Quebec North Shore Paper Co. v. The Queen, 78 DTC 6426, [1978] CTC 628 (FCTD)

Dubé, J:—Plaintiff is a corporation incorporated under the laws of the province of Quebec carrying on the business of manufacturing and selling newsprint, sulphite and groundwood pulp.

In its declaration plaintiff alleges that in its 1968 taxation year it recorded depreciation and depletion against fixed assets in its books of account in the amount of $4,006,524, and that it added $2,707,243 to the income recorded in its own books for the purposes of computing its income tax with the difference of $1,299,281 being inventory at the end of the year to be deducted in future taxation years. By reassessments dated May 5, 1971 and May 4, 1973, the Minister added the whole of $4,006,524 to plaintiff's reported income for 1958.

Plaintiff appeals that decision and in its prayer for relief requests that the proper adjustment to recorded income in respect of depreciation and depletion be declared to be the adding back to the income only that portion of depreciation and depletion recorded in the books of account for the year.

In its defence the Minister sets out two alternative positions. Firstly, that the plaintiff having included as part of the cost of goods manufactured the sum of $4,006,524 in respect of the depreciation suffered by it during the 1968 taxation year, it therefore had to add to its profit the full amount of $4,006,524 in accordance with paragraph 12(1)(b) of the Income Tax Act RSC 1952, c 148 as amended. Secondly, that if the plaintiff is entitled to prepare its accounts on the basis that the depreciation suffered during the taxation year may be allocated between the cost of the goods sold during the year and the cost of the closing inventory, then by virtue of paragraph 12(1)(b) there must be added back to its profit not only the depreciation suffered during the year but also the depreciation suffered in previous years and comprising part of the cost of the opening inventory.

At the commencement of the hearing counsel for the defendant abandoned the first alternative. As a result, the dispute between the parties is now reduced to the question of whether or not the amount of $955,186 (the depreciation and depletion content of the opening inventory as of January 1, 1968) should be added to the plaintiff’s profit in order to arrive at income for tax purposes for the 1968 taxation year.

For 1968 and prior years the plaintiff in computing its profit for its own financial statement purposes utilized a system described variously as “absorption”, or “full absorption”, or “on cost” accounting. Under that procedure both variable costs, such as the costs of material and labour as well as certain fixed manufacturing overhead costs, are treated as costs of production. That is to say, those costs are included in inventory and cost of sales. The fixed manufacturing overhead costs in question include depletion of the plaintiff’s wood assets and depreciation of its manufacturing equipment. Thus the plaintiff, by using full absorption cost accounting, included in its inventory and cost of sales account the amount of depletion and depreciation recorded in its books.

As a result, the depletion and depreciation costs are first allocated to the production and inventory accounts as goods are produced. When a sale takes place these depreciation and depletion costs form part of the cost of achieving the sale. To the extent that products remain on hand at the end of the year, the depreciation and depletion costs are included in the cost of closing inventory. The same figure becomes the opening inventory at the commencement of the following year.

The costs of goods sold by the plaintiff for the 1968 year were computed, for purposes of determining the profit as reported in its financial statement, as follows:

It bears repeating that the amount in issue in the instant appeal becomes the depreciation and depletion content ($955,186) in the opening inventory of January 1st, 1968.

For each year prior to 1968, for income tax purposes, the plaintiff added back an amount equal to the depreciation and depletion re- corded in its books of account for the year. However in respect of the 1968 taxation year a different procedure was followed. Counsel for the plaintiff admits that the change was made because the plaintiff determined the prior procedure to be erroneous.

Referring to the table for the 1968 taxation year supra the plaintiff added back the amount of $4,006,524 (depreciation and depletion for the year) and then subtracted the sum of $1,299,281 (depreciation and depletion at closing inventory). Plaintiff affirms that it thereby eliminated not only the effects of having included depreciation and depletion in the cost of goods manufactured during the year, but also the effects of having included depletion and depreciation in closing inventory.

The plaintiff did not make any adjustment for depreciation and depletion in the opening inventory ($955,186) and the Minister claims it should have done so. That is the gist of the issue.

Plaintiff called two chartered accountants in support of its position.

Ronald Walter Scott in his affidavit provided this answer to question XI:

Question XI:

If a company treated depreciation on manufacturing facilities as a product cost, and in adjusting its accounting profits to ascertain its income for tax purposes it added back the depreciation provided in the year, what adjustment would it have to make in a particular year if it wished to remove all effects of accounting depreciation from the determination of income for tax purposes?

