Wickett and Craig LTD v. Minister of National Revenue, [1978] CTC 2516, [1978] DTC 1382

Delmer E Taylor:—This is an appeal against income tax assessments in which the Minister of National Revenue increased the taxable income of the appellant for the year 1972 by an amount of $182,906, and decreased the taxable income for the years 1973 and 1974 by amounts of $90,945 and $91,961 respectively. The matter at issue is the basis of valuing and reporting inventories of goods at relevant times during these years. The appellant relied upon section 10, and the respondent relied, inter alia, upon sections 2, 3, 4, 10, and subsection 248(1) of the Income Tax Act, RSC 1952, c 148 as amended by SC 1970-71-72, c 63. Both parties also submitted for consideration the provisions of section 1801 of the Income Tax Regulations.

Facts

The appellant (hereinafter referred to as the “Company”) is a duly incorporated company with its head office in Toronto, Ontario, carrying on the business of acquiring, processing, tanning and disposing of animal hides. The inventory valuations disputed and rejected by the respondent were made on the Last-In, First-Out basis, commonly known as LIFO.

Contentions

In the Notice of Appeal, the appellant put forward the following:

—The identification of specific inventory of the appellant from time to time is not feasible.

—The hide market in Canada and elsewhere is commonly known to be a volatile and fluctuating market.

—For the purpose of valuing its inventory at the close of its fiscal periods, the appellant values the same at the lower of cost or market as required by the provisions of the Income Tax Act (Canada) and as required by generally accepted accounting principles.

—For the purpose of valuing its inventory at the close of its fiscal periods, the appellant also ascertains the inventory to be valued based upon the concept known as “last in first out” (LIFO).

—The concept or method of ascertaining inventory for valuing as aforesaid is an accepted accounting method and represents good business practice. The method as adopted by the appellant is one that best suits the business of the appellant and has been previously accepted by the respondent.

—The method as adopted by the appellant more accurately reflects at any given point in time, the profits or income of the appellant.

The respondent asserted in the Reply to Notice of Appeal:

—The appellant changed its procedures for determining the cost of its inventory of finished goods and work-in process of hides from the accounting method known as FIFO (First in, First out) to the accounting method known as LIFO. This change in accounting procedures was made the subject of a note to the financial statements of the appellant as of December 31, 1973, which note reads, in part, as follows, “cost of finished goods and work-in process is arrived at by the “last-in”, “first-out”, method of inventory pricing. Cost of the balance of the inventories is arrived at by the “first-in”, “first-out”, method of inventory pricing. If the “first-in”, “first-out” method had been in use inventories would have been approximately $137,000 higher.”

—The LIFO method of accounting is not an acceptable method for the purposes of calculating the lower of cost or fair market value of inventory under the Income Tax Act.

—In the alternative, use of the LIFO method of accounting does not result in the fairest matching of costs against revenues of the appellant’s business in respect of its 1972, 1973 and 1974 taxation years.

—In the alternative, the use of LIFO was not in accordance with recognized accounting principles which demand the use of the same method for determining opening and closing inventory values for the purpose of calculating profit pursuant to section 4 of the Income Tax Act.

In summary, counsel for the appellant put the problem in this way:

We are of course quite aware and conscious of the fact that on earlier occasions this point has arisen in which, under particular circumstances, the Courts have rejected tne concept that the appellant seeks to establish today, namely the LIFO method or a variation thereof. It will be our contention that the facts are different in this case than those in existence with respect to the other decisions. If we are correct therefore, the method with which the appellant is concerned, is a more accurate reflection of the profit than the methods suggested by the respondent on the assessment. (Italics mine.)

In replying to that suggestion, counsel for the Minister stated:

It is the position of the Minister that LIFO has judicially been prohibited in Canada for income tax purposes, in spite of the fact that LIFO may be, and is, a generally accepted accounting method of valuing inventory, although it might be quite proper for corporate purposes, it is not proper for tax purposes. And, it is a further decision of the Minister that whether or not there are exceptions to that principle, depending on the particular facts of the case, it is the position of the Minister that the evidence to be revealed will show that this particular appellant comes within the factual Situation that is prohibited judicially by case law in Canada.

This appellant is not one of those companies that is different from that which is prohibited. (Italics mine.)

Evidence

Evidence for the appellant was given by four witnesses:

Mr Jack Benedict, Secretary-Treasurer of the Company; Mr Kenneth Zealand, chartered accountant with the firm of Dunwoody & Company, auditors for the Company, and the two related Canadian companies Dominion Tanners Limited (hereinafter referred to as “Tanners”) and Dominion Tanners Sales Corporation (hereinafter referred to as “Tanners Sales”); Mr Peter Marriott, chartered accountant with the firm of Coopers and Lybrand; and Mr William Gray, chartered accountant with the firm of Price, Waterhouse & Company. There were no witnesses called by the respondent.

Essentially the evidence of Mr Benedict covered the history and development of the appellant company, its relationship to Tanners and Tanners Sales, its methods of purchasing, processing and selling hides, including his own particular responsibilities for inventory calculation and valuation. Certain important facts established were that Tanners Sales, the parent corporation of both the appellant company and Tanners, had under Tanners, operating plants in both Edmonton, Alberta and Winnipeg, Manitoba, while the appellant company processed its hides in Toronto; Tanners Sales was the world-wide sales agent for both companies (appellant company and Tanners) and a LIFO system of inventory is in use in that company for hide valuation and has been since its incorporation in 1933; that there was substantial price fluctuation in the day-to-day market for raw hides purchased by the Company, but the market was relatively stable over a longer period; the operations of the appellant company and Tanners were similar; that the hides, after limited basic processing, could be kept in storage almost indefinitely before further processing and manufacture; that there was practically no way of specifically identifying a hide or a certain purchase of hides once any processing had commenced; and that the reason the change from FIFO to LIFO was finally made for the Company was to provide a basis for comparability and standardization with the parent company Tanner Sales. A particular series of questions and answers from the hearing summarizes the position of Mr Benedict:

Q For internal purposes on a week-to-week or a month-to-month basis, there was some value in you relating your gross profit to a last in, first out system, as opposed to a first in, first out system?

