The plaintiff pleaded this inconsistency and asked that the assessment be referred back. The defendant pleaded that the opening inventory value of $142,477 had been settled between the parties. There is no evidence supporting that pleading.

On April 23, 1982, three days before the trial began, a direction under subsection 10(3) was made. The direction was not, obviously, pleaded. Such a direction must surely be made prior to the assessment giving effect to it. Ex post facto, it was a nullity.

The cost of the opening inventory for the fiscal year ended September 30, 1976, was $197,472. That is the figure the Minister accepted in reaching the 41.5% factor.

The income of a taxpayer from a business for a taxation year is his profit therefrom for the year*. [1] The Act does not define profit and it is to be determined by accepted accounting principles unless the provisions of the Act require a departure from those principles!. [2] The Act does not require such a departure in respect of the issues here beyond the limitations imposed by subsection 10(1).

I accept the expert evidence of Paul G Cherry, CA, tendered on behalf of the plaintiff, that

The preferred treatment under generally accepted accounting principles is that the opening and the closing inventories for a particular year be valued on a consistent basis.

The rules of the Canadian Institute of Chartered Accountants changed in 1978. Cherry’s preferred treatment is now the only permissible approach. However, at the relevant time, the rule was that adoption of a change in accounting principles should be applied on a retroactive basis where appropriate. It was permissible, in a strict sense, under the rule to value closing inventory by a new acceptable method without revaluing the opening inventory by the same new method but, in Cherry’s opinion, it was bad accounting. That opinion appears unassailable in logic. If the two methods led to different results, the profit would inevitably be distorted, one way or the other.

I find that, notwithstanding what was technically permissible under the CICA rules in 1976, generally accepted accounting principles required that the opening and closing inventories for a fiscal period be valued consistently in order to determine most accurately the profit for the period. The plaintiff’s 1976 assessment will be referred back to the Minister for reassessment on the basis that its opening inventory for the taxation year was $197,472.

The great bulk of the plaintiff’s efforts in this action as appears in the pleadings, the evidence and argument, has been directed to justifying, unsuccessfully, its own valuation method for income tax purposes. In the circumstances, there will be no order as to costs.