Answer:

In order to make that transition, the company would have to add back only the depreciation provided in the year less the depreciation allocated to closing inventory. It would not add back the depreciation included in opening inventory. The reason for this is historical. Over the years during which the company adjusted its accounting profits by adding back the depreciation provided in each year, it effectively included in its income for tax purposes, on a Cumulative basis, an amount equal to the depreciation in the opening inventory of the year in question. That is to say, each year the difference between depreciation in closing inventory and depreciation in opening inventory has been included in computing income. The net effect is to include in income over the years an amount equal to the depreciation in the closing inventory at the end of any particular year. This same amount is reflected in the opening inventory of the next year. Therefore, by not adding back the amount of depreciation in the opening inventory for the transition year, the company would offset the effects of the inclusion in income for tax purposes in prior years of all accounting depreciation.

Seymour Lyon Wigle in his affidavit gave these answers to questions IV, V, VI, Vil, VIII and IX:

Question IV:

If, in computing its profits for the 1968 fiscal year, the plaintiff:

(a) included the said $955,186 in opening inventory, and

(b) allocated the amount of $1,299,281 of 1968 depreciation to closing inventory,

What, in your opinion, is the effect upon profit of this, assuming all products in the opening inventory were sold during the 1968 fiscal year?

Answer:

In my opinion, the $955,186 included in opening inventory would give rise to a deduction in computing profits for the 1968 fiscal year that would, in effect, offset the $955,186 included in profits for the previous fiscal years. However, the allocation of $1,299,281 would increase cumulative profits over the period of fiscal years commencing with incorporation and ending with the 1968 fiscal year by the amount of $1,299,281.

Question V:

If, in computing its profits for its 1968 fiscal year, the plaintiff had:

(a) included the said $955,186 in opening inventory, and

(b) allocated no depreciation cost for 1968 to closing inventory,

what, in your opinion, would the result have been?

Answer:

In my opinion, the $955,186 included in opening inventory would give rise to a deduction in computing profits for the 1968 fiscal year that would offset the amount of $955,186 included for the previous fiscal years. Because no amount of depreciation would have been allocated to closing inventory, there would be no increase in profits (ie, no amount in respect of depreciation cost would be added to profits) by virtue of an allocation of depreciation to closing inventory.

Question VI:

If, in computing its profits for its 1968 fiscal year, the plaintiff had:

(a) excluded the said $955,186 from opening inventory, and

(b) allocated no depreciation cost for 1968 to closing inventory,

what, in your opinion, would the result have been?

Answer:

In my opinion, since no amount of depreciation cost would have been allocated to closing inventory for the 1968 fiscal year there would be no increase of profits for that year in the amount of depreciation cost by virtue of an allocation of depreciation to closing inventory.

However, because the said $955,186 would have been excluded from opening inventory, there would be no offset for the $955,186 of depreciation cost that had been cumulatively included in profits for fiscal periods up to the end of 1967.

Question VII:

On the understanding that, in computing its profits for the 1967 and previous taxation years, the plaintiff included $955,186 by virtue of allocating depreciation to closing inventory, in your opinion, did such treatment result in the plaintiff’s incomes as reported* [1] for those years for purposes of the Income Tax Act being $955,186 higher than they would have been had no depreciation been allocated to closing inventory?

Answer:

In my opinion, the plaintiff’s incomes for purposes of the Income Tax Act for taxation years up to the end of 1967 were $955,186 higher than they would have been had no depreciation been allocated to closing inventory.

Question VIII:

If, in adjusting its profits for the 1968 taxation year, in order to compute income for purposes of the Income Tax Act, the plaintiff:

(a) did not add back to profits the amount of $955,186 of depreciation included in opening inventory, and

(b) did not add back to profits the $1,299,281 of depreciation allocated to closing inventory,

what, in your opinion, would be the effect of this?

Answer:

In my opinion, the effect of (a) would be that the $955,186 was included in opening inventory for income tax purposes and thereby was deducted in computing income for the 1968 fiscal year, so that there was an offset to the $955,186 of depreciation cost that had, for tax purposes, been included in income of the earlier years. The effect of (b) would be that there would be no inclusion in the plaintiff’s income for tax purposes of the $1,299,281 of depreciation cost.

