Handy & Harman of Canada Ltd. v. MNR, 73 DTC 5401, [1973] CTC 507 (FCTD)

Heald, J:—This is an appeal from a reassessment by the respondent of the appellant’s income tax for the taxation year ended December 31, 1967.

The appellant was incorporated under the laws of Ontario on July 15, 1935 and since that time, has been in the business of processing precious metals and their alloys, including gold and silver, its premises being situated in the City of Toronto. In the course of its business, appellant acquires gold and silver from a variety of sources including smelters and customers’ scrap and waste materials. Appellant then melts, rolls, extrudes, draws, etc, producing alloys of these precious metals for the silverware and other industries. Its principal business consists of buying raw silver, processing it and reselling it. Appellant’s sales for 1967 were 5.6 million dollars with its silver products accounting for approximately 80% of the total. Its major silver products are fine silver anodes for use in silver plating, sterling silver (a 92 /a% silver alloy) and brazing alloys (alloys of silver used by general industry for joining metals, these alloys containing from 5% to 80% silver).

Appellant is in reality a custom processor, that is to say, it does not carry a stock of finished materials. It manufactures upon receipt of orders from its customers to the customers’ individual specifications.

When an order is received from a customer, the appellant melts the bar silver and the base metals, as required, producing a bar of metal which is then processed down to the size required by the customer. The prices charged by the appellant for its finished silver products contain two components:

(a) the value of the product on the day of shipment as determined by market quotations, ie. the replacement cost of the silver taken out of inventory,

plus

(b) the “additionals” which cover the cost of other components of the product sold, plus processing costs, plus overhead and profit.

In 1967 the additionals represented approximately 5% of the total invoice to the customer, the other 95% being represented by the cost of the precious metals which went into the finished product.

The time involved in doing the processing and shipping the product averages about one week.

In order to satisfy the requirements of its business, the appellant must maintain an inventory of silver which is physically held in the form of fine silver bars (approximately 1,000 ounces in each bar); anodes and grain; sterling; alloys; clean scrap for use in production and scrap awaiting refining. Appellant’s working inventory is comprised of silver which it owns and silver which it describes as holding on “consignment” from its customers. At the end of 1967 appellant’s total inventory of silver was 599,813 ounces of which total, 102,061 ounces were held on “consignment” from customers and the balance of 497,752 ounces was owned by the appellant.

This total silver inventory, as at December 31, 1967, breaks down as follows:

(d) Silver brazing alloys—including

finished product and scrap	133,750 ounces
(e) Refining silver—including scrap and
waste awaiting refining	170,150 ounces
TOTAL	599,813 ounces

The inventory of scrap silver turns over about once or twice a month. The rest of the inventory probably turns over about six times per year.

When a customer in the silverware and jewellery business buys a sheet stock of sterling from the appellant, his procedure is to blank out forks, spoons, etc, from long strips of sterling material, which leaves “skeleton scrap” which is returned to the appellant who buys it as clean scrap and puts it back into the process without any further analysis of the material. The customer will also generate floor sweepings, buffings, filings, etc, which are also returned to the appellant who purchases them after the contents are analysed.

The appellant describes this as a “consignment” transaction because at the time the appellant receives this scrap from the customer, it agrees to redeliver a like amount of ounces, not the same ounces of course, because this would be impossible. The customer’s scrap is intermingled with the appellant’s scrap so identity is lost. When the customer’s scrap is received by the appellant, a credit note is issued for the quantity of silver received and the customer’s consignment account credited accordingly.

When a customer orders silver from the appellant and that customer has a quantity of silver on “consignment” with the appellant, the number of ounces of silver shipped to him is charged against his “consignment” account and he is billed in dollars for the amount of the “additionals” which, as stated earlier, in 1967 amounted to approximately 5% of the total price. This method is advantageous to the customer in that it provides him with a ready market for his scrap and waste silver. It is advantageous to the appellant because it allows the appellant to operate with the customer’s silver, thus enabling it to function with a lower inventory of its own silver, thereby reducing the amount of money which appellant is required to tie up in inventory.

