Northwood Pulp & Timber Ltd. v. R., [1996] 2 CTC 2123, 96 DTC 1104

Margeson J.T.C.C.: — Before the commencement of the appeal the party filed an Agreed Statement of Facts as set out below, reserving the right to reduce evidence not inconsistent with those facts.

STATEMENT OF AGREED FACTS

For the purposes of these proceedings, the parties agree that the facts are as follows but reserve the right to adduce evidence not inconsistent with these facts.

1. The appellant is a corporation having its registered and records office at 2800-666 Burrard Street, Vancouver, British Columbia. The appellant, in the Province of British Columbia, carries on the business of harvesting logs and using those logs to manufacture finished timber and plywood for sale and to make chips to manufacture pulp for sale.

2. This is an appeal from reassessments issued under the Income Tax Act of Canada (the “Act”) as set out in:

(a) Notice of Reassessment dated March 9, 1993 with respect to the appellant’s 1987 taxation year; and

(b) Notices of Reassessment Nos. 3841868, 3841867, 3841866 and 3841865 dated August 8, 1994 with respect to the appellant’s 1988, 1989, 1990 and 1991 taxation years respectively, Notice of Reassessment No. taxation year, and Notice of Assessment No. 3860277 with respect to the appellant’s 1991 taxation year.

3892051 dated August 3,

1995 with respect to the

appellant’s 1988

The 1987, 1988, 1989, 1990 and 1991 taxation years shall hereinafter be referred to as the “taxation years”.

3. In order to harvest logs at any location in British Columbia, a person must obtain a timber harvesting licence issued under the Forest Act R.S.B.C. 1989 c. 40 in respect of that location. The Forest Act requires that, as a condition of harvesting timber at a particular location, an applicant for a timber harvesting license must:

(a) before harvesting the timber, prepare and submit for approval a preharvest silviculture plan for the land from which the timber is to be harvested; and

(b) during and after harvesting the timber, carry out the specified silvicul-

ture plan at its own expense and in accordance with the regulations.

Under the Forest Act, where the holder of a timber harvesting licence has not caused to be carried out such work as is necessary to meet the reforestation requirements of the pre-harvest silviculture prescription and has failed to comply with the terms of a notice regarding same, the regional manager shall at the expense of the licence holder cause to be carried out such work as is necessary to meet the requirements of the pre-harvest silviculture prescription.

4. Prior to harvesting timber, the appellant, like other licence holders, must file and have approved by the Government of British Columbia, a Pre-Harvest Silviculture Prescription (“PHSP”). The PHSP is signed by a registered professional forester prior to filing and sets out specific site requirements for silviculture work, including the time limit for achieving a free growing crop. Attached as Exhibit “A” to this Statement of Agreed Facts is an example of one of the appellant’s PHSP’s for the Co-op Lake area. In this example, the appellant must achieve a free growing crop within 14 to 16 years of harvesting. Attached as Exhibit “B” to this Statement of Agreed Facts is an example showing the appellant’s PHSP’s for the Torpy River area. In this example, the appellant must achieve a free growing crop within 5 to 12 years of harvesting.

5. To achieve a free growing crop, and depending on the site requirement, the appellant has to carry out various operations including site preparation, artificial and natural regeneration, windrowing (burning), brushing, spacing and stand tending, pesticide treatment and other operations if prescribed. These operations are generally completed within 7 years of harvesting but may continue until a free growing crop has been achieved.

6. Prior to October, 1987, the Government of British Columbia assumed the obligation to reforest Crown lands logged by licence holders. In estimating future silviculture costs for a particular area, the Forest Service relied, in part, on estimates provided by the licence holder in that area.

7. The estimated cost of silviculture for a particular area is expressed as a cost per cubic meter, and is a function of the size of the area, the estimated number of cubic meters harvested in that area, and the estimated cost of establishing a free growing crop, which includes among other things the cost of site preparation, planting, brushing and weeding, all of which vary depending on the species of tree to be planted, terrain, soil type, meteorological conditions and the need for pest control.

8. In the taxation years the appellant harvested timber under various licences, and became obliged under the Forest Act to perform the required silviculture and to pay the attendant costs as they arose. The obligation to perform the silviculture arose at the time the timber was harvested.

9. The appellant’s silviculture obligation is to produce a free growing crop of trees within a specified time period. This period may range from five to sixteen years commencing with the start of reforestation activities. These activities typically commence in the year following harvesting; however, where conditions are favourable, some early silviculture activities such as burning may be undertaken in the same fiscal year as the harvest. A free growing crop of trees means a crop of healthy trees, the growth of which is not impeded by competition from plants, shrubs or other trees.

10. For the purpose of preparing its financial statements for each taxation year, the appellant:

(a) in determining its cost of timber harvested for the year, made a number of estimates, one of which was the cost of the silviculture obligation with respect to the timber harvested during that year, whether or not the silviculture was performed in or paid for in the year of harvest;

(b) the cost of timber harvested so determined, expressed as an amount of money per cubic meter, was included in the cost of inventory for the taxation year;

(c) the cost of inventory so determined was added to the value of the opening inventory for the year, and the value of inventory on hand at the end of the year was subtracted from the total to determine the cost of goods sold for the year; and

(d) the cost of goods sold for the year was subtracted from receipts for the year to determine gross profit for the year.

