Scarrow’s Shoes Limited v. Minister of National Revenue, [1988] 2 CTC 2027, 88 DTC 1402

Christie, A.C.J.T.C.:—The question is whether the method adopted by the appellant in valuing its inventory [1] for the purposes of computing its income for its 1983 taxation year is permissible under the Income Tax Act. Subsection 10(1) of that Act and section 1801 of the Regulations made thereunder provide:

10(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.

1801. Except as provided in section 1802 [2] , for the purpose of computing the income of a taxpayer from a business

(a) all the property described in all the inventories of the business may be valued at the cost to him; or

(b) all the property described in all the inventories of the business may be valued at the fair market value.

The possibilities under these provisions were enumerated by Mr. Justice Noël in Irwin v. M.N.R., [1962] C.T.C. 572 at 597; 62 D.T.C. 1356 at 1370:

According to section 14(2) [now subsection 10(1)] of the Income Tax Act and section 1800 [now 1801] of the Income Tax Regulations, as we have just seen, inventory can be valued according to either of the three methods mentioned above namely:

(a) Cost (Section 1800 (a))

(b) Market (Section 1800(b))

(c) Cost or market whichever is the lower, Section 14(2).

In the latter case (c) one of three methods may be adopted: (1) each inventory item is valued at cost and at market and the lower of the two amounts is entered on the inventory sheet; (2) inventory items are grouped by departments or otherwise, each group being evaluated at cost or market whichever is the lower; (3) the taking of the lower as between cost and market is applied to the inventory total.

In (a), i.e. "Cost", the property described in all the inventories of the business may be valued at cost and in (b), i.e. "Market", all the property described in all the inventories of the business may be valued at the fair market value.

This is said about the importance of inventory valuation in determining income in the Canadian Tax Reporter, vol. 1 at p. 3942:

Inventories appear as a current asset in the balance sheet of a business at the value placed on them by the taxpayer. The value placed on inventories has considerable significance in determining the income from a business as well as for balance sheet purposes, since it is one of the factors in determining the cost of sales. The cost of sales ordinarily is calculated as being: (a) the value of inventory on hand at the beginning of the year, plus (b) the cost of purchases during the year, minus (c) the value of inventory on hand at the end of the year. Consequently, if inventory is not correctly valued the income of the business may be distorted. If the inventory on hand at the end of the year (closing inventory) is overvalued as compared with inventory on hand at the beginning of the year (Opening inventory), profits will be overstated. Similarly, if the closing inventory is undervalued as compared with opening inventory, income will be understated.

Counsel for the appellant informed the Court that in determining the value of its inventory his client did not purport to invoke the Regulations, but relied solely on the operative words of subsection 10(1). It was established and emphasized at the hearing that the procedure followed by the appellant to determine the value of its inventory for purposes of its 1983 taxation year was the same as had been adopted by it in relation to many other of its taxation years. As I see it this does not, however, contribute much, if anything, to the solution of the problem at hand. As was said by W.O. Davis, Q.C. in Fergusson Atlantic Ltd. v. M.N.R., [1967] Tax A.B.C. 715 at 728; 67 D.T.C. 526 at 534: "Consistency ceases to have any virtue if the original basis of valuation is an incorrect one. It serves but to perpetuate the error."

There is no disagreement of significance regarding the facts. They are straightforward and concise. The appellant is in the business of retailing men’s, women's and children's shoes. Four or five was given as inventory turnover or inventory utilization ratio. For the purpose of computing its income in its 1983 taxation year the appellant adopted a method of valuing its inventory that is described in evidence as follows. Its record of inventory identifies the colour of the shoes, the number of pairs of shoes, their style, the manufacturer, the bin in which the shoes were at the time the inventory was taken, the original cost as recorded on the invoice, the original cost times the number of pairs of shoes in inventory, the present cost and the present cost multiplied by the number of shoes in inventory. Thus:

The amount of $6 is the inventory value assigned to each of these pairs of shoes and that is the bone of contention. Six dollars is arrived at in this way. The normal intitial mark-up of a pair of shoes is said to have been 100 per cent of their invoiced cost so that at the outset a pair of navy Marco Kaufman shoes would have retailed for $24. When the inventory was taken the retail price of a pair of these shoes was or had been reduced by 50 per cent [3] or $12 and in order to arrive at present cost for the purpose of valuing the inventory a corresponding reduction of 50 per cent was made to the invoice cost of the shoes which, of course, produces the amount of $6. In short the evidence regarding the appellant's method of valuing its inventory is that inventory value is arrived at by reducing the initial invoice cost by the same percentage (if any) that the selling price is reduced or, to attenuate even further, the value assigned to a pair of shoes at the time the inventory is valued is one half of the retail price at that time. There may have been some initial mark-ups that exceeded 100 per cent and some that were less than that, but 100 per cent was "the average pretty well right on.”

