Supreme Court of Canada
Minister
of National Revenue v. Anaconda, [1954] S.C.R. 737
Date: 1954-11-01
The Minister of National Revenue Appellant
and
Anaconda American Brass Limited Respondent
1954: March 22, 23, 24, 25; 1954: November 1.
Present: Kerwin C.J. and Taschereau, Estey, Locke and
Cartwright JJ.
ON APPEAL FROM THE EXCHEQUER COURT OF CANADA
Revenue—Income tax—Excess profits tax—Whether respondent
in computing its net taxable income for 1947 was entitled to use the LIFO method
of inventory accounting.—Excess Profits Tax Act, 1940, S. of C. 1940, c. 88, s.
2(1) (F)—Income War Tax Act, R.S.C. 19S7, c. 97, s. 3(1).
The respondent, at its primary brass mill, produced
semi-finished copper and other copper alloys from raw metals it purchased. It
neither traded nor speculated in its raw materials. The prices at which it sold
its products were based upon the replacement cost of their metal content and a
processing charge which included all expenses, other than the replacement cost
of the metal, and an allowance for profit. The nature of its business required
a 'large inventory and the rate of its turnover was slow. It made no attempt to
use the raw materials in the order of their purchase or in any particular
order.
The respondent had been using the last in first out (LIFO) method
of inventory accounting, for its own corporate purposes, since 1936, but only
commenced using it in computing its income and excess profits tax in 1946. The
Minister refused to recognized the right to use that method and determined that
the first in first out (FIFO) method should be followed. The respondent's
appeal to the Exchequer Court in respect of its assessment for the year 1947
was successful.
Held (Kerwin C.J. and Estey J. dissenting), that the
appeal should be dismissed.
Per Taschereau and Locke JJ.: In the absence of any
statutory direction, manufacturing costs of this nature are to be determined
upon the ordinary principles of commercial trading. The evidence in this case
leads to the conclusion that, in a business such as this, the LIFO method of
inventory accounting determined what was the true income of the respondent with
greater accuracy than any other method which it was practical to apply.
Per Taschereau and Cartwright JJ.: Where, as in the
case at bar, the dispute as to what were the true gains for a particular year
centred on the question as to which of two well-recognized systems of
accounting would in the case of the business carried on by the respondent most
nearly arrive at the true figure for the materials cost of its sales for such
year, that question was one of fact. The evidence fully supported the finding
of fact made by the trial judge on this crucial question.
[Page 738]
Per Kerwin C.J. (dissenting) : Even though the LIFO assumption is recognized as a proper method for corporate
purposes, that is not sufficient for the purposes of the taxation sought to be
imposed, as it does not determine the respondent's true profits more accurately
than the FIFO method which is more in accordance with the known facts.
Per Estey J. (dissenting) : Under the LIFO
method, the current market value is used to compute the value of only
that quantity assumed to be added to the. inventory in the last year and the
valuation of the balance of the inventory is computed by using the market
values of former years. Consequently, since the assumption under the FIFO
method eliminates many of the former years, the computation under the FIFO
method more closely approximates the current value.
APPEAL from the judgment of the Exchequer Court of Canada
,
Thorson P., reversing the Minister's decision as to the method of inventory
accounting to be used by the respondent in computing its income and excess
profits tax.
C. F. H. Carson Q.C., W. R. Jackett Q.C., F. J. Cross and A. Findlay for the appellant.
A. S. Pattillo Q.C., W. E. P. DeRoche Q.C. and
A. J. Macintosh for the respondent.
The Chief Justice (dissenting)
:—This appeal involves ascertainment of the proper amount of excess profits for
its 1947 taxation year of the respondent company Anaconda American Brass Ltd.
pursuant to the Excess Profits Tax Act 1940. By Section 2(1) (f) of that
Act "profits" means the amount of the company's net taxable
income as determined under the Income War Tax Act and in accordance with
the well known Section 3(1) of the latter, "income" means the annual
net profit; that is, profits are not to be ascertained over any period except
(as applied to the present case) the 1947 calendar year.
The statement of Lord Clyde in Whimster & Co. v. The
Commissioners of Inland Revenue ,
as to the 'two fundamental matters to be kept in mind in computing annual
profits is accepted in England and is applicable here. It appears at p. 823 of
the report:—
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
[Page 739]
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.
The second of these
propositions was approved by the House of Lords in Ryan v. Asia Mill
Ltd. . At p. 293, Lord Porter states:—
It was also common ground that in computing such profits the
value of the Appellant Company's stock-in-trade in hand at 13th January, 1945,
was, in accordance with the principles enunciated in Whimster & Co. v.
Commissioners of Inland Revenue, 1926 S.C. 20 at page 25, required to be
included at a figure representing its true cost to the Appellant Company.