11. The appellant’s treatment of estimated silviculture costs as described above was the same for financial statement purposes and for income tax purposes.

12. Periodically throughout each year, the appellant compares its actual expenditures on silviculture to estimates previously made, and adjusts its cost of timber to account for any variance in an attempt to make the estimates used from time to time as accurate as possible.

13. An example of a situation which would result in a subsequent adjustment to the estimated silviculture costs is the possibility of natural regeneration, which, depending on the species of tree to be planted, could reduce the extent of the obligation. For instance, for species such as lodge pole pine, the rate of natural regeneration will be higher than that of some other species, such as spruce. While some natural regeneration may be factored into the estimates, the actual extent of natural regeneration is not known until some point after the first year following harvesting.

14. Silviculture cost estimates may also require adjustment in the following situations:

(a) changes to the Forest Act subsequent to October, 1987 requiring Northwood to use alternative equipment to access reforestation sites and to adopt new methods of site preparation as former methods, such as “broadcast burning’’, were prohibited. These changes resulted in unanticipated and increased costs of reforestation;

(b) the destruction by fire of artificial and natural regeneration prior to that date when a free growing crop has been achieved. In such cases the licence holder’s silviculture obligation continues, and the duty to provide a free growing crop remains, with some allowances for the time limit. In such cases, the silviculture costs would exceed estimates.

15. The Minister of National Revenue disallowed the amount of the estimated silviculture costs which had been included in the cost of sales and allowed only those costs for silviculture to the extent that an outlay or expenditure was made or incurred in the year as follows:

Year	1987	1988	1989	1990	1991
Estimated	$244,787 $11,279,387 $12,931,902			$11,550,387	$9,987,559
Silviculture
costs included
in cost of
goods sold
Costs made or		(1,296,307)	(5,827,064)	(10,180,313)	(9,260,513)
incurred as
allowed by
the Minister
Seedling		( 805,156)	(1,037,921)	( 813,942)	( 7,971)
Adjustment
Net	$244,787 $9,177,924		$6,066,917	$ 56,132	$ 629,075
Adjustment
to Income

16. In the particular taxation years in which the disallowance occurred, the appellant did not expend any money, or incur any debt of an ascertained amount to an identified person, with respect to the disallowed silviculture costs

Dated at Vancouver, British Columbia, this 23rd day of October, 1995

Davis & Company (Robert C. Strother)

Solicitor for the appellant

Dated at Vancouver, British Columbia, this 24 day of October, 1995.

Max Weder

Solicitor for the Respondent

Both parties filed expert reports and rebuttals in accordance with the relevant Rules on the issue as to whether or not the appellant’s treatment of the items in dispute were in accordance with generally accepted accounting principles.

Ross Smith was a chartered accountant with the office of Peat Marwick and Thorne in Vancouver. He was familiar with the appellant’s operations in the years in question. He was also familiar with the operation of other timber and forest related companies.

The witness indicated that the appellant prepared its own internal documents and Peat Marwick and Thorne were engaged to review these documents after preparation. His firm insured that the documents were prepared in accordance with generally accepted accounting principles and that the documents fairly represented the financial position of the company. This firm also insured that the income tax returns of the company were consistent with the financial statements.

Normal practice of their firm was to review “significant estimates” and they did so in respect to the years in issue for the appellant company. They reviewed all estimates of all costs for silviculture for future years. They concluded that the estimates made by the appellant were reasonable.

The firm reviewed the timber licences of the appellant and ndicated that the appellant had only “a right to cut timber”. The company has a duty to perform silviculture. The Statute required that a vested silviculture agreement be in place.

If no logging was done there would be no silviculture costs. The more logging that was done, the more would be the cost.

Insofar as the basis for the estimates was concerned, they were based upon past experience as to the cost of preparation, considering the type of timber and the cubic measure of logs that the company calculated that they would obtain from a given area.

The witness indicated that other companies with which he was familiar treated the expenses in issue here as “inventory expenses”. Northwood accounted for the expenses at the time of harvest because that is when the obligation arose.

Over the years, the estimates of expenses varied high or low in relation to the actual outlay, but there was a good average obtained.

In cross-examination the witness indicated that he performed tests to see if the estimated costs were consistent with the actual outlays. He admitted that there was nothing in their pre-harvest plan that indicated that costs were related to the amounts of timber that had to be harvested.

It was suggested to the witness that there was no rule of auditing that required the financial statement to present the “truest picture of profit”. He did not agree and said that that was precisely what he attempted to do. The costs were recognized on the books of the company after the harvest not when the plan was made. The company was basing its estimate on actual costs encountered in other areas. If they did not do the silviculture the government would do it and charge the company with the costs. This was a long term liability that was not discounted to present value.

The bulk of the site preparation was done in year one and the costs were allotted within twelve months after harvest. Some site preparation could be done in October and not much else after that until April. The witness said that the estimates of the appellant were improving and the fluctuations were smaller. Changes in government regulations could cause significant changes in estimates.

