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NO: IT-473R

DATE: December 21, 1998

SUBJECT: INCOME TAX ACT
Inventory Valuation

REFERENCE: Section 10 (also the definition of "inventory" in subsection 248(1) of the Income Tax Act and section 1801 of the Income Tax Regulations)


Notice -- Bulletins do not have the force of law

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Contents

Application

This bulletin cancels and replaces Interpretation Bulletin IT-473 dated March 17, 1981, and the related Special Release dated April 30, 1993.

Summary

In computing a taxpayer's income from a business for a taxation year, the value of property described in the inventory of the business at the end of the year must be determined. Section 10 of the Act and Part XVIII of the Regulations set out the rules pertaining to the valuation of inventory for this purpose.

In most cases, either of the following two methods of valuing inventory is available:

  • Valuation of each item in the inventory at the cost at which it was acquired or its fair market value at the end of the year, whichever is lower.
  • Valuation of the entire inventory at its fair market value at the end of the year.

Other methods of valuing inventory may be available or required depending on the type of business. For example, property described in the inventory of a business that is an adventure or concern in the nature of trade must be valued at the cost at which the taxpayer acquired the property.

This bulletin discusses the rules pertaining to the valuation of inventory for the purposes of computing a taxpayer's income from a business. It discusses the available methods of valuing inventory, change in the method of valuing inventory, the meaning of "cost," the methods of determining cost, and the meaning of "fair market value." For a list of other related bulletins, see ¶ 22 below.

Discussion and Interpretation

Meaning of "Inventory"

¶ 1. Subsection 248(1) defines "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 or would have been so relevant if the income from the business had not been computed in accordance with the cash method and, with respect to a farming business, includes all of the livestock held in the course of carrying on the business." See the income tax guide called Farming Income and the current version of IT-526, Farming -- Cash Method Inventory Adjustments for comments on valuing inventory in a farming business. Usually inventory includes all such materials to which the taxpayer has title, regardless of their location. Whether goods in transit or goods on consignment are to be included or excluded from an inventory should be decided on the basis of whether or not the taxpayer has title to the particular goods.

Determination of Quantities

¶ 2. In the usual case, a physical stocktaking should be carried out at the end of the year. Only where a reliable perpetual inventory system is employed, and then only when it has been periodically verified by reference to actual quantities on hand, will a physical count at the year end not be required.

Methods of Valuing Inventory

The basic rule

¶ 3 . In computing a taxpayer's income from a business for a taxation year, property described in the inventory of the business must be valued at the end of the year. Subject to the exceptions described in ¶s 4 to 6 below, subsection 10(1) of the Act and section 1801 of the Regulations provide for the following methods of valuing inventory:

  • Valuation of each item in the inventory at the cost at which it was acquired or its fair market value at the end of the year, whichever is lower.
  • Valuation of the entire inventory at its fair market value at the end of the year.

In comparing "cost" and "fair market value" in order to determine which is the lower, the comparison should be made separately and individually in respect of each item (or each usual class of items if specific items are not readily distinguishable) in the inventory. The lower figure for each such item, or each such class of items, should be extended and carried forward in arriving at the total value of the inventory. As an exception to this procedure, however, total costs and total fair market values should be the basis of comparison in cases where, although separate fair market values for individual items may be known, only an average cost figure is available. For information pertaining to "cost" see ¶s 10 to 17 below, and for information pertaining to "fair market value" see ¶s 18 to 21 below.

Adventure in the nature of trade

¶ 4 . If the business is an adventure or concern in the nature of trade, subsection 10(1.01) requires that the property described in the inventory of the business be valued at the cost at which the taxpayer acquired the property. Subsection 10(1.01) applies to all taxation years (fiscal periods in the case of a partnership) other than those ending before December 21, 1995 for which the inventory of the business was valued, under former subsection 10(1), at an amount that is less than the cost at which the property was acquired and such valuation is reflected in an income tax return, a notice of objection or a notice of appeal filed before December 21, 1995. In addition, this subsection does not apply to a taxation year or a fiscal period that ends before December 21, 1995, if the filing due date in respect of that year is after December 20, 1995.

As mentioned above, for taxation years (fiscal periods in the case of a partnership) ending before December 21, l995, property described in the inventory of a business that is an adventure or concern in the nature of trade may have been valued using a method provided for under former subsection 10(1). By virtue of subsection 10(9), if, for the last taxation year (fiscal period in the case of partnership) that the property was valued under former subsection 10(1), the property was valued at an amount less than the cost at which the taxpayer acquired the property, the cost of such property to the taxpayer after that time is deemed to be that lower amount.

