U.S. Securities and Exchange Commission

Form 40-F

For the fiscal year ended                   December 31, 2003                                             Commission File Number                  9682                

Domtar Inc.

Not Applicable

Canada

2621

Not applicable

395 de Maisonneuve Blvd. West, Montreal, Quebec, Canada H3A 1L6 (514) 848-5400

CT Corporation System, 111 Eighth Avenue, New York, N.Y. 10011, (212) 664-1666

                               Securities registered or to be registered pursuant to Section 12(b) of the Act.

                               Securities registered or to be registered pursuant to Section 12(g) of the Act.

Not Applicable

                               Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act.

8 ¾% Notes due 2006, 9 ½% Debentures due 2016, 7.875% Notes due 2011, 5.375% Notes due 2013

                               For annual reports, indicate by check mark the information filed with this Form:

Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the close of the period covered by the annual report.

Common Shares – 228,868,629 shares

Indicate by check mark whether the Registrant by filing the information contained in this form is also thereby furnishing the information to the Commission pursuant to Rule 12g3-2(b) under the Securities Exchange Act of 1934 (the “Exchange Act”). If “Yes” is marked, indicate the file number assigned to the Registrant in connection with such Rule.

Form 40-F

Domtar Inc.

April 1, 2004

TABLE OF CONTENTS

Exhibits

DISCLOSURE CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

In accordance with the rules of the Securities and Exchange Commission, Domtar maintains a system of disclosure controls and procedures that is designed to ensure that information required to be disclosed by Domtar is accumulated and communicated to management, including the Chief Executive Officer and the Chief Financial Officer, in a timely manner. Under the supervision and with the participation of its management, including its Chief Executive Officer and Chief Financial Officer, Domtar has evaluated the effectiveness of the design and operation of these disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, Domtar’s Chief Executive Officer and Chief Financial Officer concluded that Domtar’s system of disclosure controls and procedures is effective.

Change in Internal Controls over Financial Reporting

Domtar maintains a system of internal controls over financial reporting. There were no changes in Domtar’s internal controls that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, Domtar’s internal control over financial reporting.

38   Management’s Discussion and Analysis

MD&A

Montreal, Quebec
March 1, 2004

Management’s Discussion and Analysis (MD&A) relates to the financial condition and results of Domtar’s operations. Throughout this MD&A, unless otherwise specified, “Domtar”, “we”, “us” and “our” refer to Domtar Inc., its subsidiaries, as well as its joint ventures, and “the Corporation” refers to Domtar Inc. and its subsidiaries. Domtar’s common shares are listed on the Toronto and New York stock exchanges. Except where otherwise indicated, all financial information reflected herein is determined on the basis of Canadian generally accepted accounting principles (Canadian GAAP). This MD&A should be read in conjunction with Domtar’s consolidated financial statements and notes thereto.

In accordance with industry practice, in this MD&A, the term “ton” or the symbol “ST” refers to a short ton, an imperial unit of measurement equal to 0.9072 metric tons, and the term “tonne” or the symbol “MT” refers to a metric ton. In this MD&A, unless otherwise indicated, all dollar amounts are expressed in Canadian dollars, as are the term “dollars” and the symbols “$” and “CAN$”. The term “U.S. dollars” and the symbol “US$” refer to United States dollars.

Forward-Looking Statements
     
This MD&A contains statements that are forward-looking in nature. Statements preceded by the words “believe”, “expect”, “anticipate”, “aim”, “target”, “plan”, “intend”, “continue”, “estimate”, “may”, “will”, “should” and similar expressions are forward-looking statements. Forward-looking statements are necessarily based upon a number of estimates and assumptions that, while considered reasonable by management, are inherently subject to known and unknown risks and uncertainties such as, but not limited to, general economic and business conditions, product selling prices, raw material and operating costs, changes in foreign currency exchange rates, our ability to integrate acquired businesses into our existing operations, and other factors referenced herein and in Domtar’s continuous disclosure filings. Therefore, Domtar’s actual results may be materially different from those expressed or implied by such forward-looking statements.

2003 Overview

In 2003, we had to cope with difficult market conditions, in particular the rapid 12% decline in the year-over-year average value of the U.S. dollar when compared to the Canadian dollar, which decreased our net sales, given that most of our products are priced directly or indirectly in U.S. dollars. In fact, within the year 2003, the spot rate declined 22% from January 1, 2003 to December 31, 2003. At the same time, we also had to face a decline in demand for some of our products as well as a soft pricing environment, particularly for copy and offset papers. These difficult market conditions also led us to record an impairment loss on the book value of property, plant and equipment at our Lebel-sur-Quevillon pulp mill and to shut down one of the two paper machines at our Vancouver mill. We are, however, pleased with the performance of our four U.S. mills acquired in 2001. They have enhanced our ability to service customers and mitigated the effect of currency fluctuations by improving our geographical balance and increasing our operational flexibility.

While we experienced a difficult year in 2003, we are determined to improve our profitability. In order to do so, we have announced plans to strengthen our profitability improvement programs by further increasing the competitiveness of our Canadian mills as well as our operational flexibility. These plans are expected to entail a thorough review of our Canadian pulp and paper operations to enable them to remain profitable when the Canadian dollar is valued at 75 cents to the U.S. dollar and prices are at cycle-low levels.

Domtar Inc. 2003 Annual Report   39

Our Business

Domtar’s reporting segments correspond to the following business activities: Papers, Paper Merchants, Wood and Packaging.

Papers
     
We are the third largest integrated manufacturer and marketer of uncoated freesheet paper in North America. We operate six pulp and paper facilities in Canada and five in the United States, with an annual paper production capacity of approximately 2.7 million tons of paper, complemented by strategically located warehouses and sales offices. Over 50% of our paper production capacity is located in the United States and approximately 90% of our paper sales are made to customers in the United States. Uncoated and coated freesheet papers, our principal products, are used for business, commercial printing and publication, and technical and specialty applications. The chart below illustrates our principal paper products and our annual paper production capacity.

We sell paper primarily through a large network of owned and independent merchants that distribute our paper products from over 350 locations throughout North America. We also sell our products to a variety of customers, including business offices, office equipment manufacturers, retail outlets, commercial printers, publishers and converters. In addition, we sell pulp in excess of our own internal requirements. We also purchase pulp to optimize paper production and freight costs. At December 31, 2003, our net market pulp position (shipments less purchases) was approximately 640,000 tons.

40   Management’s Discussion and Analysis

Our Papers business is our most important segment, representing 58% of our consolidated net sales in 2003, or 64% when including sales of Domtar paper through our own Paper Merchants business.