Question IX:

If, in adjusting its profits for the 1968 taxation year, in order to compute income for purposes of the Income Tax Act, the plaintiff had:

(a) added back to profits the $955,186 of depreciation cost included in opening inventory, and

(b) not added back to profits the $1,299,281 of depreciation allocated to closing inventory,

What, in your opinion, would have been the result?

Answer:

The effect of (b) would be that there would be no inclusion in the plaintiff’s income for tax purposes of the $1,299,281 of depreciation cost. However, the effect of (a) would be to exclude the $955,186 from opening inventory for tax purposes. Consequently, in computing the plaintiff’s income for the 1968 fiscal year, there would be no deduction of the $955,186 depreciation cost that had previously been included in income for tax purposes up to the end of 1967. The effect would be to subject the plaintiff to income tax on $955,186 of depreciation cost.

Learned counsel for the plaintiff avers therefore that in order to remove all effects of accounting depreciation from the determination of income for tax purposes the amount of $955,186 representing the depreciation element in opening inventory for 1968 should not be added back to profit. He argues that if the amount of $955,186 were to be added back the effect would be to include the same amount twice in computing plaintiff’s income, thus double taxation.

He affirms that there is no longer any dispute between the parties as to the proper method of excluding all effects of depreciation for the taxation years after 1968. If the cost of sales is determined by adding the opening inventory to the cost of goods manufactured and subtracting the closing inventory, and if each of these amounts includes an element of depreciation, then in order to reverse the effects of the depreciation it will not be sufficient in ensuing years to make an adjustment which relates solely to the depreciation recorded during the year. The proper method of adjusting accounting profits to arrive at income for tax purposes after 1968 will be to add back in each year an amount equal to the depreciation content of opening inventory, plus the depreciation content of the cost of goods manufactured in the year, minus the depreciation content of the closing inventory. That procedure will eliminate entirely the effects of accounting depreciation.

But 1968 is a transitional year, and counsel claims that in order to pass from one method to the other, the depreciation content of the opening inventory should not be added back. The very nature of inventory involves an allocation of costs between different fiscal periods; this is a specific requirement of the Income Tax Act. Subsection 14(3) provides as follows:

14. (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 preceding year for the purpose of computing income for that preceding year.

On the other hand, counsel for the defendant argues that the sole issue is whether or not the provisions of paragraph 12(1)(b) of the Act preclude, in the computation of income under the Act, the deduction of any amount as allowance for depreciation which has found its way into the cost of goods sold account. Paragraph 12(1)(b) reads:

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

(b) an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part.

Filed in exhibit is a statement of the Minister which outlines the acceptable way for the plaintiff to make the necessary accounting adjustments:

The Minister acknowledges, that in those cases where the depreciation 'suffered during the year is treated on the on-cost basis, and is included in the cost of goods sold an acceptable manner of excluding from the computation of income under the provisions of the Income Tax Act any allowance for depreciation is to reduce the expenses (or add back to the profit)

(a) the depreciation element contained in the opening inventory

plus

(b) the depreciation recorded during the fiscal period

less

(d) the depreciation content of the closing inventory.

Learned counsel for the defendant does not accept, of course, that for the processus of transition from one method to another the depreciation element contained in the opening inventory should not be added back. He claims that under paragraph 12(1 )(b) no deduction whatsoever should be made for any allowance in respect of depreciation. Under the Act, in lieu of depreciation, the taxpayer may deduct capital cost allowance, in his discretion but not to exceed the maximum amount prescribed for each class of property.

He argues that to the extent that an accounting principle of practice is inconsistent with any statutory direction or prohibition in the Act, it must, in the computation of income for the purposes of the Act, give way to the express statutory provision*. [2] Counsel alleges that the consequence of the inappropriate adjustment made by the plaintiff in his attempt to reconcile his accounting with the provisions of the Act is that there. was deducted in computing income an allowance for depreciation which is prohibited. He quotes Earl Cairns in Coltness Iron Company v Black (1875-1883) 1 TC 287 at 312:

It is, as now explained, can a mine owner write off and deduct from the gross earnings of his mine in a particular year a sum to represent that year’s depreciation of all the pits in the mines whenever sunk. I am clearly of opinion that this cannot be done. It may be proper for a trader or for a trading company to perform in his or their books an operation of this kind every year in order to judge of the sum that can in that year be safely taken out of the trade and spent as trade profits. But I am clearly of opinion that the owner of a mine cannot qua owner thus manipulate his accounts when the question is under section 60 of the principal Act, what is the amount of profits received from the mine in each of the five years upon which the average is to be taken?

