Friesen v. Canada

As set out in greater detail in the reasons of my colleague Iacobucci J., the appellant was a participant in an adventure in the nature of trade involving a piece of Calgary real estate known as the "Styles Property". The Styles Property was acquired for the sole purpose of reselling it at a profit. The anticipated profit was to be split between a charitable donation to Trinity Western College and other organizations and the investors in their personal capacity. Contrary to the expectations of the investors, real estate prices fell instead of rising.

The appellant claimed business losses on his 1983 and 1984 tax returns relying on s. 10(1) of the Income Tax Act , S.C. 1970-71-72, c. 63, which permits inventory to be valued at the lower of cost or market value. The Minister of National Revenue disallowed this claim.

The narrow issue in this appeal is whether land held for resale as an adventure in the nature of trade may be valued as inventory under s. 10(1) of the Income Tax Act . I have read the reasons of my colleague Iacobucci J., and, with respect, I disagree with his conclusion. In my opinion the provisions of the Income Tax Act allow land held as an adventure in the nature of trade to be valued as inventory under s. 10(1) and therefore I would allow this appeal.

It is necessary to make some comments on the basic scheme of the Income Tax Act given my analysis of the issue raised in this appeal.

Section 3 of the Income Tax Act sets out the ground rules for the computation of a taxpayer's income for a taxation year. Section 3 recognizes two basic categories of income: "ordinary income" from office, employment, business and property, all of which are included in s. 3 (a), and income from a capital source, or capital gains which are covered by s. 3 (b). The whole structure of the Income Tax Act reflects the basic distinction recognized in the Canadian tax system between income and capital gain.

Subdivision b of Division B of the Act entitled "Income or Loss from a Business or Property" contains all the rules which govern business and property income. The leading section in this subdivision is s. 9 which provides that a taxpayer is taxable on the profit for a business or property for the year. Profit is not defined in the Income Tax Act .

Unlike business or property income which is fully taxable, income from capital sources was not subject to tax at all in Canada until 1972 and is still partially protected from taxation. Subdivision c of Division B of the Act entitled "Taxable Capital Gains and Allowable Capital Losses" contains all of the rules which apply to income derived from a capital source. The leading section in this subdivision is s. 38 which provides that a taxpayer is taxable on 3/4 of the capital gain from the disposition of property in the year.

The distinction between income from office, employment, business and property sources and that from a capital source and the preferential treatment of the latter has long been the subject of academic criticism: see B. J. Arnold, T. Edgar and J. Li, eds., Materials on Canadian Income Tax (10th ed. 1993), at p. 297; and Report of the Royal Commission on Taxation (Carter Report) (1966), vol. 3, at pp. 62-67. The distinction between amounts of an income nature and those of a capital nature was imported into the Canadian tax system from the United Kingdom where it is believed to have originated from a primarily agricultural economy whose concept of income was the fruits of productive source. In spite of the uncertainty of origins of the distinction between capital gain and other income and the criticisms of preferential tax treatment of capital gain, differential tax treatment of capital gain and income remains a fundamental feature of the Canadian taxation system.

The central question on this appeal of whether the appellant is entitled to take advantage of the inventory valuation method in s. 10 of the Act involves a careful examination of the wording of the provisions of the Act and a consideration of the proper interpretation of these sections in the light of the basic structure of the Canadian taxation scheme which is established in the Income Tax Act .

In interpreting sections of the Income Tax Act , the correct approach, as set out by Estey J. in Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536, is to apply the plain meaning rule. Estey J. at p. 578 relied on the following passage from E. A. Driedger, Construction of Statutes (2nd ed. 1983), at p. 87:

Today there is only one principle or approach, namely, the words of an Act are to be read in their entire context and in their grammatical and ordinary sense harmoniously with the scheme of the Act, the object of the Act, and the intention of Parliament.

The principle that the plain meaning of the relevant sections of the Income Tax Act is to prevail unless the transaction is a sham has recently been affirmed by this Court in Canada v. Antosko, [1994] 2 S.C.R. 312. Iacobucci J., writing for the Court, held at pp. 326-27 that:

While it is true that the courts must view discrete sections of the Income Tax Act in light of the other provisions of the Act and of the purpose of the legislation, and that they must analyze a given transaction in the context of economic and commercial reality, such techniques cannot alter the result where the words of the statute are clear and plain and where the legal and practical effect of the transaction is undisputed: Mattabi Mines Ltd. v. Ontario (Minister of Revenue), [1988] 2 S.C.R. 175, at p. 194; see also Symes v. Canada, [1993] 4 S.C.R. 695.

I accept the following comments on the Antosko case in P. W. Hogg and J. E. Magee, Principles of Canadian Income Tax Law (1995), Section 22.3(c) "Strict and purposive interpretation", at pp. 453-54:

It would introduce intolerable uncertainty into the Income Tax Act if clear language in a detailed provision of the Act were to be qualified by unexpressed exceptions derived from a court's view of the object and purpose of the provision.... [The Antosko case] is simply a recognition that "object and purpose" can play only a limited role in the interpretation of a statute that is as precise and detailed as the Income Tax Act . When a provision is couched in specific language that admits of no doubt or ambiguity in its application to the facts, then the provision must be applied regardless of its object and purpose. Only when the statutory language admits of some doubt or ambiguity in its application to the facts is it useful to resort to the object and purpose of the provision.

The primary section whose interpretation is in dispute is s. 10:

10. (1) 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.

The plain reading of this section is that it is a mandatory provision requiring a taxpayer who computes income from a business to value the inventory at the lower of cost or market value or as permitted by regulation. Thus, prima facie, the taxpayer must meet two requirements in order to use this section: the venture at issue must be a "business" and the property in question must be "inventory".

The definition of "business" in s. 248(1) specifically includes an adventure in the nature of trade:

"business", includes a profession, calling, trade, manufacture or undertaking of any kind whatever and, except for the purposes of paragraph 18(2)(c), an adventure or concern in the nature of trade but does not include an office or employment; [Emphasis added.]