As a general rule, appellant does not speculate or take positions in silver. The appellant’s view, as expressed in evidence by its comptroller, Mr Gladish, is that since the company makes a reasonably good living from processing metal, and since silver prices are completely unpredictable, that it is far more prudent for the company to refrain from such speculations. There are times when some of the appellant’s customers, believing that the silver market is about to go up, may ask the appellant to sell them a quantity of silver at the current market and hold it on consignment against future orders. Appellant’s practice is to accommodate the customer, provided the silver can be obtained. Apparently the customers are not able to go into the market and acquire the silver themselves, since the smelters are usually in short supply and sell only to their regular customers.

The appellant tries to keep its silver inventory as low as is possible. An exception arose however in 1967. In mid 1967, because of strikes in the United States smelters (one of appellant’s sources of supply at that time), the appellant, fearful of being short of the stocks necessary to operate, did build up its stocks substantially by ordering stock ahead of the strike and by purchases from a new smelter just in production at Cobalt, Ontario.

The market price for silver, which is the price paid by the appellant the day on which the silver is shipped to them from the smelter, is established in ‘an. interesting manner. The market price for silver is announced each day at noon, by Handy & Harman, appellant’s parent company, in New York. The parent company is the largest silver processor in the world. Each morning, they go into the world silver market and determine what price they have to pay to acquire the amount of silver they require for their daily operations. That price is announced to the trade at noon each day and is accepted by all the silver processors and manufacturers in North America. The appellant takes this daily rate, and using the daily exchange rate on United States dollars, converts said price to the Canadian dollar price for the Canadian precious metals industry. This price, according to the evidence before me, is accepted by the industry in Canada.

Mr Gladish testified that the appellant attempts to match its purchases of silver with its sales but that that is not completely practical since fine silver bars are purchased in lots of 50,000 ounces and since appellant rarely sells that much silver on a particular day.

Mr Gladish gave detailed evidence as to how, in 1967, the appellant accounted for corporate purposes for its cost of its sales. Since the appellant receives scrap and materials every day and since it ships Out products every day, it accordingly produces a daily report of receipts and shipments. Using this daily report as a basis of their pricing and costing, they determine the silver content of their daily shipments, apply the market prce for silver on that day’s shipments, thus producing a cost of sale which is then applied against their sales, producing a gross operating revenue.

It is clear from the evidence that the appellant keeps meticulous inventory records. Each alloy has a stock card in the office and in this way the appellant keeps track of all the receipts, shipments, transfers from one alloy to another and produces a running balance. Mr Gladish describes it as “a perpetual inventory type system”.

At the end of each month, they take a physical count of every ounce of silver and gold in the plant and then they check this against the inventory control record to make sure that all the metal that has come into the plant has been accounted for. This system enables the appellant to say, on any given day, how many ounces of silver are on the premises.

In 1967, the year under review, appellant’s cost of metal used amounted to $4,724,666.32. That figure includes cost of gold, silver, base metals, etc, together with duty costs and transportation costs. hat figure is produced through an accumulation of the daily costings described above. This daily costing figure is the first component of the price charged to the customer, as earlier described herein. This figure of $4,724,666.32 represents the replacement cost of the metal sold during the year.

The said cost of metal in 1967 was subject to a further adjustment of $1,904.54 which is described as silver and gold “market adjustment”. This adjustment arises because it is not possible to match purchases with sales every day, thus they are matched up with either the preceding day or the following day, thus this figure represents the difference in the values of the metals due to the fact that they cannot match exactly every day. The fact that the total figure for the year 1967 is small indicates that appellant did a good job of matching. This adjustment is necessary since the price payable fo silver and gold on the day of purchase will, in many instances, have been higher or lower than on the day of sale.

The said cost of metal in 1967 was subject to a further adjustment described as “Silver inventory (gain) . . . (96,211.64)”. According to Mr Gladish, this figure represents the profit realized on the difference between the opening and closing inventory. In 1967 the closing inventory was smaller than the opening inventory, thus the difference was disposed of out of base inventory and since it was sold at a price higher than the base price, the figure of $96,211.64 represents a gain to the appellant which is deducted from the appellant’s original cost of metal.

In summary, the actual effect of appellant’s 1967 method was that they costed their metals on the basis of actual cost of the metals to them for the entire year. Additionally, they took into account a profit of $96,211.64 which was the difference between the base price and the selling price of that portion of the base inventory that was liquidated during the year (70,707 ounces). However, they did not take into profit the increase in value of the inventory carried over caused by the increase in the price per ounce of silver.