At p. 300, Lord Radcliffe, with whom Lord Normand agreed, puts it thus:—
Here we are dealing with the application of "the
principle of commercial accounting … 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 the end of the period covered by the account should be entered at
cost or market price, whichever is the lower'.
Lord Clyde's two
propositions were approved by the Court of Appeal in Patrick v. Broadstone
Mills Ltd. . At p. 171 Lord Justice Singleton (with whom
Birkett and Hodson, LJJ., agreed, although the former added a comment of his
own) set out the extract given above. After setting out the headnote in Sun
Insurance Office v. Clark as it
appears in 6 Tax Cas. 59 and Lord Loreburn's examination in his speech
in that case of the previous decision of the House of Lords in General
Accident, Fire and Life Assurance Corpn Ltd v. McGowan, Lord Justice Singleton extracts what the Lord
Chancellor had said (p. 77) towards the end of his speech:—
I am equally anxious that your Lordships should not be
supposed to have laid down that the method applied by the commissioners in the
present case has any universal application. If the Crown wishes in any future
instance to dispute it they can do so by evidence, and it is not to be presumed
that it is either right or wrong. A rule of thumb may be very desirable, but
cannot be substituted for the only rule of law that I know of, viz.: that the
true gains are to be ascertained as nearly as it can be done.
[Page 740]
Leave to appeal to the House of Lords in the Patrick
case was refused by the Court of Appeal and no motion for leave has been made to the
House itself.
Two other preliminary
but important matters may be mentioned. The first of these is that in Russell
v. Town and County Bank Lord
Herschell stated:—
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.
Lord Fitzgerald, at
p. 429, in the same case, stated:—
'Profits' I read on
authority to be the whole of the incomings of a concern after deducting the
whole of the expenses of earning them—that is, what is gained by the trade.
The second is Lord
Cairns' statement in Coltness Iron Company v. Black :
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.
This part of Lord
Cairns' speech was reiterated by Lord Buckmaster (with whom Lord Atkinson
concurred) in Navel Colliery v. Commissioners of Inland Revenue to which Lord Buckmaster added:—
… But it cannot be done when the question is the amount of
profits received.
To the same effect are these statements by Lord Sands
in the Whimster case:—-
The consideration of how it would be prudent for a trader to
act does not solve the question here presented to us as one of Revenue Law.
Under this law the profits are the profits realized in the course of the year.
(p. 826).
The manner in which they have adjusted their accounts was
probably quite reasonable as a domestic arrangement, but it would lead to great
confusion if such haphazard and speculative estimates were to enter into the
business of the collection of the public revenue.
(p. 827).
The respondent was incorporated in Canada in 1922 but is a
subsidiary of The American Brass Co., a United States corporation. It operates
a primary brass mill and, from raw metals which it purchases from various
Canadian mining
[Page 741]
companies and from scrap, it produces semi-finished copper
and copper brass alloys in the form of sheets, rods, seamless tubes, and
shapes. About 90% of the metal content of its products consists of copper (over
80%) and zinc (about 15%). It purchases from companies with which it has no
connection all its raw metals at the market and has always avoided speculation
in their price as it seeks to make a profit entirely from their fabrication. The
prices charged for its products are based upon the replacement cost of the
metal content of its product and a processing charge which includes all
expenses, other than the replacement cost of the metal, and an allowance for
profit. The processing charge has never been affected by fluctuations in the
prices of the raw metals, which, particularly in the case of copper and zinc,
have, since the lifting of price controls on June 10, 1947, varied
considerably. With unimportant exceptions: from January 1, 1947, until February
28, 1947, it accepted orders on the condition that the price would be that
shown on its price list in effect of the first day of the month in which the
order was shipped; from February 28, 1947, until December 31, 1947, it accepted
orders on the condition that the price would be that shown on the price list in
effect on the date when the order was shipped.
During the first few days of each month the company
calculated the raw materials which would be required, and what orders it would
fill by shipment, in the next calendar month. The amount of raw materials
ordered was the amount so estimated to be required in that next calendar month.
The company's business is not seasonal; its turn over is slow (about three or
four times a year) and the inventory required is large physically and in value.
One pound of metal in the inventory has the same value as another, no attempt
is made to identify any portion of the inventory, and any record of scrap would
be of very little use.
The company commenced and ended the year 1947 with an
inventory of raw materials. The question is not as to the quantities but as to
values. It is settled, if not admitted, that the values must be taken at market
or cost, whichever be lower. The difficulty arises because the company put a
value on its inventory at the end of 1947 on the Lifo assumption,
that is, last in first out, while the appellant valued
[Page 742]
that stock on the Fifo assumption, that is, first in first out. Neither theory is based on any
presumption as to the actual physical movement of the metals in the course of
operations. As to Lifo, to quote Mr. DeRoche, a witness for the company,
it is an "assumption as to the order in which costs should flow into cost
of sales and for the establishing of the amount of cost to be assigned to the
quantity on hand"; it is "indicative of the flow of costs which are
employed in the method". If the company piled its metals in such a way as
to be able to allocate the actual purchase prices to the various lots there
would be no difficulty, because the cost of what had been used in processing,
whereby its profits were made, would be known. Since it did not do this it was
necessary to adopt some method, the result of which would most nearly approach
the known facts.