An "adventure in the nature of trade" is not defined in the Act but is a term which has a meaning established by the common law.

Both parties in this appeal accept that the appellant's real estate venture constitutes an adventure in the nature of trade. Nevertheless, it is useful to briefly examine the requirements for an adventure in the nature of trade since these requirements serve to limit the scope of ventures which are eligible to use the provisions of s. 10(1).

The concept of an adventure in the nature of trade is a judicial creation designed to determine which purchase and sale transactions are of a business nature and which are of a capital nature. This question was particularly important prior to 1972 when capital transactions were completely exempt from taxation. The question was succinctly stated by Clerk L.J. in Californian Copper Syndicate v. Harris (1904), 5 T.C. 159 (Ex., Scot.), at p. 166:

Is the sum of gain that has been made a mere enhancement of value by realising a security, or is it a gain made in an operation of business in carrying out a scheme for profit-making?

The first requirement for an adventure in the nature of trade is that it involve a "scheme for profit-making". The taxpayer must have a legitimate intention of gaining a profit from the transaction. Other requirements are conveniently summarized in Interpretation Bulletin IT-459 "Adventure or Concern in the Nature of Trade" (September 8, 1980) which references Interpretation Bulletin IT-218 "Profit from the Sale of Real Estate" (May 26, 1975) for a summary of the relevant factors when the property involved is real estate.

IT-218R, which replaced IT-218 in 1986, lists a number of factors which have been used by the courts to determine whether a transaction involving real estate is an adventure in the nature of trade creating business income or a capital transaction involving the sale of an investment. Particular attention is paid to:

(i)The taxpayer's intention with respect to the real estate at the time of purchase and the feasibility of that intention and the extent to which it was carried out. An intention to sell the property for a profit will make it more likely to be characterized as an adventure in the nature of trade.

(ii)The nature of the business, profession, calling or trade of the taxpayer and associates. The more closely a taxpayer's business or occupation is related to real estate transactions, the more likely it is that the income will be considered business income rather than capital gain.

(iii) The nature of the property and the use made of it by the taxpayer.

(iv)The extent to which borrowed money was used to finance the transaction and the length of time that the real estate was held by the taxpayer. Transactions involving borrowed money and rapid resale are more likely to be adventures in the nature of trade.

The factual record in this case reveals a legitimate "scheme for profit-making" with respect to the Styles Property. The appellant and his associates purchased the Styles Property with the intention of reselling it at a profit. The appellant and his associates planned to split the anticipated profit between designated charities and themselves on a pro rata basis. The persons involved in this venture were experienced business people who treated the transaction as a business venture. The land involved was undeveloped real estate which was suitable for resale but unsuitable as an income producing investment or for the personal enjoyment of the appellant or his associates.

I agree with Iacobucci J. that the appellant meets the tests which have been established in the common law for an adventure of trade. The speculative venture in which the appellant was involved was clearly an adventure of a business nature rather than an investment of a capital nature. Like my colleague, I respectfully disagree with the trial judge ([1992] 2 F.C. 552) and Marceau J.A. ([1993] 3 F.C. 607) that s. 10(1) does not apply to a business which is an adventure in the nature of trade: see Bailey v. M.N.R., 90 D.T.C. 1321 (T.C.C.), at p. 1328. I affirm the succinct summary of the law contained in IT-218R:

The word "business" is defined in subsection 248(1) so as to include, inter alia, an adventure or concern in the nature of trade. This definition can cause an isolated transaction involving real estate to be considered a business transaction. As a business, any gain or loss which arises therefrom is, by virtue of section 9, required to be included in computing income or loss, as the case may be.

In order to take advantage of the valuation method in s. 10(1), a taxpayer must also establish that the property in question is inventory. A definition of "inventory" is contained in s. 248(1) of the Act:

"inventory" means 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 first point to note about this definition of inventory is that property is not required to contribute directly to income in a taxation year in order to qualify as inventory. Provided that the cost or value of an item of property is relevant in computing business income in a year that property will qualify as inventory. Generally the cost or value of an item of property will appear as an expense (and the sale price as revenue) in the computation of income.

Reduced to its simplest terms, the income or profit from the sale of a single item of inventory by a sales business is the ordinary tracing formula calculated by subtracting the purchase cost of the item from the proceeds of sale. This is the basic formula which applies to the calculation of profit before the value of inventory is taken into account, as is made clear by Abbott J. in Minister of National Revenue v. Irwin, [1964] S.C.R. 662, at pp. 664-65:

The law is clear therefore that for income tax purposes gross profit, in the case of a business which consists of acquiring property and reselling it, is the excess of sale price over cost, subject only to any modification effected by the "cost or market, whichever is lower" rule.

Thus, for any particular item:

Income = Profit = Sale Price - Purchase Cost.

It is clear from the formula above that the cost of an item of property sold by a business is relevant in computing the income from the business in the taxation year in which it is sold. As discussed above, an adventure in the nature of trade constitutes a business under the Act. Therefore, an item of property sold as part of an adventure in the nature of trade is relevant to the computation of the taxpayer's income from a business in the taxation year of disposition and so is inventory according to the plain language of the definition in s. 248(1).

The respondent argued that even if the Styles Property were inventory in the year of disposition it would not qualify as inventory in preceding years. Specifically the respondent urged that the phrase "relevant in computing a taxpayer's income from a business for a taxation year" requires that the characterization of each item of property as inventory (or not) be made on an annual basis on the basis of the relevance of the item to the computation of income for that taxation year. The respondent relied on dicta to this effect in Canada v. Dresden Farm Equipment Ltd., [1989] 1 C.T.C. 99 (F.C.A.), at p. 105, a case which held that a taxpayer may not deduct an inventory allowance on goods in which the taxpayer has no property but merely holds on consignment. The respondent's argument on this point was accepted by Létourneau J.A. in the Federal Court of Appeal ([1993] 3 F.C. 607, at pp. 617-18) and is relied upon by Iacobucci J.