Exhibit 4 is a table prepared by Mr Gladish showing the market prices of silver between 1946 and June 1967, the high and low per ounce price of silver during the year, the year end price of silver, the value of silver in inventory as per the appellant’s books, the value of silver in inventory under the tax department’s average cost method, and the ounces of silver owned by the appellant and held in inventory at year end. This table reads as follows:

HANDY & HARMAN OF CANADA LIMITED

SILVER PRICES AND VALUES 1946—JUNE 1967

$ PER OZ.

					TAX DEPT.	YEAR
				COMPANY	AVERAGE	END
YEAR	HIGH	LOW	YEAR END	VALUE	COST	OZS.
1946	$ .90500	$ .40000	$ .84000	$.40000		869,042
1947	.86500	.60000	.74875	.4007731		872,415
1948	.77500	.70000	.70250	.4007731		606,097
1949	.80825	./0000	.80825	.4007731	$ .74000	536,831

1950	.85065	.79200	.85065	.4007731	.801675	491,728
1951	.96823	.84212	.89739	.4321893	.93968 1	529,424
1952	.89077	.79810	.81047	.4321893	.852164	481,766
1953	.85287	.80993	.83315	.4321893	.842399	480,453
1954	.84381	.82383	.82703	.433695	.835510	482,302
1955	.92020	.82490	.90665	.4340088	.874509	482,688
1956	.91846	.87656	.87970	.4361834	.897698	485,049
1957	.88587	.85790	.88503	.4365275	.879563	485,445
1958	.89311	.85164	.86895	.4642719	.872211	520,214
1959	.89027	.86714	.87313	.4704259	.880868	528,283
1960	.91368	.87028	.91282	.4974381	.888272	566,499
1961	1.09967	.90533	1.09967	.5060274	.931497	578,683
1962	1.31714	1.06655	1.30251	.5060274	1.118681	480,212
1963	1.40467	1.30828	1.40265	.5060274	1.335775	390,918
1964	1.40467	1.39174	1.39376	.5060274	1.395551	376,026
1965	1.40792	1.39255	1.39498	.6716790	1.404204	462,969
1966	1.40669	1.39336	1.40629	.8046078	1.406476	568,459
1967	(to June 67)
	1.87124	1.39821

From the above table it is noted that the company valued its inventory at the end of 1946 at 40c per ounce. This is because the government pegged the price of silver during World War H at 100 per ounce and thus appellant valued its inventory at December 31, 1946 at this pegged price.

At the end of 1947 the company’s inventory is valued at $.4007731 per ounce. This figure is produced by valuing the additional quantity of inventory acquired during the year at the lowest cost of acquisition during the year. This method was acceptable to the Department of National Revenue at the time.

In 1948, 1949 and 1950 the company valued its inventory likewise at $.4007731 per ounce, the 1947 figure, because in each of those years, the inventory is reduced and in such circumstances, the same average value for each ounce is carried forward.

A base price, once established, was used in each succeeding fiscal period until there was a fiscal period when the quantity of silver in inventory on hand at the end of the year exceeded that on hand at the beginning of the year at which time the base price was recalculated. This recalculation was on the basis of firstly adding to the value of the opening inventory/the value of the increment to the inventory (which was determined by using the lowest cost price during the year for the increment).

Thus, by looking at Exhibit 4, it is seen that the base cost shown by the company in the column headed “Company Value” is continued from year to year until a year when there is an increase in inventory when the base cost is recalculated according to the above described formula.

For the taxation years 1946, 1947 and 1948 the respondent approved appellant’s method of inventory calculation as set out above which method Mr Gladish describes as “the base stock method”. However, for the 1949 taxation year the respondent withdrew its approval of appellant’s method and required the appellant to value its opening inventory at the base cost ($.4007731) plus purchases during the year at actual cost which produced an average cost figure at the end of 1949 of 74c per ounce.

Since 1949 the respondent has required the appellant. to value its inventory on the basis of the lower of average cost or market value and to pay income tax on the increased value of its total inventory at year- end, The year-end values thus are shown on Exhibit 4 in the column headed “Tax Dept Average Cost” increasing from 74c per ounce in 1949 to $1.406476 per ounce in 1966.