As to copper, which accounts for more than 80% of the metal
content of the company's products, the situation in 1947 was that the company
purchased 63,268,555 pounds and at the end of the year 14,291,007 pounds were
on hand. Slightly more than the total closing inventory, i.e. 14,745,979 pounds
had been purchased in the last three months of the year at 21.5 cents per
pound. In using the Lifo assumption the company went back
to the year 1936 when the theory had been adopted by it for corporate purposes
and allocated the cost of the closing inventory of 14,291,007 pounds in the
following manner:—
(a) 6,500,000 pounds were regarded as having a cost of 7.5
cents per pound (the average cost of the copper in the inventory when LIFO was adopted in 1936) amounting to $487,500;
(b) 802,697 pounds were regarded as having a cost of 9.466
cents per pound (the average price paid in 1936) amounting to $75,983.30;
(c) 17,577 pounds were
regarded as having a cost of 11.191 cents per pound (the average price paid in
1937) amounting to $1,967.04;
(d) 639,807 pounds were
regarded as having a cost of 10.443 cents per pound (the average price paid in
1938) amounting to $66,847.04;
(e) 973,477 pounds were
regarded as having a cost of 11.036 cents per pound (the average price paid in,
1939) amounting to $107,432.92;
(f) 3,151;684 pounds
were regarded as having a cost of 11.5 cents per pound (the price paid in 1945)
amounting to $362,443.66;
(g) 2,205,765 pounds
were regarded as having a cost of 11.5 cents per pound (the price paid in 1946)
amounting to $53,662.97.
As more than two-thirds
of the copper inventory is continuously in process, it is evident that about
two-thirds of
[Page 743]
the 14,291,007 pounds
could not have been used in manufacturing the products sold in 1947. What is
required is the cost of the metals used in processing so as to ascertain the
profit for that year and not what the company adopts as a wise plan to cover
fluctuations over the years in the cost of its raw materials. I would think
that an assumption, the result of which indicates that 6,500,000 pounds had
been in the premises since 1936, would be unwarranted and that it is contrary
to the facts is shown by the evidence of Mr. Evans, the company's Works
Manager, and Mr. Richardson, an accountant called as a witness on behalf of the
company. At p. 139 of the record the following appears in the
examination-in-chief of Mr. Evans:—
Mr. Pattillo: Q. And do
you happen to know, Mr. Evans, of your own knowledge whether you have on hand
at the plant, copper that has been received from the refineries that has been
there for a good many years and that has never yet gone into the mill?—A. I
would not know whether there would be any around there or not.
His Lordship: Q. Is it
likely that there would likely be any considerable portion of quite old copper
in the plant?—A. No, there would not be, sir, any large quantity that you could
identify as being an old lot. There might be. There is only one instance that I
know of where we had some cast billets which had been in the yard for about five
years— that is an alloy.
Q. Some cast billets?—A.
Yes.
Q. That were in the
yard, and was that any particular kind of alloy?—
A. It was a special
alloy for which we had no orders during that period.
At p. 284 Mr.
Richardson is under cross-examination:—
Mr. Pickup: Is not the
difference this on that one point—that l.i.f.o., as you say, does not reflect
physical realities; f.i.f.o. may or may not?— A. It may approximate them. I
would doubt if you would ever have a case where it could be said that it exactly
reflected physical realities.
Q. But in many cases you
would have it where it substantially reflected physical realities. That is
true, isn't it?—A. That is right.
His Lordship: Would it
be possible for the l.i.f.o. method to reflect physical realities?—A. It would
be possible to be a reasonable reflection of the movements in a particular year
but cumulatively you would get probably further and further from reality. That
is, at the end of ten years on the method you would probably not have at that
stage the quantity of material on hand ten years old corresponding to the
quantity which was priced at the prices of ten years ago, for instance.
Mr. Pickup : Well, if we
look at Exhibit 7, we find that the exhibit is showing that in 1947 at the end
of the year the company is still, so far as reality is concerned, operating on
the basis of having an inventory that it had prior to 1936 and some more raw
copper that it got in 1936, 1937, 1938 and 1939. Is that what you mean (and I
think it is) when you say it is actually further and further away from the
reality if you use l.i.f.o.?—A. Well, I cannot speak as to the realities in
this particular case but I do not
[Page 744]
imagine that any of the company witnesses would claim for
a minute that there is a quantity of metal now on hand acquired in the year
1936 equal to the quantity which is priced at that price. I did not hear their
evidence.
