Tax Guidance On Valuing Inventory Explained By Canadian Tax Lawyer

• Published date: 27 November 2020
• Subject Matter: Tax, Income Tax
• Law Firm: Rotfleisch & Samulovitch P.C.
• Author: Mr David Rotfleisch

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.

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...