A Yes.

Q But on an annual basis, there is no evidence and your testimony doesn’t indicate, that there would have been much change over the years. We have had a stable hide market, the Wickett & Craig records show that there wouldn’t have been much difference, so can I assume that LIFO and FIFO, on an annual basis, would have produced about the same results, for both corporate and income tax purposes?

A Averaging them over a period of years?

Q Take any year. Take two or three years?

A Well, take 20 years. that would be the case.

Q Assuming we just went into business and we don’t have any inventory and we are going into the tanning business. So, let me put it this way. We need stock so on the 31st of July we buy 100 hides and they cost us $5 apiece. That is $500 we have invested. Right? On the 31st of December we buy 100 hides. We have only made two purchases in our theoretical little business here, and they cost us $10 apiece, so we have to invest another $1,000. During the year in our business we have used 100 hides. Now, we have 100 hides left over obviously. What I want you to tell me is, valuing them on a FIFO basis what is the amount of inventory, and valuing them on a LIFO basis, what is the amount of inventory?

A FIFO would produce $1,000 in inventory; LIFO would produce $500.

Q How much would replacement be?

A $1,000.

Q And how much would market be?

A $1,000.

Q So, the only variation would be on FIFO?

A Yes.

Mr Zealand provided the Board with the rationale of his firm for the inventory valuations which are in question here. A quotation from his evidence puts his view into context:

Q What you are saying is that the corporation not only did but had the option—and should have had the option, put it that way—of filing tax returns based on the FIFO basis for several years up until 1972, then of filing statements and tax returns based on a year-end result of the LIFO basis for 1972 itself, and then by 1974 use as the closing inventory figure really quite a different calculation, the lower of cost or market?

A I don’t think it is the lower that would have been used in any other situation. The FiFO method in itself still adheres to the principle of lower of cost or market. Either principle LIFO or FIFO adheres to that principle. However, we haven’t been on FIFO or LIFO as long as the market was below either of those two, it was at market.

Q OK. That is the point. One other point of clarification. I believe the previous witness said that the monthly accounting records, the on-going records of Wickett & Craig were maintained on a LIFO inventory method, but the annual financial statements and, I presume, Income Tax Returns up until 1972, were filed on a FIFO method. Is that your recollection of it? A As far as I know.

l\/lr Marriott had been called in by the Company to review the inventory situation in preparation for this hearing. Again certain quotations summarize his findings:

Q Now, Mr Marriott, the issue here is that Wickett & Craig adopted the LIFO method of costing its inventory. Is that correct?

A Yes. That is correct.

Q To show its costs. And Mr Marriott, for the record again, and in your words, what is LIFO?

A I think that first of all I should explain that in valuing inventory the accepted accounting principle is to value the inventory at the lower of cost or market value. And, I believe, that same requirement is in the Income Tax Act. In other words, there is no difference between the accounting principle and the Income Tax requirement to value inventory at the lower of cost or market.

Now, what we have to do as accountants is to interpret the word ‘cost’ and there are basically three methods used to determine cost: one is FIFO, first in first out; another is average cost; and another is LIFO or last in, first out principle. All are equally recognized as proper methods to use in costing inventory values.

To try and explain what LIFO is, I think perhaps the appropriate definition is one that states that LIFO is a method of valuing inventories which assumes that goods sold are out of the most recent purchases, and as a result the amounts charged to the cost of sales reflect current replacement costs, and the amounts carried forward in inventory values represent costs at an earlier time.

The underlying theory behind that is to properly achieve a matching of costs against revenues in a situation where you’ve got a profit and where the price fluctuates fairly widely.

Q I gather from what you say that LIFO is a method that could be appropriate to all businesses.

A It could be used for all businesses but it is more appropriate to use it in certain types of businesses, particularly those, as I Say, where they have a product where the price fluctuates, just as it did in this business, the tannery business.

Q I was going to ask you then under what circumstances would you use LIFO, and is that your answer—there are more factors and circumstances involved which would point to the use of LIFO?

A I think the decision to use LIFO in any particular circumstances would be based upon—comparing it with the other two methods, that is, average cost or FIFO, and which of the methods is appropriate in the circumstances to give you the best and fairest results of income for a period, either a monthly period or a financial, year-end period.

You have to look at those particular circumstances, but it could be appropriate for almost any business or any industry, but it is particularly appropriate in businesses where the market price of the commodity fluctuates fairly widely. This happens in the tannery business, it happens in a number of other primary processes and products. The food business. would be another type of business where it can be used.

Q It has been suggested that by either method, the LIFO or the FIFO method, for a given period of time, at the beginning and the ending that they come out in the long run and arrive at the same profit. That was sort of inferred I believe—my friend was probably going to ask you that question anyway—but ! thought I would raise it, or that suggestion. If you had a commencement point at a certain price, or cost, and you go through a period of time and you end up with the same point of cost, both methods would give you the same profit flow for the particular period?

A It would give you the same cumulative profits over the period.

Q Cumulative?

A Cumulative profits would amount to the same because you arrive at the Same ending cost that you started with. It would, however, give you different results on a period-to-period basis.

Q And is that significant, the different results on a period basis?

