Minister Of National Revenue vs Anaconda American Brass Ltd.

Rewritten Version Notice: This is a rewritten version of the original judgment.

Court: supreme-court

Case Number: Not extracted

Decision Date: 13 December, 1955

Coram: Viscount Simonds

In this case the Court recorded that the appeal concerned a decision of the Supreme Court of Canada, which itself had dismissed an appeal from a ruling of the President of the Exchequer Court of Canada. The appeal was brought by the Minister of National Revenue against the limited company Anaconda American Brass Ltd., and the matter was noted as raising a question of novelty and importance.

The Minister had, on the basis of the company’s assessment for income tax and excess profits tax for the fiscal year 1947, increased the declared taxable income by the amount of $1,611,756.43. Because of that increase the excess profits tax liability for that year was raised by roughly $241,000, and the income‑tax liability was raised by about $483,000. The company challenged that assessment before the Exchequer Court; the President of that court allowed the company’s appeal, and the Supreme Court of Canada subsequently dismissed the Minister’s appeal from the President’s judgment. The present appeal before the Supreme Court of India was limited to the issue of the excess profits tax.

The Court explained that the excess profits tax was imposed under the Excess Profits Tax Act of 1940. Section 3 of that Act provided that, in addition to any other tax or duty payable under any legislation, a tax must be assessed, levied and paid at the rate specified in the Second Schedule of the Act on the excess profits of every corporation or joint‑stock company that was resident in Canada or carried on business there. The Second Schedule set the rate at fifteen per cent of the excess profits for such corporations or joint‑stock companies.

The Act further defined “profits” to mean, for any taxation period, the amount of net taxable income for the same period as determined under the Income War Tax Act. Under the Income War Tax Act, “income” was defined, for the purposes of the present dispute, as the annual net profit or gain that could be ascertained and computed as the profit derived from any trade, commercial, financial or other business activity.

The core issue identified by the Court was whether the Minister had correctly assessed the company’s annual net profit or gain for the year 1947, or, more precisely, whether the company had succeeded in establishing that the Minister’s assessment was erroneous.

The Court noted that the material facts of the case were not contested. It observed that the respondent company was engaged in the business of purchasing metals, converting those metals into sheets, rods and tubes, and then selling the finished metal products. Approximately ninety‑eight per cent of the metals purchased by the company were copper, which accounted for more than eighty per cent of the total, and zinc, which constituted about fifteen per cent. The remaining principal metals purchased were lead, tin and nickel. The Court further recorded that the prices charged by the company for its products were closely linked to the prices it paid for the metals used in manufacturing those products.

The company priced its products by adding to the cost the amount it paid to replace the metals used in manufacturing those products, and whenever market prices of the purchased metals rose, the company immediately raised the selling prices of its products by a corresponding amount. The company pursued a continuous programme of purchasing metals to replace those that were consumed in production. Each month, at the beginning of the month, it prepared an estimate of the quantity of metals that would be required during the ensuing month and consequently placed orders with its suppliers for exactly that quantity. In order to meet production needs without interruption, the company kept a standing inventory of metals equal to roughly one‑third to one‑quarter of its annual requirement, a practice that caused the inventory to be turned over three to four times each year. Approximately two‑thirds of the copper and zinc held in inventory were constantly situated in the processing plant, indicating an average processing period of about eight weeks. The company, however, did not maintain detailed records that would allow it to identify precisely which individual metal units were used during the year or to determine the exact amounts that had been paid for those units. Instead, it retained records showing the quantities of metal that existed (a) in its inventory at the start of the fiscal year, (b) that were purchased during the fiscal year, and (c) that remained in inventory at the close of the fiscal year. In addition to these quantity records, the company kept a log of the purchase prices it paid for the metals each time a purchase was made.

Consequently, for the year 1947 the company was fully aware of the amount of metal stock it possessed at the beginning of the year, the volume of metal it had bought during that year, and the amount of metal that was still on hand at year‑end. It also knew the prices it had paid for the metals that were purchased throughout the year. Nevertheless, the company could not identify, for every unit of metal that was actually used during the year, the specific price that had been paid for that unit, nor could it determine, for every unit of metal remaining in stock at year‑end, the price originally paid for it. Yet, in order to compute its annual profit or gain for 1947, the company needed to assign the correct cost to the metals that had been consumed and the correct cost or value to the metals that remained in inventory. In the absence of such precise cost information, the company was forced to make an assumption or estimate, and it was at this point that the dispute with the Minister arose. To explain the method by which the company prepared its 1947 tax return, it is helpful to note that, prior to that year, raw‑material prices had been relatively stable. In 1947, however, the relaxation and eventual removal of wartime controls caused sharp price increases—for example, copper rose from 11.5 cents per pound on 22 January to 16.625 cents per pound, and further to 21.5 cents per pound on 10 June. Under these volatile conditions, the company, for the first time in 1947, prepared its return using the accounting approach it described.

