14 November 1991 Internal T.I. 9032767 F - Valuation of Securities

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.

7-903276

Re: Valuation of Securities

We are responding to your memorandum of March 13, 1991, with respect to an inquiry from the Laval District Office dated January 16, 1991 concerning the valuation of securities held by financial institutions. In particular, three questions were asked:

1.      Are the securities "inventory" as that word in subsection 10(1) of the Income Tax Act (the "Act")?

2.      If the securities are inventory, what is their "cost" for the purposes of inventory valuation under subsection 10(1) of the Act?

3.      Is there any reason why the taxpayer cannot value its securities using cost for financial statement purposes and market for income tax purposes

Facts:

24(1)

24(1)

Additional Considerations:

In considering the foregoing situation, it is not, in our opinion, essential to determine if the T-Bills, or other debt instruments, were acquired on income or capital account.  Nor is it necessary to determine if the T-Bills and other debt instruments constitute inventory.  Although the preferred view is that the assets are generally acquired on income account and are inventory, in our opinion, the taxpayer is not valuing the assets at "costs", for either capital or inventory purposes and, accordingly, the proposed reassessment to eliminate the write down to market value should be processed with.

The interest (or discount) accrued must be included in income pursuant to subsection 12(3) of the Act, regardless of whether the property is income or capital.  If the property is capital, subsection 52(1) of the Act requires that the amount included in income be added to the cost of the property for the purpose of determining the adjusted cost base.  There is no mechanism in the Act which permits a "write-down" to market value of capital assets.

If the property is more properly characterized as inventory, the taxpayer is required to value the asset at the lower of cost or market or at market, pursuant to section 10 of the Act.

As we understand it, the taxpayer is currently valuing its (purported) inventory using the lower of cost or market.  The basic disagreement between Revenue Canada, Taxation and the taxpayer is the issue of what constitutes "cost" for the purpose of subsection 10(1) of the Act. The taxpayer's position is that "cost" equals amortized cost or laid out cost plus the amount required to be brought into income under subsection 12(3) of the Act.  In our opinion, this position is not supportable and "cost", as used in subsection 10(1) of the Act is limited to actual laid out cost or the price paid for an) asset. 21(1)(b)               we are of the view that the jurisprudence, the Act and GAAP support our position, as described below:

A. British Jurisprudence:

There are no Canadian or British cases which deal expressly with the term "cost" in subsection 10(1) of the Act.  There are, however, cases which deal with the meaning of the word "cost" in other contexts and also Canadian cases which address the proper treatment to be given to rebates etc., if required to be accounted for in inventory:

Ryan v. Asia Mills, (1949) 32 TC 215 (HL):

The taxpayer, a wholesale cotton dealer, was required to purchase its cotton from a central authority (the Controller) which set the price. In the taxation year in issue, the Controller required the taxpayer to purchase excess cotton in January at, i.e. $100,000.00, with a caveat that the price for cotton would increase or decrease in later months according to world prices. In April, the taxpayer was required to pay an additional i.e. $25,000.00, purportedly in respect of the cotton acquired in January, to the Controller to reflect an increase in cotton prices. The taxpayer added the $25,000.00 to the cost of its stock-in-trade. Inland Revenue disallowed it. The House of Lords determined that, while the $25,000.00 was an expense paid by the taxpayer in carrying on its business, the $25,000.00 was not part of the consideration paid for acquiring the cotton, but a payment made pursuant to a contract between the taxpayer and the Controller. In determining that the $25,000.00 payment should not be added to the cost of the stock-in-trade, the court stated, inter alia, the following, per Lord Porter, at page 297:

    "Speaking for myself, I think the attribution of the sum paid as forming part of the cost of cotton held on 13th January, 1945, is to extend unduly the meaning of the word 'cost'. The additional sum paid is undoubtedly part of the expense incurred by the Appellants in carrying on their business but it is not, in my opinion, part of the cost of their stock..."

Per Lord Reid, at page 298:

    If the payments had been really adjustments of price then of course they would have to come in to the cost of the stock. But it has not been maintained that they were and clearly they were not. In the first place, the stock in 1945 included cotton bought in the old free market and not from the Controller; it could not be maintained that the price of cotton was altered by the making of these payments and secondly, there was nothing either in the agreement of 1942 or in the subsequent sales by the Controller to the Appellants which indicated that the price for any of the sales was to be subject to later adjustments..." And, at page 299:

    ...what has increased is not the cost but the value of the cotton which the Appellants then held, and in this case we are not concerned with value but only with cost..."

