The Queen v. Jawl Industries Ltd., 74 DTC 6133, [1974] CTC 147 (FCTD)

Cattanach, J:—This is an appeal by Her Majesty the Queen from a decision by the Tax Review Board whereby the defendant’s appeal from an assessment made by the Minister of National Revenue in respect of the defendant’s taxation year. ending June 30, 1969 was allowed.

In assessing the defendant as he did, the Minister disallowed as a deduction the sum of $19,589.10 which had been so claimed by the defendant in computing its income for that taxation year.

The Tax Review Board found that the amount in question was properly deductible and accordingly allowed the defendant’s appeal in this respect.

It is from that decision that the present appeal results, the sole issue being whether the sum of $19,589.10 was properly deductible by the defendant in computing its income for its 1969 taxation year.

The defendant in a joint stock company incorporated pursuant to the laws of the Province of British Columbia and at all material times has carried on the business of buying lumber and other building material and supplies for resale at a profit.

During the conduct of its business in its 1969 taxation year the defendant entered into binding and irrevocable purchase commitments with three of its principal suppliers to purchase certain quantities of lumber at fixed and specific prices.

In the circumstances that followed the purchase commitments by the defendant, the deals turned out to be imprudent ones for it.

Immediately after the defendant made its commitments the lumber market became depressed and remained so for a prolonged. period of time as a consequence of which the market value of the lumber, as at June 30, 1969, was much less than the purchase price that the defendant had committed itself to pay. The extent of that difference can best be expressed visually and narratively in tabular form as follows:

The foregoing figures are not in dispute and it is the sum of $19,589.10 which is the difference between the cost price to the defendant and the market value of the quantity of lumber covered by the defendant’s purchase commitments, as at June 30, 1969, the defendant’s financial and taxation year end, that the defendant seeks to deduct as a business loss incurred in its 1969 taxation year.

The defendant did not take physical delivery of any portion of the lumber nor were any invoices sent to or received by the defendant in respect of any portion of the lumber prior to June 30, 1969.

The defendant took delivery of all of the lumber covered by the purchase commitments in its 1970 taxation year and was invoiced therefor by its suppliers in its 1970 fiscal period and paid those invoices in that period. There was no evidence of the total amount paid by the defendant for the lumber in its 1970 taxation year but that is immaterial bearing in mind that the defendant seeks the deduction in its 1969 taxation year rather than its 1970 year and it is the assessment for the 1969 year that is under review.

In the balance sheet of the financial statements of the defendant as at June 30, 1969 there is included on the liability side an item reading as follows:

In the operating statement the gross profit of the defendant was computed as follows:

The net income of the defendant was computed and reported as $35,454.18. To this amount the Minister added the loss claimed on purchase commitments in the amount of $19,859.10 and reassessed the defendant accordingly.

Note 3 referred to in the items in the balance sheet and operating statement respecting the loss from purchase commitments reads:

Note 3:

At June 30, 1969 the Company had purchase commitments payable of $72,695.99. The current replacement cost of these goods however was $53,106.89, thus giving rise to the expense and liability of $19,589.10 reflected in these statements.

The auditors’ report to the shareholders appended to the balance sheet reads in part as follows:

fn our opinion these Financial Statements present fairly the financial position of the Company as at June 30, 1969 and the results of its opera- tions for the year then ended, in accordance with generally accepted accounting principles applied on a basis consistent with that of the preceding year.

I particularly note the use of the language in the auditors’ report to the effect that the financial statements were prepared in accordance with generally accepted accounting principles so as to truly represent the financial position of the defendant at its year end.

For the defendant’s own commercial purposes this loss on purchase commitments might well be included in its operating costs in its 1969 taxation year. The purchase commitments obligating the defendant to take and pay for a fixed quantity and quality of lumber at a fixed price were entered into by the defendant in its 1969 taxation year. It suffered a loss from what it did in 1969.

However it is not to the purpose to consider whether the incurrence of this obligation by the defendant in its 1969 year is a proper deduction from the point of view of the defendant or its auditor in making up the financial statements for the defendant’s own purposes.

The question is whether such amount is a proper deduction in computing the defendant’s income for its 1969 taxation year within the meaning of the provisions of the Income Tax Act. It is not a question of accountancy but whether the accountancy principle adopted and relied upon in this particular case is based on sound postulates.

The position taken by the Minister is that no portion of the lumber had been taken into the defendant’s inventory as at June 30, 1969 as a consequence of which there could not be deducted as an inventory loss or adjustment any portion of the sum of $19,589.10.

On the other hand it was contended on behalf of the. defendant that the lumber comprised part of the defendant’s inventory and should have been included in its year end inventory, although, as I understand the financial statement, this was not precisely what was done by the auditor. He sought, in effect, to show a loss in the 1969 taxation year.

An assumption upon which the Minister assessed the defendant as he did was that no portion of the lumber had been taken into the defendant’s inventory as at June 30, 1969.