The company prepared its income‑tax return for the year 1947 by applying a valuation method known as Lifo, or last‑in‑first‑out. This method had previously been employed by the company for internal corporate accounting of copper, but neither the company nor any other taxpayer in Canada had used Lifo for taxation purposes. The Court first explained that Lifo did not require the metal most recently received into stock to be the first material actually processed and sold. Instead, the Court emphasized that the physical flow of raw material was considered irrelevant; copper purchased in earlier years and held in inventory at the beginning of the fiscal year, as well as copper bought during the year, could both have been processed and sold within that year without affecting the Lifo calculation. Lifo focused solely on cost, and in its simplest expression it assigned the cost per pound of the most recent copper purchases to the metal content charged against the next sale of processed products. Consequently, the inventory physically on hand at year‑end had to be assigned the cost of metal that had not yet been expended, a concept the Court referred to as the unabsorbed residue of cost. Applying this principle to the appellant’s 1947 closing inventory, the Court noted that the total copper on hand amounted to 14,291,007 pounds. Under the Lifo system this inventory was allocated as follows: six million five hundred thousand pounds were valued at seven and a half cents per pound, reflecting the average cost when Lifo was originally adopted in 1936, resulting in a dollar value of $487,500; eight hundred two thousand six hundred ninety‑seven pounds were assigned a cost of nine point four six six cents per pound, the average price paid in 1936, producing $75,983.30; seventeen thousand five hundred seventy‑seven pounds were valued at eleven point one nine one cents per pound, the average price paid in 1937, giving $1,967.04; six hundred thirty‑nine thousand eight hundred seven pounds carried a cost of ten point four four three cents per pound, the average price paid in 1938, amounting to $66,847.04; nine hundred seventy‑three thousand four hundred seventy‑seven pounds were assigned eleven point zero three six cents per pound, the average price paid in 1939, resulting in $107,432.92; three million one hundred fifty‑one thousand six hundred eighty‑four pounds were valued at eleven point five cents per pound, the price paid in 1945, producing $362,443.66; and finally, two million two hundred five thousand seven hundred sixty‑five pounds were also valued at eleven point five cents per pound, the price paid in 1946, giving $253,662.97. Adding all of these components, the Court calculated that the total cost attributed to the fourteen million two hundred ninety‑one thousand seven pounds of copper in the closing inventory was $1,355,836.93, and this figure was the amount reflected in the income‑tax return.

It was observed that the company assigned a value of 7.5 cents per pound to nearly one‑half of its copper inventory. That price was lower than any price that had been in effect since 1935. The effect of this valuation was clear. By allocating a higher cost to the copper that had been processed during the year and a lower cost to the copper that remained in stock, the company was able to report profits that were considerably lower than the profits it would have shown if it had used the customary and traditional method of accounting for its inventory. The central issue that the Court was asked to decide was whether this alternative method of valuation could be permitted when the purpose of the accounting was to determine liability for income tax.

The Court emphasized that the words “for income‑tax purposes” must be given full effect. A substantial portion of the argument presented before the Court, and throughout the appeal, was devoted to establishing that, in Canada, the last‑in‑first‑out (LIFO) method of accounting is, under certain circumstances, a proper and generally accepted practice, and that those circumstances were clearly present in the case of the appellant company. That view had been endorsed by the President of the Exchequer Court of Canada as well as by the Supreme Court, and the present Lordships accepted it without reservation. Nevertheless, the Minister of National Revenue maintained that, even if the LIFO method might be appropriate for the company’s internal corporate purposes, it did not accurately reflect the company’s profit for income‑tax purposes. Accordingly, the Minister increased the assessable income by $1,611,756.43. In making this assessment, the Minister applied the first‑in‑first‑out (FIFO) method, which assumes that the copper first purchased is the copper first used. Under this assumption, the copper remaining in stock at the close of 1947 was deemed to be the copper most recently acquired. The record showed that during 1947 the company purchased at least 63,268,555 pounds of copper, and that more than 14,291,007 pounds—the amount shown in the closing inventory—had been bought at a price of 215 cents per pound in the last three months of the year. Using these figures, the Minister calculated the value of the copper in the closing inventory at $3,072,566.50, a figure that stood in stark contrast to the $1,355,836.93 declared by the company in its tax return. At this stage the Court could clarify the positions of the parties. The Minister conceded that the amount of copper actually used during the financial year needed to be determined and did not dispute that some of the copper in the closing inventory might have been purchased in earlier years. However, he argued that the method he had adopted came closer to achieving the result described by Lord Loreburn in Sun Insurance Office v. Clark, namely that “the true gains are to be ascertained as nearly as it can be done.” He further contended that a principle of income‑tax law, derived from commercial accounting practice, requires that the values of stock‑in‑trade at the beginning and end of the accounting period be entered at either cost or market value, whichever is lower, and that, for this purpose, the actual stock on hand must be considered and its actual cost ascertained as far as possible, with estimation used only where precise ascertainment is impossible.

