The corporate taxpayers, CDSL, CGI and Systems were in the business of providing consulting services in the information technology industry. For the 1998 and 1999 taxation years, the taxpayers took the position that the work in progress with respect to the ongoing services constituted inventory within the meaning of paragraph 10(5)(a) of the Act. For accounting purposes, the taxpayers calculated their work in progress on an exercise basis, which takes into account the profit that applies to the rendered services that are not yet invoiced at the end of the year. This method is consistent with Generally Accepted Accounting Principles ("GAAP").
For tax purposes, however, the taxpayers evaluated the work in progress on a cost basis, which was significantly lower than the fair market value. Accordingly, the taxpayers computed their income tax on the basis of their billed income rather than on the basis of services rendered, although this method admittedly did not reflect an accurate picture for accounting purposes.
The Canada Revenue Agency ("CRA") issued a Notice of Assessment, the effect of which was to add to the business income of the taxpayers the difference between the cost and the fair market value of their work in progress. The CRA relied on section 9 of the Act, which provides that a taxpayer’s income for a taxation year is the taxpayer’s profit from that business for the year. The taxpayers’ appeals were heard together on common evidence.
The issue in the appeal was the interplay of sections 9 and 10, and whether one section prevails over the other in determining an accurate picture of profit. Specifically, does section 10 "override" section 9?
For the Tax Court of Canada, Justice Rip (as he then was) stated that, based on the Canada v. Cyprus Anvil Mining decision, sections 9 and 10 were complimentary and that he did not need to determine whether one prevailed over the other. The two sections must be read together. The Minister had admitted that the taxpayers met the requirements of section 10 and thus section 10 applied. However, the determination of profit is made via a method selected by the taxpayer and such method must reveal an accurate picture of the financial situation of the business. For a business with inventory, it will be necessary to consider the inventory in calculating profit.
The Tax Court stated that the objective of section 10 was to value the inventory and to determine the method to account for the inventory in the calculation of income according to section 9. Section 10 cannot be used to reduce the profit associated with the work in progress.
In support of this conclusion, the Tax Court stated that the taxpayers’ interpretation of section 10 would have the effect of obliterating the purpose of section 34, which authorizes certain professionals to exclude an amount with respect to their work in progress from their income.
On appeal to the Federal Court of Appeal, Justice Noël began his analysis by noting that the standard to review on a question of law was the correctness and that the determination of profit according to section 9 of the Act was a question of law. Furthermore, Justice Noël stated that the determination of the profit must be in accordance with the general accepted business practices, which includes GAAP except to the extent that GAAP is incompatible with the Act.
Justice Noël summarized the steps that must be used to calculate the income of a taxpayer. First, the taxpayer must calculate gross profit (proceeds of sale - the cost of sale). The cost of sale is calculated as follows:
Cost of sale = (value of inventory at the beginning of the year + cost of inventory acquisitions) – value of inventory at the end of the year.
Section 10 establishes that the value of inventory is the lesser of its cost and its fair market value. Consequently, where the fair market value is less than the cost, a loss is recorded in the year. Another consequence is that an inherent gain is only realized when it is realized.
Justice Noël concluded that there is, in fact, a conflict between sections 9 and 10. He explained that Justice Rip could not rely on Cyprus since the Act was amended to confirm that section 10 applies to compute a taxpayer’s income for a taxation year.
The only question remaining was to determine if section 10 prevails over section 9. According to Justice Noël, the question was settled by the Supreme Court of Canada in Friesen v. R., supra, wherein the Court decided that section 10 obliges a taxpayer to estimate his inventory according to its provisions. The fact that this method may provide a result that is not in accordance with the GAAP is not an impediment.
Moreover, Justice Noël stated that sections 10 and 34 each apply in a different way and the two are compatible. Finally, Justice Noël pointed out that when a provision is unambiguous, the courts must interpret and apply the provision in the way that was intended by Parliament.
Thus, the Federal Court of Appeal allowed the appeal and held that the taxpayers could ignore GAAP in computing their incomes without including the inherent profit in their unbilled work in progress.