For a discussion of an adventure or concern in the nature of trade, see the current version of IT-459, Adventure or Concern in the Nature of Trade.

¶ 5 . Under subsection 10(10), if the taxpayer is a corporation and there is an acquisition of control of the corporation, the property described in the inventory of the corporation's business that is an adventure or concern in the nature of trade must be valued, at the end of the taxation year that ends immediately before the acquisition of control, at the cost at which the corporation acquired the property or its fair market value at the end of the year, whichever is lower. After that time, the cost at which the corporation acquired the property is deemed to be that lower amount. The application date for subsection 10(10) is the same as the application date for subsection 10(1.01) (see ¶ 4 above). For a discussion on "acquisition of control," see the current version of IT-302, Losses of a Corporation -- The Effect that Acquisitions of Control, Amalgamations, and Windings-up have on Their Deductibility -- After January 15, 1987.

Artistic endeavour

¶ 6 . In computing the income of an individual (other than a trust) from a business that is the individual's artistic endeavour, the individual may, under subsection 10(6), elect to value the inventory of that business at nil. A "business that is an individual's artistic endeavour" is defined in subsection 10(8) to mean the business of creating paintings, prints, etchings, drawings, sculptures or similar works of art, where such works of art are created by the individual, but does not include a business of reproducing works of art. For more information, see the current version of IT-504, Visual Artists and Writers.

Change in the Method of Valuing Inventory

¶ 7 . Under subsection 10(2.1), where the inventory of a business (other than a business that is an adventure or concern in the nature of trade) is valued at the end of a taxation year in accordance with a method provided for under section 10, that method must, except where the taxpayer elects to value the inventory at nil under subsection 10(6) (see ¶ 6 above), be used to value the inventory of the business at the end of the following year unless a change in method of valuing inventory is approved by the Minister. Note that subsection 10(2.1) applies to the method of valuing property described in an inventory (see ¶ 3 above) and not to the method of determining the cost or the fair market value of such property. For example, a taxpayer valued the inventory of a business at the end of the 1997 taxation year at the lower of the cost at which it was acquired and its fair market value. The taxpayer used the average cost method to determine the cost of the property for this purpose. At the end of the 1998 taxation year, the taxpayer wishes to value the entire inventory at its fair market value. As the method of valuing inventory is changing (i.e., from the lower of cost and fair market value to fair market value), the approval of the Minister under subsection 10(2.1) is required in this situation. If, however, at the end of the 1998 taxation year, the taxpayer continues to value the inventory at the lower of cost and fair market value, but wishes to use the first in, first out method to determine the cost of the inventory, the approval of the Minister under subsection 10(2.1) would not be required. For information pertaining to the determination of the cost or the fair market value of property described in an inventory, see ¶s 10 to 21 below.

¶ 8. A change in the method of valuing inventory will generally be approved by the Minister if it can be shown that, considering the circumstances, the new method:

  • is a more appropriate way of computing the taxpayer's income;
  • will be used for financial statement purposes by the taxpayer; and
  • will be used consistently in subsequent years.

If a change in valuation methods is desired, the taxpayer or an authorized representative should write to the Director of the tax services office in the taxpayer's region and set out the reasons why the new method is more appropriate. The letter should provide:

  • relevant financial statements and tax schedules;
  • a summary of the effect of the change on the financial statements;
  • a statement that the new method is in accordance with the financial statements; and
  • an undertaking that the new method will be used consistently in subsequent taxation years.

The request should normally be made before the taxpayer files an income tax return for the year of the contemplated change.

¶ 9. Subsection 10(2) provides that the inventory at the beginning of a taxation year of a business shall be valued at the same amount as the amount at which the inventory was valued at the end of the immediately preceding year.

Subsection 10(3) provides a mechanism whereby the Department can change the method used to value inventory at year end from an unacceptable to an acceptable method without also adjusting the value of the inventory at the start of the year. For example, if a taxpayer, with a December 31 year end, has for several years calculated the value of the inventory using an inappropriate method and the Department determines that valuing the inventory at the lower of cost and fair market value for each item produces an appropriate income for 1997, the Department may assess the income for that year using the redetermined valuation for the closing inventory and the Minister may issue a direction under subsection 10(3) deeming that the 1997 opening inventory was properly valued. This direction prevents the taxpayer from redetermining the 1997 opening inventory which, pursuant to subsection 10(2), would necessitate revising the closing inventory for 1996.