Log inventory was valued at lower of cost or market. There was no deduction from the cost of inventory. The formula used was opening inventory + cost of purchases less closing inventory equals cost of goods sold. Within that concept (cost of goods sold) was the estimated cost of the silviculture obligation. That figure was deducted from revenue to arrive at gross profit.

Patricia O’ Malley was qualified as an expert to give opinion evidence with respect to generally accepted accounting principles and as to why businesses account for certain transactions in certain ways.

She was a partner in the firm of Peat Marwick Thorne in the National Office. She considers standards in relation to a specific set of facts. She said to treat the silviculture items other than as the appellant treated them here would result in an inaccurate picture of the company’s business. Harvested logs became part of the inventory. Cost of logs harvested became part of the costs of inventory. It was proper to take into account the costs of the reforestation in determining the proper costs of the logs.

Accrual accounting, she said, reflects the financial effects of the expenses in the period to which they relate. You must have periodic accounting to determine how a business is doing at any time. The matching principle is a way of applying the accrual process. Using the cash basis in the case at bar would create a distortion over the years. You should record the expense at the time when you incur it or when you incur the obligation.

The witness described periodic costs as those relating to a specific period and those which are expended at that time. Costs creating benefits during other periods are related to assets. These capital assets are charged to income over the period of time the asset is used. She further referred to inventory costs, pointing out that if all the inventory was used up in the year there would be no problem. However, when the inventory is not sold by the year-end you have some inventory being obtained at different costs but the inventory cannot be differentiated. It is necessary to develop a method for determining cost of inventory.

In the manufacturing business it is much more difficult to determine cost of inventory. You must take into account all costs related to the process of manufacturing the inventory. One must attempt to show the most direct relationship between the expense and the manufactured goods. The farther away one gets from the direct relationship, the less likely you will include the expense in the cost of inventory.

This witness indicated that in the forest industry, costs such as cutting down trees would be costs of inventory. If there is a causal connection between the expense and the inventory it should be included in the cost of inventory. Inventory costs are costs of assets held for sale. They are not related to capital assets which are held for use. She indicated that the calculation of inventory cost by estimates was not novel or unique. It is necessary to make some kind of assumption as to how the expenses incurred to acquire inventory relate to each part. An estimate of cost is not a reserve. One is estimating the cost of an obligation, it does not relate to some even that might not occur.

In the case at bar there was an obligation to do the silviculture. It was necessary to file a plan. The proper time to record the obligation was when it occurred. That time was when the trees were harvested. If the company did not do it that way it would not be showing a true picture of the existing obligation.

If you did not do the estimate at that time you would be underestimating the company’s obligation. The proper treatment is to include such expenses in the cost of inventory. Such expenses are directly related to the cost of the final product.

Silviculture is a cost that is necessarily incurred in harvesting timber. Costs of silviculture vary directly with the number of logs cut down and to that extent it varies proportionately to the area as Mr. Smith indicated in his testimony. The greater the area harvested, the greater the silviculture expenses. They are not periodic costs because they cannot be carried forward to future periods. There is a direct relationship to the cost of inventory because of the liability. She considered the term “period cost” to be a catch all phrase used at the end of the day when a direct relationship could not be found ‘between the expenses and the other items.

In arriving at a determination as to what is a generally accepted accounted principle treatment given by her peers was an important consideration for her.

In cross-examination, this witness indicated that there was no generally accepted accounting principle known as the “truest picture” of the company’s position as reflected by the financial statements. It was suggested that the real audit question is whether or not the specific treatment “fairly represents the financial position of the company under generally accepted accounting principles”. The witness admitted that the term “gross profit” was not referred to in the handbook on generally accepted accounting principles but is discussed in most textbooks in intermediate accounting. There is no separate line on the statements requiring a gross profit figure.

She confirmed her position that the silviculture expenses were “product costs”. She said that without it there would be no harvesting. She could think of no other product costs that were not included in “costs of inventory”.

She confirmed that the logs would have no added value because of the silviculture costs and that such costs were not a cost of direct labour applied to the product but were an applicable share of overhead expenses even though they were not “laid-down” expenses. Silviculture expenses are variable overhead costs dealing directly with the quantity of inventory produced.

It was suggested to the witness that the amount of the expenses varied directly with the estimate, not according to the actual expenses and therefore it was immaterial as to how they were allocated. The witness disagreed. She stated that the expenses varied directly according to the timber harvested or logs produced. She did not consider whether or not the production might be cancelled if the silviculture work was not performed.

She did not discount the costs to reflect what amounts might actually be paid out as expenses in light of the short periods of time involved, in this case five years. She did not consider “stumpage” in relation to silviculture expenses and indicated that if the silviculture expenses were treated as “operating expenses” the charge to income would be higher and the net income would be lower.

Counsel for the appellant read into evidence certain parts of the discovery evidence by agreement.

Ross Smith was recalled and testified that in his review of the company affairs he had considered the status of the licenses, their duration and their type. There were no assurances that the licences would be renewed year after year. The appellant has no right to harvest the product when grown even though they perform the requisite silviculture.