Paper Merchants
     
Our Paper Merchants business comprises the purchasing, warehousing, sale and distribution of various products made by us and by other manufacturers. These products include business and printing papers, graphic arts supplies and certain industrial products. Our Canadian paper merchants operate a total of eight branches in eastern Canada (three by Buntin Reid in Ontario, two by JBR/La Maison du Papier in Quebec and three by The Paper House in the Atlantic Provinces), while our U.S. paper merchant (RIS Paper) services a large customer base from 20 locations in the Northeast, Midwest and Mid-Atlantic regions of the United States. Our Paper Merchants business represented 23% of our consolidated net sales in 2003, or 17% when excluding sales of Domtar paper.

Wood
     
Our Wood business comprises the manufacturing and marketing of lumber and wood-based value-added products, as well as the management of forest resources. We operate 11 sawmills, one planer mill and one remanufacturing facility, with an annual capacity of 1.2 billion board feet of lumber. We also have investments in three businesses that produce wood products. We seek to optimize 22 million acres of forestland for which we are responsible in Canada and the United States through efficient management and the application of certified sustainable forest management practices such that a continuous supply of wood is available for future needs. Our Wood business represented 7% of our consolidated net sales in 2003.

Packaging
     
Our Packaging business comprises our 50% ownership interest in Norampac Inc. (Norampac), a joint venture between Domtar Inc. and Cascades Inc. The Board of Directors of Norampac is composed of four representatives each from Domtar Inc. and Cascades Inc. The Chairman of the Board is a Domtar Inc. representative, while the President and CEO is a Cascades Inc. representative. Norampac’s debt is non-recourse to Domtar Inc. As required by Canadian GAAP, we account for our 50% interest in Norampac using the proportionate consolidation method.

Norampac’s network of 24 corrugated packaging plants, strategically located across Canada and the United States, provides full-service packaging solutions and produces a broad range of products. These facilities are fully integrated on a direct or indirect basis with Norampac’s eight containerboard mills (located in Ontario, Quebec, British Columbia, New York State and northern France) for a combined annual capacity of more than 1.6 million tons. Our Packaging business represented 12% of our consolidated net sales in 2003.

Business Strategy
     
Our overall strategic objective is to be a world leader in the paper industry, particularly in the fine paper segment. We have developed our business strategies around three pillars: meeting and anticipating the ever-changing needs of customers, providing our shareholders with attractive returns, and fostering a dynamic and creative environment for our employees in which shared human values and personal commitment prevail.

Our business strategies are to continue to:

Through these strategies, we aim to be one of the most attractive investments in the North American basic materials sectors by providing superior returns to our shareholders.

Domtar Inc. 2003 Annual Report   41

Summary of Financial Results

42   Management’s Discussion and Analysis

Unusual items affecting results and non-GAAP measures

Our operating results include unusual items affecting the comparability of our results. To measure our performance and that of our business segments from period to period without variations caused by special or unusual items, we focus on EBITDA excluding unusual items, operating profit excluding unusual items, net earnings excluding unusual items, net earnings per share excluding unusual items, and other such measures excluding unusual items. Unusual items are defined as items such as charges for: impairment of assets, facility or machine closures, changes in income tax legislation, debt restructuring, and other significant items of an unusual or non-recurring nature.

EBITDA excluding unusual items, operating profit excluding unusual items, net earnings excluding unusual items, net earnings per share excluding unusual items and other such measures excluding unusual items are non-GAAP measures. We believe that it is useful for investors and other users to be aware of the unusual factors that adversely or positively affected our GAAP results, and that these non-GAAP measures provide investors and other users with a measure of performance to compare our results between periods without regard to these unusual items. These measures have no standardized meaning prescribed by GAAP and are not necessarily comparable to similar measures presented by other companies and therefore should not be considered in isolation.

The following table reconciles our net earnings (loss) and net earnings (loss) per share, determined in accordance with GAAP, to our net earnings excluding unusual items and net earnings per share excluding unusual items, and reconciles our EBITDA and operating profit (loss) to our EBITDA excluding unusual items and operating profit excluding unusual items:

Domtar Inc. 2003 Annual Report   43

44   Management’s Discussion and Analysis

Net sales of $4.8 billion

Net sales in 2003 totaled $4,777 million, down $713 million or 13% from net sales of $5,490 million in 2002. This decrease was mainly attributable to the effect of a 12% rapid decline in the year-over-year average value of the U.S. dollar when compared to the Canadian dollar (approximate $490 million impact, net of the effect of our hedging program) on both our domestic and export sales, and to lower shipments for all of our principal products, except corrugated containers, caused primarily by weak demand (approximate $150 million impact). In addition, the results for 2002 were impacted by the reversal of a $28 million provision, of which $8 million was recorded in the first quarter of 2002 and $20 million was recorded in the second half of 2001 for countervailing and antidumping duties pertaining to the Canada-U.S. softwood lumber dispute. Overall, our U.S. dollar denominated transaction prices for 2003 remained low at 92% of trend¹ prices, unchanged in comparison to 2002. Within Canada, however, the decline of the U.S. dollar negatively impacted our Canadian dollar denominated prices, which are derived from U.S. dollar denominated prices.

Operating loss of $92 million

Cost of sales decreased by $374 million or 9% in 2003 compared to 2002. This decrease was mainly due to the impact of a weaker U.S. dollar on our U.S. dollar denominated operating expenses, lower shipments and the impact of our quality and profitability improvement programs. These factors were partially offset by higher energy costs, as well as by the inclusion of fewer investment tax credits related to research and development expenses of current and prior years in 2003 ($10 million) compared to 2002 ($16 million).

Sales, general and administrative (SG&A) expenses decreased by $11 million or 3% (or $13 million or 4% when excluding unusual items of $2 million pertaining to the write-off of transaction costs) in 2003 compared to 2002. This mainly reflected the impact of a weaker U.S. dollar on our U.S. dollar denominated costs and the inclusion of a $6 million mark-to-market gain on certain foreign exchange contracts not considered as hedges for accounting purposes. Lower employee profit-sharing expenses in 2003 compared to 2002 and other cost reduction initiatives also contributed to the decrease in SG&A. These factors were partially offset by an increase in stock-based compensation and pension expenses.

Operating loss was $92 million in 2003 compared to an operating profit of $384 million in 2002. When excluding unusual items, operating profit amounted to $135 million in 2003, down $312 million or 70% from an operating profit excluding unusual items of $447 million in 2002. This decrease was largely due to the $222 million impact of the weaker U.S. dollar on both domestic and export sales net of U.S. dollar costs and net of the effect of our hedging program, lower shipments for all our principal products except corrugated containers, higher energy costs, and higher countervailing and antidumping duties on our softwood lumber exports to the U.S. However, the positive impact of our quality and profitability improvement programs, when excluding the impact of lower shipments, allowed us to more than offset the impact of inflation on salaries and benefits.

