Kelly, Douglas & Company Limited v. Minister of National Revenue, [1976] CTC 2107

A W Prociuk (orally: October 31, 1975):—The appellant, Kelly, Douglas & Company Limited, appeals from the respondent’s reassessment of its income for the taxation year ended December 31, 1971, wherein the deduction of $53,331, representing the cost of its stationery and special forms on hand at the end of the year, from its income was disallowed on the ground that it was inventory within the meaning of subsection 14(2) and paragraph 139(1)(w) of the Income Tax Act then in force, and should be carried forward into the succeeding year. The relevant provisions of the Income Tax Act read as follows:

14, (2) For the purpose of computing income, 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. .—

139. (1) In this Act,

(w) “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;

The appellant takes the position that the stationery was not inventory in the sense that it was a marketable commodity in any form, and also that its cost was a recurring operating expense and therefore the appellant is entitled to charge it to income when the expense is

The appellant is a wholesale and retail grocer, operating some 13 branches in British Columbia and the Yukon and nine cash-and-carry outlets. Its head office is in Burnaby, British Columbia and it administers general merchandising operations. Mr D A McWilliams, employed by the appellant company as an accountant in its head office, testified on behalf of the appellant. He described in some detail the manner in which the appellant has organized its administration, with a threefold purpose in mind: economy in purchasing; control of branch operations; and cost allocation to branches—principally to influence branch managers to be prudent business men. To accomplish these ends with greater certainty, the appellant purchases supplies of specially designed stationery, vouchers, invoices, IBM cards, etc, each group being consecutively numbered, which stationery is kept in a stationery stockroom. Exhibit A-2 consists of some 18 typical forms commonly used by appellant in its daily operations. Exhibit A-3 is a manual which outlines step-by-step stockroom procedure. This Stationery is distributed to its branches as required and a record is kept of its distribution. I gather from the evidence that this system, which has been used by the appellant for a number of years, has eliminated much waste and increased the company’s all-round efficiency. The stationery balance on hand at the end of the year 1971 was, for the purposes of its internal control, shown as inventory in the sum of $53,331, and in the balance sheet it appears, together with stock on hand, under the heading “Inventories at the lower of cost and net realizable value”, for the total sum of $15,749,325. The stationery then on hand was sufficient to last for approximately 21/2 months of the succeeding year.

For tax purposes, the appellant charged to income the total cost of its stationery as it had done in the past. There was some slight evidence, however, of the appellant using the deferred method in 1968 or earlier, that is to say, charging to income the cost of such portion of the stationery as was actually used up in the taxation year involved. The Department of National Revenue conducted its routine audit of the appellant’s records some time in 1973 and, in reassessing as a consequence thereof, added the said sum of $53,331 back to income.

Mr John K W Pearson, CA, of the Department’s Regional Appeals Branch, testified on behalf of the respondent. He confirmed the assessment, stating that the amount involved was, in his opinion, substantial enough to warrant such action, and that, in dealing with smaller companies, or where the amount is not significant, the full amount is charged to income when incurred. He further stated that the factor of matching profits and expenses was also considered, as was the matter (and this, I take it, was his main thrust) of whether or not there was consistency in the method adopted by the taxpayer.

It is agreed by both parties that, strictly speaking, the stationery here was not inventory in the sense that the term is normally used; that it has no market value at all; and that it is of no use to anyone other than the appellant. The evidence satisfies me that the only purpose it served on the balance sheet was to keep its cost within the appellant’s internal control for accounting purposes. There was no evidence that the method was used by the appellant to distort the financial picture as it might affect taxation, nor was it part of any scheme to reduce artificially the appellant’s income. The appellant has been consistent in its accounting practices for taxation purposes as well as for its own internal control purposes. The quantity remaining on hand, having regard to the size of the operation, is, in my opinion, not out of proportion. I note in the textbook entitled Income Tax Law of Canada, 6th edition, by Arthur R Scace, at page 390, under the heading of “Prepaid Expenses”, that the learned author has this to say—and this is dealing with the new Act:

No change has been made with respect to prepaid expenses and caution should still be exercised. It is the practice of the Department of National Revenue to permit prepaid expenses to be deducted when incurred, even though good accounting practice would dictate otherwise, because there would be an improper matching of revenue and expenses.

There is no provision in the Act to direct the appellant which method it must use. In my opinion, the appellant, on the evidence, is entitled to succeed, and the appeal is allowed.

Appeal allowed.