The onus is upon the defendant to “demolish” that assumption and, in my opinion, the defendant has not successfully discharged that onus.

On this particular point the evidence of Mr Jawl was unsatisfactory. He purported to speak of matters which were beyond his knowledge and what he did say in this respect was contradicted by a witness called by the plaintiff having precise knowledge of the subject matter whereof he spoke.

At this point reference to the British Columbia Sale of Goods Act, R.S.B.C. 1960, c. 344, is useful.

Section 8, subsections (1), (3), (4) read:

8. (1) A contract of sale of goods is a contract whereby the seller transfers or agrees to transfer the property in goods to the buyer for a money consideration, called the “price.” There may be a contract of sale between one part owner and another.

(3) Where under a contract of sale the property in the goods is transferred from the seller to the buyer, the contract is called a “sale”; but where the transfer of the property in the goods is to take place at a future time or subject to some condition thereafter to be fulfilled, the contract is called an “agreement to sell.”

(4) An agreement to sell becomes a sale when the time elapses or the conditions are fulfilled subject to which the property in the goods is to be transferred.

Subsection 11(1), under the heading “Subject-matter of Contract”, reads:

11. (1) The goods which form the subject of a contract of sale may be either existing goods owned or possessed by the seller, or goods to be manufactured or acquired by the seller after making of the contract of sale (in this Act called “future goods”).

Under the heading “Transfer of Property as between Seller and Buyer”, sections 22 and 23 read:

22. Where there is no contract for the sale of unascertained goods, no property in the goods is transferred to the buyer unless and until the goods are ascertained.

23. (1) Where there is a contract for the sale of specific or ascertained goods, the property in them is transferred to the buyer at such time as the parties to the contract intend it to be transferred.

(2) For the purpose of ascertaining the intention of the parties, regard shall be had to the terms of the contract, the conduct of the parties, and the circumstances of the case.

Section 24, unless a different intention appears, outlines rules for ascertaining the intention of the parties as to the time at which property in goods is to pass to the buyer.

The contention by the Minister is that in the circumstances of the present appeal Rule 5(1) so outlined in section 24 is applicable.

Rule 5(1) reads:

Rule 5. (1) Where there is a contract for the sale of unascertained or future goods by description, and goods of that description and in a deliverable state are unconditionally appropriated to the contract, either by the seller with the assent of the buyer, or by the buyer with the assent of the seller, the property in the goods thereupon passes to the buyer. Such assent may be express or implied, and may be given either before or after the appropriation is made;

“Specific goods” are defined in section 2 as meaning goods identified and agreed upon at the time the contract of sale was made.

It follows that non-specific or unascertained goods, though not defined in the statute, are goods that are not identified.

With respect to when goods are in a deliverable state, section 5 reads:

5. Goods are in a “deliverable state” within the meaning of this Act when they are In such a state that the buyer would under the contract be bound to take delivery of them.

Mr Jawl testified that the lumber covered by the purchase commitments was identified and appropriated to the defendant as buyer by the vendors. If that were the case there would have been an unconditional contract for the sale of specific goods in a deliverable state and property in the goods would have passed to the buyer when the contract was made.

I have already stated that in testifying as he did Mr Jawl purported to speak of subject matter beyond his knowledge.

With respect to the transactions between the defendant and BC Forest Products, Mr C L Clagu, the sales manager of that company, carefully examined each purchase order placed by the defendant with his company. From his detailed knowledge and long experience in this industry he unequivocally stated that with respect to the bulk of the orders so placed the lumber was not available. It was in log form or standing in the forest. The company did have some lumber on its premises at certain times answering the description of that ordered by the defendant but that lumber was stored in a common pile and was available to all of its customers. None of that lumber had been allocated to the defendant.

Furthermore Mr Clagu testified that all lumber on its premises was the property of BC Forest Products and that insurance was carried on it as inventory. He also described how the lumber was picked up by the local market. The purchaser would send a truck to pick up lumber. It would be loaded on the purchaser’s truck from the common pile. That common pile was available to all customers. The load was then tallied and the amount of the load was deducted from the purchase commitments outstanding if those commitments existed. Between an order and a pick up the lumber continued to be inventory of the vendor and was treated as such.

It is impossible that the lumber could be carried on the inventory of two different persons, that is on that of both the vendor, in this case BC Forest Products, and the buyer, in this case the defendant.

There is no doubt that, with respect to the lumber covered by the purchase commitments of the defendant to BC Forest Products, the contracts were for the sale of unascertained or future goods and that goods of that description in a deliverable state were not unconditionally appropriated to those contracts.

Therefore property in the lumber did not pass to the defendant in its 1969 taxation year and the lumber did not form part of the defendant’s inventory. It was acknowledged that the vendors “owed” the defendant the quantity of lumber ordered by it at the agreed price but that is far different from title to the lumber passing to the defendant in its 1969 taxation. year.