A Very significant from an accounting point of view to determine the appropriate results for a period, so you want to use the method that is going to give you the fairest results in terms of income measurement, and I would assume that is the case for tax purposes as well as for accounting purposes.

Q Are there any particular advantages that you see to LIFO over FIFO? You mentioned that it was the fairest under some circumstances and could you explain that?

A Yes I can. Under FIFO you have to be very careful when you use that method, especially if you’ve got a period of rapidly rising price levels as we have experienced in the last. three or four years. Particularly FIFO because it tends to value inventories at the most recent cost, and therefore measure against sales the earlier costs—you can tend to overstate your income because, as I say, you are matching sales today against costs incurred in a prior time period.

Q You mentioned a period of rising prices such as today. But that in itself would not be extraordinary in itself and there would be nothing, as I see it, wrong with that.

A I was explaining that context—the FIFO method will tend to overstate the profits, and therefore, when you are comparing the method more suitable, FIFO has the inherent danger that it could overstate profits in a particular time period.

Q Well, you are saying that LIFO would tend to lower them. Is that what you are saying?

A That’s right. And the profits would not be as high and would be more correctly recorded under the LIFO method in those situations.

Q You mentioned earlier about wide price fluctuations. How. does this affect it?

A How does that affect the . . .

Q The situation as between LIFO and FIFO?

A It affects it fairly significantly because the LIFO method as such takes into or matches recent purchases against recent sales, and therefore tends to level out the price fluctuations in transactions as and when they are recorded, whereas the FIFO method ignores those fluctuations and tends to build them up in the inventory cost.

Mr Gray brought forward the following in his evidence, responding to questioning by counsel for the appellant:

Q In those circumstances as you describe them, that is LIFO to which you are referring?

A Yes.

Q And it is an acceptable method of accounting?

A Yes.

Q And FIFO is the other method to which you alluded, it was also an acceptable standard of accounting?

A Yes.

Q Does one method over the other, and I am now talking about FIFO and LIFO, does one method over the other have any more advantage in respect of the matter of costs for instance?

A Each is appropriate in a particular situation. In other words, LIFO has a relatively narrow application in the criteria I am suggesting, and it is a matter of judgment in the circumstances of a particular company, based particularly on the industry as to which is the more appropriate way to do it.

Q And does either method have attached to it the ascertainment, one over the other, in respect to say the physical flow of goods?

A No. The physical flow of goods I would say was not relative in either case. You are looking really at the conceptual apportionment of these costs, the early costs and the late costs. I don’t, think that the flow of goods has any relevance or, if it has, it certainly has been superceded in the LIFO technique. In other words, it disregards the flow of goods because it isn’t relevant for cost measurement.

Q As a practising chartered accountant' with Price Waterhouse, you are aware, I presume, that that question or method had been previously tested in Court in the Anaconda case. You are aware of that?

A Yes. .

Q Do you consider, in spite of that decision, do you consider LIFO a proper accounting method for profits in the manner we have described?

A Well, I am conscious that the Anaconda case didn’t necessarily test the method, because my understanding is that the method got considerable approval from certain members of the Court. But the final decision was based on the facts of that particular case.

Mr Pearson: Mr Chairman, I would like to object at this point. The witness is giving his opinion on, or really arguing the Anaconda case . . .”

And under questioning by the Presiding Chairman:

Q The Minister has proposed basically three reasons for his dissatisfaction with the company’s original tax reporting. Without reading the long paragraphs, as Mr Irving has already read this to previous witnesses, it comes down to . because the LIFO, last-in, first-out method of accounting is not an acceptable method for the purposes of calculating the lower of costs or fair market value.” Now, what is your response to that statement? A So far as generally accepted accounting principles are concerned, it is an accepted method of arriving at costs, and when you come to lower of cost or market, it seems to me you are discussing the lower of costs under either of those interpretations, either FIFO or LIFO.

Q In other words Mr Gray, may I Summarize your point by saying that your evidence is that LIFO method, FIFO or average cost are all methods of arriving at cost?

A Right.

Q But they do not have. by your definition at least, a relationship at that point in time with the market value?

A That’s right.

Q Secondly, the Minister proceeds . . . “In the alternative . . . (obviously that means that if the Board should not find too much merit in his first point), he suggests this: ‘The LIFO method of accounting does not result in the fairest matching of costs against revenues in the appellant’s business in those years.” Now, what is your response to that kind of comment?

A The process of LIFO, I believe, does make a proper matching under the conditions and criteria stated. I have not gone into a detailed examination of the facts of the case against the criteria that I indicated but if it meets the criteria, then I consider the method a perfectly fair and a proper matching, a better matching than FIFO.

Q Let me ask you the question then this way, M Gray. Are you aware of, in your own professional practice, situations in which LIFO does present a fair matching of costs against revenue?

A No. In my local practice and in my local experience I have not had a client using LIFO. And, as I admitted earlier, it is an unusual situation, peculiar to a few industries.

Q But what would you consider to be a fair matching of costs against revenues? What does that really mean?

A It really means that you are trying to match the word “expenditures” which includes what has been sold and what is still there, and trying to apportion that in such a way that it gives the fairest division, and the fairest division should be such as to eliminate vagaries of pricing, which tend in the industry, to wash themselves out, because at the point of sale you are trying to match your costs of your current purchases. The whole theory of this new method was to meet conditions where the sales price did move around concurrently with the new purchase price.

Q Continuing from there, the Minister presents a second alternative . . ., which means that, if the Board does agree that (1) LIFO is not an acceptable method, or does not agree with him that (2) L/FO does not represent a fair matching of costs, he says . . . that the use of the LIFO method—I am paraphrasing slightly ‘. was not in accordance with recognized accounting principles, which demand the use of the same method for determining opening and closing inventory values for the purposes of calculating profit, pursuant to section 4 of the Income Tax Act.” Now, what is your response to that?

