31 October 1980 Income Tax Severed Letter

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.

October 31, 1980

Attention: XXXX

Dear XXXX

This letter is to bring to your attention a recent position change of the Department regarding the practice of reducing the valuation of an inventory, arrived at under the Retail Inventory Method, by a certain percentage.

The Retail Inventory Method, if applied in a generally accepted manner, is a method accepted by the Department for valuing an inventory since the general effect of it is to state the inventory at the lower of cost or market. In certain circumstances, however, it is contended that the Retail Inventory Method results in an over valuation of an inventory. This contention was presented to the Department in 1952 by the Retail Merchants Association and others. The reasons given to support their contention were as follows:

(a) Mark-downs of prices are heaviest in the months immediately following the business year-end. This may be occasioned by an effort to clear out obsolete, slow moving or shop-worn merchandise. If such merchandise is not fully marked-down by the year-end, an inventory taken at that time, and valued by means of the Retail Inventory Method, would result in an over valuation as far as that merchandise was concerned.

(b) The conversion rate from selling prices to the lower of cost or market is generally the average rate of mark-up on goods purchased during the year or during a certain period in the year. The usual experience is that goods carrying less than the average rate of mark-up sell more rapidly than those carrying more than the average rate of mark-up. Consequently, at the year-end proportionately more of the latter type would normally be still on hand. Where this is the case, the application of the average rate of mark-up would result in an over valuation of the inventory. The extent of this over valuation would depend on the degree of departmentalization of the inventory. If, as is proper, a separate average rate of mark-up is used for each department, the degree of error should be less than if an over-all average mark-up is used for the whole business.

(c) A factor that has a bearing on the extent of any over valuation that may be present because of the circumstances described in (a) and (b) above is the manner in which the average rate of mark-up is determined. In particular, it is necessary to know whether the average rate of mark-up takes into account mark-downs during the period or whether it is based on mark-ups only. If mark-downs are taken into account in arriving at the average rate of mark-up, the resulting inventory valuation will be greater than if such mark-downs are ignored.

As a result of the aforementioned representations, the Department adopted in 1952 the following practice:

"Where, in accordance with the points discussed above in items (a), (b) and (c), it is considered that a reduction in the valuation of an inventory may properly be allowed, the valuation arrived at under the Retail Inventory Method may be reduced by one or both of the following deductions:

(a) not more than 5% to compensate for obsolete, slow moving, or shop-worn merchandise;

(b) not more than 2 1/2% to compensate for the margin of error in the average rate of mark-up.

The above deductions will be allowed only where:

(i) reasonable proof is submitted by the taxpayer to show that the circumstances in his business make necessary either one or both of the adjustments;

(ii) all items of merchandise, regardless of age or condition, are included in the inventory at the selling price asked at that time;

(iii) no other provision is made for anticipated mark-downs;

(iv) no other provision is made for obsolete, slow moving or shop-worn merchandise;

(v) any deduction or deductions allowed are recorded in the taxpayer's books of account and reflected in his financial statements."

With respect to inventory valuation in general, the Department's position is that where a method of valuing an inventory is considered acceptable because of its practicality, the Department expects that generally accepted accounting principles will be applied in arriving at the value of the inventory and that such value will be reflected both for tax purposes and for financial statement purposes.

It has come to our attention that taxpayers using the Retail Inventory Method are apparently looking to the percentage reductions allowed by the Department as representing generally accepted accounting principles and therefore taking such reductions as a matter of course, which needless to say was never the intent. To avoid this and to properly reflect the general position of the Department as stated in the immediately preceding paragraph, the Department has decided to discontinue the practice of stating a certain percentage that will be accepted by it. In future, where a taxpayer has valued its inventory under the Retail Inventory Method and then reduces that value by a certain percentage, the taxpayer will be required to show that the reduced value has been established in accordance with generally accepted accounting principles. The onus therefore will be on the accounting profession to establish what reduction, if any, is appropriate in the circumstances.

This new practice will be effective for taxation years beginning after 1980.

Yours sincerely,

Director General Corporate Rulings Directorate Legislation Branch