In the United States Fifo had been in
use for years and efforts to secure permission from the taxing authorities to
use the Lifo method in connection with such industries as
The American Brass Company did not succeed until 1938. It was only when
legislation in that year permitted the use of this method for tax purposes,
subject to certain conditions, that the United States parent company made its
tax returns in that form. Such a method, either with or without conditions, has
never been permitted in Canada. This was known to the company, which, although
for corporate purposes had made use of the theory as early as 1936, adopted it for
tax purposes in Canada only on June 16, 1947, when it filed its tax returns for
the year 1946. Before that date very considerable increases in the price of
copper and zinc had occurred as a result of the relaxation and later of the
removal of price controls. The company's appeal to the Exchequer Court from the
appellant's assessment of it for 1946 was abandoned and was dismissed without
costs.
Even though the Lifo assumption is
recognized as a proper accounting method for corporate purposes, the
authorities noted above show that that is not sufficient and, therefore, the
view of the learned President of the Exchequer Court that the
question to be determined was whether Lifo was an
acceptable accounting method for the company is, in my opinion, incorrect. The Lifo method does not determine the company's profits for 1947
more accurately than the Fifo method which later, for the
reason given, is more in accordance with the known facts. The following
statement by Lord Loreburn in Sun Insurance Office v. Clark may, I think, be repeated with
advantage:—
A rule of thumb may be very desirable, but cannot be
substituted for the only rule of law that I know of, viz. : that the true gains
are to be ascertained as nearly as it can be done.
The appeal should be allowed, the judgment of the Exchequer
Court set aside, and the assessment made by the appellant restored with costs
throughout.
[Page 745]
Taschereau, J.
:—For the reasons given by Locke J. and Cartwright J, I would dismiss this
appeal with costs.
Estey, J.
(dissenting) :—The respondent, at its primary brass mill in Toronto, produces
copper and copper-base alloys for which it requires and purchases large
quantities of copper and zinc and smaller quantities of lead and tin. At all
times it has on hand a quantity of these metals. In 1946, for the first time,
and again in 1947 the respondent, in preparing its income tax returns, computed
the value of the inventories of these metals under the l.i.f.o. system of
accounting. The appellant refused to accept this computation and insisted that
the valuation of these metals be computed, as in former years, under the
f.i.f.o. system. Upon an appeal to the Exchequer Court the learned President upheld the respondent's
contention. In part, the learned President stated:
Under the circumstances, I find that the l.i.f.o. method was
appropriate in the circumstances of the appellant's business. This means that
it was entitled to use the method in ascertaining the cost of the metal content
of its finished products that was properly chargeable against its gross income
for sales and that the method correctly reflects its net taxable income in 1947
and I so find. It follows that the appeal from the assessment for 1947 must be
allowed.
In a business such as that of the respondent it is, in any
practical sense, impossible to precisely identify each item in its inventory
and allocate to it the exact cost thereof. It is, therefore, conceded that some
assumption or arbitrary method must be adopted in determining the valuation.
In 1946 the difference in the computation under the two
systems was not sufficient to warrant that the proceedings in respect to that
year be continued and we are, therefore, here concerned only with the year
1947. The valuation of the inventory as computed under l.i.f.o. for the year
1947 was $1,611,756.43 less than the valuation computed under the f.i.f.o.
system . The older system which the respondent used in computing its income tax
returns prior to 1946, and which the appellant in this case insists upon, is
known as f.i.f.o. Under this system it is assumed that the items in the
inventory first received are the first used, or, as expressed by the letters
"f.i.f.o.," first in first out.
[Page 746]
Under the l.i.f.o. system the difference material hereto is
that it is assumed the last items received are the first used. This may be
illustrated by observing how the respondent's copper inventory was computed in
1947. On January 1, 1936, the year in which the company adopted the l.i.f.o.
system, it had on hand 6,500,000 pounds of copper, the average price of which,
in 1935, was 7.5¢ per pound, a total of $487,500. The weight and the price of
the copper added to the above 6,500,000 pounds in the subsequent years are as
follows:
Date Weight Cost
per lb. Total
Jan.
1, 1937 ……………. 802,697 lbs. 9.466¢ $ 75,983.30
Jan. 1, 1938 ……………. 17,577 lbs. 11.191 1,967.04
Jan. 1, 1939 ………...…. 639,807 lbs. 10.443 66,847.04
Jan. 1, 1940 ………….… 973.477 lbs. 11.036 107,432.92
Jan. 1, 1946 ……….…… 3,151,684
lbs. 11.5 362,443.66
Jan. 1, 1948 ……….…… 2,205,765
lbs. 11.5 253,662.97
The foregoing figures
show that on December 31, 1947, the total inventory of copper was 14,291,007
pounds and the cost thereof $1,355,836.93.