Domtar Inc. 2003 Annual Report   45

As a result of the above-mentioned factors, EBITDA for 2003 amounted to $516 million (or $519 million when excluding unusual items) compared to $809 million (or $845 million when excluding unusual items) in 2002.

Quality and profitability improvement programs

In 2002, we launched a quality and profitability improvement program aimed at achieving $100 million of savings by the end of 2003 through higher efficiencies, an improved customer base and product offerings, and reduced operating costs. Unfortunately, the success of this program in 2003 was hampered by difficult market conditions, including a significant drop in shipments ($63 million) caused by weak economic conditions, our decision to adjust production to customer needs and end the practice of selling papers that did not meet our quality standards (seconds), and the impact of labor disruptions and the August 2003 power outage. Nonetheless, the cost reduction initiatives undertaken have allowed us to more than offset the impact of inflation on salaries and benefits.

In January 2004, we announced plans to strengthen our quality and profitability improvement programs in order to increase our competitiveness and counteract the impact of difficult market conditions. More specifically, we will:

We expect these measures to increase our operational flexibility and enhance the competitiveness of our Canadian mills. We further anticipate that they will mitigate the impact of rising costs, particularly in the areas of energy and fiber, the latter having also been affected by the Canada-U.S. softwood lumber dispute.

Net loss of $190 million

Net loss for 2003 amounted to $190 million ($0.84 per common share) compared to net earnings of $141 million (or $0.62 per common share) in 2002. When excluding unusual items, net earnings

46   Management’s Discussion and Analysis

totaled $5 million ($0.02 per common share) in 2003, down $178 million from net earnings when excluding unusual items of $183 million ($0.80 per common share) in 2002. This year-over-year deterioration in net earnings was attributable to the factors mentioned above, partially offset by a decrease in financing expenses due to lower interest rates, the positive impact of a weaker U.S. dollar on our U.S. interest expense and lower debt levels, and lower income taxes.

ROE¹ of negative 8%
      
One of the measures we use to assess shareholders’ return is ROE. Our objective is to achieve a 15% ROE under normal market conditions. In 2003, our ROE was negative 8% compared to a positive 6% in 2002. When excluding unusual items, ROE in 2003 was at break-even (see “ROE Reconciliation” table below) and at 7% in 2002. This decrease in ROE is explained by the above-mentioned factors.

Achieving a 15% ROE target remains a challenge, given current market conditions (weakness of the U.S. dollar, cycle-low prices for copy and offset papers, weak demand, and the ongoing Canada-U.S. softwood lumber dispute). We expect the rationalization programs we are initiating and the implementation of strategic tools such as new business processes and an ERP system to partially offset the impact of difficult market conditions and improve our return to shareholders.

Free cash flow²
      
Despite difficult market conditions, we generated free cash flow (cash flows from operating activities less net additions to property, plant and equipment) of $123 million in 2003 compared to $454 million in 2002. Free cash flow generated in 2003 was applied primarily to debt reduction and the payment of dividends.

Domtar Inc. 2003 Annual Report   47

Papers

Sales and operating profit
      
Net sales in our Papers business amounted to $2,791 million in 2003, a decrease of $443 million or 14% in comparison to 2002. This decrease was primarily due to the unfavorable impact of a weaker U.S. dollar on both domestic and export sales and lower shipments for both paper and pulp. These factors were partially offset by overall higher selling prices, as decreases in the selling prices for copy, offset and uncoated paper products were more than offset by increases in the selling prices for coated and technical and specialty paper products, as well as for hardwood and softwood pulp.

Operating loss in our Papers business totaled $90 million in 2003 (or an operating profit of $135 million when excluding unusual items of $225 million pertaining to an impairment charge and closure costs) compared to an operating profit of $301 million in 2002 (or $346 million when excluding unusual items of $45 million pertaining to closure costs). This $211 million decrease in operating profit when excluding unusual items

48   Management’s Discussion and Analysis

stems primarily from the negative impact of a weaker U.S. dollar, lower shipments for both paper and pulp, and higher energy and purchased fiber costs, partially offset by higher selling prices and the benefits stemming from our quality and profitability improvement programs.

Pricing environment
      
In our Papers business, our average transaction prices, denominated in U.S. dollars, increased in 2003 compared to 2002. Within Canada, however, the decline of the U.S. dollar negatively impacted our Canadian dollar denominated prices, which are derived from U.S. dollar denominated prices.

Our average transaction prices for 20 lb copy sheets (business papers) and 50 lb offset rolls (uncoated commercial printing & publication papers), which represented 43% of our paper sales in 2003, decreased by an average of US$32/ton in 2003 compared to 2002. We have announced a US$60/ton price increase for both copy papers and offset rolls, effective March 1, 2004.

Our Northern Bleached Softwood Kraft (NBSK) and our Northern Bleached Hardwood Kraft (NBHK) pulp transaction prices increased by US$53/tonne and US$44/tonne, respectively, in 2003 compared to 2002. We have announced a US$20/tonne price increase for softwood pulp, effective February 1, 2004.

Operations
      
Our paper shipments to capacity ratio stood at 91% for 2003 compared to 95% in 2002. Our Papers business was impacted by weak economic conditions, our decision to curtail production to match customer demand and end the practice of selling seconds, and the impact of production disruptions caused by the mid-August 2003 power outage in the eastern United States and eastern Canada as well as labor issues.

In the third quarter of 2003, new six-year labor agreements were signed with PACE union members at our Port Huron, Port Edwards, and Nekoosa mills.

In November 2003, employees at our Vancouver paper mill went on strike after rejecting our offer for the renewal of their collective agreement. In January 2004, the strike was resolved and a new five-year labor agreement was signed with CEP union members. The mill resumed operations in early-February 2004.

Certain collective agreements for the Cornwall, Ottawa-Hull, Espanola, Lebel-sur-Quevillon and Wisconsin mills are due for renewal in 2004.

In January 2004, we proceeded with our plans to reorganize production activities at our Vancouver paper mill to better meet customer demands and increase the mill’s profitability. Accordingly, we shut down one of the mill’s two paper machines and restructured the activities of the other to optimize manufacturing of our Domtar Luna coated paper. This process resulted in the permanent curtailment of 45,000 tons of paper manufacturing capacity and the termination of 85 employees. These steps are expected to increase product quality and availability, expand our market share of coated papers, improve the mill’s efficiency and better respond to Asian competition.

Domtar Inc. 2003 Annual Report   49

Paper Merchants

Sales and operating profit
      
Our Paper Merchants business generated net sales of $1,074 million in 2003, a decrease of $119 million or 10% in comparison to 2002. This decrease was due to the negative impact of a weaker U.S. dollar and a reduction in overall tons sold compared to the prior year.

