Cyprus Anvil Mining Corp. v. The Queen, 85 DTC 5306, [1985] 2 CTC 74 (FCTD), rev'd 90 DTC 6063 (FCA) [by the reasons for judgment of Urie J.A., but not by those of Hugessen J.A.]

Collier, J:—The plaintiff is appealing the reassessment by the Minister of National Revenue, of its 1974 income tax.

The facts, most of which were agreed upon, are, from a tax point of view, somewhat unusual. There was a difference of opinion between two expert witnesses.

At the material times, the plaintiff was a mining company, operating at Faro, YT. It was a subsidiary of a United States company. Prior to 1969, it developed a new mine at Faro. The mine came into commercial production effective February 1, 1970. It qualified for exemption from tax for three years from that date: subsection 83(5) (now repealed) of the Income Tax Act. More accurately, for the three-year period, the income derived from the mining operation “shall not be included in computing the income of a corporation”. The plaintiffs exclusion period ran, therefore, from February 1, 1970 to January 31, 1973.

The plaintiff’s taxation year was the calendar year.

The plaintiff filed income tax returns, accompanied by financial statements, for the years 1969 through 1974. Its “taxable income” or “net income for income tax purposes”, for the years 1969 through 1973, was shown as “nil” (see Exhibits 6-10). For 1974, its net income for income tax purposes was declared at approximately $7.5 million.

In all of the financial statements for those years, concentrate inventory was valued by the company at cost. As I understood it, the plaintiff, because its parent company adopted (in the United States) the lower of cost or fair market value, chose the same basis of valuation.

In its financial statements for 1973, the opening inventory figure was the same as the closing inventory figure for the preceding fiscal period ending December 31, 1972. All the financial statements, accompanying the income tax returns for the years earlier referred to, used that same method: the closing figure for the previous period became the opening figure for the new fiscal year.

In its return for 1973, the financial statements for the whole year contained a statement for the one-month period ending January 31, 1973: the only portion of that year in which any income from the mining operation for that period was, by subsec 85(3), not to be included. That was the end of the so-called “exempt period”. The closing inventory, as of January 31, 1973, was, as usual, valued at cost.

In computing its income for 1973, exploration and development expenses were deducted in an amount sufficient to reduce its taxable income to nil. The Revenue Department assessed on that basis.

In computing its income for 1974, exploration and development expenses were again deducted. As earlier noted, its net income was filed at approximately $7.5 million.

In 1977 and 1978 there was a dispute between the plaintiff and the Revenue Department as to the correct treatment of certain “deferred” sales in 1973. The plaintiff’s advisers felt the problem could be resolved by valuing the inventory, as of January 31, 1973, at market, and so advised the Department. That concentrate inventory had, in fact, been produced in the "exempt" period. Cost value was $2,343,000. Market was $4,985,000. The difference was $2,642,000. This, if done and accepted, would have decreased taxable income for the eleven-month period, February 1, 1973 to the end of the year, by the same figure.

That proposed inventory valuation adjustment remained unresolved until the plaintiff was, on January 21, 1976, assessed for the year 1974, the first year in which it showed net taxable income. There was a reassessment dated December 21, 1979. The plaintiff objected, and appealed, contending its income for 1974 was . . overstated by $2,642,000.00, being the difference between cost and market value of its closing inventory at January 31, 1973/' (Agreed facts)

Put another way, the plaintiff says it is entitled to change the valuation of inventory, at the beginning and end of the three-year period, from cost to market. This has a two-fold effect:

(a) It puts $2,642,000 income, now in 1974, back into the three-year "exempt" period.

(b) The plaintiff has conceded, if it is entitled to change from cost to market, it should make the same change at the beginning of the "exempt" period. The concession was made from an accuracy and consistency point of view; it was pointed out there is nothing in the Income Tax Act requiring the same method of valuation to be used at the beginning and end of a fiscal period. The difference between cost and market, at January 31, 1970, was $339,000. The effect of the valuation change is to put $339,000 income into the period preceding February 1, 1970.

