Tax Guidance on Valuing Inventory Explained by Canadian Tax Lawyer

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A taxpayer’s intentional adjustment to fix its unintentional understatement of the cost of its inventory was denied by the Canada Revenue Agency

Yorkwest Plumbing Supply Inc. (the “taxpayer”), a Canadian-controlled private corporation that supplies plumbing equipment to contractors, decided to switch its inventory tracking system from a periodic system to a more modern perpetual system on March 1, 2009 which was the beginning of its 2010 taxation year. The taxpayer acquired $1,294,623 of inventory immediately before March 1, 2009 and the purchase orders of these goods were not created in the new system due to the transition in the inventory tracking system. In early March 2009, the taxpayer decided to use an accounts payable account number from the old tracking system to create an account from which the invoices of the inventory purchases could be paid. In 2012, the taxpayer realized that the continued existence of this account had caused an understatement of the cost of goods sold for its 2010 and 2011 fiscal years, and accordingly had caused an overstatement of its gross profits for each of the 2 years. The taxpayer then made a compensatory adjustment for its 2012 fiscal year by writing down $1,294,623 from the value of its inventory and adding the same amount to the cost of purchases made in 2012. After Canada Revenue Agency (CRA) denied the compensatory adjustment, the taxpayer appealed to the tax court of Canada.

The tax court dismissed the appeal on the basis that:

1. The write-down sought by the taxpayer for goods that had already been sold was precluded by s.10(1) of the Income Tax Act even if it is permitted by GAAP;
2. Under case law principles, the cost of inventory is recognized only in the taxation year in which it is sold. Therefore, the taxpayer could not deduct the inventory acquired immediately before March 1, 2009 from the income of its 2012 taxation year;
3. An unintentional understatement of the cost of goods in its 2010 and 2011 taxation years cannot be remedied by an intentional overstatement of the cost of goods sold in its 2012 taxation year.

GUIDE TO VALUING INVENTORY

Gain insights on valuing inventory by reading this tax guidance from an experienced Canadian tax lawyer. For more tax tips and guides, schedule an assessment with a tax lawyer from Rotfleisch & Samulovitch PC today.

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Relevant provisions from the Income Tax Act to Inventory writing-down

The tax court set out its analysis by first laying out relevant provisions of the Income Tax Act:

S.9(1) Subject to this Part, a taxpayer’s income for a taxation year from a business or property is the taxpayer’s profit from that business or property for the year…

S.10(1) For the purpose of computing a taxpayer’s income for a taxation year from a business…, 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.

S.248(1) defined inventory as “…a description of property the cost or value of which is relevant in computing a taxpayer’s income from a business for a taxation year…”

The value of inventory cannot be written down in a taxation year after the goods are sold

The tax court then focused on two issues and the first one is whether the value of the inventory can be written down in a taxation year after the goods are sold. The tax court cited the Supreme Court of Canada’s decision in Friesen v Canada, [1995] 3 SCR 103 and decided the meaning of “inventory” means an item of property which a business keeps for the purpose of offering it for sale at any time prior to the sale of that item.  The tax court also referred to the decision in CDSL Canada Ltd. v The Queen, FCA 400 where the judge ruled that writing down the value of inventory must be done in accordance with s.10(1) of the Income Tax Act and it could not be achieved though s.9. Since s.10(1) only allows a write-down of inventory which means goods that are held for future sale, the tax court concluded the taxpayer was precluded from writing down the value of the inventory acquired in 2009.

The cost of Inventory cannot be deducted in a taxation year after the goods are sold

The second issue the tax court sought to answer was whether the cost of inventory is deductible after the goods are sold. In considering this issue, the tax court looked into how costs of goods sold in the year was to be computed. By referring to Justice Jackett’s decision in Oryx Realty Corporation v MRN, [1974] 2 FC 44 and Brian Arnold’s textbook Timing and income Taxation, the court concluded that the cost of inventory is recognized only in the taxation year in which the inventory is sold, it cannot be recognized in the taxation year in which it is acquired or after it was sold. Therefore, the taxpayer was precluded from deducting the cost of the inventory acquired in 2009 in computing income for its 2012 taxation year.

Pro tax tips – taxpayers are not allowed to claim a deduction just because they failed to take it on time

The taxpayer in the case was unfortunate as the CRA even agreed that it probably paid more tax than it should. However, the corporation’s management team didn’t deal with this issue immediately when they first realized there was an understatement of the cost of inventory. In tax law, timing matters. The correct tax guidance probably would have been to do a prior period adjustment and amendment of prior year tax returns to adjust the inventory in the year of sale. If you have any concern regarding your tax affairs, contact our office to speak with an experienced Canadian tax lawyer.

About the Author

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David J. Rotfleisch

David J. Rotfleisch, a leading Canadian tax lawyer, is not only a certified specialist in taxation but also a chartered professional accountant. Most recently, David is a pioneer in Canadian crypto taxation.

As of April 2020, he was one of 12 Ontario Certified Specialists In Taxation™.

Learn more about David J. Rotfleisch