In the years December
31, 1939, to December 31, 1944 inclusive, as well as in 1947, the company used
more copper than it purchased. In such years under the l.i.f.o. system the
excess used over purchases was subtracted from the surplus in the last year in
which there was a surplus. This may be illustrated by referring to the years
1946 and 1947. In 1946 the excess in the quantity purchased over that which was
used was 2,936,468 pounds. In 1947 the company used more than it purchased to
the extent of 730,703 pounds. This quantity was; in the inventory, deducted
from the 1946 surplus, leaving, as shown in the above table, as of January 1,
1948, 2,205,765 pounds and, of course, the earlier weights remained unchanged.
The value of these 2,205,765 pounds was, therefore, computed at 11.5¢ per pound, being the average cost thereof in 1946.
The inventory of all metals as of December 31, 1947,
computed on the l.i.f.o. basis, totalled $1,848,497.89. Mr. Gordon, who
supervises the auditing of respondent's books, when asked if this figure was
either the cost or the market price of the metals, replied : "No. It is
certainly not the market price —nothing to do with it—and it depends on what
you mean by 'cost price'. It is 'cost' as considered on the last-in, first-out
basis." The accountants called as witnesses made it clear
[Page 747]
that the l.i.f.o. method is not intended to indicate
physical flow of goods. Rather, as one stated, "it is a statement of an
assumption as to the order in which costs should flow in and out of an
inventory account on the calculation under this method." When asked if he
would apply the same principle if it was known, as a fact, that the raw
materials last in were not the first used, he replied: "In appropriate
circumstances I would apply the principle because, as I indicated, I do not
think that physical identification of goods has anything to do with proper
determination in certain circumstances." Or, as otherwise stated, "In
my opinion, first-in, first-out again is a description of a costing method and
refers to the order in which items of cost recorded through the inventory
account should be taken out of the inventory account." And again, "I
thought I had made it clear that the question of physical identification is
not, in my opinion, a factor which governs the determination of income."
In 1936 the respondent adopted the l.i.f.o. system of
accounting, but until 1946 continued to file its income tax returns as prepared
under the f.i.f.o. system because it had been informed that the Department of
National Revenue would not accept returns prepared under the l.i.f.o. system.
In the years immediately preceding the war the prices of
these metals, particularly copper, which constitutes 83% of the respondent's
inventory, remained rather constant. Throughout the war period and until June
10, 1947, the prices of these metals were fixed. With the increase in the price
of these metals, particularly copper, the difference in the computation of the
inventory under f.i.f.o. and l.i.f.o. was such that the company decided to
insist upon the appellant accepting its computation of its inventory under the
l.i.f.o. system. That the difference may be substantial is evident from the
fact that in 1947 the computation of the inventory arrived at under the
l.i.f.o. system was $1,611,756.43 less than that arrived at under the f.i.f.o.
system. Though the company computed its income tax returns in 1946 on the
l.i.f.o. basis, the change in prices was not such as to make a great
difference, but in 1947, as indicated by the figures, the position was entirely
changed.
The issue here raised is whether, under the Income War
Tax Act and the Excess Profits Tax Act, the Minister must accept
returns computed under any recognized accounting
[Page 748]
system which is deemed appropriate to its business by a
company, or whether the Minister in a particular case may insist upon that
accounting system which will the more closely arrive at the actual value of the
inventory.
Mr. Richardson stated:
The question is as to what portion of the expenditure for
the purchases of raw material, for labour and for manufacturing supplies, and
expenses, is properly chargeable against the gross revenues from sales during
the year ; and what portion is properly to be carried forward as a charge
against future periods.
In order to more fully appreciate the purpose and object of
the l.i.f.o. system it is of some assistance to consider the circumstances
under which is was developed. Mr. Peloubet, of the accounting firm of Pogson,
Peloubet and Company of New York, explained that in the years 1916 and 1917
management then using the f.i.f.o. method was disturbed not so much by the
general increase but by the fluctuation in prices. As he stated:
… what they did not like was the fluctuation and the idea:
'If we end the year with a higher price, we are 'going to show a terrific
profit which is not there and if we end it at a low price we are going to show
an apparent shortage which is not there'.
Mr. Peloubet also stated :
… the management of the company realized in the middle and
late 20's that their accounts were not on a correct profit basis, that they
were not correct for dividend purposes. Of course, it had no relation at that
time to taxation because no one even thought of taxation in connection with
this but the company was definitely disturbed about their profit showing and
they were definitely disturbed about the amount of inventory profits that were
shown.
There is no necessary conflict between a system that
computes profits for dividend purposes and one that computes profits for
taxation purposes, but, of course, there may be.
It is obvious that if the respondent continues in business
and to use the l.i.f.o. method of accounting for 100 or even 1,000 years and
never, at any time, utilizes its entire inventory or stock of metals, the
inventory will be computed as containing some copper at 7.5¢ per
pound, i.e. the average price paid in 1935, or, as otherwise stated, if the
6,500,000 pounds shown in the inventory as on hand on January 1, 1936, never
becomes exhausted the remaining portion thereof, whatever it may be, will be
computed at 7.5¢ per pound, irrespective of what current market values may be.