If the plaintiff is right in its contention that these changes are, within the Income Tax Act, permitted, there are further consequences. I quote directly from the evidence, in chief, of the witness Andrew, the vice-president and comptroller of the plaintiff:

Q Now how is it that the value of closing inventory at market at the end of the exempt period, January 31, ’73, apparently came up in connection with the 1974 taxation year?

A For the taxation year 1973, for which we would be taxable for eleven months only, we had more than sufficient allowances for expenditures on exploration and development, and for expenditures qualifying for capital cost allowance.

These expenditures were more than was necessary to offset taxable income in the year ’73. These amounts would therefore carry over into the year 1974 during which we had substantial taxable income. And these were not sufficient to write off or offset the whole taxable income of the year 1974.

And therefore, this is the first year in the sequence of Cyprus Anvil’s business where the effect of revaluing our inventory under the tax laws would have a beneficial tax effect on the company.

During the "exempt" period, the plaintiff deliberately did not claim, in its returns, capital cost allowance, or deductions for drilling and exploration expenses.

There is one further relevant fact. The plaintiff had long-term contracts, into 1977, with Japanese and German interests, to purchase all the mine concentrates produced. Delivery was to commence in late 1969. The prices were fixed pursuant to a formula based on world prices from time to time over the contract years.

I turn now to the issue on this appeal.

Is the plaintiff legally entitled, in this case, to change, for the three-year period when its income from the mine was not to be included in the calculation of its taxable income, the valuation of its inventory from cost to market?

Counsel for the plaintiff submitted it is, on both technical and conceptual grounds.

Counsel for the defendant relied primarily on the proposition, based on generally accepted accounting principles (GAAP), requiring consistency from year to year in accounting methods, including methods of valuing inventory; the statute does not authorize major departures of that kind where the only purpose is to reduce tax.

I say, at this point, reduction of tax can be a legitimate business purpose: Stubart Investments Ltd v The Queen, [1984] 1 SCR 536, at 540 and 575; [1984] CTC 294 at 314 and 318.

The plaintiff agreed the consistency rule of generally accepted accounting principles is applicable to treatment of inventory. It also agreed, in computing profit from its business for the year, “. . . profit must be determined on ordinary commercial principles unless the provisions of the Income Tax Act require a departure from such principles/': Dominion Taxicab Association v MNR, [1954] SCR 82, at 85; [1954] CTC 34 at 37.

The witness Harrison is a well-qualified chartered accountant with extensive private practice. He testified for the plaintiff. He gave a number of examples where there were important differences between income, calculated in accordance with gaap, and income, calculated for tax purposes — differences permitted by the statute. He noted, among others: book depreciation as contrasted with capital cost allowance; exploration and developments costs, which for tax purposes can be deferred; the choices in valuation of inventory, with no rules requiring consistency. I have confined my references to the differences applicable in this case.

He described his experience, and the mining industry experience, in respect of the "new mine” provisions of then existing subsection 83(5): the mining companies, in taking the benefit of this legislation, maximized their income during the three-year period. This was done in various ways, chiefly by valuing inventory at market, and by not claiming capital cost allowance or deduction for exploration and development expenses, all in the three- year period.

The evidence of Harrison on all these matters was both uncontradicted and convincing.

I turn to the "technical" argument, put forward by counsel for the plaintiff, and the position taken by counsel for the defendant.

The legislation, it was said, permits three methods of valuing inventory: cost, market, or the lower of cost or market. (See subsection 10(1) of the Act, and section 1801 of the Regulations.) The defendant does not dispute that proposition.

A taxpayer, it was further said, is not bound, by anything in the statute, to adhere, year to year, to any one method of valuation of inventory. Reference was made to former subsection 14(1) of the "old" Income Tax Act. If a taxpayer, then, proposed to do, now, what this taxpayer asserts: to change his method of valuation in a succeeding year: ministerial concurrence was required. That subsection was repealed in 1959. There was no counterpart at material times. There is no counterpart now. The only statutory restric- tion, at the relevant times here, is that opening inventory must be valued at the same amount as closing inventory of the previous year (subsection 10(2)); but there is no requirement that closing inventory be valued on the same basis as opening inventory.