In Duple Motors Bodies Ltd v. Commissioners of Inland Revenue, (1961) 39 TC 537 (HL), the House of Lords was asked to determine the proper method of calculating cost for inventory purposes for work in process or manufactured goods. At page 569, Lord Reid stated:

    "Then the question, what figure should be taken to represent the stock-in-trade. If it consists of articles bought for resale, the answer is obvious-the price the taxpayer paid for them, or their cost to him.

In the same case, Lord Guest, made the following observations:

    "The proper approach to the matter was given by Lord President Clyde in Whimster & Co. v Commissioners of Inland Revenue,...12 T.C. 813 at page 823:

         "In computing the balance of profits and gains for the purposes of Income Tax...two general and fundamental commonplaces have always to be kept in mind. 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 or accounting period and the expenditure laid out to earn those receipts. In the second place, the account of profit or loss to be made up for the purpose of ascertaining the difference must be framed consistently with the ordinary principles of commercial accounting, so far as applicable, and in conformity with the Income Tax Act..."

Later, Lord Guest quoting from Naval Colliery Co. Ltd. v. Commissioners of Inland Revenue, 12 T.C. 1017, Rowlatt,. J, said, at page 1027:

         "Now, one starts, of course, with the principle that has often been laid down in many other cases...that the profits for Income Tax purposes are the receipts of the business less the expenditure incurred in earning those receipts. It is quite true and accurate to say...that receipts and expenditures require a little explanation.  Receipts include debts due and they also include, at any rate in the case of a trader, goods in stock. Expenditures include debts payable; and expenditures incurred in repairs, the running expenses of a business and so on, cannot be allocated directly to corresponding items of receipts, and it cannot be restricted in its allowance in some way corresponding, or in an endeavour to make it correspond, to the actual receipts during the particular year...."

It is the expenditure of running the business as a whole in each year which is to be looked at, not the expenditure related to any particular item of profit... Work in process is a receipt of the business as a result of work done during the year. The direct cost method ascertains the amount which the production of work in process has actually cost".

There are certain principles which may extracted from these cases. First, "cost" is the price or the consideration or the laid out invoice cost, plus or minus any adjustments to the cost. Secondly,adjustments to something other than the cost are expenses. Thirdly, expenses may affect the value of an asset but not the cost and, hence, expenses do not enter into the calculation of cost of goods sold.

B. Canadian Jurisprudence:

The above conclusions have been implicitly recognized in Canada in the following cases:

Oxford Motors Limited v. MNR, [1959] CTC 195 (SCC):

The taxpayer was a retailer of automobiles. It had a large inventory on hand which was not selling. To alleviate the problem, the supplier gave the taxpayer a rebate of $250.00 for every automobile sold. The Supreme Court of Canada held that the effect of the receipt of the rebate was to decrease the cost to the taxpayer of every car sold by $250.00.

While it should be noted that the issue in this case was whether the rebates were income or capital, rather than the correct accounting treatment of the rebates, the Court implicitly accepted the position that the rebates constituted an adjustment to cost and would, presumably, reduce the inventory "cost" of each automobile. This position was accepted in a subsequent Canadian decision:

MNR v. Enjay Chemical Co., [1971] CTC 535 (FC-TD):

The taxpayer received abatements from its supplier in order to ensure that the taxpayer remained solvent. The taxpayer attempted to argue that the abatements were capital receipts. The court disagreed and found that they were income receipts. The court was then faced with the question of whether the abatements should be brought into income when they were received or over a number of accounting periods, which matched the sale of inventory. The court stated, at page 553: 

"...the respondent [taxpayer] should have reduced its cost of inventory on hand in 1962 by $112,350 Canadian, and since all the inventory on hand was not sold in 1962, the reduction in the cost of inventory should be reflected in the Respondent's cost of goods sold in I962 and 1963 by reference to the amounts of [inventory] sold in each of those years respectively."

Both the Oxford Motors case and Enjay Chemical case stand for the proposition that the "cost" of an inventory item is the laid out cost, less any rebates. The purpose of having the rebates reduce the cost of goods sold figure is to ensure that the matching principle is upheld.

In The Queen v. Stirling, 85 DTC 5199 (FCA), the taxpayer attempted to deduct interest and safe keeping charges from the "cost" when calculating his capital gain on the disposition of gold bullion. In dismissing the appeal, the Federal Court of Appeal stated, at page 5200:

    "In trying to support that judgment, counsel for the respondent argued in substance that capital gain should be computed according to the same rules as income from a business or property. That argument, while attractive, does not find any support in the Income Tax Act which provides special rules for the computation of capital gain. Under those rules, as they are found in subparagraph 40(1)(c)(i) and section 54, the interest and safekeeping charges here in question could only be deductible if they were part of the cost of the gold bullion. In our opinion, they were not. As we understand it, the word "cost" in those sections means the price that the taxpayer gave up in order to get the asset; it does not include any expense that he may have incurred in order to put himself in a position to pay that price or to keep the property afterwards."

