Her Majesty the Queen v. Cyprus Anvil Mining Corporation, [1990] 1 CTC 153

Urie, J.A.:—This appeal from a judgment of the Trial Division was brought on an agreed statement of facts supplemented by the oral opinion evidence of two experts and the evidence of an officer of the respondent corporation.

Briefly stated the facts are these. At all material times the respondent, or a predecessor corporation, operated a mine in the Yukon Territories, the income from which was by virtue of subsection 83(5) [1] of the Income Tax Act, 1952 (the "Act"), and section 28 [2] of the Income Tax Application Rules, ("the Rules”) 1971 exempt from income tax for the three year period commencing February 1, 1970 and ending January 31, 1973. With its income tax return for the tax year ending on December 31,1973, (which also was its fiscal year end) the respondent filed not only the financial statements for its fiscal year but also a financial statement for the month ending January 31,1973 in which its closing inventory at that date was valued at cost in the sum of $2,343,000. Its opening inventory for the tax year 1973 was also valued at cost and was the same amount as its closing inventory for the year ending December 31, 1972. In completing its income tax return for the 1973 tax year, the respondent deducted exploration and development expense which it had accumulated and none of which had been utilized for tax relief before, in an amount sufficient to reduce its otherwise taxable income for the period to zero and was subsequently assessed on that basis, as it had been for each of the taxation years in which the tax exempt period fell are January 1, 1970 to December 31, 1973. During all of those years the respondent's inventory had been valued at the lower of cost or market in accordance with the policy of its United States parent.

For the 1974 tax year, the respondent carried forward and deducted the balance of its unused exploration and development expense and paid income tax on its net taxable income remaining after making that deduction.

In due course, on December 21,1979, the respondent was reassessed on its 1974 income. It then filed a notice of objection to the reassessment claiming that its 1974 reassessed income had been overstated by $2,642,000, being the difference between the cost and market value of its closing inventory as at January 31, 1973. The reassessment was subsequently confirmed as a result of which the respondent appealed to the Trial Division which allowed the appeal and referred the matter back to the Minister for reassessment. It is from that judgment that this appeal has been brought by the appellant.

It should be noted that in 1967 and 1969 the respondent had entered into contracts with Japanese and German buyers respectively for sale of its complete production of zinc and lead concentrates and bulk flotation concentrates, which agreements remained in effect until November 1977 and December 31, 1977. It is also worthy of note that for financial statements and for tax purposes, it was admitted by the respondent's witness, Andrews, that inventory at all times had been valued at the lower of cost or market but that for the tax exempt period it took the position that it was entitled to maximize its income by valuing the inventory at market. For the year ending Decem ber 31, 1972, inventory had been valued at cost. As subsection 10(2) requires, the opening inventory for January 1, 1973 was shown at the same figure - cost. By changing the valuation of the inventory to market at the end of the three-year exempt period, January 31, 1973, the tax exempt profit for that period increased by $2,642,000. Commencing on February 1, 1973, the earnings of the respondent became liable for income tax and on that date the inventory was, as required, valued at market but at year end, December 31, 1973, the company's normal practice of valuing inventory at the lower of cost or market was again adopted, cost being lower at the time. The result was that the net profit for the period was lower so that less of the exploration and development expense had to be utilized to reduce the taxable income for the period to nil and the balance of such expense became greater than at the time of filing its 1973 tax return, a larger deduction from 1974's taxable income. It is for this reason that the respondent objected to the reassessment of its 1974 income alleging that it was overstated by $2,642,000 which was income attributable to the exempt period. As will later be examined that figure was subsequently reduced by the trial judge by the sum of $339,000.

All of the foregoing leads to the statement of the issue by the appellant in her memorandum of fact and law as:

. . . whether the Respondent (Plaintiff) was legally entitled to change the valuation of its inventory from cost to market at the beginning and end of the three-year period during which its income from the mine was not to be included in the calculation of its taxable income.

The respondent did not dispute the issue per se but stated its position on the issue in the following terms:

The respondent says that as the operator of a new mine, it was entitled by provisions of the Income Tax Act to value its closing inventory at market instead of cost at the end of its three-year exemption period, and that that inventory valuation basis provided the most accurate determination of its income through the three-year period.