BC Forest Products was but one supplier of three to the defendant under commitment orders. However because the other two suppliers carried on their business in a like manner, which is one common to the industry, on the balance of probabilities it has not been proven by the defendant that title passed to it from the other two suppliers but rather the preponderance of the evidence was that property remained in them. also until delivery.

It is for these reasons that I have concluded that the defendant has not discharged the onus cast upon it to establish that property in the lumber passed to it in its 1969 taxation year. Therefore the defendant has not demolished the Minister’s assumption that no portion of the lumber was taken into the defendant’s inventory in its 1969 taxation year.

On behalf of the defendant it was submitted that, quite apart from the question of the property to the lumber passing to the defendant in its 1969 taxation year, the defendant entered into agreements with its suppliers in its 1969 taxation year and thereby incurred, during the course of its business in that year, a binding legal obligation to pay for the lumber at that price. While the price was paid in 1970 the obligation was incurred in 1969 from which it was argued that the loss was deductible in the 1969 taxation year.

In answer to this submission by the defendant the Minister submits that the deduction of the sum of $19,589.10 as a loss on the purchase commitments is a deduction which is prohibited in computing the defendant’s income by the provisions of paragraph 12(1)(e) of the Income Tax Act reading:

12. (1) In computing income, no deduction shall be made in respect of

(e) an amount transferred or credited to a reserve, contingent account or sinking fund except as expressly permitted by this Part,

The plan of the Income Tax Act is that tax is payable for each taxation year. It follows that the profits of a business shall be computed annually. Accordingly only those elements of profit or gain enter into that computation which are earned or ascertained in the year in question. In like manner only those elements of loss or expense enter into that computation which are suffered or incurred during that year.

It is clear from a commercial point of view the defendant would have to take a loss in the future, but I fail to follow how that loss can be fairly measured by the difference between the agreed and certain contract price for the lumber and the market value as at June 30, 1969, being the date of its year end, when its balance was struck.

There was evidence that the lumber market continued to be depressed at a constant level but this is hindsight. The defendant could not foresee as at June 30, 1969 what the market value of the lumber would be on the dates when delivery was taken. The difference between the contract price and the market price on those dates is, in my opinion, the true measure of the defendant’s loss and those dates, in my opinion, are the dates on which the defendant’s loss occurred.

In my view the issue falls to be determined on the question whether the lumber was taken into the defendant’s inventory in its 1969 taxation year and the appropriate inventory accounting in that event.

In the computation of business profits it has long been recognized that the value of stock-in-trade is an important element and that the right method of ascertaining profit is to take into account the value of the stock-in-trade at the beginning and at the end of the accounting period. While for income tax purposes profits are normally those realized in the course of the taxation year, nevertheless the ordinary principles of commercial accounting have provided an exception where traders still hold goods in inventory at the end of the year. The trader is permitted, in compiling his inventory, to enter those goods at cost or market value, whichever is the lower.

The accounting practice so described has been included in the Income Tax Act, subsection 14(2) of which is as follows:

14. (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 manner as may be permitted by regulation.

The effect of subsection 14(2) is to permit, what is in common parlance, a “hidden reserve” which, but for subsection 14(2), would otherwise be precluded by paragraph 12(1 )(e) quoted above.

Since the value of the closing inventory is deducted from the value of the sum of the opening inventory and goods purchased during the accounting period to obtain the cost of the goods sold and the result is, in turn, deducted from the value of the sales to arrive at the profits, it follows that it is a distinct advantage to the taxpayer, in order to reduce the amount of the profit which would be subject to tax, to enter the closing inventory at as low a figure as possible.

In the present appeal the defendant by virtue of subsection 14(2) would have the choice of determining the value of each item of its inventory at the lower of its cost or its fair market value.

However the foregoing is predicated upon the lumber in question comprising part of the defendant’s inventory in its 1969 taxation year. For the reasons given I have concluded that the lumber was not part of the defendant’s inventory in that year.

If the lumber is not inventory of the defendant in its 1969 taxation year, as I have found it not to be, then the amount of the loss which the defendant suffered when delivery of the lumber was taken in 1970 was unknown, unforeseeable and contingent as of June 30, 1969 and therefore the defendant is precluded from deducting the sum of $19,589.10 in its 1969 taxation year by the provisions of paragraph 12(1 )(e) of the Income Tax Act.

For the reasons I have given I find that the defendant, in computing its income for its 1969 taxation year, is not entitled to deduct the sum of $19,589.10 as a loss incurred in that year.

In summary those reasons are:

(1) the lumber was not part of the defendant’s inventory in its 1969 taxation year;

(2) not being inventory resort could not be had to the provisions of subsection 14(2) of the Income Tax Act to fix an inventory valuation and the deduction of the amount claimed as a loss in the 1969 taxation year is prohibited by paragraph 12(1)(e) of the Act; and

(3) the loss would be difference between the contract price and the market price when delivery was taken in 1970 and 1970 would be the taxation year in which the loss was suffered.

The appeal is allowed and Her Majesty the Queen is entitled to Her taxable costs.