Ms. Kathryn Holgate was called by counsel for the Respondent. She was qualified to give opinion evidence with respect to generally accepted accounting principles. She filed an expert report in chief and a rebuttal report.

This witness indicated that the period between 1987 and 1991 was a period of great change in the forest industry. It was difficult to isolate generally accepted accounting principles relative to this industry.

It was her position that there may be more than one acceptable method of treating the silviculture expenses. She took the position that the preferable treatment was to regard them as “period costs” and not “direct expenses”.

She agreed that generally accepted accounting principles could be derived from usage. This enables one to know what others are doing.

Then you can assess its appropriateness according to the circumstances. If a new issue arises, you look to see how similar issues are being dealt with or have been dealt with.

She considered the treatment given to silviculture expenses by companies in Canada and the United States. Not all companies treated them the same way according to this witness. She based her ultimate opinion on the “deductive approach”. She would be surprised if a large number of companies were treating them as product costs but it would not change her opinion.

She concluded that silviculture costs were not related to the “cost of product”. It is an expense that occurs in a later time period. It is a compliance cost because of the law.

Silviculture costs do not add value to the product. There is no future benefit. Therefore, they are period costs. They are costs quite remote from the cost of producing logs. They may be related to inventory but not as a product cost. Silviculture costs are similar to a sales tax cost. They are created by Legislation.

She considered whether or not the silviculture costs were a replacement for the stumpage charge. She concluded that the appellant did not use the stumpage fee as a basis for determining silviculture cost.

She said that any benefit that silviculture costs added to the inventory was shortlived since Northwood turned over its inventory 7 times per year.

In cross-examination, she agreed that an argument could be made that Northumberland’s treatment was an acceptable one but that was not the preferred treatment. She agreed that in order for it to be a product cost it need not benefit the product. Where there is a direct relationship between the cost and the product, it is more likely to be treated as a “product cost” and not a “period cost”.

She concluded that there was nothing wrong with treating the item as the appellant did but from a cost accounting point of view there was a preferable method of treatment. It would not change her opinion even if 100% of the companies treated the item as a cost of inventory. She saw no advantage from a cost accounting point of view of treating the item as Northwood did after the first year. The bottom line would change little. If there were no sales then there would be a difference. This was the second time she had dealt with the forest industry.

Jerry Miller, Colin Campbell and Kevin Irvine all took issue with some of the facts referred to in the Respondent’s expert report. They all indicated that the type of expenses in issue here were treated by Coopers & Lybrand, Deloitte and Touche and Slocom Forest Products as costs of inventory.

Mr. Michael MacCallum was a partner of the firm Price Waterhouse. He was familiar with the results of a survey in the forest industry sent to 68 companies, 45 of which responded. He also considered the annual reports of 49 companies and included that information in the study.

Thirty-six of the companies who responded incurred silviculture costs and all treated them as costs of inventory, thirty of those companies at the year of harvest and 6 at other times. Five of the six recorded expenses in the year that silviculture was done. Three of these latter companies were in the same group of companies.

Universally, he said, they were not written off as “period costs”.

Argument of the appellant

The appellant had only the right to harvest timber from the land. As a pre-condition, it had to prepare for approval a plan of silviculture and had an obligation to carry out that silviculture and to pay stumpage.

The appellant estimated its cost of silviculture at the time of harvest and included that cost as a cost of timber which in turn was the cost of inventory. The method is to estimate the silviculture cost for the area in question, estimate the quantity of timber to be harvested from the area, divide the estimated silviculture cost by the estimated cost of timber to determine on a cubic metre basis the estimated silviculture cost. That goes in to the inventory together with other costs of harvesting the timber.

Experience has shown that the actual cost of silviculture varies directly with the volume of wood harvested. Estimates are based on experience and are constantly upgraded.

Counsel considered that there was a direct causal connection between the harvesting of the logs and the cost of silviculture, therefore, it was correct to treat the silviculture cost as one related to the inventory of logs harvested and not as a period cost.

Counsel argued that both expert witnesses agreed that accrual accounting is the proper method for a business such as the appellant. They agreed that matching expenses with revenue is a proper technique in accrual accounting. It was proper to estimate silviculture expenses and the appellant’s estimates were reasonable. They did not agree on the “methodology”.

Counsel took the position that both experts agreed that the cost must be accounted for at the time of the harvest whether they are treated as period costs and deducted from income immediately or inventory costs that are written off as the inventories were used.

Both experts agreed that the accounting method used was in accordance with generally accepted accounting principles and commercial accounting principles. The only debate was whether or not there was a “preferred treatment” to that used by the appellant.

Counsel argued that Ms. Holgate based her opinion partly on a misreading of certain corporate financial statements such as West Fraser, Slocan and Doman. She interpreted these financial statements as if they treated the silviculture costs as period costs. This conclusion was rebutted by the witnesses called by the appellant who had a personal knowledge of the way in which these companies treated silviculture costs. They agreed that they were treated as product costs or costs of inventory. Further evidence of Mr. MacCallum confirmed the latter treatment being given by these companies involved in the forest industry.