A I would say that in a given period that was a fair statement.

Q In a year?

A In a year, a taxation year.

Q What do you think is meant by . demand the use of the same method?” Now the valuation of inventory, according to the Income Tax Act and generally recognized in the accounting profession, is lower of costs or fair market value. Do you accept that—the lower of one or the other?

A Yes, that is the method.

Q I think on that we generally all agree. Now, if ! follow what you are telling me, you are saying, separating those two (cost and fair market value), that one can arrive at cost by FIFO, LIFO or average cost?

A Right.

Q Those are three methods to arrive at cost—Correct? Now, if you say . . . st . . demand the use of the same method for determining opening and closing inventories . . .” in your view does that mean that you must always use cost at both the opening and the closing; that you must always use “market” at both the opening and closing, or have you a choice of using either cost or market, at either end?

A No. I think it means that you are confined to the full method each time, the lower of cost or market.

Q I don’t want to take your words incorrectly, you are saying that you would have the option of using what was a determined and agreed on cost figure at the start of the year (we are not talking about this case at the moment), and for good and sufficient reasons using a fair market value figure at the end of the year, which might be lower in terms of unit value than that at the start of the year. You could take your choice, but still within the framework of the Act?

A No. I think what I am saying is that at the beginning of the year you establish your cost and the market at that point in time and you choose the lower. At the end of the year you again establish cost or market at that point in time and have to choose the lower.

Q Being a professional in the business you have said it much better than I can, out I expected that. But one does have the option as long as it is the lower?

A The option?

Q The option of either cost or market, and you take the lower?

A Yes, there is no option.

Q There is no option in fact, but you must determine both and then take the lower?

A Yes.

Q Now, leaving aside fair market value, which one should be able to determine with reasonable ease since there are three methods of determining cost, FIFO, Average Cost and LIFO, would you agree that one would have also the option, and I am using the word “option” rather loosely, also the option of choosing among those three methods at any one point in time. Giving you an example which comes down very much to this case— accepting that one can choose cost or fair. market value, whichever is lower, do you also have the option of alternating back and forth among FIFO, LIFO and Average Cost as a process of determining cost?

A No. I would say that one would have to make a case for one of the three as being appropriate in his circumstances and stay with it. And, if circumstances were such that it became inappropriate and you wanted to make a case for a different one, it would have to be a properly negotiated turnover.

Q In other words, using a very outside example, one could not, over a two or three-year span, use a FIFO cost basis at January 1 of a period, a LIFO basis at the end of the period, which obviously would carry forward as the same for the start of the next period, and then at the end of the next period, for example, use an Average Cost basis? One could not alternate back and forth among the three choices?

A No. I would say that wouldn’t be reasonable and probably should have the same kind of problem to go through as if a company were changing the year ehd. You would have to indicate and defend your reasons and make a reasonable deal with the Minister and indicate why it was a proper change. It certainly couldn’t be done loosely or frivolously, or with intent to minimize the taxes in a given year.

Documentation submitted by the appellant and used during the presentation of evidence by the witnesses was:

Exhibit A-1 : Graph showing average cost of hides;

Exhibit A-2: Monthly and Weekly Chart of Hide prices for 1950-1957;

Exhibit A-3: Financial Statement—1972;

Exhibit A-4: Financial Statement—1973;

Exhibit A-5: Financial Statement—1974;

Exhibit A-6: Schedule of Adjustments—1972;

Exhibit A-7: Schedule of Adjustments—1973;

Exhibit A-8: Graph of Average Selling Prices from 1972 to date;

Exhibit A-9: Graph Average Canadian Hide Prices—January 1972 to Date;

Exhibit A-10: Inventory Units—1972-1977;

Exhibit A-11: Schedule of Profits on a LIFO and FIFO basis, Wickett & Craig;

Exhibit A-12: Summary of Income before Taxes for Wickett & Craig Ltd;

Exhibit A-13: Comparison of LIFO and FIFO methods of Inventory Pricing.

Argument

Counsel for the appellant made reference to the case of MNR v Anaconda American Brass Ltd, [1955] CTC 311; 55 DTC 1220, and argued as follows:

The points which I wish to make, therefore, are as follows: One—this is an important decision and I, the taxpayer and the professional advisers who have given testimony in this matter, are very conscious and aware of that fact. They are also aware of earlier suggestions and proceedings which indicate that LIFO may not be acceptable.

I wish to say at the outset that, for myself, and I believe for the professional advisers who have given testimony, they are not suggesting that, in the event you are to satisfy yourself on the facts of this matter, the method adopted by this taxpayer is correct and more accurately reflects profits than the methods suggested by the respondent (in all cases).

We are aware that it is confined to limited circumstances that exist in a very unique situation and it is not for general application.

Secondly, it is true that the appellant had been on the FIFO method and changed that method in 1972 which created the problem, if that is the word to use. It is also apparent from the testimony of Mr Benedict that, in actual fact, had the conversion taken place at an earlier point in time, there would not have been any kind of severe dislocation, and the adjustment involved would have been quite minor.

There was no gain or loss from the tax point of view by the taxpayer. The reason, Mr Chairman, was quite simply because of the relationship of this corporation to the parent and the fact that its parent had been using the LIFO method with good results and without any degree of impropriety for the years since 1933.

Thirdly, we are concerned with the question of profit and its meaning. Now, “profit” is not defined under the provisions of the Income Tax Act. And we are left to the devices, opinions and views of good accounting as expressed by professionals as to what profit is and the best measure, manner and means of producing and showing profit for any particular period.