Meaning of "Cost"

¶ 10 . "Cost" as used in the phrase "cost at which the taxpayer acquired the property" in section 10 means the original cost of the particular item of inventory plus all costs which may reasonably be considered as having been incurred to bring that particular item of inventory to its condition and location at the end of the taxation year.

¶ 11. In the case of inventories of merchandise purchased for resale or of raw materials acquired for a manufacturing process, cost means laid-down cost. This includes invoice cost, customs and excise duties, transportation and other acquisition costs and, where they are significant, storage costs.

¶ 12 . In the case of inventories of work in process and finished goods, cost means the laid-down cost of materials plus the cost of direct labour applied to the product and the applicable share of overhead expense properly chargeable to production. Either direct costing, which allocates variable overheads to inventory, or absorption costing, which allocates both variable and fixed overheads to inventory, is acceptable as a method of costing inventory, but the method used should be the one that gives the truer picture of the taxpayer's income. Prime costing, a method in which no overhead is allocated to inventory, is not accepted for income tax purposes as a method of costing inventory. Again, where they are significant, storage costs should be reflected in product cost.

¶ 13. Taxpayers who follow the practice of including an allowance in respect of depreciation, obsolescence or depletion in inventory are required by paragraph 12(1)(r) to include in income an amount equal to the portion of the cost amount of the year end inventory representing this allowance. The amount included in income under paragraph 12(1)(r) is deductible in the following year under paragraph 20(1)(ii), as illustrated in the Appendix.

¶ 14. In some manufacturing organizations only standard costs are developed. In such cases, "standard cost" is an acceptable basis for inventory valuation provided that there is no significant variation between the aggregate standard costs and the aggregate actual costs properly applicable to the inventory. If actual costs and standard costs are substantially different, it is usual to adjust the standard cost to estimated actual costs by applying a percentage factor based on production.

Method of Determining Cost

Commonly used methods

¶ 15. Where it is practical to identify costs by reference to specific items, the cost is determined by ascertaining the laid-down cost of the specific items. If it is not practical to determine cost by reference to specific items, it is necessary to use an arbitrary cost selection method which has the effect of making a presumption as to the order in which inventory is sold. Among the methods most commonly used in determining cost are:

  • specific item
  • average cost
  • first in, first out (fifo)

The last in, first out method (lifo) and the base stock method are not accepted for income tax purposes as methods of determining cost.

¶ 16 . The method used in determining cost for income tax purposes should normally be the same as the method used for financial statement purposes. However, if there is more than one acceptable method of determining cost according to generally accepted accounting principles, the method used for income tax purposes should be the one that gives the truer picture of the taxpayer's income. The method used must also be followed consistently from year to year and a change will only be accepted if the new method is more realistic in the circumstances and gives the truer picture of the taxpayer's income.

Retail inventory method

¶ 17. The retail inventory method is generally acceptable to the Department if it meets all of the following conditions:

  • The method is used only where there are many different commodities for resale, e.g., a grocery store or a department store.
  • The values are established in accordance with generally accepted accounting principles.
  • The values so established are used for both tax and financial statement purposes.

Meaning of "Fair Market Value"

¶ 18 . Except as indicated in ¶ 19 below, the term "fair market value," as used in section 10 of the Act and section 1801 of the Regulations, is synonymous with the word "market" which is used in the accounting phrase "lower of cost or market." The term generally refers to either replacement cost or net realizable value. The method used in determining "fair market value" for income tax purposes should normally be the same as the method used to determine "market" for financial statement purposes. However, if there is more than one acceptable method of determining "market" according to generally accepted accounting principles, the method used in determining "fair market value" for income tax purposes should be the one that gives the truer picture of the taxpayer's income. The method used must also be followed consistently from year to year and a change will only be accepted if the new method is more realistic in the circumstances and gives the truer picture of the taxpayer's income.

¶ 19. Under paragraph 10(4)(a), the fair market value of work in progress of a business that is a profession means the amount that can reasonably be expected to become receivable in respect thereof after the end of the year. Under paragraph 10(4)(b), the fair market value of advertising or packaging material, parts, supplies or other similar property of a business means the replacement cost of the property except where such property is obsolete, damaged or defective, or unless the taxpayer is in the business of selling or leasing such property.

