1 May 2000 Internal T.I. 1999-0010677 - Inventory Valuation

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues: Inventory Valuation Following Amalgamation

Position: New Corporation May Adopt Any Inventory Valuation Method Permitted by Subsection 10(1)

Reasons: No Statutory or Legal Basis to Deny Taxpayers Right to Choose

		May 1, 2000

Mr. Barry Hassar	Reorganizations and International
	Appeals Branch	 Section
	Income Tax Appeals Division	D. Boychuk
(613) 957-2123
	Attention:  Mike Brescacin

Inventory Valuation - Amalgamated Corporations

Further to your memorandum of September 30, 1999, we have reviewed our position on the valuation of inventory as set out in our memorandum dated February 27, 1991. As a result of this review, we have revised our position in the manner described below.

Revised Position

There is no legal requirement for an amalgamated corporation to value its closing inventory on the same basis as the closing inventory of its predecessor corporations. Accordingly, an amalgamated corporation is free to choose any inventory valuation method permitted under subsection 10(1). However, the amalgamated corporation must use a method for determining the cost or fair market value of its inventory (i.e. FIFO, average cost, etc.) which yields a true picture of its profit.

Background

In our memorandum dated February 27, 1991 (hereafter, the "Memo"), the Financial Industries Division ("FID") advised the Appeals Branch of our views on the appropriate method of valuing inventory in the first taxation year of a corporation formed on an amalgamation pursuant to section 87 of the Income Tax Act (Canada) (the "Act").

The question which had been asked was whether an amalgamated corporation is bound to use the same inventory valuation method as its predecessors or whether it is free adopt any of the valuation methods permitted under section 10 of the Act.

The provisions in issue are section 10 and paragraph 87(2)(b) of the Act.

The relevant portion of paragraph 87(2)(b) (which has not been amended in any respect material to the question dealt with herein) reads as follows:

For the purpose of computing the income of the new corporation, where the property described in the inventory, if any, of the new corporation at the beginning of its first taxation year includes property that was described in the inventory of a predecessor corporation at the end of the taxation year of the predecessor corporation that ended immediately before the amalgamation (which taxation year of a predecessor corporation is referred to in this section as its "last taxation year"), the property so included shall be deemed to have been acquired by the new corporation at the beginning of its first taxation year for an amount determined in accordance with section 10 as the value thereof for the purpose of computing the income of the predecessor corporation for its last taxation year, . . .

Subsection 10(1) provides:

For the purpose of computing a taxpayer's income for a taxation year from a business that is not an adventure in the nature of trade, property described in an inventory shall be valued at the end of the year at the cost at which the taxpayer acquired the property or its fair market value at the end of the year, whichever is lower, or in a prescribed manner.

In the Memo, FID expressed the view that the legislature likely intended the amalgamated corporation to have acquired the inventory valuation method of its predecessor corporations. The reasons cited in support of this view were as follows:

(a) the reference in paragraph 87(2)(b) to section 10 implicitly imposes a continuity requirement on the amalgamated corporation; and

(b) the reference to the "value" instead of the "cost" in paragraph 87(2)(b) implies that the amalgamated corporation does not acquire inventory at a cost in respect of which the new corporation may choose a different valuation method.

FID also supported its view by reference to The Queen v. Cyprus Anvil Mining Corporation, 90 DTC 6063 (FCA). In that case, the Federal Court of Appeal held that, in computing its income for tax purposes, the taxpayer corporation was not free to change its inventory valuation method following a period it was exempt from tax.

Analysis

In our view, the reasons set out in the Memo do not adequately justify our current position. First, the Memo does not provide a clear answer to the question as to which inventory valuation method is to be used by an amalgamated corporation where the predecessor corporations use different valuation methods. Second, it is not clear that the reference to section 10 in paragraph 87(2)(b) imposes an obligation on the amalgamated corporation to use the same inventory valuation method as its predecessor corporations.