In the Minister’s assessment, the value of the closing inventory could be determined only insofar as it could be ascertained with certainty, and any assumption or estimate was required only where precise determination was impossible. On that basis, the Minister argued that the FIFO method more closely reflected the factual situation than the LIFO method. To support this claim, he pointed to the substantial purchases of metal made in the final months of 1947, purchases that could scarcely have been processed within that same financial year. He also highlighted that the LIFO approach would require assuming that £6,500,000 worth of copper acquired in or before 1936 remained in stock at the close of 1947, an assumption he regarded as unrealistic. Consequently, the Minister maintained that no evidence had been presented to show that the LIFO method provided a truer picture of the company’s income for tax purposes. He did not argue that a taxpayer could never demonstrate that an alternative method other than FIFO might better represent taxable income when the raw material is homogeneous and cannot be individually identified. Nor did he consider it necessary for the Court to decide whether a different technique, such as the average‑cost method, might occasionally be appropriate for tax purposes. The Minister’s sole contention was that, in the present case, the LIFO method did not more accurately produce the true income than FIFO, and that precise question was left for the Court’s determination. The company, in contrast, asserted that the Income War Tax Act contained no definition of “annual net profit or gain” and gave no specific rules for computing profit or cost of sales, and therefore such matters should be resolved by applying ordinary commercial principles unless the Act expressly excluded them. The company further argued that the question of what constitutes ordinary commercial principles was a factual one, noting that the President of the Exchequer Court had found, as a matter of fact, that the company’s return complied with those principles, a finding that the majority of the Supreme Court had affirmed. In short, the company contended that annual taxable income should be determined according to accepted accounting practice unless the statute provides otherwise, and that the President had held not only that LIFO was an acceptable accounting method but that it was the most appropriate method, whereas the Minister’s chosen method was not proper. The Court observed that these contentions had been rejected by the minority of the Supreme Court, specifically Kerwin C.J. and Estey J., and recalled the foundational principles of Canadian income‑tax law as articulated by Lord Clyde in Whimster & Co. v. Inland Revenue Commissioner, emphasizing that profits for a particular year are the difference between receipts from trade and the expenditures incurred to earn those receipts, and that the profit‑and‑loss account must be prepared consistently with ordinary commercial accounting principles, subject to the Income‑Tax Act and related statutes.

The Court explained that profit for a trade or business during a particular year or accounting period is measured by the difference between the receipts generated in that period and the expenditures incurred to earn those receipts. It further stated that the profit and loss account prepared for this purpose must be drawn up in accordance with ordinary commercial accounting principles, to the extent they apply, and must also comply with the rules of the Income‑Tax Act or with any modifications introduced by the statutes governing Excess Profit Duty. As an illustration, the Court noted that commercial accounting practice requires that, in the profit and loss statement of a merchant or manufacturer, the values of stock‑in‑trade at the start and at the end of the period be recorded at the lower of cost or market price, even though the statutes contain no explicit provision to that effect. Historically, for many years before and after the cited decision, the value assigned to opening and closing inventories for tax purposes has been the actual stock, as far as it could be ascertained. The Court regarded it as a novel and almost revolutionary suggestion to disregard those observable physical facts, even when they could be wholly or partially verified, and instead to rely on a theoretical assumption based on a presumed “flow of cost” and an “unabsorbed residue of cost.” The expert witness called for the company testified that he could not imagine any of the company’s witnesses claiming that a quantity of metal held on hand in 1936 was valued at its 1936 cost. Nevertheless, the company’s 1947 closing inventory included more than six and a half million pounds of copper, to which the 1936 cost had been attributed. The expert added that, provided the business continued and existing stocks were not substantially reduced, the same situation would recur each year; for example, the 1987 closing inventory would also contain stock valued at 1936 costs. This, the Court observed, clearly demonstrates the effect of the LIFO method and shows how far it has diverged from the traditional approach used in assessing taxable income. The respondent strongly argued that, when dealing with homogeneous material, applying an actual‑user test by identifying parcels bought at different prices would produce arbitrary and illogical outcomes. Even assuming that the actual‑user test might not always be the final determinant, the Court held that this argument does not, in its view, establish a justification for the LIFO method. The Court suggested that, in such circumstances, a properly applied method—like FIFO—would bring the cost of each purchase into the account in its appropriate year.