To this the appellant replies that the shift to valuation at market offends an accounting principle (one of the rules of generally accepted accounting principles, hereafter referred to as g.a.a.p.) that requires consistency in year-end inventory valuation method from year to year. The respondent agrees that its market valuation of closing inventory at the end of its 1974 [sic] taxation year was inconsistent with the g.a.a.p. consistency rule, but says that its market inventory valuation basis was specifically allowed by provisions of the Income Tax Act, which prevail over g.a.a.p., and resulted in the most accurate measurement of its income in the three-year exemption period.

The Income Tax Act is silent on the question of conformity between tax accounting and financial statement presentation for the very good reason that the Department of National Revenue has never wanted the determination of taxable income to be based on what one judge once called "the shifting sands of accounting opinion.”

The learned trial judge found, first, that:

The change to a market value basis of valuing closing inventory at January 31, 1973, while it involves a departure from the accounting principle of consistency, [in year- to-year financial reporting] is a departure permitted by the statute.

Secondly, in respect of the so-called "conceptual argument" advanced by the respondent he said:

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

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

Thirdly, he held that the appellant Minister’s argument that the respondent was estopped from changing its basis for inventory valuation had no substance because it imposed no detriment to the appellant so that the principle of estoppel did not apply.

Having made these findings the respondent's appeal from the 1979 reassessment was allowed and the matter was referred back to the Minister with directions.

I will deal with counsel for the appellant's attacks on each of those findings in the order in which they appear above.

I Technical Argument

Subsection 10(1) of the Act and Regulation 1801 [3] of the Regulations prescribe the acceptable methods of valuing inventories for tax purposes. The necessity for the valuation of inventories in the computation of the profit of a taxpayer was pronounced upon by Martland, J. in the Supreme Court of Canada case of M.N.R v. Shofar Investment Corp. [4] when, at page 5849 of the report, he approved of what Jackett, C.J. had said on the appeal in in the following excerpts from his judgment: —

What we are concerned with here is "gross profit”. "The law is clear. . . that for income tax purposes gross profit, in the case of a business which consists of acquiring property and re-selling it, is the excess of price over cost .. ." (see M.N.R. v. Irwin, [1964] S.C.R. 662, per Abbot J. . . . In the ordinary trading business, however, the practice, which has hardened into a rule of law, is that profit for a year must be computed by deducting from the aggregate "proceeds" of all sales the “cost of sales" computed by adding a value placed on inventory at the beginning of the year to the cost of acquisitions in the year and deducting a value placed on inventory at the end of the year.

Statutory recognition of the possibility of valuing inventory in a manner which might not accord with generally accepted accounting principles was given when subsection 14(2) came into force in 1949. It is identical to the present subsection 10(1) and, it will be noted that it is "for the purpose of computing income . . ." and gives to the taxpayer three options in the valuation of its inventory. In fact, "inventory" then and in 1978 was defined in similar terms, viz: —

''inventory" means a description of property the cost or value of which is relevant in computing a taxpayer's income from a business for a taxation year."

[Emphasis added.]

Subsection 9(1) relates income for a taxation year from a business to his profit therefrom for the year. It reads as follows: —

9.(1) Subject to this Part, a taxpayer's income for a taxation year from a business or property is his profit therefrom for the year.

The Income Tax Application Regulation giving the third option is 1801 quoted above.

In essence, it was the contention of the appellant's counsel that the combination of subsection 10(1) and its complementary subsections (2) and

(3) (which for purposes of this appeal are not important) and Regulation 1801, do not override the requirement of accounting principles of consistency in computing business income. A long line of cases such as Dominion Taxicab Assoc, v. M.N.R [5] , Canadian General Electric Co. v. M.N.R. [6] , and Neonex International Ltd. v. The Queen [7] , have held that profits from a business must be determined in accordance with "ordinary commercial principles unless the provisions of the Income Tax Act require a departure from such principles’. In counsel's submission, permitting by statute a taxpayer a choice of three methods of inventory valuation in computing its income does not per se derogate from the overriding accounting principle of requiring consistency in financial reporting to ensure that the true financial picture of the taxpayer has been portrayed in its accounts. Since the valuations of the opening and closing inventories are important elements in the computation of profit for a year normally the same method should be used to avoid distortion of profits for the year.