In Brault-Clement Inc. V The Queen, 86 DTC 6277 (FC-TD), the issue was whether or not taxes paid to the Quebec provincial government on tobacco products by a retail vendor formed part of the "cost amount" for the purposes of calculating the inventory allowance. Although the decision was decided on the basis of the unique relationship between the vendor and the Quebec government, the Court did determine that the taxes paid to the Quebec government were not part of the "cost amount".

There were no cases which could be found which consider that the word "cost" is anything other than laid out cost except for the rebate cases.

C. The Effect of an Intervening Event:

Avondale Manor Land ComPany, Limited v MNR, (1959) 23 Tax A.B.C. 123:

The Appellant company was incorporated to acquire real estate. It initially purchased the subject land in 1930 for $87,460.00. Subsequently, the appellant defaulted on its obligations to the vendors and was unable to pay municipal taxes. The municipality became the owner of the lands. In 1935, the municipality agreed to sell the lands back to the appellant for $2,540.00. The Appellant treated the land as inventory and disposed of all the lots comprising the land by 1958. The question before the Tax Appeal Board was whether the cost of the land was $87,460.00 or $2,540.00. The Board determined that the "cost" of the property was $2,540.00. The Board stated that the effect of an intervening event, namely the passing of title from the appellant to the municipality, had the effect of giving the Appellant a new cost and making the old cost irrelevant.

Although this case is based on a rather unique set of facts, it does raise the issue of the effects of an intervening event on the cost of an inventory asset.  Although there is very little consideration of this question in the jurisprudence, the issue was noted in The Meaning of Cost in Canadian Income Tax, by D. Keith McNair, Canadian Tax Paper, No. 69, at page 63, where the author stated:

    "Assume that a particular item was in inventory at the end of the previous year, valued at its market value, which was lower than cost. If that item remains in inventory at the end of the next  fiscal period, what amount should be used for the purpose of applying the lower of cost or market valuation?  That is, has the intervening event-the end of the first fiscal period for the purpose of this rule operated to replace the original cost at cost of the item with the amount used at the inventory value of the item at that first year end? As there appears to be no authority in Canada on this question, it would appear that original cost would be relevant no matter how long the item remains in inventory."

The position that flows from the above statement and the Avondale case is that the original cost remains the cost for inventory purposes over fiscal year ends unless a significant event, such as the passing of title, occurs. To a large extent, this position is consistent with conceptual accounting principles; namely that the year end is a  convenient fiction for giving a snapshot view of the finances of an entity at that point in time, but it does not, in and of itself, affect the financial position of the company. If this is correct, then the existence of a year end would not be considered an event giving rise to changes in the cost of an asset, unless statutorily required.

D. Revenue Canada's Position:

Revenue Canada in Interpretation Bulletin IT473, paragraphs 6, 7 and 8, states as follows:

6. 'Cost' in the context of 'inventory' means all costs which may reasonably be considered as having been incurred to bring the particular item of inventory to its condition and location at the end of the year.

7. In the case of inventories of merchandise purchased for resale or of raw materials acquired for a manufacturing process, cost  means laid-down cost. This includes invoice Cost customs and excise duties, transportation and other acquisition costs and, where they are significant, storage costs.

8. In the case of inventories of work in process and finished goods, cost means the laid down cost of materials plus the cost of direct labour applied to the product and the applicable share of overhead expense properly chargeable to production....

E. The Income Tax Act:

There are numerous provisions in the Income Tax Act which differentiate between the term "cost" and other amounts that are a variation of cost. For example:

1) Subsection 138(11) takes profits and losses of an insurer in excess of its amortized cost;

2) Subsection 248(1) defines "amortized cost" as applying only to loans or lending assets, (We are assuming that T-Bills are maintained in a bank's trading account or a credit union's inventory and, therefore, would not be considered loans or lending assets, pursuant to the definition of loans or lending assets in subsection 248(1) of the Act);

3) Subsection 248(1) defines "cost amount". Paragraph (e) of the definition of 'cost amount" in subsection 248(1) of the Act states that the "cost amount" where there is a debt owing to the taxpayer who does not have (or deemed to have) an amortized cost, is the amount of the debt or right outstanding at the time;

4) Paragraph (c) of the definition of "cost amount" in subsection 248(1) of the Act defines the "cost amount" of property described in an inventory as the value at that time to the taxpayer; (although this definition does not apply to subsection 10(1), there may be an argument that because T-Bills are not defined as having an amortized cost, they must only have a cost).