Counsel argued that the main question to be decided is “what is profit”? Profit is not defined in subsection 9(1) of the Income Tax Act. In this case the issue is whether or not in determining profit we should treat silviculture costs as costs of inventory or period costs. The appellant determined “profit” correctly by treating silviculture cost as costs of inventory, there is nothing in the Income Tax Act to prevent that treatment. What follows for the purposes of accounting necessarily follows for the purpose of income tax in this case.

The resolution of this issue in the case at bar depends upon whether or not the Court accepts or rejects as the proper accounting treatment the method which the appellant used here. Counsel argued that the question of what is profit is a question of law for the Court to determine but the Court can look to expert opinion for guidance. If the Court decides that there was a preferred method to that used by the appellant, then that is what governs the determination of profit in section 9.

Counsel quoted Mr. Justice MacGuigan in West Kootenay Power & Light Co. v. R., (sub nom. West Kootenay Power & Light Co. v. Canada), [1992] 1 C.T.C. 15, 92 D.T.C. 6023, at page 22 (D.T.C. 6028) where he said:

The approved principle is that whichever method presents the “truer picture” of a taxpayer’s revenue, which more fairly and accurately portrays income, and which “matches” revenue and expenditure, if one method does, it is the one that must be followed.

The position taken by Mrs. O’Malley was that you treat the silviculture costs as costs of inventory just the same as “stumpage” costs or part of log costs. Therefore, it becomes part of inventory costs and therefore part of the cost of goods sold formula. On the other hand, Ms. Holgate says that you write if off as you incur it, when you are obliged to do the silviculture work. This Court must decide which is correct.

Counsel suggested that Ms. Holgate’s position is incongruous. She would treat stumpage costs as a cost of inventory but would treat silviculture costs in a different manner. Yet, neither the stumpage charge nor the silviculture costs add anything to the value of the logs but both are obligations that must be met to obtain the right to harvest the logs. Ms. Holgate had no experience with the forest industry and her conclusion was based on “analogy”. She overlooked the analogy that was close at hand to the facts upon which she was giving an opinion. The weight of the evidence should favour the treatment given by the appellant.

Once the Court concludes that the treatment afforded by the appellant in the determination of profit is the correct one, it must then conclude whether there are any provisions in the Income Tax Act which dictate another result. He opined that there are not.

His position was that subsection 18(1) of the Income Tax Act:

18(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of....

[Emphasis added.]

does not apply because the cost of inventory is not a “deduction”.

Counsel relied upon Oryx Realty Corp. v. Minister of National Revenue, [1974] C.T.C. 430, 74 D.T.C. 6352 (F.C.A.), Minister of National Revenue v. Shofar Investment Corp., [1980] 1 S.C.R. 350, [1979] C.T.C. 433, 79 D.T.C. 5347, and Friesen v. R., (sub nom. Friesen v. Canada), [1995] 3 S.C.R. 103, [1995] 2 C.T.C. 369, 95 D.T.C. 5551 in support of this proposition.

Finally, the appellant argued that the cases of Nomad Sand & Gravel Ltd. v. Minister of National Revenue (sub nom. Nomad Sand & Gravel Ltd. v. Canada), [1991] 1 C.T.C. 60, (sub nom. R. v. Nomad Sand & Gravel Ltd.), 91 D.T.C. 5032 (F.C.A.) and R. v. Burnco Industries Ltd., [1984] C.T.C. 337, 84 D.T.C. 6348 (F.C.A.) have no application here.

The appellant argued that the appeal should be allowed with costs.

Argument of the respondent

The Respondent took the position that the Court should first of all consider whether the costs in question are prohibited from deduction by some provision of the Income Tax Act.

Counsel argued that the cases of Oryx Realty Corp., supra, and Shofar Investment Corp., supra, talk about the cost of inventory as such as not being a deduction per se but he disagreed that because you run such a cost through the cost of goods sold formula that that figure is somehow not a deduction in computing income. This is tantamount to arguing that section 18 of the Income Tax Act applies only to those deductions which are running expenses. It does not apply any time when generally accepted accounting principles allow the expense to be run through inventory.

Counsel argued that in order for the costs to be recognized as a cost of goods sold it must satisfy the test under paragraph 18(l)(a) that it was made and incurred and must not be excepted by paragraph 18(l)(e), that it was a contingent liability.

Counsel argued that the appellant’s position was that such costs do not apply in the computation of “gross profit” and he disagreed with that submission. There is nothing in paragraph 18(l)(a) which makes it applicable to running expenses or current expenses only. Both experts testified that cost of goods sold was an expense. That is what the Minister of National Revenue has done here. He has disallowed the amount that was charged to cost of goods sold that was the estimated amount. He has allowed the expenditures on silviculture as they were made or incurred. The appellant is in a better position than if they were run through the inventory account. Thus, if paragraph 18(l)(a) prevents the deductions until made or incurred, the advantage is to the appellant. Nothing turns on the Minister’s treatment of the expenses but the appellant is better off by that treatment than if the Court should decide to refer the assessment back on the basis that the cost of goods sold included the silviculture costs as incurred.