Operating profit in 2003 totaled $20 million (reflecting an operating margin of 1.9%) compared to $25 million in 2002 (reflecting an operating margin of 2.1%). This decrease in operating profit and related margin was mainly attributable to a decrease in warehouse shipments, which generate higher gross profit than direct mill shipments, and to the negative impact of a weaker U.S. dollar.

Wood

50   Management’s Discussion and Analysis

Sales and operating profit
     
Our Wood business generated net sales of $342 million in 2003, representing a $120 million decrease compared to net sales of $462 million in 2002. This decrease is mainly attributable to increased countervailing and antidumping duties on our softwood lumber exports to the U.S. ($34 million impact), which reflect the reversal of a $28 million provision for duties in the second quarter of 2002 (of which $8 million was recorded in the first quarter of 2002 and $20 million was recorded in the second half of 2001), and the negative impact of a weaker U.S. dollar on both domestic and export sales, as well as lower selling prices and lower shipments.

Cash deposits of $45 million were made on our softwood lumber exports to the United States during the year ended December 31, 2003, compared to $31 million in the corresponding period of 2002. Since May 22, 2002, cash deposits of $76 million for countervailing and antidumping duties have been made and expensed by Domtar.

Operating loss in 2003 amounted to $68 million (or $66 million when excluding unusual items of $2 million pertaining to the write-off of transaction costs) compared to an operating loss of $16 million (or operating profit of $2 million when excluding unusual items of $18 million reflecting closure costs pertaining to our Daveluyville and Sault Ste. Marie facilities closures) in 2002. This $68 million decline in operating profit when excluding unusual items is largely the result of an increase in countervailing and antidumping duties on our softwood lumber exports to the U.S. resulting from the reversal of a provision in 2002, the negative impact of a weaker U.S. dollar, lower lumber selling prices and lower shipments. These factors were partially offset by sustained efforts to improve efficiency and reduce costs during the year.

Pricing environment
     
Our transaction prices for Great Lakes 2x4 studs and random lengths decreased by US$7/MFBM and increased by US$7/MFBM, respectively, in 2003 compared to 2002. The decline of the U.S. dollar negatively impacted our Canadian dollar denominated prices in our domestic marketplace, given that these are derived from U.S. dollar denominated prices.

Operations
     
During the past two years, there have been a number of mill closures, both temporary and permanent.

In June 2002, a decision was taken to halt the Ste. Marie sawmill operations for an undetermined period of time due to the Canada-U.S. softwood lumber dispute. The Ste. Marie sawmill resumed full operations on May 20, 2003. In July 2002, the Grand-Remous sawmill ceased operations due to a dispute between the Barriere Lake First Nation and the governments of Quebec and Canada. The dispute was settled and the Grand-Remous sawmill resumed full operations on April 28, 2003.

The usual two-week holiday shutdowns at the Lebel-sur-Quevillon, Matagami and Malartic sawmills in 2002 were extended for an additional two weeks to avoid inventory buildups in a declining product price environment. These sawmills resumed operations on January 20, 2003. Our Ontario sawmills also took some market-related downtime in January 2003.

In March 2003, we sold the Sault Ste. Marie hardwood lumber facility, and in April 2003, we sold the Daveluyville remanufacturing facility, following an earlier decision in November 2002 to shut down these facilities because they were not cost competitive.

Domtar Inc. 2003 Annual Report   51

On June 23, 2003, we halted production at the White River sawmill for an expected six-month period due to difficult market conditions brought about by overcapacity within the North American market and the Canada-U.S. softwood lumber dispute. Following a continuous improvement workshop held with the employees to reduce costs, the sawmill resumed operations in mid-February 2004.

In June 2003, we announced an agreement-in-principle with Tembec Inc. for the creation of a joint venture that would merge certain of our respective lumber and timber operations. Following an extensive due diligence of the timber and lumber operations of both companies, we concluded in November 2003 that we could not ensure our shareholders that this transaction would create value from “day one”. Given our stated commitment in this regard, it was preferable not to proceed with this transaction.

In August 2003, we announced the permanent closure of our Sault Ste. Marie planer facility effective October 17, 2003 because it was not cost competitive.

On January 16, 2004, we announced the formation of a 50-50 joint venture with Gogama Forest Products Ltd., which will create a fully integrated sawmill, kiln and planer operation to produce approximately 60 Mmfbm of lumber in Northern Ontario. The transaction is expected to close in the first quarter of 2004.

Despite the challenging environment in our Wood business, we continued to pursue sawmill modernization projects aimed at improving profitability. In 2003, the Elk Lake, Val d’Or, Matagami, Timmins, White River, Chapleau, Malartic and Grand Remous sawmills achieved productivity improvement gains.

Packaging

Sales and operating profit
     
Our 50% share of Norampac’s net sales amounted to $570 million in 2003, a decrease of $31 million or 5% over 2002. This decrease was mainly due to the negative impact of a weaker U.S. dollar, which resulted in lower average net selling prices for both containerboard and corrugated products, partially offset by an increase in shipments for corrugated containers attributable to recently acquired facilities.

52   Management’s Discussion and Analysis

Our 50% share of Norampac’s operating profit amounted to $48 million in 2003, a $26 million or 35% decrease from the $74 million operating profit reported in 2002. This decrease was explained by the same factors impacting net sales and by higher energy costs, partially offset by a decrease in purchased fiber costs.

Pricing environment
     
Norampac’s average Canadian dollar net selling prices for containerboard products decreased by 9% in 2003 compared to 2002. This decrease is primarily due to the impact of the weaker U.S. dollar on Norampac’s net selling prices. Norampac announced a US$50/ton price increase for container-board effective February 23, 2004.

Norampac’s average Canadian dollar net selling prices for corrugated boxes in 2003 decreased by 9% compared to 2002.

Operations
     
During 2003, Norampac’s North American containerboard mill capacity utilization rate was approximately 90%, down from 91% in 2002. This reflects Norampac’s commitment to adjust production to customers’ needs. In addition, Norampac’s North American integration level, the percentage of containerboard produced by Norampac that is consumed by its own box plants, increased to 60%, up from 59% in 2002.

Financing Expenses and Income Taxes

Financing expenses
     
In 2003, financing expenses amounted to $169 million compared to $192 million in 2002. When excluding unusual items pertaining to debt refinancing charges ($17 million impact), financing expenses amounted to $152 million in 2003, representing a $40 million decrease compared to 2002. This decrease mainly reflects the impact of lower interest rates, a weaker U.S. dollar on our U.S. dollar interest expense, and lower debt levels.