The appellant, for its own corporate purposes and for the purposes of its own financial statements, has continued to use the “base stock method” of inventory valuation and has done its costing on a daily market basis which it considers to be the most correct method of proceeding.

To comply with the respondent’s directives, when preparing its income tax returns, prior to 1967, appellant produced a figure of net income using the daily costing basis, and then, at year end, it would make an adjustment for tax purposes to accommodate the difference between the opening inventory value and the closing inventory value on the total quantity of silver owned by the company.

In the appellant’s 1967 financial statement the appellant valued its silver inventory at $.8046078 per ounce, being the base price established in 1966 as shown on Exhibit 4, on the basis above described. The actual value according to the market at the end of 1967 was approximately $2.27 per ounce. The respondent reassessed the appellant for 1967 using the average cost method.

The appellant objects to the respondent’s method of inventory valuation, first adopted in 1949 and continued thereafter, because, in the appellant’s view, it is being taxed on the increase in value of its basic inventory, an inventory that it has to have in order to remain in business. The appellant says that it does not realize any income from the increased value of that inventory and feels that it is being taxed on income that does not really exist. This is the sole issue in the appeal.

It seems to me that the effect of the method used by the appellant is that an important asset—inventory—is carried in the appellant’s balance sheet at a value considerably lower than either its market value or the expenditure actually incurred in ‘procuring that inventory. In appellant’s balance sheet as of December 31, 1967, the closing inventory of silver is valued at $400,494.93 and yet the market value at that same date was $1,130,415.25, a difference of some $729,920.32. Furthermore, said silver inventory is valued at the end of 1967 at $.8046078 per ounce whereas the lowest price per ounce appellant paid at any time either in 1966 or 1967 was $1.39 per ounce.

The net result, under the system of inventory valuation used by the appellant, is that said gains accruing to the appellant by virtue of the substantial increases in the price of silver would not be finally brought into taxable income unless the appellant were to go out of business and liquidate all its assets. The net effect of appellant’s method is that in times of rising prices (as was the case in 1967 when the price per ounce of silver rose very substantially) the cost of goods sold will be higher than if it had been determined by reference to the actual cost of the articles sold, and the reported profits will be correspondingly lower.

In my view, the determining facts in the case at bar are closely similar to those in the case of MNR v Anaconda American Brass Ltd, [1956] AC 85; [1955] CTC 311; 55 DTC 1220.

In that case, Anaconda was in the business of purchasing metals manufacturing them into sheets, rods and tubes and selling the manufactured metals. As in this case, the company said that it did not trade in raw metals, that it deliberately avoided speculation in them and that it made its profit solely by processing its metals into finished products. The prices which the company charged for its products were closely related to the prices paid by it to replace the metals used in manufacturing its products and, when market prices of purchased metals were increased, it, at once, correspondingly increased the prices of its products. It maintained an inventory of metals at all times of about one-third to one-quarter of its annual requirements so that. it turned its inventory over about three or four times a year. The company did not keep records from which the actual metals used during the year could be identified or the amounts paid for those metals determined. It did keep records of the quantities of metals (a) in its inventory at the beginning of the year, (b) purchased during the year, and (c) in its inventory at the end of the year. It also kept records of the prices paid for the metals purchased from time to time. The company did not know, however, and could not ascertain either in respect of all the metals which it used during the year what price had been paid for them or in respect of all the metals which it had at the end of the year what price had been paid for them. In those circumstances, the company, for the purposes of determining its annual profit or gain for income tax purposes for the year 1947, in the absence of knowledge of the proper cost to be ascribed to the metals used during that year and the proper cost or value of the metals remaining in stock, adopted a system known as LIFO, or last in, first out, in which the cost per pound of the metal most recently purchased and added to stock was the cost per pound of metal content to be charged against the next sale of processed metal products. In 1947 there had been large increases in the price of metals, and by thus attributing the higher costs to the metals processed and the lower cost to those retained in stock, the company was able to show far lower profits than if it had followed the accustomed and traditional method of return.