In answer to all that, the defendant's position was that GAAP requires consistency; that principle is implicit in the Income Tax Act; there should be no change in the method of inventory valuation, unless the new method more properly or accurately reflects the taxpayer’s income for the period in question.

I agree, generally, with the plaintiff's contention. The change to a market value basis of valuing closing inventory at January 31, 1973, while it involves a departure from the accounting principle of consistency, is a departure permitted by the statute. It is an example, in computing income for tax purposes, of a number of instances, described by Harrison, of permitted departures from GAAP.

Further, the change sought by the plaintiff is, from an accounting point of view, supported by the evidence. Harrison, after consideration of the longterm contracts for the sale of the concentrates, testified the valuation of inventory at market, in his view, results in a more accurate measurement of the plaintiff’s income in the three-year period.

Again, that evidence was uncontradicted. I accept.

I go now to what counsel for the plaintiff termed “the conceptual proposition".

The submission ran this way: The legislative intent in subsection 83(5) was to exclude, in the computation of income, all income derived from the mine, for a fixed period of three years; the three-year period has no connection with the fiscal year of a corporate taxpayer (except by pure chance); it is based on the date the mine came into production; it has nothing to do with fiscal or taxation years, or with “events" outside the three-year period; consistency of method of inventory valuation, as compared with other periods, is not required; accounting principles may require consistency of method from year to year, but in income tax, the focus is on a single taxation year; in this case, there is a particular and peculiar three-year period, unrelated to the usual taxation year; on the facts here, having in mind the provisions of the long-term sales contracts, the most accurate way of arriving at the real profit or income, amassed in the total three-year period, was to value inventory at market; all this accords with the legislative intent to provide a tax incentive for the development of new mines.

Counsel for the defendant, in answer to that submission, relied again on the GAAP consistency principle. Even if the Income Tax Act focuses generally on income for a taxation year, and assuming subsection 83(5) is an exception directed to a particular three-year period, unconnected with fiscal or taxation years, nevertheless, it was said, there must be consistency of method in three temporal areas: the “pre-exempt period", the “exempt" period, and the “post-exempt" period; otherwise distortion of income results.

I do not agree.

The three-year period, is, as I see it, an income-earning period, for tax purposes, separate and apart from the plaintiff's fiscal taxation periods. The taxpayer is entitled to use, for that period, the method of valuing inventory most appropriate for arriving at a true picture of income in that precise period. On the evidence in this case, the valuation of inventory at market, is justified.

The plaintiff, as earlier recounted, used a cost basis (the lower of cost or market) for its 1973 fiscal and taxation year, and again for its 1974 year, as well as for the preceding fiscal years. The defendant submits the consistency principle must be applied: if market is appropriate for the three-year period, then, absent any reasonable factual basis otherwise, market should be used for all the other periods. But again, the statute and regulations, to my mind, permit the plaintiff to compute its income in the three-year period as it proposes. That period is not, as the defendant submitted, inexorably tied into other fiscal and taxation periods.

A further argument was put forward on behalf of the defendant. It was submitted the plaintiff is estopped from changing its basis for inventory valuation. This is so, it was said, because the proposed $339,000 increase in inventory as at January 31, 1970, results in an increase in income for the period of January 1, 1970 to January 31, 1970; the plaintiff cannot now be reassessed.

There is, in my view, no detriment to the defendant. The plaintiff agrees, as does the defendant’s expert witness McDonald, that the amount of $339,000 must be deducted from the sum of $2,642,000, having a net adjustment, in respect of inventory of $2,303,000.

The appeal is, therefore, allowed. The reassessment of the plaintiff’s income tax for the year 1974 is referred back to the Minister, with the direction that the plaintiff’s income for that year be reduced by $2,303,000.

The plaintiff is entitled to its costs.

Appeal allowed.