Income taxes
     
Our income tax recovery for 2003 was $67 million reflecting an effective income tax rate of 26%, compared to an income tax expense of $56 million for 2002, reflecting an effective income tax rate of 28%. In 2003, an increase in statutory enacted future income tax rates and a corresponding revaluation of future income tax assets and liabilities resulted in an additional income tax expense of $31 million. Excluding this item, income tax recovery in 2003 would have been $98 million, reflecting an effective income tax rate of 38%. The variation in the effective tax rate in 2003 over 2002, excluding this item, results mainly from the mix and level of earnings between our different tax jurisdictions and differences in tax rates applicable to our foreign subsidiaries.

Balance Sheet

Our total consolidated assets were $5,855 million as at December 31, 2003 compared to $6,847 million as at December 31, 2002. Receivables amounted to $197 million as at December 31, 2003, a decrease of $107 million when compared to $304 million as at December 31, 2002. This decrease reflects the effect of a weaker U.S. dollar on our U.S. dollar denominated retained interest in trade receivables sold through our securitization program and on our U.S. dollar denominated other receivables, as well as overall lower net sales. Total inventories as at December 31, 2003 were $670 million, a decrease of $66 million when compared to $736 million as at December 31, 2002. This decrease reflects

Domtar Inc. 2003 Annual Report   53

market-related and other downtime taken in our Papers business in order to adjust our production to meet customers’ needs, temporary closures in our Wood business, the impact of a weaker U.S. dollar, and the impact of inventory reduction programs. Property, plant and equipment as at December 31, 2003 totaled $4,540 million compared to $5,387 million as at December 31, 2002. This $847 million decrease was mainly due to the effect of a weaker U.S. dollar on our U.S. mill assets, an impairment charge recorded to write-down the book value of property, plant and equipment at our Lebel-sur-Quevillon pulp mill, and a lower level of capital expenditures compared to amortization expense during the year. Other assets stood at $212 million as at December 31, 2003 compared to $205 million as at December 31, 2002. This $7 million increase was mainly due to an increase in the funding of our pension assets compared to pension expense, partially offset by an $11 million reclassification of share purchase loans receivable to common shares.

     Trade and other payables were $653 million as at December 31, 2003 compared to $749 million as at December 31, 2002, reflecting a decrease of $96 million. This decrease was mainly due to lower employee profit-sharing accruals and the effect of a weaker U.S. dollar on our U.S. dollar denominated trade and other payables. Long-term debt (including the portion due within one year) as at December 31, 2003 decreased to $2,059 million compared to $2,514 million as at December 31, 2002, mainly reflecting a decrease in the Canadian value of our U.S. dollar denominated debt due to the impact of a declining U.S. dollar and debt repayments made throughout the year. Accumulated foreign currency translation adjustments were negative $145 million as at December 31, 2003, a decrease of $147 million from the balance as at December 31, 2002. This decrease mainly reflected the net impact of a weaker U.S. dollar on the net assets of our self-sustaining U.S. subsidiaries, or $391 million, net of the impact of a weaker U.S. dollar on the long-term debt designated as a hedge of the above-mentioned net assets, or $282 million, and its corresponding income tax effect of $38 million. Had we not designated part of our long-term debt as a hedge of our net investment in self-sustaining foreign subsidiaries, the $244 million unrealized foreign exchange gain net of income taxes currently recorded in the “Accumulated foreign currency translation adjustments” account would have increased our results of operations for the year ended December 31, 2003.

Liquidity and Capital Resources

54   Management’s Discussion and Analysis

Our principal cash requirements are for working capital, capital expenditures, principal and interest payments on our debt and dividend payments. We expect to fund our liquidity needs primarily with internally generated funds from our operations and, to the extent necessary, through borrowings under our revolving credit facility. We also have the ability to fund liquidity requirements through the issuance of debt and/or equity. Our access to current and alternate sources of financing at competitive cost is dependent upon our credit ratings.

Operating activities
     
Cash flows provided from operating activities in 2003 amounted to $348 million compared to $677 million in 2002. This decrease is primarily due to a significant decrease in EBITDA, notably caused by lower net sales reflecting the negative impact of a weaker U.S. dollar, weak demand and higher duties on softwood lumber exports to the United States, as well as higher energy costs. Our operating cash flow requirements are primarily for salaries and benefits, the purchase of fiber, energy and raw materials, and other expenses such as property taxes.

Investing activities
     
Cash flows used for investing activities in 2003 totaled $238 million compared to $244 million in 2002. Investing activities in 2003 included $11 million related to our portion of Norampac’s business acquisitions, while this amount represented $27 million in 2002.

Net additions to property, plant and equipment amounted to $225 million in 2003 (or 59% of amortization) compared to $223 million in 2002 (or 56% of amortization). The overall increase in net additions to property, plant and equipment in comparison to the previous year relates primarily to the implementation of an ERP system within our Papers business. We intend to limit our annual capital expenditures to well below 75% of amortization, or $290 million in 2004, including approximately $120 million for capital expenditures relating to the long-term sustainability of our equipment.

Free cash flow (cash flows from operating activities less net additions to property, plant and equipment) for 2003 amounted to $123 million compared to $454 million in 2002. This decrease in free cash flow on a year-over-year basis is attributable to reduced operating cash flow. Free cash flow generated in 2003 was applied primarily to debt reduction and the payment of dividends.

Financing activities
     
Cash flows used for financing activities totaled $96 million in 2003 compared to $431 million in 2002. The decrease in cash flows used for financing activities was due to lower net repayments of long-term debt in 2003 compared to 2002.

As at December 31, 2003, our net debt-to-total capitalization ratio stood at 48% (or 46% when excluding unusual items incurred in 2003) compared to 49% as at December 31, 2002. Net indebtedness, including $180 million representing our 50% share of the net indebtedness of Norampac, was $2,030 million as at December 31, 2003. This compares to $2,496 million as at December 31, 2002, including $191 million for our 50% share of the net indebtedness of Norampac. The $466 million decrease in net indebtedness was largely due to the positive impact of a weaker U.S. dollar on our U.S. dollar denominated debt. We were able to achieve a net debt-to-total capitalization ratio of

Domtar Inc. 2003 Annual Report   55

48% (or 46% when excluding unusual items incurred in 2003) compared to our stated objective of 45% absent the impact of any growth-related initiatives.

In November 2003, we filed a shelf registration statement providing for the issuance of up to US$500 million of debt securities over the next two years. Pursuant to this, we completed shortly thereafter a public offering in the United States of US$350 million ($456 million) aggregate principal amount of 5.375% notes due 2013 at an issue price of US$347 million ($452 million), the proceeds of which were used to repay part of our bank term loan. Subsequently, the Corporation entered into interest rate swap contracts for a nominal value of $452 million (US$350 million) ending in December 2013. These swaps were designated as hedges of the fair value of the 5.375% notes. As at December 31, 2003, these interest rate swap contracts had a fair value under $1 million.