Under the LIFO method of inventory valuation, it does not mean that the metal last to be received into stock is in fact the first to be processed and sold. On the contrary, the actual physical flow of the raw material is regarded as irrelevant, that which was purchased in previous years and was in stock at the opening of the relevant financial year or that which was purchased during that year may have been processed and the products sold during that year; this is of no account. It is to cost that LIFO looks, and in the simplest terms, it means that the cost per pound of the metal most recently purchased and added to stock is the cost per pound of metal content to be charged against the next sale of processed metal products.

The Judicial Committee of the Privy Council rejected the LIFO method of inventory valuation for income tax purposes, Viscount Simonds, in delivering the judgment of the Court said at page 100 [319-21,1224-5]:

. . . The income tax law of Canada, as of the United Kingdom, is built upon the foundations described in Lord Clyde in Whimster & Co v Inland Revenue Commissioners ((1925) 12 TC 813, 823) in a passage cited by the Chief Justice which may be here repeated. “In the first place, the profits of any particular year or accounting period must be taken to consist of the difference between the receipts from the trade or business during such year or accounting period and the expenditure laid out to earn those receipts. In the second place, the account of profit and loss to be made up for the purpose of ascertaining that difference must be framed consistently with the ordinary principles of commercial accounting, so far as applicable, and in conformity with the rules of the Income Tax Act, or of that Act as modified by the provisions and schedules of the Acts regulating Excess Profits Duty, as the case may be. For example, the ordinary principles of commercial accounting require that in the profit and loss account of a merchant’s or manufacturer’s business the values of the stock-in-trade at the beginning and at the end of the period covered by the account should be entered at cost or market price, whichever is the lower; although there is nothing about this in the taxing statutes.” For many years before and ever since this decision what is to be valued at the beginning and end of the accounting eroid has for tax purposes been taken to be the actual stock so far as it can be ascertained. It is in fact, so far as tax law is concerned, a novel and even revolutionary proposal that the physical facts should even where they can wholly or partly be ascertained be disregarded for the purpose of the opening and closing inventory and a theoretical assumption made which is based on a supposed “flow of cost” and an “unabsorbed residue of cost”. An expert witness called for the company observed that he did not imagine any of the company’s witnesses would claim for a minute that there was a quantity of metal then on hand acquired In the year 1936 equal to the quantity which was valued at the then cost. Yet there was no less than six and a half million pounds of copper in the 1947 closing inventory to which the 1936 cost was ascribed. He might have added that year by year the same thing would happen so long as the business went on and existing stocks were not seriously diminished: in 1987 as in 1947 the closing inventory would carry stock to which 1936 costs would be ascribed. This illustrates clearly the Lifo method and shows how far it has travelled from the conception which has prevailed in the assessment of income for tax purposes.

It was strongly pressed by the respondent that in dealing with homogeneous material the actual user test, If It could be applied by identification of parcels purchased at varying prices, would lead to capricious and illogical results. Assuming that this is so and that actual user should not in some cases be regarded as the final test, this does not in their Lordships opinion establish the case for Lifo. It might be that in such cases, though their Lordships do not decide it, the average cost method could properly be adopted, for that method, like the Lifo method, brings into the account the cost of every purchase in its order. But the present case shows that under the Lifo method, if the business continues and stock is carried forward, substantial purchases may never come into the profit account at all.

Their Lordships do not question that the Lifo method or some variant of it may be appropriate for the corporate Purposes of a trading company. Business men and their accountant advisers must have in mind not only the fiscal year with which alone the Minister is concerned. It may well be prudent for them to carry in their books stock valued at a figure which represents neither market value nor its actual cost but the lower cost at which similar stock was bought long ago. A hidden reserve is thus created which may be of use in future years. But the Income Tax Act is not in the year 1947 concerned with the years 1948 or 1949: by that time: the company may have gone out of existence and its assets been distributed. Seventy years ago Lord Herschell said in Russell v Town of County Bank ((1888) 13 App Cas 418, 424; 4 TLR 500): “The profit of a trade or business is the surplus by which the receipts from the trade or business exceed the expenditure necessary for the purpose of earning those receipts.” This is only one of many judicial observations in which it is implicit that no assumption need be made unless the facts cannot be ascertained, and then only to the extent to which they cannot be ascertained. There is no room for theories as to flow of costs, nor is it legitimate to regard the closing inventory as an unabsorbed residue of cost rather than as a concrete stock of metals awaiting the day of process. It is in their Lordships’ opinion the failure to observe, or, perhaps it should be said, the deliberate disregard of, facts which can be ascertained and must-have their proper weight ascribed to them, which vitiates the application of the Lifo method to the present case. it is the same consideration which makes it clear that the evidence of expert witnesses, that the Lifo method is a generally acceptable, and in this case the most appropriate, method of accountancy, is not conclusive of the question that the court has to decide. That may be found as a fact by the Exchequer Court and affirmed by the Supreme Court. The question remains whether it conforms to the prescription of the Income Tax Act. As already Indicated, in their Lordships’ opinion it does not.