¶ 20. The use of replacement cost in determining fair market value may not give a proper result where goods or materials have deteriorated in value by year-end to the extent that they cannot be disposed of in the normal way (i.e., those goods or materials that are in such condition that a taxpayer would have to depart from the normal merchandising procedure in order to dispose of them). In such a case, the use of net realizable value (the estimated selling price in the ordinary course of business less reasonably predictable preparation and marketing costs) in determining the fair market value for these goods or materials will be accepted, notwithstanding that the taxpayer may use replacement cost in determining the fair market value for the remainder of the inventory.

¶ 21. Regardless of the method used to determine fair market value, a reduction in inventory value to reflect losses that are anticipated after the year-end is not acceptable. Also, the recording of a loss on inventory account in the current taxation year in order to preserve a regular (or any) profit margin for the subsequent year of disposition is not acceptable.

Other Bulletins

¶ 22 . In connection with the subject matter of this bulletin, the current version of one or more of the following bulletins may be of interest:

IT-51   Supplies on Hand at the End of a Fiscal Period
IT-153   Land Developers -- Subdivision and Development Costs and
Carrying Charges on Land
IT-165   Returnable Containers
IT-283   Capital Cost Allowance -- Video Tapes, Videotape Cassettes,
Films, Computer Software and Master Recording Media
IT-302   Losses of a Corporation -- The Effect that Acquisitions of
Control, Amalgamations, and Windings-up have on
Their Deductibility -- After January 15, 1987
IT-328   Losses on Shares on Which Dividends Have Been Received
IT-457   Election by Professionals to Exclude Work in Progress
from Income
IT-459   Adventure or Concern in the Nature of Trade
IT-482   Capital Cost Allowance -- Pipelines
IT-483   Credit Unions
IT-501   Capital Cost Allowance -- Logging Assets
IT-504   Visual Artists and Writers
IT-526   Farming -- Cash Method Inventory Adjustments

Appendix -- Depreciation in Inventory

Assume
              Year 1               Year 2
Inventory at beginning of year   $ 0   $ 20,000
Cost of sales   80,000   200,000
Inventory at end of year   20,000   25,000
Depreciation for year   5,000   10,250
Depreciation included in closing inventory   1,000   1,250
Net income for year per financial statements   50,000   90,000

Computing Net Income for Tax Purposes
       
Net income for the year per financial statements   $ 50,000   $ 90,000
Add: Depreciation included in opening inventory $ 0   $ 1,000  
Depreciation for year 5,000   10,250  
Less: Depreciation included in closing inventory (1,000) 4,000 (1,250) 10,000
------- ------- -------- ---------
Net income for tax purposes before CCA   $ 54,000   $ 100,000
Add: Adjustment required by paragraph 12(1)(r) $ 1,000   $ 1,250  
Deduct: Adjustment required by paragraph 20(1)(ii) 0 1,000 (1,000) 250
------- ------- -------- ---------
Net income for tax purposes before CCA   $ 55,000   $ 100,250
  =====   ======

Explanation of Changes

Introduction

The purpose of the Explanation of Changes is to give the reasons for the revisions to an interpretation bulletin. It outlines revisions that we have made as a result of changes to the law, as well as changes reflecting new or revised departmental interpretations.

Reasons for the Revision

This bulletin is being revised to reflect amendments to the Income Tax Act enacted by S.C. 1998, c. 19 (formerly Bill C-28). Generally, the amendments clarify that property described in the inventory of a business that is an adventure or concern in the nature of trade is to be valued at the end of the year at cost and not, for example, at the lower of cost and fair market value as allowed in subsection 10(1). This is in line with the Department's historical policy that any income or loss from such property is recognized only on disposition. These amendments respond to the decision of the Supreme Court of Canada in Jake Friesen v. Her Majesty the Queen, [1995] 2 CTC 369, 95 DTC 5551, in which it was held that the rules applying to the valuation of business inventory for the purpose of computing income from business also apply to property held as an adventure or concern in the nature of trade, thus allowing losses on such property to be recognized prior to the year of disposition. The comments in this bulletin are not affected by any other draft legislation released before December 3, 1998.

Legislative and Other Changes

¶ 3 contains information from former ¶s 4 and 15. It reflects two clarifying amendments made to subsection 10(1). The first amendment changes the phrase "cost to the taxpayer" to "cost at which the taxpayer acquired the property." The purpose of this amendment is to clarify that when property described in an inventory is valued at the lower of cost and fair market value, the reference to cost is to the original cost of the property and not its last lowest value. This ensures that inventory that has been written down is adjusted upwards if the inventory subsequently increases in value. The second amendment changes the term "fair market value" to "fair market value at the end of the year."