As at December 31, 2003, the balance of the US$1 billion bank term loan initially entered into to finance our 2001 acquisition was US$76 million ($99 million) compared to US$480 million ($758 million) as at December 31, 2002. This decrease was due to the application of the proceeds from the US$350 million public debt offering and the free cash flow generated to the partial repayment of this loan. The term loan bears interest based on the U.S. dollar LIBOR rate or the U.S. prime rate, plus a margin that varies with Domtar’s credit rating.

As at December 31, 2003, of the US$500 million revolving credit facility, US$23 million ($30 million) was drawn, US$8 million ($10 million) of letters of credit were outstanding and US$5 million ($7 million) was drawn in the form of overdraft and included in “Bank Indebtedness”, resulting in US$464 million ($600 million) of availability under this facility. No provision was recorded relating to outstanding letters of credit. As at December 31, 2002, US$5 million ($8 million) was drawn in the form of overdraft and US$6 million ($9 million) of letters of credit were outstanding. Borrowings under this revolving credit facility bear interest at a rate based on the Canadian dollar bankers’ acceptance or the U.S. dollar LIBOR rate or the prime rate, plus a margin that varies with Domtar’s credit rating. This bank facility also requires commitment fees in accordance with standard banking practices.

Our borrowing agreements contain restrictive covenants. In particular, our unsecured bank credit facility contains covenants that require compliance with certain financial ratios on a quarterly basis. In addition, the indentures related to the 10% and 10.85% debentures limit the amount of dividends that we may pay, the amount of shares that we may repurchase for cancellation and the amount of new debt we may incur.

In 2003, common shares amounting to $15 million, versus $16 million for 2002, were issued pursuant to our stock option and share purchase plans. We did not purchase for cancellation any of our common shares in either of the years ended December 31, 2003 or December 31, 2002.

On May 1, 2003, we announced an increase of our annual common share dividend to 24 cents per share (or 6 cents per quarter) from 14 cents per share (or 3.5 cents per quarter). This increase is the first step towards our goal of paying a dividend of approximately 20% of normalized net earnings over a business cycle, provided we are able to maintain a strong balance sheet.

As at February 27, 2004, we had 229,233,581 common shares, 69,576 Series A Preferred Shares and 1,580,000 Series B Preferred Shares, which were issued and outstanding.

As at February 27, 2004, we had 6,017,254 common shares purchase options issued and outstanding under the Executive stock option and Share purchase plan.

56   Management’s Discussion and Analysis

Off Balance Sheet Arrangements

In the normal course of business, we finance certain of our activities off balance sheet through leases and securitizations.

Leases

On an ongoing basis, we enter into operating leases for property, plant and equipment. Minimum future rental payments under these operating leases, determined as at December 31, 2003, amounted to $142 million, of which $28 million related to our proportionate 50% share of Norampac.

Securitizations

We sell a portion of our Canadian and American receivables through securitization programs. We use securitization of our receivables as a source of financing by reducing our working capital requirements. This securitization consists of the sale of receivables on a limited recourse basis, or the sale of senior beneficial interest in them, to special purpose trusts managed by financial institutions for multiple sellers of receivables. The agreements normally allow the daily sale of new receivables to replace those that have been collected. They also limit the cash that can be received from the sale of the senior beneficial interest. The subordinate interest retained by us is included in “Receivables” and will be collected only after the senior beneficial interest has been settled.

As at December 31, 2003, the value of securitized receivables amounted to $227 million compared to $264 million as at December 31, 2002. We expect to continue to sell receivables on an ongoing basis, given the attractive discount rates. Should we decide to discontinue these programs, our working capital and our bank debt requirements would increase. Such sales of receivables are contingent upon the Corporation retaining specified credit ratings. The loss of such ratings would, absent appropriate waivers, increase our working capital and our bank debt requirements.

Guarantees

Pension plans

Domtar has indemnified and held harmless the trustees of Domtar pension funds, and the respective officers, directors, employees and agents of such trustees, from any and all costs and expenses arising out of the performance of their obligations under the relevant trust agreements, including in respect of their reliance on authorized instructions of Domtar or for failing to act in the absence of authorized instructions. These indemnifications survive the termination of such agreements. As at December 31, 2003, we had not recorded a liability associated with these indemnifications, as we do not expect to make any payments pertaining to these indemnifications.

E.B. Eddy acquisition

On July 31, 1998, we acquired all of the issued and outstanding shares of E.B. Eddy Limited and E.B. Eddy Paper, Inc. (E.B. Eddy), an integrated producer of specialty paper and wood products. The purchase agreement includes a purchase price adjustment whereby, in the event of the acquisition by a third party of more than 50% of the shares of the Corporation in specified circumstances, the Corporation may have to pay up to a maximum of $120 million, an amount which is gradually declining over a 25-year period. As at December 31, 2003, the maximum amount of the purchase price adjustment was $110 million. No provision was recorded related to this potential purchase price adjustment, as we do not expect to make any payments pertaining to this purchase price adjustment.

Sales of businesses and real estate

In the normal course of business, the Corporation offers indemnifications relating to the sale of its businesses and real estate. In general, these indemnifications may relate to claims from past business operations, to the failure to abide by covenants and to the breach of representations and warranties included in the sales agreements. Typically, such representations and warranties relate to litigations as well as taxation, environmental, product and employee matters. As the nature and scope of such indemnifications is contingent upon future events, none of which can be foreseen as at December 31, 2003, no provisions have been recorded in the

Domtar Inc. 2003 Annual Report   57

financial statements. These indemnifications have not yielded significant expenses in the past.

Debt agreements

Certain debt agreements require the Corporation to indemnify the parties in the event of changes in elements such as withholding tax regulations. As the nature and scope of such indemnifications is contingent upon future events, none of which can be foreseen as at December 31, 2003, and the structure of such transactions make these events unlikely, no provisions have been recorded in the financial statements.

Leases

The Corporation has guaranteed to various lessors $8 million of residual value of its assets under operating leases. If the fair value of the assets at the end of the lease terms is lower than the residual value guaranteed, the Corporation would be held liable for the shortfall. The Corporation’s management does not believe that these are likely to be called upon and, as such, no provisions have been recorded in the financial statements with respect to these guarantees.

Contractual Obligations and Commercial Commitments

In the normal course of business, we enter into certain contractual obligations and commercial commitments. The following tables provide our obligations and commitments as at December 31, 2003:

Contractual obligations

Commercial commitments

For 2004 and the foreseeable future, we expect cash flows from operations and from our various sources of financing to be sufficient to meet our contractual obligations and commercial commitments.

58   Management’s Discussion and Analysis

Selected Quarterly Financial Information (unaudited)

Selected quarterly financial information for the eight most recently completed quarters ending December 31, 2003 is disclosed below:

Net sales and operating profit have experienced a steady decline since the beginning of 2003. This is mainly in line with the steady weakening of the U.S. dollar and lower shipments, as reflected by our shipments to capacity ratio for papers. In addition, lower selling prices in Canada have impacted our results, as they are derived from U.S. dollar denominated prices.