It is this feature that I assume Mr. Richardson had in mind
[Page 749]
when he said the longer
the period the farther the inventory computation becomes from reality. He quite
properly pointed out that f.i.f.o. is often far from reality because, whatever
the system used, some arbitrary assumption must be made, but the problem which
must be decided for taxation purposes is which of the two more nearly
approaches the actual value, or market value. The respective assumption are :
under f.i.f.o. the first metals received are the first used in production and
under l.i.f.o. the last metals received are the first used.
The income tax law is
concerned with commercial and industrial operations within the taxation period
and with the computation of profits upon operations carried on in an exchange
or market sense during that period. Therefore, an accounting system which tends
to minimize fluctuations in prices and business losses and gains and,
therefore, provides a more even accounting history for dividend and other
purposes, may possess the greatest merit from a corporate point of view, but it
does not follow that the Minister must, for taxation purposes, accept that
method.
Throughout the evidence
the profits shown in periods of rising prices are referred to as fictional
profits and the losses in periods of falling prices as fictional losses. It is
obvious that accountants, in so describing these losses, are considering the
interests of the company over a period of years and, as Mr. Peloubet states,
such fictional profits and losses were not "correct for dividend purposes."
Mr. Richardson stated :
The objective is to
arrive properly at profits or losses and in the sort of illustration which I
gave you on Exhibits 25 and 26 it may arrive at a more stable result by
avoiding the showing of fictional profits or losses ; it is not a process of
levelling for the sake of levelling. There is nothing arbitrary about the
process about which you could say: 'This is something which a prudent business
man might feel that he should do in the interests of conservatism' or anything
of that kind.
Then, after
pointing out that where physical identification is, as here, impossible, some
assumed basis must be accepted, he was asked :
Q. Well, do you agree
with this, that above all any assumption adopted should not be unduly out of
line with the ascertainable unquestioned physical facts?—A. No. I do not agree
with that, Mr. Pickup.
[Page 750]
In fact, as Richardson
stated, referring to. both systems,
They are not based on
presumption as to the physical movement—or what we sometimes call the 'physical
flow of goods through the inventory and out to customers,' but rather are
indicative of the flow of costs which are employed in the method.
or, as he stated
when specifically referring to l.i.f.o.,
It represents rather an
assumption made as to the order in which costs should flow from the inventory
account into the cost of sales in the process of determining income.
It is the acccountants'
conception of how "costs should flow" that commends the l.i.f.o.
system. They find in l.i.f.o. that over a period of years it, to a large
extent, eliminates the artificial profits or losses and goes far to compute how
the costs of the company should flow.
It may well be that
where, as here, the inventory is neither subject to "physical
determination" nor to "style changes or obsolescence" that, from
the point of view of the company which is concerned with how costs should flow
and dividends be paid over a period of years, l.i.f.o. is the more acceptable
system of accounting. It does not, however, follow that, apart from legislation
particularly directed to l.i.f.o., its computation of the inventories must be
accepted by the Minister.
The word
"profits" is not defined in either the Income War Tax Act or
the Excess Profits Tax Act, but it has been repeatedly defined as that surplus
in the taxation period by which the receipts from a trade or business exceed
the ' expenditures necessary for the purpose of earning those receipts. Fletcher Moulton L.J. stated in In re Spanish
Prospecting Company, Limited
The word 'profits' has
in my opinion a well-defined legal meaning, and this meaning coincides with the
fundamental conception of profits in general parlance, although in mercantile
phraseology the word may at times bear meanings indicated by the special
context which deviate in some respects from this fundamental signification.
'Profits' implies a comparison between the state of a business at two specific
dates usually separated by an interval of a year. The fundamental meaning is the
amount of gain made by the business during the year. This can only be
ascertained by a comparison of the assets of the business at the two
dates.
… Even if the assets were identical at the two periods it
would by no means follow that there had been neither gain nor loss, because the
market value—the value in exchange—of these assets might have altered greatly
in the meanwhile … A depreciation in value, whether from physical or commercial
causes, which affects their realizable value is in truth a business loss.
[Page 751]
The income tax statutes
are concerned with business and commercial enterprises the assets of which
possess a value to the extent that they may be used or exchanged. As stated by
Fletcher Moulton L.J. in In re Spanish Prospecting Company, Limited, supra, at
p. 100:
The figure inserted to represent stock in trade must be
arrived at by a valuation of the actual articles. Property, of whatever nature
it be, acquired in the course of the business has a value varying with the
condition of the market.