In the case at bar, the appellant also processed raw metals and sold a finished product. Here also, the sale price of the company’s finished product was closely related to the replacement cost of the metal used. Here, the inventory turned over approximately six times a year compared to three or four times a year in the Anaconda case (supra). Here also, it was not possible for the appellant to keep records which would identify the actual metals used during the year or to determine the amounts paid for the metals actually used during the year. It did, however, as in Anaconda (supra), have accurate records of Its opening and closing inventories and a most meticulous daily and monthly costing record of the metals purchased during the year.

The appellant seeks to distinguish the Anaconda case (supra) on the basis that the method of inventory valuation here being used is the “base-stock method” which, in the submission of the appellant, the evidence establishes as being in accordance with commonly accepted commercial and accounting principles.

It is true that appellant called two expert accounting witnesses who said that in their view, the method used by the appellant, was in accordance with commonly accepted commercial and accounting principles. However, these opinions were flatly contradicted by Mr Rennie, the expert accounting witness called by the respondent.

Mr Rennie testified that the method used by the appellant was in fact neither the base stock nor the LIFO method but was nevertheless similar to both, particularly to LIFO. Mr Rennie’s opinion was that appellant’s method was not in accordance with generally accepted accounting principles because it is based on a method of inventory calculation which applies to every unit of inventory held at a determined price which bears no relationship: to the current market value, the average cost or the specific cost of either the entire inventory or any identifiable portion thereof. Mr Rennie also gave as his professional opinion that appellant’s method is not described in any professional literature which would give it authoritative support.

The two experts called by the appellant, while saying that appellant’s method was proper from an accounting point of view, both conceded that said method was rarely if ever used by other firms in a similar business. Mr Lancelot Smith, one of said experts, said he had never seen this method used before.

The other expert, Mr Richard Parkinson, had difficulty in recalling a case where a base stock method was used, where, as here, the base stock from year to year was not constant.

Taking the evidence of all three experts on balance, I hold that the appellant has failed to establish that the method of inventory valuation used by it in 1967 is in accordance with commonly accepted commercial and accounting principles.

The base stock method of inventory valuation was rejected as being improper for tax purposes in the English case of Patrick v Broadstone Mills Ltd, [1954] 1 All ER 163. The objectionable features of the method there used are present in the case at bar.

The base stock method has also been rejected by the Courts in Australia* [1] and in the United States of America.! [2]

Whether appellant’s method be called the base-stock method or a modified, base-stock method, or the LIFO method, it seems clear from the evidence to have all the objectionable features referred to in the Anaconda case (supra) and the Broadstone Mills case (supra). It also appears to be contrary to subsection 14(2) of the Income Tax Act.t [3]

The appellant’s comptroller, Mr Gladish, conceded that because of the turnover of inventory five or six times a year, there was no possibility whatsoever that the company would have any, £ars of silver in inventory on December 31, 1967 that had been in inventory on January 1, 1967. And yet, the appellant values its entire inventory on December 31, 1967 at slightly over 800 per ounce when it could not possibly have paid less than $1.39 per ounce for said inventory.

Furthermore, it values its inventory at December 31, 1967 at $400,494.93 when the market value at that date was $1,130,415.25. Whether appellant recognizes it or not, the fact of the matter is that at December 31, 1967, it had an asset worth $1,130,415.25 rather than $400,494.93.

To place the stamp of approval on a system of accounting which so disregards the known physical facts could not possibly be justified.

The appeal is therefore dismissed with costs.