Counsel argued that in Associated Investors of Canada Ltd. v. Minister of National Revenue, [1967] C.T.C. 138, 67 D.T.C. 5096 (Ex. Ct.) the Court recognized the cost of goods sold as a deduction. Counsel argued that there was no expense until there was the obligation to pay money to someone, until the work had to be done or until there was an identifiable credit, or until the amount was ascertained. If the expenses were running expenses, then under Burnco, supra, and Nomad Sand and Gravel Ltd., supra, the deductions would be prohibited under paragraph 18(1 )(a) of the Income Tax Act.

J.L. Guay Ltée. v. Minister of National Revenue, [1971] C.T.C. 686, 71 D.T.C. 5423 (F.C.T.D.) held that amounts held back from subcontractors were not deductible from income other than for the period in which the expenses were paid. Further, the amounts could not be exactly determined and in some cases might not even be payable. They were not certain or current expenses.

Counsel pointed out that no distinction was made in this case between current expenses and costs of inventory or costs of goods sold. The case points out what kind of deductions the Act seeks to prevent.

It may be that many estimates must be made by a taxpayer in determining what profit is for the purpose of the financial statements but there is a clear difference for tax purposes between the types of estimates.

On the one hand, you have estimates related to work done here and now, such as the cost of labour in harvesting a particular amount of logs. If such an estimate is done in accordance with generally accepted accounting principles, then that is what it is for tax purposes. But, where, as in the case at bar, the estimate goes beyond the year-end, it is uncertain, the present cost is applied to logs to be harvested in the future, where there may be factors affecting the reforestation obligations such as forest fires, decrease or increase in actual costs, whether the costs will be greater or less than the taxpayer estimated or that which was suggested in the preharvest silviculture plan, then this is a different situation.

It is not a question of measuring it at the end of the taxation year but estimating what will happen in the future. This may be acceptable for financial statement purposes but not for income tax purposes. This type of expense has consistently been held to be non-deductible whether it is a current expense or a cost of goods sold.

What the Minister had done has been to consider the formula, opening inventory, plus costs of acquisitions, less closing inventory equals cost of goods sold. The Minister has removed from cost of goods sold the estimated amount. The taxpayer receives no credit for it until it is incurred, in the sense that there is an identifiable creditor or certain obligation.

That is what happened in Burnco, supra, where the Federal Court of Appeal, reversing the Trial Division decision, in essence decided that even though there was a contractual obligation to do the backfilling and the taxpayer’s treatment was satisfactory from an accounting point of view, if the obligation was not matched with the revenues from the gravel pit, the treatment would be inappropriate. There must be an expense in the tax sense to make the matching relevant.

If there is a prohibition in the Statute which says that the expense cannot be recognized for tax purposes, matching is not to be considered.

In Canderel Ltd. v. R., (sub nom. Canderel Ltd. v. Canada), [1995] 2 C.T.C. 22, (sub nom. R. v. Canderel), 95 D.T.C. 5101 (F.C.A.), the “matching principle” was held to apply and the Court matched the lease inducement payment to the income from the lease by amortizing it over the term of the lease. Expenses were related to a particular item of income and were not running expenses.

The case at bar is almost the opposite. The expense will not be incurred until some time in the future depending upon how much time it takes to produce a free standing growing crop.

In the case of Newfoundland Light & Power Co. v. R., (sub nom. Newfoundland Light & Power Co. v. Canada), [1990] 1 C.T.C. 229, 90 D.T.C. 6166 (F.C.A.), at pages 238-40 (D.T.C. 6173), the Court found that holdbacks of moneys owed to subcontractors, the payment of which was subject to the satisfaction of a series of contractual conditions, including the settlement by the contractor (to the satisfaction of the taxpayer) of any claims by third parties, and the certification by the taxpayer’s own engineers, made the holdbacks non-deductible, contingent liabilities. This finding applied to holdbacks related to work of a capital nature as well as holdbacks related to maintenance work claimed as a current expense.

This conclusion was reached in spite of expert testimony being led from a chartered accountant that the holdbacks qualified as liabilities under generally accepted accounting principles on the basis that the total billings did not exceed the value received by the company and that the holdback on an asset purchase was reflected as a liability. The cost of the asset at that point in time included the amount of the holdback. The holdback on a service purchase was reflected as a liability and the expense for the period included that amount.

Counsel took the position that this case stands for the proposition that no conditional, contingent, unsubstantiated capital cost can be recognized until that cost comes into existence.

The holdbacks for current expenses are disallowed by paragraph 18( 1 )(a) under Burnco, supra. Capital cost is a deduction from income not defined in the Act. It is a special allowance under section 20 of the Act and therefore different from the costs we are taking about in this case under section 9. Normally where we do not have a defined term under the Act, we look at the cost for accounting purposes, but the Federal Court of Appeal has said no, the obligation to pay that cost must come into existence.

Counsel contended that the case of Shofar, supra, and Oryx Realty Corp., supra, deal with the issues raised by the appellant that the deduction from cost of goods sold is not a deduction for purposes of paragraph 18(1)(a).

In Shofar and Oryx, supra, the Minister sought to apply section 78 because when the property was sold there was unpaid inventory. The Court held that the section did not apply. But in that case there was no cost of goods sold in the prior year. In the case at bar there has been a resale of the asset in normal trading operations and therefore there is a deduction of an amount in determining cost of goods sold.