It has been suggested and probably will be relied on by my friend that the Anaconda case (supra) has somehow made the distinction in this regard. I wish to point out. Mr Chairman, that the Anaconda case did not disapprove of the LIFO method as such, but considered it good accounting and a recognized procedure as it did for FIFO.

But the Anaconda case, it must be appreciated, was decided on the basis of the existing facts for that case. And I believe therefore that the comments on the law, as expressed in that case, should be recognized as certainly—in terms of legal parlance as we refer to it—that any case is only as good as the facts upon which it is decided.

I think it is a mistake to suggest that the Anaconda case decided for all times and forever that the LIFO method was not, and never to be used for income tax purposes. Indeed, the comments of the Law. Lords in the above case, as reported at (1955) CTC 311 and 55 DTC 1220, as stated by Viscount Simonds at pages 318 and 1223 particularly, made the point clearly as to the nature of the issue being decided, in referring to the arguments that were presented by the respondent and the appellant (see Note [1] *), and read as follows:

“He is not concerned to contend that the company (or some other taxpayer) may not be able to establish that some other method than FIFO more accurately represents the income for tax purposes where the raw material used is homogeneous and no substantial part of it can be identified. Nor is it necessary for their Lordships to determine whether some other method, as for instance the ‘average cost’ method, may not in some circumstances be properly adopted for tax purposes. What the Minister urges is that the LIFO method does not more nearly than FIFO produce the true income in the present case and that is the question for their Lordships’ decision.”

That is a clear statement that I think can be made as to what was then being decided. The Court was simply deciding, in these circumstances, was FIFO or LIFO the better method. And it is quite clear, when we read the facts of the case at hand, that the company (the taxpayer) was using for the inventory base prices that represented costs in about 1936 for the 1947 taxation year, when in fact the prices during that interlude from 1936 to 1937 had risen considerably and had stayed up.

On those facts the Court of course became quite aware and quite concerned that there had developed a reserve, as they call it, but it is not agreed to as being a reserve but rather a form of undervaluation, as referred to by Mr Gray, and I believe by Mr Marriott, and that, from this point of view, on those facts LIFO was not doing the job and FIFO was the more accurate method to use. (Italics mine)

That, I suggest, is all that was being decided in that case, Mr Chairman.

In this situation in the present case we are not faced with a gradual rising of prices which stayed there. If anything the LIFO method is an applicable method—and it has been stated before but this is the first time to my knowledge, the first case which has come before you, which graphically shows the fluctuations involved. And in that sense, the LIFO method more accurately reflects profits than FIFO and we are not faced with the gradual increasing or rising prices that occurred in the Anaconda case (supra) and in the Handy & Harman of Canada Ltd v MNR case, [1973] CTC 507; 73 DTC 5401.

And you see, it is because of the wide price fluctuations, and this is my next point Mr Chairman, that really it arises with the development of the LIFO theory, because as I understand the witnesses, they are being more realistic. . . .

We had this substantial profit created by the FIFO method, and it disappears by the whims of the market in the next accounting periods. And it is for that reason that LIFO takes a firmer hand, shall we say, and attempts to smooth out these ruffles in the fluctuations of the market, and gives a much more steady and reassuring concept and idea of what the profit is for that distance.

Nowhere is it said or suggested—I qualify that—mowhere is it stated in the Tax Act that there is a prohibition against any particular method of calculating inventory costs and, in general, there is no particular prohibition against the LIFO method. They are not mentioned there.

The only suggestion that has ever arisen through all these years is that the Anaconda case, representing what we call “Judge-made Law”, has decided that. Therefore, to go back to one of my earlier points, I urge upon you that in my submission that is not the .case—they did not decide forever and for all times that the LIFO method is precluded, but merely said that it was precluded in that case and on those facts. I believe that is clearly stated at pages 318 and 1223 of the Judgment. The Court has set out the conditions on which it says it was about to make its decision, and then proceeds to review the facts and came to the conclusion that LIFO is wrong in that situation. That was the rationale of that decision.

Counsel for the respondent, in addition to the above-noted cases referred the Board to Handy. & Harman (supra), Willingdale (Inspector of Taxes) v International Commercial Bank Ltd, [1977] 2 All ER 618, MNR v Joseph Irwin, [1964] CTC 362; 64 DTC 5227; Pearce (Inspector of Taxes) v Woodall-Duckham Ltd, [1977] 1 All ER 753 and Wallaceburg-Singer Limited v MNR, [1972] CTC 2109; 72 DTC 1087. His significant comments were:

It is my submission then that we are attempting to determine here what is the income of the appellant, Wickett & Craig, (as income is defined in section 9 of the Act), that is, what is its profit for the year.

There is no exact definition in the Income Tax Act of what a taxpayer’s profit from the year is. The specific problem we have is of course on the valuation of inventory of Wickett & Craig, and as to the acceptability of several methods of valuing the inventory. Again, the Income Tax Act has a provision which relates to. the valuation of inventory property and that is section 10(1) which reads:

“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.”

At issue here today is the applicability of the LIFO method of valuing inventory cost, as opposed to the FIFO method of valuing inventory cost. The applicability of LIFO therefore, for income tax purposes, in computing the profit of Wickett & Craig falls within the provisions of section 9(1) of the Act. So, the question to be decided is whether the profit ‘and where the Income Tax Act does not speak of the exact definition of profit, it is computed specifically with reference to the inventory valuation element of the property in the profit) is calculated according to the normal rule of generally-accepted accounting principles to come up with the calculation of that profit.