In light of such a weak U.S. dollar, we plan to undertake a complete review of our Canadian pulp and paper operations to ensure that they are profitable when the Canadian dollar is valued at 75 cents to the U.S. dollar and prices are at cycle-low levels. In addition, our quality and profitability improvement programs initiated in 2002 contributed to the positive results in that year, but were hampered by difficult market conditions in 2003. These programs, when excluding the impact of lower volumes, did enable us to more than offset the impact of inflation on salaries and benefits. We plan to strengthen these programs so as to reduce our costs further.

Typically, second and third quarters are seasonally stronger in terms of results, as demand normally picks up during the spring and summer months.

The decline in our fourth quarter 2003 results in comparison to the fourth quarter of 2002 was attributable to a significant weakening in the value of the U.S. dollar versus the Canadian dollar and overall lower selling prices for our products, as well as a drop in shipments. This decline in shipments was due to weak demand and was aggravated by temporary circumstances such as market-related downtime and labor disruptions.

Domtar Inc. 2003 Annual Report   59

2002 compared to 2001

Net sales in 2002 totaled $5,490 million, up $1,113 million or 25% from net sales of $4,377 million in 2001. This increase was mainly due to the inclusion of net sales of the four U.S. integrated pulp and paper mills (the Acquired Mills) acquired on August 7, 2001 for the twelve months in 2002 compared to five months in 2001. The inclusion of our share of Norampac’s 2002 acquisitions also contributed to the increase. Excluding the impact of these acquisitions, net sales would have decreased by $22 million in 2002 over 2001, mainly due to lower product prices, partially offset by higher shipments in all of our businesses except for container-board and the positive impact of a stronger U.S. dollar. Our transaction prices for 2002 were at 92% of trend prices compared to 97% in 2001.

Cost of sales increased by $807 million in 2002 or by 23% compared to 2001. This was mainly due to the inclusion of cost of sales of the Acquired Mills for twelve months in 2002 compared to five months in 2001, our share of Norampac’s cost of sales related to recent acquisitions, and higher shipments in all of our businesses other than container-board. This increase was partially offset by lower purchased fiber and energy costs and a $16 million investment tax credit for research and development expenditures in prior years.

SG&A expenses increased by $68 million in 2002 or 27% compared to 2001. This increase was mainly due to the inclusion of SG&A expenses of the Acquired Mills and our share of Norampac’s acquisitions, partially offset by the impact of our cost reduction initiatives. 2001 SG&A expenses had been reduced by $14 million following the cashing in of certain insurance policies.

As a result of the above-mentioned factors, EBITDA for 2002 amounted to $809 million (or $845 million when excluding unusual items) compared to $607 million in 2001 and operating profit amounted to $384 million (or $447 million when excluding unusual items) for 2002 compared to $313 million in 2001.

Net earnings in 2002 amounted to $141 million ($0.62 per common share) compared to net earnings of $140 million ($0.72 per common share) in 2001. Excluding unusual items, net earnings in 2002 amounted to $183 million (or $0.80 per common share). The 2001 net earnings included an income tax benefit of $39 million ($0.20 per common share) related to a reduction in enacted income tax rates and a revaluation of future income tax assets (unusual item).

In 2002, we delivered a 6% ROE compared to 7% in 2001. Excluding unusual items, ROE in 2002 was 7% compared to 6% in 2001, despite a difficult economic environment as evidenced by the 5% decrease in our selling price index.

We generated free cash flow of $454 million in 2002 compared to $447 million in 2001. When excluding net additional cash proceeds received from the sales of receivables, free cash flow amounted to $428 million in 2002 compared to $269 million in 2001. Free cash flow generated in 2002 was applied primarily to debt reduction.

As at December 31, 2002, our net debt-to-total-capitalization ratio was 49%, a decrease of 6% over the 55% as at December 31, 2001. Net indebtedness, including $191 million representing our 50% share of the net indebtedness of Norampac, was $2,496 million at December 31, 2002. This compares to $2,930 million at the end of 2001, including $192 million for our 50% share of the net indebtedness of Norampac. The value of securitized receivables amounted to $264 million as at December 31, 2002 compared to $238 million as at December 31, 2001.

60   Management’s Discussion and Analysis

Accounting Changes

Share purchase financing

On January 1, 2003, we adopted prospectively the new Canadian Institute of Chartered Accountants’ (CICA) Emerging Issues Committee Abstract 132 “Share Purchase Financing” concerning share purchase loans (the loans) receivable. Accordingly, loans as at January 1, 2003 amounting to $11 million were reclassified from “Other assets” to “Common shares” and interest revenue was treated as a reduction of dividends. The common shares purchased with these loans are held in trust as security for the loans. The loans are interest bearing at the dividend rate and have defined repayment terms not exceeding 10 years. As at December 31, 2003, there were 922,994 common shares (December 31, 2002 – 1,000,333 common shares) held in trust with respect to employee loans of $12 million (December 31, 2002 – $11 million). The market value as at December 31, 2003 of the shares held in trust was $15 million or $16.25 per share (December 31, 2002 – $16 million or $15.70 per share). These common shares were not considered as being outstanding for the calculation of the basic earnings per share but were considered in the calculation of the diluted earnings per share. The adoption of this abstract had no significant impact on the diluted earnings per share for the year ended December 31, 2003.

Impairment of long-lived assets

On January 1, 2003, we early adopted the new CICA Handbook Section 3063 “Impairment of Long-lived Assets” recommendations. These recommendations provide accounting guidance for the recognition, measurement and disclosure of impairment of long-lived assets, including property, plant and equipment and intangible assets with finite useful lives. They require the recognition of an impairment loss for a long-lived asset when events or changes in circumstances cause its carrying value to exceed the total undiscounted future cash flows expected from its use and eventual disposition. The impairment loss is calculated by deducting the fair value of the asset from its carrying value. This change in accounting policy has been applied prospectively.

Based on past operating losses of certain Canadian operations and deteriorating market conditions, we conducted an impairment study of several of our Canadian-based long-lived assets in the fourth quarter of 2003. As a result, we recorded an impairment loss of $201 million ($135 million net of income taxes or $0.59 per common share) pertaining to our Lebel-sur-Quevillon pulp mill.

Exit and disposal activities

Disposal of long-lived assets and discontinued operations

We prospectively adopted the revised CICA Handbook Section 3475 “Disposal of Long-lived Assets and Discontinued Operations” recommendations for disposal activities initiated on or after May 1, 2003, as required by the transitional provisions. These recommendations establish standards for the recognition, measurement, presentation and disclosure of disposals of long-lived assets as well as for the presentation and disclosure of discontinued operations. The adoption of these new recommendations had no significant impact on our December 31, 2003 consolidated financial statements.