New ¶  4 reflects new subsections 10(1.01) and 10(9). Subsection 10(1.01) requires that the inventory of a business that is an adventure or concern in the nature of trade be valued at the cost at which the taxpayer acquired the property. Subsection 10(9) provides that, where property described in an inventory of a business that is an adventure or concern in the nature of trade has been written-down under former subsection 10(1) for a taxation year for which that valuation method was available, the cost of the property to the taxpayer after that time is deemed to be the value last assigned by the taxpayer under former subsection 10(1).


These subsections apply to all taxation years (fiscal periods in the case of a partnership) other than those ending before December 21, 1995 for which the inventory of the business was valued, under former subsection 10(1), at an amount that is less than the cost at which the property was acquired and such valuation is reflected in an income tax return, a notice of objection or a notice of appeal filed before December 21, 1995. In addition, the amendments do not apply to a taxation year or a fiscal period that ends before December 21, 1995, if the filing due date in respect of that year is after December 20, 1995.

New ¶ 5 reflects new subsection 10(10). This subsection requires that accrued losses in the inventory of a business that is an adventure or concern in the nature of trade be recognized in the taxation year that is deemed to end by virtue of subsection 249(4) immediately before an acquisition of control. This is consistent with how accrued losses on other inventory are treated on an acquisition of control. Subsection 10(10) also deems the cost of the property to the taxpayer after the acquisition of control to be the lower of the cost and the fair market value of the property immediately before the acquisition. New subsection 10(10) has the same application date as new subsection 10(1.01) (see the above comments for new ¶ 4).

¶ 6 contains information from former ¶ 4. It has been expanded to provide the definition for a "business that is an individual's artistic endeavour."

¶ 7 contains information from former ¶ 4. It clarifies that subsection 10(2.1) does not apply to property described in the inventory of a business that is an adventure or concern in the nature of trade. It also clarifies that subsection 10(2.1) does not apply in the determination of the method to be used in determining the cost or fair market value of property. In other words, subsection 10(2.1) does not go beyond the determination of the method of inventory valuation to be selected from among the statutory alternatives.

¶ 10 (former ¶ 6) has been revised to reflect the phrase "cost at which the taxpayer acquired the property" contained in the amendments to section 10. This phrase clarifies that when property described in an inventory is valued at the lower of cost and fair market value, the reference to cost is to the original cost of the property and not its last lowest value. This ensures that inventory that has been written down is adjusted upwards if the inventory subsequently increases in value.

¶ 12 (former ¶ 8), ¶ 16 (former ¶ 16), and ¶ 18(from former ¶s 12 and 16) have been revised to clarify that if a taxpayer can select from among a number of accounting methods, each one being in accordance with generally accepted accounting principles, the method used for income tax purposes should be the one that presents the truer picture of the taxpayer's income. This position is supported by the decision in West Kootenay Power and Light Company Limited v. The Queen, 92 DTC 6023, [1992] 1 CTC 15.

¶ 22 (former ¶ 18) has been expanded to include other bulletins that may be of interest to the reader.

The illustration in the Appendix has been amended and information that is not relevant for the purposes of current taxation years has been deleted.

We have made a number of other changes to improve the overall clarity and readability of the bulletin.


Notice -- Bulletins do not have the force of law

Interpretation bulletins (ITs) provide Revenue Canada's technical interpretations of income tax law. Due to their technical nature, ITs are used primarily by departmental staff, tax specialists, and other individuals who have an interest in tax matters. For those readers who prefer a less technical explanation of the law, the Department offers other publications, such as tax guides and pamphlets.

While the ITs do not have the force of law, they can generally be relied upon as reflecting the Department's interpretation of the law to be applied on a consistent basis by departmental staff. In cases where an IT has not yet been revised to reflect legislative changes, readers should refer to the amended legislation and its effective date. Similarly, court decisions subsequent to the date of the IT should be considered when determining the relevancy of the comments in the IT.

An interpretation described in an IT applies as of the date the IT is published, unless otherwise specified. When there is a change in a previous interpretation and the change is beneficial to taxpayers, it is usually effective for all future assessments and reassessments. If the change is not favourable to taxpayers, it will normally be effective for the current and subsequent taxation years or for transactions entered into after the date of the IT.

A change in a departmental interpretation may also be announced in the Income Tax Technical News.

If you have any comments regarding matters discussed
in this IT, please send them to:

Director, Business and Publications Division
Income Tax Rulings and Interpretations Directorate
Policy and Legislation Branch
Revenue Canada
Ottawa ON K1A 0L5

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