In Addie v Solicitor for Inland Revenue (1875-1883), 1 TC 1, the taxpayer in computing his profit sought to deduct as depreciation expenses part of the cost of his machinery and plant. The Lord President said at 4:

As soon as you ascertain that this is an expenditure of additional capital, there is an end to any proposal to deduct anything in respect of it; and on that simple ground I think the judgment of the Commissioners right.

In BSC Footwear Ltd v Ridgway (Inspector of Taxes), [1972] AC 544, Lord Reid made the following comments at 555:

It was said in Duple Motor Bodies Ltd v Inland Revenue Commissioners [1961] 1 WLR 739 that a long-standing practice of this kind ought not to be changed without good reason. If a practice infringes a rule of law that would be a good reason. But it is admitted that this matter is not governed by any rigid rule of law. It depends on general principles which have been elaborated by the courts for the purpose of ensuring that so far as practicable profits shall be attributed to the year in which they were truly earned.

There is one strong reason for not imposing this different system of valuation. The Crown does not seek to reopen the appellant’s accounts for tax purposes for the year 1958 where the stock-in-hand on December 31, 1958, was valued by the appellant’s method. But if a new method of valuation is to be required for 1959 admittedly that necessarily involves applying the new method in valuing the stock-in-hand at January 1, 1959. So different values will be shown for the same stock, and, again admittedly, that means, according to which way the difference is, that a sum equal to that difference will either be taxed twice or will escape taxation altogether. It is a fundamental principle of income tax law that the same sum shall not be taxed twice. It may be that in the present case if the Crown are successful the appellants will escape from a considerable amount of tax which they will have to pay if they succeed. That does not appear to affect the minds of either party to this case. The Crown want a uniform system and the appellants will continue to present their accounts to their shareholders framed by their existing method because they think it gives a better picture of their results. But in my judgment this House ought to avoid if possible a decision which results in taxable profits escaping taxation. [The underlining is mine]

In my view, paragraph 12(1)(b) of the Act does not mean that a taxation year must be assessed in total isolation and without regard for the years which precede and follow it. The Minister himself in his filed statement acknowledges that, where the depreciation is treated on the on-cost (absorption) basis; an acceptable manner of excluding the depreciation is to add back the depreciated element in the Opening inventory, plus the depreciation recorded in the-year, less the depreciation content in the closing inventory. So he does consider the depreciation elements in both the preceding and the following year. His learned counsel had no qualm at the outset of the trial about dropping the first alternative argument in his statement of defence which resulted in the plaintiff not having to add back to profit the depreciation content of the closing inventory. Of course, the aforementioned subsection 14(3) of the Act provides that the opening inventory of a taxation year shall be valued at the same amount as the closing inventory of the preceding year. And defendant’s second alternative alleges that there must be added back “‘the portion of the depreciation and depletion suffered in previous years".

I accept the uncontradicted expert opinion of both chartered accountants that the net effect of adding the depreciation content of $955,186 to the 1968 profit would be to compute the same amount twice for income tax purposes. The fair and equitable way to make the transition would be, as R W Scott puts it, “to add back only the depreciation provided in the year less the depreciation allocated to closing inventory . . . not add back the depreciation included in Opening inventory’’.

Counsel for the defendant argued at the end of the trial that the plaintiff had not proved that the sum of $955,186 represented the cumulative effect of the allocation of depreciation in closing inventory from incorporation to the end of the 1967 fiscal year. But his statement of defence had not raised that particular issue and had not put the plaintiff to the strict proof of all its accounts from the start of its operations to 1968. A myriad of questions have been asked by the defendant (and answered by the plaintiff) pursuant to a notice to admit facts, but that information was not requested.

The uncontradicted evidence of Robert Bryant, treasurer of the plaintiff and himself a chartered accountant, and of the expert witness S L Wigle who is personally familiar with plaintiff’s books, leads me to the conclusion that the amount of $955,186, the depreciation content in the opening inventory of 1968, reflects the historical depreciation content adjusted over the years up to the closing inventory of 1967.

The appeal, therefore, is allowed and the reassessments appealed from are referred back to the Minister for reconsideration and reassessment accordingly, the whole with interest and costs.