In my opinion, the interpretation urged by the respondent runs contrary to the natural meaning of the words used in the definition of inventory in s. 248(1) and to common sense. The plain meaning of the definition in s. 248(1) is that an item of property need only be relevant to business income in a single year to qualify as inventory: "relevant in computing a taxpayer's income from a business for a taxation year". In this respect the definition of "inventory" in the Income Tax Act is consistent with the ordinary meaning of the word. In the normal sense, inventory is property which a business holds for sale and this term applies to that property both in the year of sale and in years where the property remains as yet unsold by a business.

In addition to the plain meaning of the words, several other considerations militate against the respondent's interpretation of the definition of "inventory" in s. 248(1).

First, an examination of other definitions in the Income Tax Act reveals that there is a particular phraseology used in the definition of things, amounts or concepts which must be determined on an annual basis. The definitions of income (in s. 9) and taxable capital gain (in s. 38), both of which must be determined on an annual basis, contain the characteristic phraseology which denotes that requirement:

9. (1) Subject to this Part, a taxpayer's income for a taxation year from a business or property is his profit therefrom for the year.

(2) Subject to section 31, a taxpayer's loss for a taxation year from a business or property is the amount of his loss, if any, for the taxation year from that source computed by applying the provisions of this Act respecting computation of income from that source mutatis mutandis.

38. For the purposes of this Act,

(a) a taxpayer's taxable capital gain for a taxation year from the disposition of any property is 3/4 of his capital gain for the year from the disposition of that property;

(b) a taxpayer's allowable capital loss for a taxation year from the disposition of any property is 3/4 of his capital loss for the year from the disposition of that property; [Emphasis added.]

This formulaic phraseology appears innumerable times in the definitions in the Income Tax Act : see for example: s. 3 "income"; s. 5 "income from office or employment" and "loss from office or employment"; s. 38 (c) "allowable business investment loss"; s. 39 "capital gain", "capital loss" and "business investment loss"; s. 41 "taxable net gain"; s. 63(3) (c) "eligible child"; s. 127.2(6) (a) "share-purchase tax credit"; s. 127.3(2)

The respondent is asking this Court to interpret the definition of "inventory" as though it read:

"inventory" [for a taxation year] means a description of property the cost or value of which is relevant in computing a taxpayer's income from a business for [the] taxation year;

The principal problem with the respondent's interpretation is that the bracketed words do not appear in the definition in the Income Tax Act . The addition of these words to the definition effects a significant change to the sense of the definition. It is a basic principle of statutory interpretation that the court should not accept an interpretation which requires the insertion of extra wording where there is another acceptable interpretation which does not require any additional wording. Reading extra words into a statutory definition is even less acceptable when the phrases which must be read in appear in several other definitions in the same statute. If Parliament had intended to require that property must be relevant to the computation of income in a particular year in order to be inventory in that year, it would have added the necessary phraseology to make that clear.

The second problem with the interpretation proposed by the respondent is that it is inconsistent with the basic division in the Income Tax Act between business income and capital gain. As discussed above, subdivision b of Division B of the Act deals with business and property income and subdivision c of Division B deals with capital gains. The Act defines two types of property, one of which applies to each of these sources of revenue. Capital property (as defined in s. 54 (b)) creates a capital gain or loss upon disposition. Inventory is property the cost or value of which is relevant to the computation of business income. The Act thus creates a simple system which recognizes only two broad categories of property. The characterization of an item of property as inventory or capital property is based primarily on the type of income that the property will produce.

As discussed above in the context of the definition of an adventure in the nature of trade, a comprehensive discussion of whether the sale of real estate will create income or capital gain can be found in Interpretation Bulletin IT-218R (September 16, 1986). The full title of this Interpretation Bulletin, "Profit, Capital Gains and Losses from the Sale of Real Estate, Including Farmland and Inherited Land and Conversion of Real Estate from Capital Property to Inventory and Vice Versa" emphasizes what the bulletin makes clear -- real estate, like other forms of property, must fall into one of two basic categories under the Income Tax Act : inventory or capital property.

IT-218R clarifies that real estate which is held by the taxpayer as capital property may be used as personal-use property or as an investment for the purpose of gaining or producing income. The sale of this kind of property creates capital gain or capital loss. On the other hand, real estate which is purchased for profitable resale value is inventory which creates business income or loss. In determining whether the gains from a sale of real estate are income or capital particular emphasis is placed on the taxpayer's intention at the time of the initial purchase of the real estate. Thus, a particular piece of real estate becomes either inventory or capital property in the hands of the taxpayer from the time of the original purchase.

The basic scheme of dividing property into one of two broad classes under the Income Tax Act is further assisted by ss. 13(7) and 45(1) . These sections make specific provision for the conversion of real estate from capital property to inventory and vice versa in particular circumstances. As IT- 218R explains, these circumstances arise only when the taxpayer's intention and use of the property change subsequent to the initial purchase. Sections 13(7) and 45(1) provide for the transfer to be made by means of a deemed disposition and reacquisition at fair market value. The deemed reacquisition at the time when the taxpayer's intention with respect to the property is materially changed reflects the fact that the category of the property is determined according to the taxpayer's intention at the time of acquisition.

The interpretation of "inventory" urged by the respondent is fundamentally incompatible with the statutory dichotomy between inventory and capital property in two respects. First, it would require a change in the characterization of particular items of property on the basis of annual relevance to income rather than according to the carefully tailored circumstances enumerated in ss. 13(7) and 45(1). Second, and more seriously, if an item of property is not relevant to income in a particular year, it does not convert to capital property unless it meets the requirements of ss. 13(7) and 45(1). Under the respondent's proposed interpretation, an item of property would not be inventory in a year in which it was not relevant to income and thus would cease to exist for the purposes of the Income Tax Act in that year. This runs contrary to the scheme of the Act which classifies every piece of property owned by a taxpayer into one of the two broad classes. It creates an absurdity for items of property held for sale by a business to simply disappear from the scheme of the Act in years prior to sale.