It is, therefore,
the current commercial trading or market values that these statutes contemplate
should be used in the computation of profits. If it be, from a business or
commercial sense, impracticable to determine that valuation with accuracy, then
that method which more closely approximates the current market value should be
used.
In Whimster & Co.
v. The Commissioners of Inland Revenue the company prepared its income tax returns and
allowed for losses which it anticipated in the following year. It had, in fact,
settled with one of its partners who was retiring upon the basis of that
statement. It was conceded that such was not a usual method and was not
"in accordance with ordinary commercial practice." Lord Clyde states
at p. 823:
In such a case the trader may, as a matter of ordinary
commercial prudence, decline to treat the profits shewn in his accounts in the
same way as he would have done if the circumstances of his business had been
liable only to the normal fluctuations of trade. He may, for instance, prefer
to carry his profits forward, or put them to reserve, rather than consume or
divide them. But they are none the less profits of the year or accounting
period to which the accounts relate, and as such assessable to Income Tax or
Excess Profits Duty … It is therefore nothing to the point—say, as regards
assessment to Income Tax—that if a particular trader's profits were computed on
an average of two years instead of three, or simply on the results of the year
immediately preceding the year of assessment, an apparent profit might be
turned into an apparent loss.
and at p. 825:
But all this cannot affect the answer to the question; what
are the actual profits made during the accounting period? Whatever the bargain
made with the retiring partner—generous or strict, fair or unfair—the question
remains the same and so also does the answer.
The metals here in question do not suffer a physical
depreciation in value. Their commercial or market values, however, do fluctuate
from time to time. Under l.i.f.o. the current market value is used to compute
the value of only
[Page 752]
that quantity assumed to be added to the inventories in the
last year and the valuation of the balance of the inventories is computed by
using the market values of former years. The assumption under f.i.f.o.
eliminates many of the former years and, therefore, the computation thereunder
more closely approximates the current value than that made under l.i.f.o.
Moreover, the l.i.f.o. system is comparatively new. While
the reason for its development in the early 20's, as explained by Mr. Peloubet,
had no relation to taxation, it has become more widely adopted in the United
States since the passage of the legislation in 1938 and 1939, permitting a
company to compute its income tax returns under the l.i.f.o. system, subject to
certain specified conditions. As stated by Mr. Butters:
In contrast, since 1939 few management decisions on Lifo have been made without reference to their tax effects.
Decisions as to whether to use Lifo how to apply it, and
even as to the industries in which the method constitutes acceptable accounting
practice, have been dominated by tax considerations.
The l.i.f.o. system provides an alternative method which, as
illustrated in this case, may produce a valuation substantially different from
f.i.f.o. While the Income War Tax Act and the Excess Profits Tax Act contemplate
that the valuation of these inventories be computed according to the recognized
or accepted accounting methods, these statutes do not contemplate that a
company may, from time to time, adopt that which may best serve its ends. Many
companies would not, and I do not suggest the respondent did or would, from
year to year, adopt that method which would result in a lower tax. It would
seem that the statutes do not provide against this possibility. Moreover, that
it can be done by a company in any year without changing its accounting system
is illustrated by the fact that the respondent adopted the l.i.f.o. system in
1936 for accounting purposes, but continued to compute its income tax returns
on the f.i.f.o. basis until 1946. It was no doubt such considerations which
caused the United States to enact legislation in 1938 and 1939 which permitted
a company to prepare its income tax returns under the l.i.f.o. system, but only
upon certain conditions, which may be summarized :
(a) The company must start with a cost inventory on the same
basis as it ended its last f.i.f.o. period of cost.
[Page 753]
(b) Once adopted the l.i.f.o. method cannot be changed
without the consent of the appropriate revenue officials.
(c) The company must keep its corporate accounts on the same
basis as its tax accounts.
(d) It is not a compulsory system, but a company may elect
to adopt the l.i.f.o. method.
The Income War Tax Act and the Excess Profits Tax
Act, 1940, do not contain any such provisions.
In my opinion the Minister was justified in refusing the
respondent's computation and requiring that the company compute its inventories
upon a basis that more nearly approximated the current market value thereof.
In my opinion the appeal should be allowed with costs.
Locke, J.
:—This is an appeal by the Minister of National Revenue from a judgment of the
President of the Exchequer Court by which the appeal of the
respondent from an assessment for excess profits tax for the taxation year 1947
was allowed. While the respondent also appealed from the assessment for income
tax made in respect of the same year, we were informed that the parties had
agreed that they would regard themselves in that matter as bound by the outcome
of this appeal, this for the reason that the question for determination is the
same in both appeals, that is, as to the amount of the taxable income of the
respondent as defined by section 3 (1) of the Income War Tax Act.