The method by which the inventory was valued by the respondent is set out in paragraphs 6(e) to (g) of the reply to notice of appeal. They read:

(e) the Respondent computed the value of the Appellant's inventory as at December 31, 1983, on the basis of the lower of cost and market value;

(f) the Respondent determined that the lower of cost and market value was cost, and valued the Appellant's inventory as at December 31, 1983, at $191,175.00, and based upon that value reassessed the Appellant to include $72,718.00 in income for the 1983 taxation year. The details of the Respondent's computation are as follows:

Original Cost	$198,175.00
Less: writedown for inventory
having a market value less
than original cost
(i.e. obsolescence)	7,000.00
Revised inventory	191,175.00
Less: inventory as reported
by Appellant	118,457.00
Understatement of inventory
and understatement of income	$ 72,718.00

(f) [4] the market value of the obsolete items described in the Appellant's inventory as at December 31, 1983, was an amount of not more than $7,000.00. The market value of the remaining items described in the Appellant's inventory as at December 31, 1983, exceeded the cost thereof.

(g) at all material times, the Appellant's normal gross profit margin was approximately 33%.

With respect to paragraph (g), it was shown by financial statements as of December 31, 1983, that in that year the appellant’s sales were $925,965 and its gross margin was $307,257 or 33 per cent.

I cannot accept the manner in which the appellant has valued its inventory because it does not constitute a realistic way of determining that value. The valuation placed on inventory in compliance with subsection 10(1) must tell the truth as far as it can be reasonably ascertained about its commercial value so that income and, consequentially, liability to tax can also be determined on a reasonable basis.

Exhibits A-1 and A-2 are books of inventory prepared in accordance with the previously described procedure. To my mind this documentary evidence, rather than assisting the appellant in its appeal, serves to thoroughly undermine the appellant's contention that it has complied with subsection 10(1). Exhibit A-1 consists of 43 pages and contains some 1112 entries. Exhibit A-2 consists of 44 pages and some 1145 entries. These documents show that in each instance the inventory value placed on a pair of shoes is below cost. Eleven per cent of the stock-in-trade is valued at one-half of invoice cost; 64 per cent exceeds one-half of invoice cost and is less than that cost and the remaining 25 per cent is less than one-half of invoice cost. The analogous percentages for Exhibit A-2 are 10 per cent, 62 per cent and 28 per cent. There is nothing in evidence to sustain the view that these amounts have any true relationship to “fair market value" within the meaning that those words are used in subsection 10(1). Indeed what is in evidence indicates the opposite. I cannot imagine the appellant offering to sell its stock-in-trade in the normal course to anyone at prices arrived at on the basis of the method it employed in valuing its inventory for the purpose of computing its income for its 1983 taxation year. The valuation formula adopted by the appellant is artificial and produces unrealistic results.

B.S.C. Footwear Ltd. v. Ridgway (Inspector of Taxes), [1972] A.C. 544, involved a dispute over the manner in which the appellant company had valued its inventory for income tax purposes. The appellant's business was retailing shoes on a large scale. The view of the majority of the judges who dismissed the appeal regarding the meaning of "market value" in the phrase "cost or market value, whichever is the lower” is that it connotates the price at which the stock-in-trade was expected to be sold in the market, i.e. the retail market in which it was intended to sell the goods. Lord Pearson said at page 570: “It seems to me the correct principle is that goods should not be written down below cost price unless there really is a loss actual or prospective. So long as the fall in prevailing prices is only such as to reduce the prospective profit the initial valuation at cost should be retained."

The appellant in the case at hand having failed to value its inventory within the contemplation of subsection 10(1) the respondent was, I think, entitled to reassess on the basis that he did. It was a reasonable course of action in the circumstances. The evidence does not challenge either the $198,175 as being the original cost of the inventory or the $7,000 deduction for items in inventory having a market value less than original cost. I have some initial doubt whether the legislation pertaining to the method adopted by the respondent includes the deduction of the $7,000 which I understand to be a rounded estimate pertaining to "obsolescence". Nevertheless I have not delved into this because it is something that enures to the benefit of the appellant and consequently is not a matter that is subject to alteration by the Court on this appeal. The basic question to be determined on an appeal from an assessment or reassessment is whether it is too high: Harris v. M.N.R., [1964] C.T.C. 562 at 571; 64 D.T.C. 5332 at 5337 (Ex.Ct.) and Shiewitz v. M.N.R., [1979] C.T.C. 2291 at 2293; 79 D.T.C. 340 at 341 (T.R.B.).

The appeal is dismissed.

Appeal dismissed.