Thirdly, the interpretation proposed by the respondent is inconsistent with the commonly understood definition of the term. In the ordinary sense of the term, an item of property which a business keeps for the purpose of offering it for sale constitutes inventory at any time prior to the sale of that item. The ordinary sense of the word also reflects the definition of inventory which is accepted according to ordinary principles of commercial accounting and of business. The Canadian Institute of Chartered Accountants has defined "inventory" as including, inter alia "[i]tems of tangible property which are held for sale in the ordinary course of business": Terminology for Accountants (3rd ed. 1983), at p. 81. In the specific context of real estate the Canadian Institute of Public Real Estate Companies states that land held for sale and land held for future development and sale is inventory: Canadian Institute of Public Real Estate Companies Recommended Accounting Practices for Real Estate Companies (November 1985), at p. 204-1.

It was held in Bailey, supra, and is accepted by Iacobucci J., that single pieces of real estate held for sale as an adventure of the nature of trade meet the definitions of inventory accepted by the commercial and accounting worlds. These definitions are consistent with the plain meaning interpretation of the definition in the Act which would require only that the item of property be relevant to the computation of income in a single year. However, the interpretation sought by the respondent is considerably more restricted because it would require a connection to income in years prior to sale. I agree with my colleague that the express wording of the Income Tax Act is capable of overruling accounting and commercial principles where it is sufficiently explicit. Nevertheless, the Court should be cautious to adopt an interpretation which is clearly inconsistent with the commonly accepted usage of a technical term particularly where an interpretation consistent with common usage is more natural on a plain reading of the definition.

The fourth problem with the interpretation of "inventory" proposed by the respondent is that the relationship between s. 10(1) and the definition of "inventory" in s. 248 would become circular. Specifically, reading s. 10(1) and the definition of "inventory" proposed by the respondent in tandem would mandate the conclusion that s. 10(1) applies if the property in question is inventory and that the property in question is inventory if s. 10(1) applies. Under the respondent's interpretation, if the inventory valuation method in s. 10(1) applies then the cost or value of the property is relevant in computing income in the year in question and the property is inventory. On the other hand, if the valuation method does not apply then the cost or value of the property is not relevant to the computation of income and the property is not inventory. Interpretations which lead to circular definitions are contrary to common sense and should be avoided.

For all of the reasons discussed above, I conclude that the correct interpretation of the term "inventory" in s. 248(1) is the one which appears most obvious on a literal reading of the wording that an item of property is inventory if it is relevant to the computation of business income in a year. As a general principle, items of property sold by a business venture will always be relevant to the computation of income in the year of sale.

To the extent that Dresden Farm Equipment, supra, relies upon an interpretation which is inconsistent with this approach, I choose not to follow it as it does not deal directly with the issue raised in this case. Instead I prefer to follow the well-established line of cases which have specifically held as part of their rationes decidendi that real estate held for resale in an adventure in the nature of trade constitutes "inventory" for the purposes of s. 10(1): Bailey, supra; Weatherhead v. M.N.R., [1990] 1 C.T.C. 2579 (T.C.C.); Van Dongen v. The Queen, 90 D.T.C. 6633 (F.C.T.D.); Skerrett v. M.N.R., 91 D.T.C. 1330 (T.C.C.); and Cull v. The Queen, 87 D.T.C. 5322 (F.C.T.D.). I endorse the approach taken in these cases of considering the definition of "inventory" in the context of the basic distinction between business income and capital gain. As Cullen J. stated in Van Dongen at p. 6634:

The characterization of these properties as inventory is significant, because any gain or loss from the disposition of the inventory will be treated as business income or loss rather than a capital gain or loss. [Emphasis added.]

The Styles Property was relevant to the computation of business income in the taxation year of disposition and therefore it is correctly categorized as "inventory" for the purposes of the Income Tax Act both in that year and in preceding years.

As noted earlier in these reasons, a taxpayer must establish that he or she is involved in a "business" and that the property in question is "inventory" before the valuation scheme in s. 10(1) can be invoked. Since the appellant's adventure in the nature of trade was a "business" and the Styles Property constituted "inventory", the appellant was prima facie entitled to make use of the valuation scheme set out in s. 10(1). However, as Iacobucci J. has pointed out, the valuation scheme in s. 10(1) does not provide an automatic deduction from income nor does it mandate that any taxpayer with inventory can deduct any loss on fair market value arising therefrom. Rather s. 10(1) mandates how the valuation procedure must take place when ordinary commercial and accounting principles establish that the value of inventory is relevant to the computation of business income in a taxation year.

The computation of business income is rooted in s. 9 of the Income Tax Act . Section 9 provides that the income from a business for a year is the profit and that loss is to be calculated by applying the same provisions mutatis mutandis:

9. (1) [Income from business or property] Subject to this Part, a taxpayer's income for a taxation year from a business or property is his profit therefrom for the year.

(2) [Loss from business or property] Subject to section 31, a taxpayer's loss for a taxation year from a business or property is the amount of his loss, if any, for the taxation year from that source computed by applying the provisions of this Act respecting computation of income from that source mutatis mutandis.

The Act does not define "profit" nor does it provide any specific rules for the computation of profit. Tax jurisprudence has established that the determination of 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 the specific provisions of the Income Tax Act : see Gresham Life Assurance Society v. Styles, [1892] A.C. 309 (H.L.); Neonex International Ltd. v. The Queen, 78 D.T.C. 6339 (F.C.A.); Symes v. Canada, [1993] 4 S.C.R. 695, at p. 723; Materials on Canadian Income Tax, supra, at p. 291; and R. Huot, Understanding Income Tax for Practitioners (1994-95 edition), at p. 299.