We also note that the Memo implies that the word "value" in paragraph 87(2)(b) precludes the amalgamated corporation from adopting an inventory valuation method which differs from its predecessors since the amalgamated corporation is not deemed to have acquired its inventory at a cost in respect of which it can choose a different valuation method. There are at least two reasons why we have decided to rethink this approach. First, the use of the word value may be explained on the basis that the provision deems the amalgamated corporation to acquire the inventory at the same amount assigned to the value of the closing inventory of the predecessor. Since the closing inventory of a predecessor may be based on either cost or fair market value, the use of the broader term value appears to be more appropriate. Second, having prescribed the amount at which the inventory is acquired, paragraph 87(2)(b) arguably results in that inventory being acquired at a cost equal to the value of the closing inventory of the predecessor.¹

Relationship Between Accounting Principles and Inventory Valuation

The particular relationship between ordinary principles of commercial accounting and the computation of income was summarized by Major, J. in Friesen v. The Queen, 95 DTC 5551 (SCC) at 5558, as follows:

. . . profit under s. 9(1) is a question of law to be determined according to the business test of "well-accepted principles of business (or accounting) practice" or "well-accepted principles of commercial trading" except where these are inconsistent with specific provisions of the Income Tax Act.

More recently, the Supreme Court of Canada has sought to refine the relationship between accounting principles and income computation for tax purposes. In Canderal Limited v. The Queen, 98 DTC 6100, Iacobucci, J. speaking for the Court stated as follows:

The starting proposition, of course, must be that the determination of profit under s. 9(1) is a question of law, not of fact. Its legal determinants are two in number: first, any express provision of the Income Tax Act which dictates some specific treatment to be given to particular types of expenditures or receipts, including the general limitation expressed in s. 18(1)(a), and second, established rules of law resulting from judicial interpretation over the years of these various provisions.

Beyond these parameters, any further tools of analysis which may provide assistance in reaching a determination of profit are just that: interpretive aids, and no more. Into this category fall the "well-accepted principles of business (or accounting) practice . . ."²

Consistency Principle

One of the well-accepted principles of business (or accounting) practice which is directly relevant to the valuation of inventory is the consistency principle. The consistency principle, simply stated, refers to the requirement to use the same accounting principles from one period to another.³ A change in an accounting principle to a more preferred method results in inconsistency, however, such a change is acceptable provided the effect of the change is disclosed and, where applicable, prior period adjustments are made.³

The application of the consistency principle in valuing inventory for tax purposes was considered in The Queen v. Cyprus Anvil Mining Corporation, 90 DTC 6063 (FCA). In that case, the corporate taxpayer was entitled to a three-year exemption from tax on mining income. During the non-exempt period, the taxpayer valued its inventory at the lower of cost or market. The issue was whether the taxpayer could value its inventory on a market basis for the purpose of computing its income during the exempt period. The Court held that nothing in the Act permitted the taxpayer to deviate from the consistency principle and that, in computing the income of a taxpayer, the same inventory valuation method should be employed on a year to year basis to avoid a distortion of profits. Urie, J. stated at page 6067:

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 the scheme and with the object and intention of Parliament. 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.

Earlier on the same page:

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. . . . 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.

In Consoltex Inc. v. The Queen, 96 DTC 1812, the issue before the Tax Court of Canada was whether the taxpayer could adopt a different valuation method for a specific period of time following the winding up of a subsidiary corporation. Lamarre, TCCJ concluded at 1820 (TCC):

I am of the opinion on the one hand, that the appellant was not entitled to take advantage of section 10 of the Act in valuing its inventory at market without regard to well-accepted principles of business or accounting practice. On the other hand, the appellant has not convinced me that by changing its method of valuing inventories for tax purposes to market, without having regard to cost, for the taxation years 1980, 1981 and 1982, it presented a fair and accurate picture of its income for those years or that it presented a truer picture of its income.

Both Cyprus Anvil and Consoltex conclude that the choice of an inventory valuation method is subject to well-accepted principles of business or accounting practice and to any overriding principles of tax law which insure that a true picture of income emerges. Each of these cases, however, deals with successive taxation years of a single taxpayer. As a result, it is arguable that the consistency principle does not extend to an amalgamated corporation. In addition, to the extent that the inventory valuation method adopted by an amalgamated corporation is subject to well-accepted principles of business and accounting practice, it appears that subsection 10(1) legislatively overrides the consistency principle.4 In this respect, we note that subsection 87(2) contains numerous provisions deeming the amalgamated corporation to be a continuation of its predecessor corporations. It does not, however, contain a deeming rule for the purposes of subsection 10(1).