Counsel conceded, however, that if the method used in such valuations does not, in the computation of income for tax purposes, fairly and accurately portray the profit picture of a taxpayer, the principle of consistency will not apply and, since the repeal of subsection 14(1) which permitted a change in inventory valuation methods only with the consent of the Minister, a taxpayer may change to one of the other methods of inventory valuation without the permission of the Minister having to be obtained, if it is only in this way that a true and accurate profit of the taxpayer can be ascertained.

Counsel for the respondent argued that the only requirement in the Act or Regulations as among the three permitted methods of inventory valuation, is that the opening inventory be valued at the same amount as the closing inventory of the preceding year. There is no requirement, in his view, that closing inventory be valued on the same basis as opening inventory. Nor is there, he said, a requirement in the Act or Regulations that the taxpayer's method of inventory valuation be the same from year to year and cited the evidence of his expert witness, Harrison, to support this assertion. He agreed with appellant's counsel that section 9 of the Act requires computation of profit, prima facie, to be made in accordance with generally accepted accounting principles including the requirement of consistency in reporting. However, in his submission, section 10 specifically permits a departure from such principles and, therefore, must prevail over the general provisions of section 9.

I am unable to agree with the respondent's submissions, particularly the latter one.

Subsection 9(1) prescribes that a taxpayer's income for a taxation year from a business is his profit therefrom for the year.

Subsection 10(1), and Regulation 1801, on the other hand, both include the opening words "[if] for the purpose of computing income from a business. . .”. It is not limited to any particular period of time whether it be the taxpayer's fiscal year, his taxation year or any longer or shorter period. In other words, it is a provision of general application conferring the possibility for a taxpayer to make a choice of his method of inventory valuation without reference to any time period. Computation of income, on the other hand, must relate to the taxpayer's taxation year. I do not think, therefore, that it can be said that subsection 10(1) is a specific provision overriding the general one, section 9.

Admittedly, subsection 10(1), (a) neither contains a prohibition against changing the method of inventory valuation from time to time, nor (b) permits the method selected to be changed at will, nor (c) provides a departure from the generally accepted accounting practice of valuing inventory only at cost or the lower of cost or market. But, in my view, it must be construed within the context of the Act and be harmonious with its scheme and with the object and intention of Parliament. [8] To permit the change in inventory valuations espoused by the respondent as approved by the trial judge, has the effect of distorting the respondent's profits in both the 1973 and 1974 tax years. In other words, by failing to adhere to the consistency principle in the computation of income, the respondent has not fairly and accurately portrayed its profit picture. The witness Harrison testified to the effect that valuing the inventory at market at the end of the exempt period more accurately reflects the profit earned in that period for the purpose of maximizing the tax advantages accruing from the exemption. But even he admitted that although it had been a practice which had been frequently resorted to by mining companies, apparently without question by the taxing authorities, it was contrary to generally accepted accounting principles to do so. The critical principle, however, is that there be consistency in the computation of profit as that term is understood in subsection 9(1) of the Act which means that it must be the computation thereof for a taxation year. The profit calculation under subsection 10(1) ought not to be a different one from that made for the same or overlapping period for tax purposes. If a different principle of computation of profit for the exempt period were permissible, surely the Act or the Regulations would have so stated. They did not.

For these reasons, it is my view that the appellant must succeed on this branch of her appeal.