In calculating profit under s. 9 of the Income Tax Act , a business calculates its gross profit and then subtracts allowable operating and non-operating expenses. Under well-accepted principles of business and accounting practice gross profit for a business involved in sale is calculated according to the following formula:

Gross Profit = Proceeds of Sale - Cost of Sale and:

Cost of Sale = (Value of Inventory at beginning of year + Cost of Inventory acquisitions) - Value of Inventory at end of year.

Thus for a business involved in sales:

Gross Profit = Proceeds of Sale - [(Value of Inventory at beginning of year + Cost of Inventory acquisitions) - Value of Inventory at end of year].

This formula was originally designed for companies with significant inventories at a time when computer technology did not allow the specific cost of each item to be easily traced on an individual basis. The formula allowed a business to calculate gross profit on the basis of a single inventory valuation each year rather than keeping detailed ongoing records. It is rather an anachronism in an age where most businesses with significant inventories carefully track both the cost and sale price of each item by means of computer technology. A moment of thought, however, will lead to the conclusion that this formula is merely a convenient shorthand for a two-step process which recognizes profit as the excess of sale proceeds over value for inventory sold in the year and the change in the value of inventory still on hand at the end of the year. Thus the formula could equally be expressed as:

Gross Profit = (Proceeds of Sale - Value of Inventory Sold) + Change in Value of Unsold Inventory.

Thus, under well-accepted principles of commercial and accounting practice the value of unsold inventory is relevant to the computation of business income. This is based on the accounting presumption that holding onto unsold inventory represents a cost to a business. This is a principle generally applicable to the calculation of business income from businesses of any size and with inventories of any size although the popular formula was originally created as a convenient shortcut for the computation of business income for companies with large inventories.

Section 10(1) of the Income Tax Act recognizes the well accepted commercial and accounting principle of requiring a business to value its inventory at the lower of cost or market value. This principle is an exception to the general principle that neither profits nor losses are recognized until realized. As well, it represents a departure from the general principle that assets are valued at their historical cost. The underlying rationale for this specific exception to the general principles is usually explained as originating in the principle of conservatism. The generally accepted accounting principle applicable in this situation is explained by D. E. Kieso et al., Intermediate Accounting (2nd Canadian ed. 1986), at pp. 421-22, as follows:

A major departure from adherence to the historical cost principle is made in the area of inventory valuation. Applying the constraint of conservatism in accounting means recognizing known losses in the period of occurrence. In contrast, known gains are not recognized until realized. If the inventory declines in value below its original cost for whatever reason ..., the inventory should be written down to reflect this loss. The general rule is that the historical cost principle is abandoned when the future utility (revenue-producing ability) of the asset is no longer as great as its original cost. A departure from cost is justified on the basis that a loss of utility should be reflected as a charge against the revenues in the period in which the loss occurs. Inventories are valued, therefore, on the basis of the lower of cost and market instead of on an original cost basis. [Emphasis added.]

As the above passage makes clear, the well-accepted principle of conservatism which underlies the valuation method in s. 10(1) represents not only an exception to the realization principle (in cases of loss) but also an exception to the principle of symmetry since gains are not recognized until they are realized. Thus the taxpayer who is entitled to rely on s. 10(1) is allowed to claim a business loss where the value of inventory falls but is not required to declare a business profit until the inventory is sold even if the value of the inventory rises.

In Ostime v. Duple Motor Bodies, Ltd., [1961] 2 All E.R. 167 (H.L.), at pp. 172-73, Lord Reid discussed the fact that generally items should be valued at historical cost but that the "lower of cost or market" exception allows valuation at market value only if market value falls below cost. As Lord Reid pointed out, this lack of symmetry is not entirely logical but it represents good conservative accountancy and therefore has always been recognized as legitimate for taxation purposes:

If market value [rather than cost] were taken [in all cases], that would generally include an element of profit, and it is a cardinal principle that profit shall not be taxed until realised; if the market value fell before the article was sold the profit might never be realised. But an exception seems to have been recognised for a very long time; if market value has already fallen before the date of valuation, so that, at that date, the market value of the article is less than it cost the taxpayer, then the taxpayer can bring the article in at market value, and in this way anticipate the loss which he will probably incur when he comes to sell it. That is no doubt good conservative accountancy, but it is quite illogical. The fact that it has always been recognised as legitimate is only one instance going to show that these matters cannot be settled by any hard and fast rule or strictly logical principle. [Emphasis added.]

The well-accepted business and accounting principles applicable to real estate held out as inventory are illustrated in the Canadian Institute of Public Real Estate Companies Handbook (September 1990), at sections 301 and 302:

301. INTRODUCTION

301.1. Real estate property is normally carried at the lower of cost and net realizable value if it is held as inventory and at cost if it is held for investment purposes....

302. PROPERTY HELD AS INVENTORY

302.1.Property held as inventory should be stated at the lower of cost and net realizable value.

302.2. Land held for sale currently and land held for future development and sale is inventory and generally accepted accounting principles require that it be stated at the lower of cost and net realizable value.

(Note that "net realizable value" is the estimated selling price plus other estimated revenue reduced by the costs to improve and sell the property -- for the purposes of this analysis it is equivalent to fair market value.)

In summary, I conclude that the valuation method in s. 10(1) is available for inventory held as part of an adventure in the nature of trade. The valuation method becomes relevant in any particular taxation year through the calculation of business income. Business income is calculated according to well-accepted commercial and accounting principles. According to these principles the value of inventory is relevant to the computation of income in years prior to sale since it comprises part of the cost of sale. According to the same principles inventory is to be valued at the lower of cost or market value, a specific exception to the general principle of realization. This exception is well accepted in the specific instance relevant to this appeal: the valuation of real estate inventory. This conclusion is fully consistent with the line of cases following Bailey. As Cullen J. states in Van Dongen, supra, at p. 6639:

The later Bailey case appears to have settled the issue that land held as an adventure in the nature of trade is eligible for inventory write-down.

See also: Weatherhead, Skerrett, and Cull.