That, of course, is what was an issue in the case of the Minister v Anaconda American Brass Ltd, which appears as No 1 in my case book. In that case there is a discussion of what the definition of “profit’’ is for the purposes of income tax reporting.

I submit that in that case. the passage that my friend read to you, what the Minister urges is that the LIFO method does not, more nearly than FIFO, produce the true income in the present case, and that the question for their Lordships’ decision is based on- à determination of what is the proper meaning of the word “profit’’ under the Income Tax Act. At page 1224 of the DIC report, Viscount Simonds, in attempting to arrive at a definition of the word “profit’’ for income tax purposes, quotes the case of Whimster and Co v CIR, 12 Tax Cases 813, and quoting the relevant portions of that decision, I would say : . .

“In the first place, the profits of any particular year or accounting period must be taken to consist of the difference between the receipts from the trade or business during such year ar accounting period and the expenditure laid out to earn those receipts. In the second place the account of profit and loss to be made up for the ascertaining that difference must be framed consistently with ordinary principles of commercial accounting so far as applicable and in conformity with the rules of the Income Tax Act . .

It-is my submission, Mr Chairman, that what Viscount Simonds found was that the LIFO method of valuing inventory in the Anaconda case, although it was acceptable for accounting purposes and was in fact the most applicable system of valuing the inventory for accounting purposes of the Anaconda company, it was not acceptable for income tax purposes. And it was therefore rejected.

In my submission the overriding principle of tax law that we have here (referring to the case of Willingdale v International Commercial Bank Ltd, (1977) 2 All ER 618) is that found by Viscount Simonds again in the Anaconda case that LIFO, for this particular kind of company at least, at most LIFO generally, is not applicable for the computing of profits in reporting profits for tax purposes, although it might be for accounting purposes.

In coming to this conclusion Sir John Pennycuick quotes from Lord Denning in Heather (Inspector of Taxes) v P E Consulting Group Ltd, another tax case referred to therein, where in the last part of the quote he says at page 631:

“The courts have always been assisted greatly by the evidence of accountants. Their practice should be given due weight; but the courts have never regarded themselves as being bound by it. It would be wrong to do so. The question of what is capital and what is revenue is a question of law for the courts.’’

I submit that what is profit based on the valuation of the inventory therefore is a question of law for you to find, Mr Chairman. I continue with the above quotation:

“They are not to be deflected from their true course by the evidence of accountants, however eminent.’’

So, in conclusion, I would just like to say again that although we have a great deal of accounting evidence which supports the use of LIFO as a method for valuing the cost of inventory, we have an overriding tax principle of Viscount Simonds in the Anaconda case which does not accept LIFO, and in my submission that is the principle which must apply for tax purposes.

Finally, from counsel for the appellant:

Of course the initial point of disagreement between myself and my friend is the question as to whether or not there is an overriding principle of income tax law which governs this matter, regardless of what professional evidence has been adduced.

I wouid agree with him that no amount of evidence, professional or otherwise, with regard to opinions as to what should be done in given circumstances where theory is relevant, that the Statute governs and if the Statute says no, then that is the end of the matter.

And I would agree with him as well that if there is some overriding principle which has the same effect in law, namely, it says no, then that is also the end of it. The disagreement between us is that, in my submission, Anaconda did not decide forever and for all time that LIFO is out. It only decided it for that case, and I would just refer again to [1965] CTC page 321 of the decision which I have alluded to, and this is what Viscount Simonds said:

“It is in their Lordships’ opinion the failure to observe, or, perhaps it should be said, the deliberate disregard of, facts which can be ascertained and must have their proper weight ascribed to them which vitiates the application of the LIFO method to the present case.’’

He is confining. himself to the present case and the facts of the case and LIFO to the facts of that case. He is not saying anything more than that. And, he goes on to describe why it wasn’t applicable. The reason why it wasn’t, and the objectionable feature, is that the costs used in the inventory went back many, many years to the 1936 period. And this he found, or the Court found, was objectionable. The same is true of the Handy case.

I say to you, Mr Chairman, that that is not the case here. The costs used in the inventory are current and have to be current because of the fluctuations in prices. There were no price fluctuations in the Anaconda case with which they were contending.

Findings

In writing this decision the Board has quoted rather extensively from the evidence and argument of counsel in order that the fullest possible value be accorded not only the professional advice given, but also the views and contentions of counsel. The system of inventory valuation in this matter, while differing in some respects from that described respectively in Anaconda and Handy & Harmon (supra) is essentially the same. While it may be labelled differently (base stock, for example), it is a LIFO system in that certain significant values attached to costs are those having a direct relationship to the most recent purchases. From this perspective therefore, there is no material distinction to be made between the facts and issue in this case and the facts and issue dealt with in Anaconda.

The fundamental argument from counsel for the appellant is that the features of the inventory valuation which the Privy Council found “objectionable” in Anaconda do not exist in this case. Therefore, according to counsel, since the procedure followed here meets generally accepted accounting principles and produces a profit figure identifiable with the operations conducted, such LIFO inventory valuation should be accepted as consistent with a proper interpretation of the Income Tax Act.

Counsel for the respondent holds that notwithstanding accounting acceptance, the LIFO system is barred from use by virtue of the Anaconda decision. I should like to recognize with appreciation the effort and dedication both of counsel and the witnesses. It was noted by counsel that except for Handy & Harmon (supra), the issue here put into question has remained virtually unchallenged since the Anaconda decision (supra). All parties giving evidence and professional opinions were lucid and precise, with an unusual level of understanding and -perception of the particular subject at hand. Representing as they did a considerable body of contemporary accounting thought, and cost apportionment methods and procedures, their views are highly respected. Although counsel for the respondent did not present opposite accounting opinion in the case, it is noted that he did have such professional competence available at the hearing. The preparation and presentation of the two competing viewpoints, in my opinion, was carefully done and complete.