The amount involved in the case at bar was an estimated amount as in Burnco, supra, and there is no identifiable creditor. The work has not been done. Therein lies the difference between the case at bar and that of Shofar, supra.

Counsel argued that the quotation of Jackett C.J. in Oryx, supra, at page 433 (D.T.C. 6354) was not relevant to the case at bar. This quotation was made in reference to subsection 12(3). That quotation relied upon by the appellant in the case at bar is as follows:

In considering what application subsection 12(3) has, there can be no doubt that “gross profit” must be computed before income can be determined and that, at least in the second method of computing “gross profit” indicated above, the price for which the property was bought is “deductible” in its computation. If, on the other hand, the computation of “income” for a taxation year is thought of as commencing with “gross profit” then the “cost” of the property bought is not an amount that is “deductible” in its computation. When, moreover, one thinks of applying subsection 12(3) to a trader whose transactions are so numerous or of such a character as to dictate the use of the proceeds of sales less cost of sales formula, then, in the “computation” of the “taxpayer’s income for a taxation year” there is no deduction, at least as such, of the cost of the goods that were sold in the year.

Counsel argued that the case at bar can also be distinguished from Mara Properties Ltd. v. R., (sub nom. Mara Properties Ltd. v. Canada), [1993] 2 C.T.C. 3189, 93 D.T.C. 1449 (T.C.C.). In that case, the Court held that you cannot attack the deemed cost of inventory where there was nothing artificial in the transaction and the cost of inventory was not, in or of itself, a deduction in computing income. In the case at bar, what the Minister was attacking was an estimation, not the cost of inventory. It was an amount charged to the cost of goods sold.

If the appellant’s argument is upheld, in the case of a contractor the holdback would be deductible so long as it went through the inventory account and nothing in section 18 would prevent it. However, if the holdback goes through as a current expense it is not permitted. Likewise, an expense like that referred to in subparagraph 18( 1 )(l)(ii), membership fees would not be deductible if charged to current expenses but if the expenses were charged through inventory, they would be deductible.

For income tax purposes they cannot be recognized as costs but may be for financial statement purposes. That is the thrust of the Income Tax Act as referred to in J.L. Guay Ltée, supra. That distinguishes something like work in progress which may be difficult to measure, or the amount of timber which may be harvested, which may be difficult to measure as compared to the type of costs in issue here, which at the end of the year and beyond are contingent, conditional, uncertain and unascertainable. The reforestation obligation has all of those component factors.

On the issue of whether the cost is a period cost or a product cost, it does not matter from the distortion point of view according to Ms. Holgate in light of the high rate of turnover of the inventory. It was the position of counsel that Ms. Holgate, as an expert did not want to appear to be too much of an advocate and was willing to consider other possibilities. However, Ms. O’Malley was very emphatic in her position and did not appear willing to consider alternative conclusions.

With respect to “matching” the appellant is not only harvesting timber but producing logs, fulfilling a future obligation under their licences. Matching is not so clear as in Canderel, supra.

Whether or not it is a period cost is up to the Court to decide. The appellant says that paragraph 18(l)(a) does not apply but if the Court finds it to be a period cost, then on the basis of Burnco, supra, and J.L. Guay, supra, the deductions cannot be allowed as the appellant claims.

The question is for the Court to decide whether the decisions in Shofar and Oryx, supra are on point to the extent that they decided that where an estimated amount is deducted from gross profit, then paragraph 18(l)(a) has no application.

In rebuttal, counsel for the appellant reiterated that where a cost has been charged to cost of goods sold, it falls into a formula: Opening inventory + purchases - closing inventory = cost of goods sold. That was what Mr. Justice Jackett was saying in Oryx, supra, that you do not deduct cost of inventory. Counsel referred to subsection 10(1) of the Act which says:

(1) For the purpose of computing income from a business, 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 other manner as may be permitted by regulation.

Section 18 does not apply to inventories, it is covered in section 10.

Analysis and Decision

The Court accepts the propositions that the accrual method of accounting was proper for a business such as that of the appellant, that the method of matching expenses with revenue is a proper technique in accrual accounting and that in the case at bar, from an accounting point of view it was reasonable and proper for the appellant to estimate the silviculture expenses. The estimates prepared were as reasonable and accurate as they could be. However, they were estimates only in light of the fact that they were based to some extent upon the appellant’s experience in the forest industry.

The Court has considered the expert’s reports, the rebuttal reports and the evidence of both experts given in Court, that the treatment was generally acceptable in the forest industry by companies that were responsible for silviculture expenses but that from a cost accounting point of view there might have been a better method of treatment. However, the fact that such a method was acceptable from an accounting point of view does not mean that that is the way the expenses must be treated for taxation purposes.

In J.L. Guay Ltée, supra, at page 691 (D.T.C. 5426), Noël A.C.J. said:

The Income Tax Act does not always give a complete answer to the question as to what the total amount of profits and earnings in the year assessed is. In determining the taxable profits of a taxpayer we can take as a starting point the profit and loss statement prepared according to the rules of accounting practice. However, the profit shown on this statement has always to be adjusted according to the statutory rules used in determining taxable profits. This is because a number of facts taken into consideration by accountants are excluded by certain provisions of the Income Tax Act in the determining of taxpayers’ profits.