The final argument of the respondent which should be addressed is that the inventory valuation method in s. 10(1) is simply a codification of the common law and so is restricted to stock-in-traders. The respondent is correct to note that the common law recognized an exception to the realization principle by allowing inventory to be valued at the lower of cost or market value in the case of stock-in-trade. The common law in Canada is summarized in Minister of National Revenue v. Anaconda American Brass Ltd., [1956] A.C. 85, a Canadian case which was appealed from this Court to the Privy Council. Viscount Simonds, speaking for the Privy Council stated (at pp. 100-101):

The income tax law of Canada, as of the United Kingdom, is built upon the foundations described by Lord Clyde in Whimster & Co. v. Inland Revenue Commissioners (1925), 12 T.C. 813, 823, in a passage cited by the Chief Justice which may be here repeated. "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 and loss to be made up for the purpose of ascertaining that difference must be framed consistently with the ordinary principles of commercial accounting, so far as applicable, and in conformity with the rules of the Income Tax Act , or of that Act as modified by the provisions and schedules of the Acts regulating Excess Profits Duty, as the case may be. For example, the ordinary principles of commercial accounting require that in the profit and loss account of a merchant's or manufacturer's business the values of the stock-in-trade at the beginning and at the end of the period covered by the account should be entered at cost or market price, whichever is the lower; although there is nothing about this in the taxing statutes." [Italics in original; underlining added.]

See also: Whimster & Co. v. Inland Revenue Commissioners (1925), 12 T.C. 813 (Ct. Sess., Scot.), at p. 823 (per Lord Clyde); and BSC Footwear Ltd. v. Ridgway, [1971] 2 All E.R. 534 (H.L.).

Interestingly, the exception to the realization principle for stock-in-traders existed at common law without any statutory authorization and was based solely on ordinary commercial principles as they existed at that time. As discussed above, ordinary commercial principles would now suggest that all inventory be valued at the lower of cost or market value. The respondent, however, argues that s. 10(1) is merely a codification of the common law as it existed in 1948 when the provision first appeared in the Income Tax Act . This argument is accepted by Iacobucci J. who cites the comments of Abbott J. in Irwin, supra, as authority for this proposition.

I do not accept the argument that s. 10(1) is merely a codification of ordinary commercial principles as they existed and were recognized by the common law in 1948. The obiter comments by Abbott J. in Irwin (at p. 665) to the effect that the former version of s. 10(1), s. 14(2), was merely a codification of the common law and that s. 14(2) probably did not apply to single pieces of real estate were explicitly not made part of the ratio of the decision. Abbott J. did not give any consideration to the specific wording of s. 14(2) which would have been a sine qua non to expressing an authoritative opinion on this point.

The appropriate focus in determining whether s. 10(1) is a mere codification of the common law is upon the wording of the section itself. For ease of reference I quote that section once again:

10. (1) 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. [Emphasis added.]

The common law rule was restricted to stock-in-traders. Section 10(1) on the other hand explicitly states that it applies to the inventory of a business. As discussed above, the word business is defined in the Act and specifically includes adventures in the nature of trade. If Parliament had wanted to simply codify the common law it could and would have used the term "ordinary trading business" or "stock-in-trader" both of which had judicially established definitions. Since Parliament chose to use the broader term "business", there is simply no basis on which to assume that s. 10(1) was no more than a codification of a common law rule. To place such a judicial limit on the clear and unambiguous wording of the statute is a usurpation of the legislative function of Parliament.

In rejecting the principal argument of the respondent that s. 10(1) is restricted to stock-in-traders, I must also, with respect, reject a number of other corollary arguments accepted by Iacobucci J.

First, I do not accept the argument that s. 10(1) applies only to those who "carry on a business". A specific judicial interpretation has evolved for the phrase "carry on a business". That phrase is used in the Income Tax Act and is useful for determining the residence of a taxpayer (see s. 253). Once again if Parliament had intended to restrict the ambit of s. 10(1) to taxpayers which carry on a business it would have done so. I can do no better on this point than to quote with approval the response of Rip T.C.J. to this argument in Bailey, supra, at p. 1330:

Subsection 10(1) directs a property to be valued "for the purpose of computing income from a business". The phrase does not contemplate computing income only from carrying on a business, as suggested by counsel for the respondent. The phrases "carrying on a business" and carried on a business" are found in several provisions of the Act: see, for example, paragraph 2(3)(b), and subsections 115(1) and 219(1). "To carry on something," stated Jackett P. in Tara Exploration [and Development Co. v. M.N.R., 70 D.T.C. 6370], page 6376, "involves continuity of time or operations such as is involved in the ordinary sense of a `business'". When this expression "carry on" is used in the Act, Parliament describes a continuity of time or operations with respect to the factual situation contemplated by the particular provision. Such continuity is not required in subsection 10(1) and its addition to that provision would add nothing to that provision's ordinance.

I am also unable to accept the argument that because s. 10(1) represents an exception to the general commercial and accounting principle of realization (see Minister of National Revenue v. Consolidated Glass Ltd., [1957] S.C.R. 167, at p. 174 (per Rand J.)) and because this exception has been the subject of some academic criticism (see B. J. Arnold, Timing and Income Taxation: The Principles of Income Measurement for Tax Purposes (1983), at pp. 332-33), therefore the exception should be read more narrowly than the express words chosen by Parliament.

Although the inventory valuation scheme in s. 10(1) represents an exception to the normal principle of realization, the exception itself is also a well-accepted commercial and accounting principle. While the realization principle applies with respect to capital property, it is subject to an exception in the case of inventory as Rand J. recognized in Consolidated Glass, at p. 174:

"Losses sustained" and "profits and gains made" are clearly correlatives and of the same character; but how can profits and gains be considered to have been made in any proper sense of the words otherwise than by actual realization? This [sic] is no inventory valuation feature in relation to capital assets. [Emphasis added.]