Accordingly, we are of the view that an amalgamated corporation, as a new corporation, does not acquire the inventory valuation method(s) of its predecessor corporations, but only acquires its inventory at an amount prescribed by paragraph 87(2)(b). As a result, an amalgamated corporation is free to choose any inventory valuation method sanctioned by subsection 10(1).

Although an amalgamated corporation is free to choose any inventory valuation method permitted by subsection 10(1), it must utilize an inventory costing method which results in a true picture of the corporation's income. For example, in MNR v. Anaconda American Brass Ltd., 55 DTC 1220 (PC), the Privy Council rejected the LIFO method of valuing inventory on the basis that LIFO did not accurately reflect the flow of goods in the taxpayer's business and, therefore, did not yield a true picture of the corporation's income.

The courts have also applied a true picture of income test to determine which of two competing accounting methodologies is appropriate for computing income for tax purposes where each methodology is acceptable for accounting purposes. In West Kootenay Power and Light Company Limited v. The Queen, 92 DTC 6023, MacGuigan, J.A. stated at page 6028:

In my view, it would be undesirable to establish an absolute requirement that there must always be conformity between financial statements and tax returns, and I am satisfied that the cases do not do so. The approved principle is that whichever method presents the "truer picture" of a taxpayer's revenue, which more fairly and accurately portrays income, and which "matches" revenue and expenditure, if one method does, is the one that must be followed.⁵

More recently, Iacobucci, J. stated in Canderal:

However, when no specific rule has been developed, either in the case law or under the Act, the taxpayer will be free to calculate his or her income in accordance with well-accepted business principles, and to adopt whichever of these is appropriate in the particular circumstances, is not inconsistent with the law, and, as I shall elaborate upon below, yield an accurate picture of his profit for the year.

. . .

In general, the Minister will not be entitled to insist that one method supported by business practice and commercial principles be employed over another, equally supported method, unless, as I will develop below, the method chosen by the taxpayer fails to yield an accurate picture of his or her income for the taxation year.⁶

Iacobucci, J. later summarized his conclusions at page 6109:

It follows from all this that in calculating his or her income for a taxation year, the taxpayer must adopt a method of computation which is not inconsistent with the Act or established rules of law, which is consistent with well-accepted business principles, and which will yield an accurate picture of his or her income for that year.

Conclusion

An amalgamated corporation has the right to choose any inventory valuation methodology permitted by subsection 10(1). However, the amalgamated corporation must use a method for determining the cost or fair market value of its inventory (i.e. FIFO, average cost, etc.) which yields a true picture of its profit.

In circumstances where an amalgamation is undertaken principally to effect a change in an inventory valuation method used by a predecessor corporation, we would consider the application of the general anti-avoidance rule.

Please contact Daryl Boychuk if you have any questions.

Roy Shultis
Director General
Income Tax Rulings Directorate
Policy and Legislation Branch

ENDNOTES

¹ Cost for tax purposes is generally the amount at which property is acquired.

² Page 6906.

3 CICA, paragraph 3030.01 provides that, in respect of inventory, "(a)s with all accounting procedures where alternatives exist, it is presumed that, once a basis for determining cost has been selected, it will be followed consistently from one period to another unless circumstances warrant a change.

⁴ CICA, para. 1506.13.

⁵ Subsection 10(2.1) provides that the closing inventory of any given year must be valued according to the same method as the valuation of the inventory for the end of the previous year, unless the consent of the Minister is obtained. No reference is made to amalgamated corporations. Consequently, there is no rule which ties the inventory valuation method of a predecessor corporation to the amalgamated corporation.

⁶ See also Maritime Telegraph and Telephone Company Limited v. The Queen (1990), 91 DTC 5038 (FCTD).

⁷ Page 6107.

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