The facts disclosed by the evidence as to the manner in
which the respondent company carried on its operations are described fully in
the judgment appealed from and it is unnecessary to repeat them. The respondent
operates what is described in the evidence as a primary mill producing copper
and copper alloys in the form of sheets, rods and tubes for use in the
manufacturing operations of motor car and other manufacturers. It is, according
to the evidence of the Manager of the Copper and Brass Research Association, a
typical brass mill similar to those of the American Brass Company, of which the
Canadian Company is a wholly owned subsidiary. The point to be determined is as
to what is the method of inventory accounting which will most accurately
determine the income of the respondent for the year in question, as that term
is defined by the Act.
[Page 754]
It is clear from the
evidence that, in view of the magnitude of the operations and the manner in
which it is necessary they should be carried on, the cost of the metal content
of the products sold cannot be calculated with exactness on the basis of what
is referred to by the accountants as the "physical flow" of the
inventory. It is also shown by the evidence that, at least as conditions were
during the year 1947, there was no means by which the respondent company could
hedge its purchases of raw material and it is the fact that, owing to the
fluctuations in copper and zinc prices which took place during the year 1947,
the calculation of such costs was not exact.
Neither of the statutes
defines the manner in which manufacturing costs of this nature are to be calculated
and, in the absence of any such direction, they are to be determined, in my
opinion, upon the ordinary principles of commercial trading. My consideration
of the evidence in this matter leads me to the conclusion that, in a business
operation such as this, the last in first out method of inventory accounting
determines what was the true income with greater accuracy than any other method
which it was practical to apply.
I respectfully agree
with the conclusion of the learned President of the Exchequer Court and would
accordingly dismiss this appeal with costs.
Cartwright
J.:-—In this appeal I agree with the
reasons and conclusion of the learned President and propose to add only a few
observations.
In my view the only
questions of difficulty raised in this case are questions of fact. I do not
disagree with any of the principles of law stated in the authorities quoted in
the reasons of my Lord the Chief Justice and I do not understand the learned
President to have done so. The effect of these authorities is, I think,
accurately summarized in the statement quoted from the judgment of Earl
Loreburn L.C. in Sun Insurance Office v. Clark that the only rule of law is "that the true
gains are to be ascertained as nearly as it can be done." Where, as in the
case at bar, the dispute as to what are the true gains for a particular year
centres
[Page 755]
on the question as to
which of two well-recognized systems of accounting will in the case of the
business carried on by the respondent most nearly arrive at the true figure for
the materials cost of its sales for such year that question is one of fact. In
my opinion the evidence fully supports the findings of fact made by the learned
President on this crucial question.
While I have already expressed
my agreement with the reasons of the learned President, I wish to quote two
paragraphs therefrom which sum up his findings and in support of which the
evidence seems to me to be overwhelming.
After careful
consideration of the opinions of the experts I have come to the conclusion that
where a manufacturing company avoids speculation or trading in its materials
and makes the sales price of its finished products closely reflect the current
replacement cost of their materials content and matches its purchases of
materials to its sales of finished products so that the inflow of the materials
equals the outflow of the materials content of the finished products and it
must continuously maintain a large inventory and the rate of its turnover is
slow the l.i.f.o. method of inventory accounting and ascertaining the materials
cost of its sales for the year is the method that most nearly accurately
reflects its income position according to the manner in which it carries on its
business and is the method that ought to be applied in ascertaining the
materials cost of its sales and determining its net taxable income.
. . . . . . . . . . . . . . . . . . .
While I need not say
more I also find that the method employed by the Minister in arriving at his
assessment was not a proper one. This is not a case in which either of two
accounting methods is acceptable. Only the one method, namely, the l.i.f.o.
method, is appropriate. The Minister used the f.i.f.o. method in ascertaining
the appellant's materials cost of sales which left it with a much larger income
than it earned. The result of this method has been to ascribe to it greater
profit than could have come to it through its processing charges. The
additional profit so ascribed is said to be inventory profit. The criticisms of
the f.i.f.o. method mentioned by Mr. Richardson apply here. It seems plain to
me that when a company so conducts its business as to avoid the risk of profit
or loss through the rise or fall of its raw materials its income position
cannot be correctly determined if so-called inventory profits or losses which
it has not earned or sustained are brought into its accounts. To do so is to
use an accounting system that is not in accord with its business policy and
practice and does not fairly reflect its income position.
In a year in which the
prices of the metals used by the respondent remain constant it is a matter of
little importance so far as the result is concerned whether the f.i.f.o. or the
l.i.f.o. method of accounting is used. The evidence appears to me to establish
that in a year in which the prices of such metals rise or fall the l.i.f.o.
method will shew the true gain for the year as nearly accurately as is possible
[Page 756]
while the f.i.f.o.
method will in the case of a rise shew a fictitious profit and in the case of a
fall shew a fictitious loss.
I would dismiss the
appeal with costs.
Appeal
dismissed with costs.
Solicitor for the
appellant: F. J. Cross.
Solicitors for the respondent: Blake, Cassel &
Graydon.
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