Furthermore, it is not the role of the court to restrict the interpretation of the clear statutory language because the exception created by the language has been the subject of academic criticism. Many sections of the Income Tax Act have been the subject of academic criticism. By way of example, the basic distinction between capital gain and income has been criticized in a tax text edited by the same Professor Arnold whose criticisms of conservative inventory valuation are relied upon by Iacobucci J.: see Materials on Canadian Income Tax, supra, at p. 297. Moreover, Professor Arnold's criticisms of conservative inventory valuation are aimed at any exception to the realization principle and have no greater force when applied to an adventure in the nature of trade seeking to apply the exception on a single item of inventory than to stock-in-trader who seeks to apply the exception to hundreds if not thousands of items of inventory.

My colleague Iacobucci J. accepts the fact that s. 10(1) applies to an adventure in the nature of trade. However, he would restrict the use of the valuation method in s. 10(1) to stock-in-traders and those who "carry on" a business. This effectively prevents s. 10(1) from being applied to an adventure in the nature of trade since by definition an adventurer in the nature of trade is neither a stock-in-trader nor does he "carry on" a business. The restriction placed upon this section by my colleague is based on his view that the object and purpose of the section is to provide a limited exception to the realization principle for stock-in-traders as was provided for at common law. However, as discussed at the beginning of these reasons, the clear language of the Income Tax Act takes precedence over a court's view of the object and purpose of a provision. As Hogg and Magee stated in Principles of Canadian Income Tax Law, supra, at p. 453:

It would introduce intolerable uncertainty into the Income Tax Act if clear language in a detailed provision of the Act were to be qualified by unexpressed exceptions derived from a court's view of the object and purpose of the provision.

Therefore, the object and purpose of a provision need only be resorted to when the statutory language admits of some doubt or ambiguity. In this case, there is no doubt or ambiguity in the statutory language of s. 10(1) which clearly applies to the inventory of a business including an adventure in the nature of trade. Although there is no need to resort to the object and purpose of the section in this case, I would note that the object and purpose of s. 10(1) is fully consistent with allowing the valuation method in that section to be used for adventures in the nature of trade. Section 10(1) is specifically designed as an exception to the principles of realization and matching in order to reflect the well-accepted principle of accounting conservatism. In addition to recognizing accounting conservatism, the section is designed to stop a business from accumulating pregnant losses from declines in the value of inventory. The object and purpose of the section is to prevent businesses from artificially inflating the value of inventory by continuing to hold it at cost when the market value of that inventory has already fallen below cost.

Thus, it should not be assumed that Parliament is opposed to the inventory valuation exception to the realization principle simply because this exception allows unrealized losses in certain circumstances. Although the principal goal of the Income Tax Act is to raise national revenue, there are many competing demands and priorities which may shape tax policy in any given circumstances. Changes to the Income Tax Regulations, C.R.C. 1978, c. 945, made subsequent to the years at issue in this appeal strongly suggest that Parliament supports the principle of accounting conservatism which underlies the inclusion of inventory valuation in the determination of business income.

Section 10(1) provides that inventory must be valued at the lower of cost or fair market value or as otherwise permitted by regulation. The relevant regulation is Regulation 1801 which read as follows in the years in question on this appeal:

1801. [Valuation] Except as provided in section 1802, for the purpose of computing the income of a taxpayer from a business

(a) all the property described in all the inventories of the business may be valued at the cost to him; or

(b) all the property described in all the inventories of the business may be valued at the fair market value.

The combined effect of s. 10(1) and Regulation 1801 was explained in Interpretation Bulletin IT-473 "Inventory Valuation" (March 17, 1981 (as revised by Special Release dated December 5, 1986)) as follows:

Valuation of Inventory

4. Except where an individual has elected under subsection 10(6) to value inventory at nil in computing income from an artistic endeavour (see IT-504), subsection 10(1) of the Act and section 1801 of the Regulations provide three alternative methods of valuing inventory. These are:

(a) valuation at the lower of cost or fair market value for each item (or class of items if specific items are not readily distinguishable) in the inventory;

(b) valuation of entire inventory at cost;

(c) valuation of the entire inventory at fair market value.

Once a taxpayer has adopted, or has been required to adopt, one of the foregoing methods of valuing inventory, the taxpayer must continue to use that method on a consistent basis in subsequent years....

In 1989, Regulation 1801 was amended to read:

1801. [Valuation] Except as provided by section 1802, for the purpose of computing the income of a taxpayer from a business, all the property described an all the inventories of the business may be valued at its fair market value.

The 1989 amendment removed from the taxpayer the option of choosing to value inventory at historical cost and left only the more conservative methods of fair market value or the lower of cost or market value. The practical effect of this amendment is that in years following 1989 the taxpayer must declare a loss for taxation purposes in any year in which the fair market value of inventory falls below historical cost. The taxpayer no longer has the option of postponing this loss until the taxation year in which the loss is actually realized upon sale of the inventory. This is made clear in the "Regulatory Impact Analysis Statement" published along with the amended regulation, SOR/89-419:

This change, which is part of the measures announced by the Minister of Finance on January 15, 1987 relating to the application of losses and other deductions, will prevent a corporation from maintaining at cost inventories which have declined in value and thereby deferring the recognition of a loss by postponing the write-down to fair market value until after a change in control.

The Department of Finance release of January 15, 1987 which accompanied the introduction of this and other amendments to the Income Tax Act amply supports the appellant's submission that this amendment was part of a concerted effort by the Department of Finance "to prevent trafficking in loss companies, that is, the acquisition by a profitable company of a `pregnant loss' company". Thus the Department had a valid policy reason to change the exception to the realization principle recognized by accounting conservatism from an optional to a mandatory requirement.

Finally, I wish to address some of the policy concerns raised by counsel for the respondent.