Again, at page 692 (D.T.C. 5427), the learned A.C.J. said:

The difficulty arises from the fact that making it possible to determine the taxpayer’s tax liability is not the main purpose of accounting.

In the case at bar, two experts agreed that the appellant’s treatment of the silviculture expenses was in accordance with generally accepted accounting principles, one expert believed that there was a preferred method and both experts differed on their characterization of the same expenses. One expert believed that the expenses were period costs, to be expended when they occurred and the other emphatically stated that the only proper method of dealing with the silviculture costs was to include those costs in the costs of inventory.

Counsel for the appellant suggested that the evidence must be weighed as in a balance and when the Court does so the balance is tilted in favour of the appellant’s position.

It is clear that the Court must look to other than accounting principles on the facts of this case to determine the proper characterization of these expenses in issue. The Court certainly takes into account what the experts said, what the other witnesses had to say, what treatment the forest industry gives to these expenses and considers the facts established in light of the case law and the Income Tax Act.

The type of expenses in issue here have never been considered by any other Court. None of the cases referred to were entirely on point because of the nature of these expenses, although some of the characteristics of the expenses in the cases cited were similar in that they were estimates, unascertained amounts, had not been paid, were provisional, contingent or uncertain.

Those cases are helpful in giving the Court some guidance as to what principles and factors the Court should consider in characterizing expenses but they do not answer the question as to what is the proper characterization of the expenses in issue here.

Counsel for the appellant took the position that once you charge the silviculture costs to the cost of goods sold then they fall into a formula and the formula says you take your opening inventory, you add your purchases in the year, you subtract your closing inventory and that gives you cost of goods sold. That of course pre-supposes that the silviculture expenses are properly added to the cost of goods sold. Surely that is the main issue. Surely an expense does not become deductible for income tax purposes just because it is treated in a certain manner for accounting purposes. The question becomes, was it proper for income tax purposes to treat the silviculture expenses as costs of inventory or cost of goods sold. What is otherwise a non-deductible expense does not become deductible merely because you run the expense through the inventory account. The expense must firstly be properly chargeable to inventory.

The thrust of the cases referred to by both counsel show that the Courts have consistently disqualified for income tax purposes, in calculating taxable profits, amounts that are provisional estimates, are conditional, contingent or uncertain. The estimates disallowed by the Minister here were certainly of that nature.

In the case of Newfoundland Light & Power Co., supra, such expenditures were both of a capital nature and a current expense nature, Mr. Justice Pratte, at page 239 (D.T.C. 6173) said as follows:

Indeed, in order for an expense to be incurred during a year, the obligation to pay must be created during that year; similarly, there is no cost of property to a taxpayer as long as the obligation to pay that cost has not come into existence.

As pointed out by counsel for the Respondent, that case disallowed the current expenses under paragraph 18(1 )(a) based upon the decision in J.L. Guay Ltée, supra. It is true that the expenses in issue in that case were holdbacks, but their undesirable qualities were similar to those possessed by the estimates in issue in this case.

The Court concludes that the obligation to pay the costs had not come into existence in the case at bar. Ms. Holgate in her testimony concluded that silviculture costs were not related to the “cost of product”. It was an expense that occurred at a later time period. It did not add value to the product. It had no future benefit. It was a period cost and quite remote from the cost of producing logs. It may be related to inventory but was not a product cost. It was similar to a sales tax cost. It was created by legislation. She could not see any direct relationship between the cost and the product and it would be more normal to treat it as a period cost.

Ms. O’ Malley testified that the silviculture costs were directly related to the cost of the final product.

The Court finds that the position of Ms. Holgate was more realistic and it has difficulty in finding a direct relationship between the silviculture costs and the end product costs.

With respect to the issue under paragraph 18(1 )(a), as the Court has found, the costs were “period costs” and paragraph 18(l)(a) disallows their deduction in the year under appeal. The cases of Burnco and J.L. Guay Ltée, supra, are applicable here.

The Court is satisfied that the costs in question here are not the type of costs referred to in Shofar and Oryx, supra, and those cases do not prevent the application of paragraph 18( l)(a) here.

The Court does find that these expenses were not reserves as contemplated by paragraph 18(l)(e) but that the Minister has afforded the expenses the proper treatment under the Income Tax Act for the years in question.

The parties have filed a partial Consent to Judgment and on that basis the assessments for the 1988 to 1991 taxation years will be referred back to the Minister for reassessment and reconsideration on the basis that the amounts of $323,672 in 1988, $603,395 in 1989, $991,300 in 1990 and $506,772 in 1991 are current expenses in respect of seedlings and deductible in those years and the appellant’s seedling inventory and cost of sales for 1988 to 1991 be adjusted accordingly.

The Respondent will have its costs to be taxed on the disallowed silviculture expenses issue and the appellant will have its costs to be taxed on the seedling issue.

Costs disallowed.