II The Conceptual Argument

Counsel for the respondent relied principally on this argument as the foundation of his case. The nub of the argument is this: —

The three-year exempt period granted by subsection 83(5) of the Act and section 28 of the I.T.A.R. was provided as a tax incentive for the development of new mines and, according to the respondent, its purpose was to exempt from tax the fruits of the income earning process carried on in the prescribed three years. Given the fact that all of the concentrate on hand at January 31, 1973 was being sold under long term contracts, its market value should be utilized in the accurate determination of the respondent's income for the last of its three exempt years. To obtain such an accurate determination requires valuation of the closing inventory at market, despite the fact that valuing closing inventory at market was a variation from the valuation basis used in its financial statements or that doing so violated an accounting principle, namely, consistency in reporting. It was necessary in view of the pre-sold production from the mine and the necessity for accurately measuring income during the exempt period. To do otherwise, it was argued, would be to move the profit component contained in the market value of that inventory, produced in the exempt period, into the succeeding period where it would be subject to tax which it ought not to be, he said, if the intent of the legislation were to be fully observed.

By the same token, the profit component contained in the market value of inventory produced before commencement of the exempt period and on hand at its commencement on February 1, 1970 should be excluded and taxed as belonging to the previous taxable period. To accomplish this the respondent agreed to an adjustment of $339,000 of market over cost at the commencement of the exempt period. The trial judge thus, as previously alluded to, reduced the overstatement of income for the 1974 taxation year by that amount. That year, the assessment for which is the subject of this appeal, was the only year in which either or both adjustments could be made because it was the first year in which the respondent had taxable income.

In essence what this submission means is that no matter how the respondent calculates its profit for either financial statement or tax purposes, it is entitled by virtue of the intention of the incentive legislation to maximize its profits for that exempt period.

It seems to me that when the issue is stated succinctly and baldly in that way, it immediately discloses the fallacy in the respondent's position. The tax exempt period cannot exist in isolation and the rules to be applied in determining the profit which the company earns from its production of concentrates during the exempt period must be determined, as was said by this Court in a different factual and statutory context in Denison Mines Ltd. v. M.N.R. [9] :

. . must be determined by sound business or commercial principles and not by what would be of greatest advantage to the taxpayer having regard to the idiosyncrasies of the Income Tax Act.

The undoubted fact that subsection 83(5) is incentive legislation does not, as I see it, entitle the recipient of the statutory beneficence to propose a method of computing the profit it purported to derive during the exempt period in a manner which is contrary to its method of computing its income before, during and after the exempt period both for its own financial reporting purposes and for its tax reporting purposes. To permit the taxpayer to change its usual accounting practices solely to maximize its profits during the exempt periods distorts not only the income during that period but also that in the periods before and after it. This is neither logical, authorized by statute nor consistent with good business or accounting practice.

I would allow the appeal on this branch of the argument also. III The Estoppel Argument

In view of the disposition which I propose for the appeal it is not necessary for me to comment on this branch of the appellant's argument other than to say that I do not disagree with what the learned trial judge had to say in respect thereto.

Accordingly, for all of the foregoing reasons, I would allow the appeal with costs both here and below.

Hugessen, J.A.: —I have had the benefit of reading the reasons for judgment prepared by my brother Urie, J.A. I am in entire agreement with his proposed disposition of the appeal but prefer to base myself solely on the grounds described, both here and below, as "The Conceptual Argument".

The deduction of which the respondent seeks to take advantage is claimed under the provisions of the then subsection 83(5) of the Income Tax Act:

83. . . .

(5) Subject to prescribed conditions, there shall not be included in computing the income of a corporation income derived from the operation of a mine during the period of 36 months commencing with the day on which the mine came into production.

Put in its simplest terms, what the respondent is seeking to do is to compute its income for the 36-month exemption period on a basis different from that in which it computed its income for each of the four taxation years in which that 36-month period fell. In my view, the text simply does not allow such an exercise. The operative part of the exemption reads:

. . . there shall not be included in computing the income of a corporation income derived from the operation of a mine . . .

[Emphasis added.]

Those words can only mean that the income derived from the operation of the mine must be computed on the same basis as the income from which it is to be deducted. To give the meaning argued for by the respondent, Parliament would have said something along the lines of

there shall not be included in the income of a corporation computed for income tax purposes income derived from the operation of a mine and computed for the purposes of the present section.

Clearly it did not do so.

I would conclude as does Mr. Justice Urie.

Appeal allowed.