5) Section 53 describes the adjusted cost base of a capital property as the "cost to him of such property" and adjustments. In this context, the Sterling decision determined that "cost" was laid out cost;

6) Paragraph 13(21)(a) defines "conversion cost" for the purpose of a vessel;

7) Subsection 26(13) of the Income Tax Application Rules defines "actual cost" to be, generally, the cost of the property to the taxpayer, less any part of that cost that was deductible by the taxpayer in computing his income for any taxation year prior to 1972;

8) the Income Tax Application Rules, paragraph 26(12)(a) also defines amortized cost.

The foregoing examples indicate that "cost," as used in subsection 10(1) of the Act is to be interpreted differently from the provisions where the word "cost" is qualified; for example, "amortized cost". If Parliament intended the word "cost" in subsection 10(1) of the Act to be interpreted as "amortized cost", it would have expressly provided for same. As it did not, "cost" should be interpreted in accordance with its usual meaning, which appears to mean laid out cost.

F. GAAP:

The CICA Handbook states that inventory cost is:

     " .05 In the case of inventories purchased for resale or of raw materials, cost should be laid down cost.

     " .06 In the case of work in process and finished goods, cost should include the laid-down cost of material plus the cost of direct labour applied to the product and the applicable share of overhead expense properly chargeable to production.

13(1)(c)

G. Conclusions:

The conclusions to be drawn from the foregoing authorities are:

     1.      Merchandise purchased for resale has a cost equal to the laid down cost.

     2.      Work in process has a cost equal to the sum of the laid out costs for the materials and the laid cut costs for direct labour and overhead.

     3.     If a cost cannot be associated (including overhead if it is a manufacturing concern) with a particular item in inventory, it is generally an expense of the business and does not enter the cost of goods sold calculation.

4.      Both costs and expenses must be incurred prior to entering the cost of goods sold calculation or the profit and loss statement, respectively, unless there is a specific statutory exception.

5.      After the acquisition of an inventory asset, the receipt or expenditure of money purportedly in respect of that asset must be characterized as an adjustment to purchase price, an expense of doing business or something else. If it is an adjustment to purchase price, it enters the cost of goods sold calculation, as in the Enjay Chemical case. If it is not an adjustment to purchase price, it either is an entry on the profit or loss statement (as in Asia Mills),or something else.

In the present situation, the taxpayer is adding an amount equal to the amount recognized as income from the accrual of the discount for income tax purposes at the year-end to its "cost" of the inventory asset. In our opinion, this is not proper for the following reasons:

     1.      The addition to cost must be a laid out, incurred cost.

     2.      If inventory cost equals purchase price, plus or minus adjustments, the adjustment in this particular instance is not one which affects the cost.  The adjustment arises as a result of a statutory requirement to recognize the accrued interest.  This "adjustment" is not related to the purchase of the inventory asset.  The taxpayer is adding to the "cost" the deemed recognition of income required pursuant to subsection 12(3) of the Act. It is difficult to understand how, for either GAAP or income tax purposes, an income recognition entry enters into the Cost of goods sold calculation, which calculation is primarily concerned with Costs or expenses, not income or revenue.

     3.     The cost of an inventory asset should not be affected by a fiscal year-end, which is, essentially, an artificial event.

     4.      The use of the unqualified word "cost" in subsection 10(1) of the Act would seem to imply that "cost" as used therein should be given a different meaning than other qualified uses of the word "cost", particularly "amortized cost".

     5.      GAAP indicates that cost is generally laid out cost in respect of the particular asset. No adjustments should be made to cost except where the inventory asset is being manufactured or where the direct costing method is appropriate.

H. Is there any reason why the taxpayer cannot value its securities using the lower of Cost or market for financial statement purposes and market for income tax purposes?

Assuming that a taxpayer is using an acceptable method (either lower of cost or market or market) for valuing its inventory for financial statement purposes, it is our opinion that the taxpayer must use that same method for income tax purposes. Recently, in the context of paragraph 12(1)(b) of the Act, the Federal Court-Trial Division, in the decisions of West Kootenay Power and Light Company Limited v. The Queen, 1991 DTC 5214 and Maritime Telegraph and Telephone Company v. The Queen, [1991] 1 CTC 28, determined that it was improper to use different GAAP principles for financial statement and for income tax reporting purposes, even though both GAAP principles in issue in those cases were acceptable for income tax purposes. It is our understanding that both decisions have been appealed by the taxpayer.

We trust the foregoing comments are of assistance. Please do not hesitate to contact us if you have further questions.

Yours truly

for DirectorFinancial Industries DivisionRulings Directorate