In this case the Court observed that under the last‑in‑first‑out (Lifo) method, if a business continues operating and carries stock forward, large purchases may never be reflected in profit calculations. The Court stated that it does not dispute that Lifo or a variant may be suitable for the corporate purposes of a trading company. It emphasized that businessmen and their accounting advisers must consider more than the fiscal year that is of interest to the Minister. They may find it prudent to record inventory at a figure that does not represent current market value or actual cost, but rather the lower historical cost at which similar items were purchased long ago. Such practice creates a hidden reserve that could be useful in later years. However, the Income‑Tax Act of 1947 does not concern itself with the years 1948 or 1949, by which time a company might have ceased to exist and its assets distributed. The Court recalled a statement made seventy years earlier by Lord Herschell, who described surplus as “the receipts from the trade or business excess the expenditure necessary for the purpose of earning those rejects.” The Court noted that this observation is among many judicial comments implying that no assumption should be made unless facts cannot be ascertained, and even then only to the extent of that uncertainty. The Court rejected any theory that costs flow in an indeterminate way, and refused to treat closing inventory as an unabsorbed residue of costs rather than as a concrete stock of metal awaiting processing. In the Court’s view, the failure to observe, or deliberate disregard of, ascertainable facts and to give them proper weight defeats the proper application of Lifo to the present case. The Court further reasoned that this same consideration renders the testimony of an export witness, who claimed that Lifo is generally acceptable and, in this instance, the most appropriate accounting method, insufficient to resolve the issue before the Court. While the Exchequer Court and the Supreme Court may find that fact, the remaining question is whether Lifo conforms to the requirements of the Income‑Tax Act. The Court concluded that, in its opinion, it does not.

The Court then turned to the historical background of the adoption of Lifo in Canada by the respondent company and possibly by other firms. It observed that the method appears to have originated in the United States and was first adopted there by an American corporation that served as the parent of the respondent before 1938. However, the method could be used for tax purposes in the United States only after an amendment to the existing revenue law that year permitted it. Subsequent amendments in 1939 further refined the statutory conditions, and at present the method is permitted only subject to those conditions, which the Court noted are summarized in the relevant provisions.

In this case the Court began by referring to the judgment of Estey J. in the Supreme Court and observed that the many differences that exist between the revenue laws of the United States and those of Canada prevent the Canadian courts from giving great weight to the approach that in the United States may be undertaken only where statutory safeguards have been enacted, while in Canada the same approach is being attempted without any specific legislation. The Court noted that this comparison nonetheless supports the principle that accounting theories, even when they are widely accepted and practiced by businesspeople, do not ultimately determine the taxable income of a trading company for the purposes of the Income‑Tax Act. The Court further acknowledged that, although the appeal must be decided by reference to Canadian law, it was useful to consider the reasoning of a United States decision in which the so‑called “base stock” method was being examined. In that United States case Brandeis J. employed language that is also applicable to the Lifo method, stating: “In years of rising price, the ‘base stock’ method causes an understatement of income; for it disregards the gains actually realized through liquidation of low‑price stock on a high‑price market… This method may, like many reserves which business men set up on their books for their own purposes, serve to equalize the results of operations during a series of years…” (see Lucas v. Kansas City Structural Steel Co. 1). The Court explained that this passage draws a clear line between what is permissible for tax purposes and what prudent businessmen may consider appropriate for internal accounting. The Court then turned to the United Kingdom, noting that there had been an unsuccessful attempt there to preserve the base‑stock method for income‑tax purposes. In the recent decision of Patrick v. Broadstone Mills Ltd. 2, Singleton L.J., using language that would also be appropriate if applied to the Lifo method, declined to accept the base‑stock method as consistent with income‑tax law, even though the method might be acceptable under accounting practice. After considering these authorities, the Court concluded that the appeal should be allowed, that the judgments of the appeal by the respondent company against the Minister’s assessment must be reversed, and that it would respectfully advise Her Majesty accordingly. The Court emphasized that this conclusion was not reached because it disagreed with any factual findings of the President of the Exchequer Court, whose judgment was described as lucid and exhaustive and therefore not open to criticism on factual grounds; rather, the Court held that the factual findings did not provide a complete solution to the legal question presented. Finally, the Court ordered that the respondent company should bear the costs of this appeal and also the costs of the proceedings that occurred in the Canadian courts.