The major point proposed by counsel for the appellant was that the 1955 Privy Council Anaconda decision did not rule out with finality the use of LIFO, but rather the application of LIFO under the circumstances evident in that case negated its use therein. To put this contention into proper context it would be worthwhile to review briefly the history of that Anaconda decision. The case arose from Anaconda using the LIFO method in the valuation of its 1947 year-end inventory for determining profit for income tax purposes. The then Exchequer Court of Canada (Thorson P) on hearing the appeal gave judgment [1952] CTC 116; 52 DTC 1111 in favour of the company, dismissing the objections to LIFO raised by the Minister and used the following expressions, as reported at 117 [1122]:

The objection is due to a misconception of the true nature of the closing inventory.

and

. . . it is sufficient to say that within the modern concept of it the closing inventory is not to be regarded as an asset to be liquidated but rather as a residue of unabsorbed costs incurred in the past but applicable to the future to be charged against the gross income of a future period.

To put it in other phraseology . . . The method that ought to be selected is the one that is in accord with the company’s genius of profit-making and most nearly accurately reflects its income position according to the manner in which it carries on its business.

In effect, the Court decided that the issue in dispute was the determination of profit, and that was accomplished not only best, but in the only appropriate way in that case at bar, by the LIFO method.

The appeal to the Supreme Court of Canada from the Exchequer Court decision was heard in 1954 and while the majority of the Court in the decision [1954] CTC 335; 54 DTC 1179, upheld the earlier judgment, there were significant points raised in the views expressed by the two dissenting opinions. Both the views of Chief Justice Kerwin and Judge Estey individually reflected the opinion that while both LIFO and FIFO made certain assumptions in relation to flow of goods, the real question was that an assumption of any kind in determining inventory value could only be made to the extent that the facts were not ascertainable. LIFO, in the view of both, disregarded the fact that purchases made during the last three months of fiscal 1947 could not possibly have been used up in manufacturing before the end of the year, and therefore must have formed part of the inventory and in their view, the inventory calculated on a LIFO basis made an assumption that certain inventory had been on the premises since 1936, a situation no one in the appellant company would allege to be a fact.

It is this disregard of facts, and their substitution by assumptions which the minority opinion of the Supreme Court found objectionable— not particular circumstances applicable to that case.

On further appeal in 1955 the Judicial Committee of the Privy Council, in Viscount Simonds’ decision [1955] CTC 311; 55 DTC 1220, upheld this minority view of the Supreme Court. Speaking of the Minister’s contention on pages 318 and 1223 respectively of that judgment, he said:

Upon this basis he says that the FIFO method more nearly than the LIFO method represents the facts and supports that contention by reference not only to the large purchases of metal during the last months of 1947 which can hardly have been processed during that year but also to the fact that the LIFO method involves the assumption of 6,500,000 pounds of copper purchased in or before 1936 being still in stock at the end of 1947. (Italics mine)

In this appeal the appellant must show the Board that these two objections are not relevant and indeed that there are no facts disregarded or no unwarranted assumptions made. The Privy Council decision in Anaconda, in emphasizing these objectionable features, rejected for income tax purposes the proposition evident in that appeal that the closing inventory was to be regarded as an extension of or factor in the internal costing system. At [1955] CTC 318 and 55 DTC 1225 the judgment reads:

There is no room for theories as to flow of costs: nor is it legitimate to regard the closing inventory as an unabsorbed residue of cost rather than as a concrete stock of metals awaiting the day of process.

Simply stated, the facts which may be determined and applied to the specific act of valuing closing inventory for income tax purposes may not be disregarded in favour of some rationale or assumptions which may quite properly fit internal processes for establishing costs or selling prices. It is evident to the Board that the perspective of the witnesses in this case is that found unsupportable to their Lordships in Anaconda (supra). While it may be stated by the witness Mr Gray that “the physical flow of goods was not relevant in either case” (FIFO or LIFO), their Lordships have basically held that such physical flow cannot be ignored or even supplanted by assumptions which contradict facts about such physical flow of goods which can be ascertained. That there is an assumption regarding the flow of goods (whether such flow is regarded as relevant or not from an accounting perspective) is shown in the evidence of Mr Marriott:

To try and explain what LIFO is, I think perhaps the appropriate definition is one that states that LIFO is a method of valuing inventories which assumes that goods sold are out of the most recent purchases, and as a result the amounts charged to the cost of sales reflect current replacement costs, and the amounts carried forward in inventory values represent costs at an earlier time.

It has been argued, and probably with considerable rectitude, that the FIFO system also makes an assumption, similar but opposite to that made in LIFO—that in FIFO it is the first purchases which are first processed. However, it is the bases for that assumption, seen in the argument proposed by the Minister in Anaconda, which their Lordships viewed as supportable on the facts—that inventory purchased in the early months as contrasted with the later months of 1947 could and probably would have been processed during that year, and that inventory purchased in 1936 would not have been present in the stock-taking of 1947.

While the difficulty encountered by the factual distortion of inventory valuation by the LIFO method may be compensated for company purposes by internal costing and pricing benefits, it cannot be overcome for income tax purposes by adopting a position that the physical flow of goods is not relevant. The following comment of Mr Marriott, in evidence, deserves review:

I think that first of all I should explain that in valuing inventory the accepted accounting principle is to value the inventory at the lower of cost or market value. And, I believe, that same requirement is in the Income Tax Act. In other words, there is no difference between the accounting principle and the Income Tax requirement to value inventory at the lower of cost or market.