The respondent has raised the concern that if s. 10(1) inventory valuation applies to adventures in the nature of trade then the realization principle will only apply to capital property. The respondent also argued that the inventory valuation scheme in s. 10(1) undermines the matching principle and gives rise to asymmetry since it allows for business losses when inventory declines in value but does not create taxable income where there has been an unrealized gain created by a rise in fair market value. All of these are valid criticisms of the inventory valuation scheme in s. 10(1) but they cannot serve to thwart the intention of Parliament as expressed in the plain wording of the statute. Furthermore these criticisms are relevant to s. 10(1) as a whole and have no particular application to adventures in the nature of trade. I cannot accept that applying s. 10(1) to adventures in the nature of trade in accordance with the wording of that provision will cause significant harm especially when the respondent admits that the same section should be applied to all the inventory of all businesses with significant quantities of inventory.

Of greater concern is the interpretation proposed by the respondent which would create a whole new category of property unrecognized in the Act. This new class of property would attract the higher tax rate applicable to business income upon disposition but in years prior to disposition would be subject to the strictures which the realization, matching and symmetry principles impose upon the disposition of capital property. The Income Tax Act has established a system with two distinct categories of property -- inventory, which creates business income or loss, and capital property, which creates capital gain or loss. There are separate rules for each of these two categories of property and the taxpayer should be entitled to take the benefit as well as bear the burden applicable to the category into which the property falls. As Reed J. stated in Cull, supra, at pp. 5325-26:

Had the partnership realized a profit from the venture, there can be no question that, on the basis of the Fraser line of cases, it would have been business income, and not a capital gain. Thus, the taxpayer should be allowed to treat the losses according to the same principle.

It is true that an annual appraisal of the property which constitutes inventory is required in order for the taxpayer to comply with the requirements of s. 10(1). This, however, is simply a cost of doing business which must be borne by the taxpayer and it is no more burdensome than the same requirement which is imposed upon companies with far larger inventories to value that inventory each year. It should be remembered that the categorization of inventory (and hence s. 10(1)) will only apply to those who meet the judicially established test for an adventure in the nature of trade, namely that the taxpayer has a trading or business intention with respect to the property. This categorization will not apply to taxpayers who own personal-use property or who hold property for the purpose of long-term investment since this is categorized as capital property.

The fear that allowing adventures in the nature of trade to take advantage of the inventory valuation in s. 10(1) will lead to tax avoidance is unfounded. It is the rare taxpayer who will be faced with the situation of this appellant. In order to meet the test for an adventure in the nature of trade the taxpayer must have an intention to enter into a "scheme of profit-making". It is only where that scheme goes awry contrary to the intentions of the taxpayer that the taxpayer will be entitled to take advantage of the inventory valuation scheme in s. 10(1) in order to recognize a business loss. Schemes entered into with the intention of creating a business loss would not qualify as adventures in the nature of trade and would be tantamount to a sham. Further, any loss claimed by a taxpayer when the fair market value falls below cost is subject to recapture by the Minister in the year of disposition if the fair market value rises again. For greater clarity, in the year of disposition the taxpayer is subject to taxation on the difference between the proceeds of sale and the lowest value ascribed to the inventory in the years prior to sale.

It is true that the application of the formula Gross Profit = Proceeds of Sale - Cost of Sale [(Value of Inventory at beginning of year + Cost of Inventory acquisitions) - Value of Inventory at end of year] could lead to a negative cost of sale if the taxpayer chose to value inventory at fair market value as permitted by the current Regulation 1801. This problem can be obviated if the taxpayer chooses to value according to the lower of cost or fair market value method set out in s. 10(1). This method only recognizes unrealized losses and never recognizes unrealized gains. It is only unrealized gains which could give rise to a negative cost of sale. A negative cost of sale is not, however, a problem confined to single items of inventory used in an adventure in the nature of trade where the fair market value method is chosen. Trading companies with larger inventories would face the same problem on a larger scale in any year where the increase in the market value of inventory on hand exceeds the value of new inventory purchased in a year.

Further, the fact that proceeds of sale may be zero in a given year does not cast any doubt on the applicability of the formula. In any year in which there is a loss under this formula, the proceeds of sale will be less than the cost of sale and the fact that proceeds of sale are zero simply reflects this general truth on a smaller scale. A taxpayer is statutorily entitled by s. 9(2) to calculate loss using the same formula as would apply for the calculation of profit. Moreover, it is conceivable that a company with a large inventory could generate no sales in a year. It would be far more anomalous if the ability of such a company to recognize declines in the value of its inventory in a year were dependent on the existence of a single sale.

In summary I arrive at the following conclusions:

1.The appellant's venture is a business pursuant to the definition in s. 248(1) of the Act since it meets the test for an adventure in the nature of trade.

2.The Styles Property is inventory pursuant to the definition in s. 248(1) because its cost or value is relevant to the computation of business income in a taxation year, namely the year of disposition.

3.The use of the valuation system established in s. 10(1) and Regulation 1801 is governed by the application of well-recognized commercial and accounting principles. These principles establish that the value of inventory is relevant to the calculation of business income because it contributes to the cost of sale.

4.The valuation system established in s. 10(1) and Regulation 1801 is a specific legislated exception to the principles of matching, realization and symmetry and reflects well-recognized commercial and accounting principles which aim to achieve a conservative picture of business income.

5.Neither the common law restriction to stock-in-traders nor other policy considerations can serve to override the explicit wording of s. 10(1) which makes the valuation system therein applicable to all inventory used in the computation of business income.

6.The plain reading of s. 10(1) would allow single items of inventory held as part of an adventure in the nature of trade to utilize the inventory valuation method contained therein. This conclusion is consistent with the basic dichotomy in the Act between income and capital and the different schemes for taxing each of these.

7.For all of the above reasons, the appellant was entitled to make use of the inventory valuation method in s. 10(1) in order to recognize a business loss on the Styles Property in the taxation years in question, namely 1983 and 1984.

I would allow the appeal with costs in this Court and in the courts below and would direct that the Minister's assessment for the taxation years 1983 and 1984 be set aside and that the appellant's tax liability for the years in question be redetermined in a manner consistent with these reasons.