This position is only correct to the degree that the reflection of generally accepted accounting principles in the process by which cost is to be determined (FIFO, LIFO, or Average Cost), is not in itself discreetly selective of facts or assumptions, with the result that the inventory is altered from a recognizable asset to a residue of unabsorbed costs.

Counsel for the appellant further proposed that the weakness in the appeal of Anaconda was that “the prices during that interlude from 1936 to 1947 had risen considerably and stayed up, . . . and that there had developed a reserve’’, whereas in the present matter, “the hide market, contrary to what may or may not have existed in any other situation (eg Anaconda), is one that has basically remained at a level and that it did not create through the LIFO system any kind of permanent, hidden or constant reserve’’. While counsel’s point that over many years the hide market “remained at a level’’ may have some validity in relation to the graphs and charts presented, nevertheless it is equally true, as evidenced by the witnesses, that major fluctuations, yearly, monthly, weekly or even daily, did occur in the shorter term in these prices paid by the Company for hides. Indeed, the description provided to the Board is one of a rather volatile market “because you are in a fluctuating area, prices are going up and down continually’’—“they jump around considerably’’. Whether either the volatility in the shorter term or the stability in the longer term should serve as a rationale for internal use of LIFO inventory valuation does not seem material to me for purposes of this appeal. Neither touches the points of concern, dealing with the facts, raised by their Lordships in Anaconda (supra) and it does not seem to me that the supposed creation of a reserve troubled their Lordships in the Privy Council decision of Anaconda and accordingly, it should not be of great concern here. At pages 1225 and 320 respectively of that decision, it is stated:

It may well be prudent for them to carry in their books stock valued at a figure which represents neither market value nor its actual cost but the lower cost at which similar stock was bought long ago. A hidden reserve is thus created which may be of use in future years. But the Income Tax Act is not in the year 1947 concerned with the years 1948 or 1949: by that time the company may have gone out of existence and its assets been distributed.

Neither the existence of a reserve (as alleged for LIFO in Anaconda) or the effect of a disbenefit due to overstatement of profits (as alleged by the appellant in this case for FIFO) in my view entered directly into the judgment of their Lordships in Anaconda. They were primarily concerned that the inventory of goods be regarded as an asset, containing in its valuation and calculation the maximum of ascertainable facts and the minimum of assumptions. That procedure would then produce a profit for income tax purposes, for the one year under review, without regard to the benefits or disbenefits flowing therefrom for company purposes.

In the case at hand, the purchases made in the last two or three months before the end of each fiscal year could not all have been processed during that year—a situation identical to that of Anaconda; and a December 31, 1971 unit value has been ascribed to the inventory of hides as at December 31, 1972 and December 31, 1973, and calculated for comparison as at December 31, 1974, while there is no evidence at all nor even a suggestion by the witnesses that any of the inventory on hand as at December 31, 1971 was held in stock on the three succeeding year-end dates. That the closing inventory of December 31, 1974 for financial statement purposes did not reflect the LIFO method was attributable only to the calculations which showed market to be the lower “of cost or market” in valuing the inventory. But the basis upon which cost as the alternative had been determined was LIFO, and it included inventory unit prices from December 31, 1971. If there is any foundation for a claim to be made that there is a distinction between Anaconda and the present case, it would probably be that Anaconda showed the longer time span—some eleven years as opposed to three—but in my view that only served in Anaconda to magnify and highlight the distortion which their Lordships perceived, but which nevertheless remains to be observed in this case.

The above opinions, at least in my judgment, dispose of the specific question raised in this appeal—whether there were distinctions of Substance between it and Anaconda. However, it seems to me that they may go a step further. Reference is made to the main contention of the Minister and the two alternatives quoted earlier in this decision from the Reply to Notice of Appeal. In my view, both of the alternatives are of questionable merit as support for the Minister’s assessment. Their inclusion in the Reply as alternatives left a cloud over the prime contention of the Minister—“the LIFO method of accounting is not an acceptable method for the purposes of calculating the lower of cost or fair market value of inventory under the Income Tax Act". I stress the point that this does not refer to “calculating its taxable income” (first alternative) or “calculating profit” (second alternative). Its reference point is simply and solely the valuation of inventory, not as “an unabsorbed residue of cost”, but rather as ‘‘a concrete stock”. The LIFO method, as portrayed to their Lordships in Anaconda, was based on the principle that closing inventory was an unabsorbed residue of costs, and it was the reflection of that element, in the facts disregarded and the assumptions made which rendered it objectionable and unacceptable to them.

It is evident that the same principle was at work in the determination of inventory values in this case, and the arguments from both cases would lead to the conclusion that it is fundamental to LIFO as a system, and not just relevant to these two matters. The reasons that under certain circumstances inventory valuation methods other than FIFO might produce supportable and indeed very appropriate profit figures have been referenced in all three learned judgments dealing with the Anaconda case, and counsel for the respondent in this matter acknowledged that their Lordships apparently left some flexibility for other valuation methods. I would suggest seriously, however, that one of the closing paragraphs of that judgment, on pages 322 and 1225 respectively, should be viewed not only as supportive but virtually conclusive of the Minister’s prime contention, and that it leaves little room for optimism that LIFO as an inventory valuation method could receive the approbation of the authorities under the existing provisions of the Income Tax Act:

So also in the United Kingdom, an attempt has been vainly made to uphold the base stock method for income tax purposes. In the recent case of Patrick v Broadstone Mills Ltd, (1954) 1 WLR 158, Lord Justice Singleton in words that are equally apt, if applied to the LIFO method, declined to accept the base stock method as conformable to income tax law, though it might be approved by accountancy practice.

Decision

The appeal is dismissed.

Appeal dismissed.