Severance, termination benefits and costs associated with exit and disposal activities
We prospectively adopted the new CICA Emerging Issues Committee Abstract 134 “Accounting for Severance and Termination Benefits” and Abstract 135 “Accounting for Costs Associated with Exit and Disposal Activities (Including Costs Incurred in a Restructuring)” relating to exit or disposal activities initiated after March 31, 2003, as required by their transitional provisions. These abstracts provide guidance on the timing of recognition and measurement of liabilities as well as disclosures for the various types of severance and termination benefits related to the termination of employees’ services prior to normal retirement and costs associated with an exit or disposal activity. Under this new guidance, liabilities for these costs are to be recognized in the period when they are incurred and measured at their fair value. We applied the guidelines in these two abstracts for the closure costs related to the permanent shutdown of a paper machine at our Vancouver mill in December 2003.

Domtar Inc. 2003 Annual Report   61

Impact of Accounting Pronouncements not yet Implemented

GAAP and financial statement presentation

In July 2003, the CICA issued new Handbook Sections 1100 “Generally Accepted Accounting Principles” and 1400 “General Standards of Financial Statement Presentation.” Section 1100 describes what constitutes Canadian GAAP and its sources. It also provides guidance on sources to consult when selecting accounting policies and determining appropriate disclosures in the case where a matter is not dealt with explicitly in the primary sources of GAAP, thereby recodifying the Canadian GAAP hierarchy. Section 1400 provides general guidance on financial statement presentation and further clarifies what constitutes fair presentation in accordance with GAAP. These recommendations are effective for fiscal years beginning on or after October 1, 2003.

The Corporation records delivery costs, as well as countervailing and antidumping duties on exports of softwood lumber to the United States, as a reduction of gross sales to determine net sales in accordance with industry practice. For the year ended December 31, 2003, delivery costs amounted to $345 million and softwood lumber duties amounted to $45 million. Commencing in 2004, both delivery costs and softwood lumber duties will be recorded under cost of sales, as industry practices are no longer acceptable under the new GAAP hierarchy defined in Section 1100. The Corporation does not expect these recommendations to have any other significant impact on its consolidated financial statements upon adoption.

Hedging relationships

In November 2002 and June 2003, the CICA amended the accounting guideline relating to hedging relationships. This accounting guideline must be applied to hedging relationships in effect in fiscal years beginning on or after July 1, 2003. This accounting guideline addresses the identification, designation, documentation and effectiveness of the hedging relationships for the purpose of applying hedge accounting. In addition, it deals with the discontinuance of hedge accounting and establishes conditions for applying hedge accounting. Under this guideline, documentation of the information related to hedging relationships is required and the effectiveness of the hedges must be demonstrated and documented. Effective January 1, 2004, we have in place all necessary hedge documentation to be able to apply hedge accounting for interest rate swaps, forward foreign exchange contracts, foreign currency options, pulp swaps and energy swaps.

62   Management’s Discussion and Analysis

Asset retirement obligations

In March 2003, the CICA issued Handbook Section 3110 “Asset Retirement Obligations” which requires entities to record a liability at fair value when there is a legal obligation associated to the retirement of an asset in the period in which it is incurred. The associated costs are capitalized as part of the carrying value of the related asset and depreciated over its remaining useful life. The liability is accreted using a credit adjusted risk free interest rate. Section 3110 is analogous to U.S. GAAP SFAS 143 “Accounting for Asset Retirement Obligations”, which was adopted for U.S. GAAP purposes on January 1, 2003. Asset retirement obligations in connection with the adoption of SFAS 143 were primarily linked to landfill capping obligations, asbestos removal obligations on equipment and demolition of certain abandoned buildings. Taking into consideration the existing assets and liabilities for these items, the impact of the implementation of SFAS 143 was not considered significant at January 1, 2003. No asset retirement obligations were recorded for assets that have indeterminate settlement dates, such as asbestos removal relating to buildings. For such assets, a liability will be initially recognized in the period in which sufficient information exists to estimate a range of possible settlement dates. Section 3110 is applicable to fiscal years beginning on or after January 1, 2004 and must be applied retroactively with restatement of prior periods. As at December 31, 2003, the adoption of SFAS 143 has increased our loss by $3 million, decreased our assets by $8 million and decreased our liabilities by $5 million.

Consolidation of variable interest entities

In June 2003, the CICA issued Accounting Guideline 15 (AcG-15) “Consolidation of Variable Interest Entities”. This guideline requires that an enterprise holding other than a voting interest in a variable interest entity (VIE) could, subject to certain conditions, be required to consolidate the VIE if it is considered its primary beneficiary whereby it would absorb the majority of the VIE’s expected losses and/or receive the majority of its expected residual returns. AcG-15 applies to annual and interim periods beginning on or after November 1, 2004. We do not expect this guideline to have an impact on our financial statements.

Domtar Inc. 2003 Annual Report   63

Critical Accounting Policies

The preparation of financial statements in conformity with Canadian GAAP requires management to make estimates and assumptions that affect our results of operations and financial position. On an ongoing basis, management reviews its estimates, including those related to environmental matters, useful lives, impairment of long-lived assets and goodwill, pension and other employee future benefit plans, and income taxes based upon currently available information. Actual results could differ from those estimates.

The following critical accounting policies reflect matters that contain a significant level of management estimates about future events, reflect the most complex and subjective judgments, and are subject to a fair degree of measurement uncertainty.

Environmental matters
      
Environmental expenditures for effluent treatment, air emission, landfill operation and closure, asbestos containment and removal, bark pile management, and sylviculture activities (together referred to as environmental matters) are expensed or capitalized depending upon their future economic benefit. In the normal course of business, we incur certain operating costs for environmental matters which are expensed as incurred. Expenditures for property, plant and equipment that prevent future environmental contamination are capitalized and amortized on a straight-line basis over a period of 10 to 30 years. Provisions for environmental matters are not discounted and are recorded when remediation efforts are likely and can be reasonably determined.

As at December 31, 2003, we had a provision of $67 million for environmental matters. While we believe that we have determined the costs for environmental matters likely to be incurred, based on known information, our ongoing efforts to identify potential environmental concerns that may be associated with our former and present operations may lead to future environmental investigations. These efforts may result in the determination of additional environmental costs and liabilities, which cannot be reasonably estimated at this time.

In addition, the pulp and paper industry in the United States is subject to Cluster Rules that further regulate effluent and air emissions. We comply with all present regulations and we anticipate spending approximately $44 million over the next three years to meet further Cluster Rules requirements.

As at December 31, 2003, anticipated payments in each of the next five years are as follows:

In 2003, our operating expenses for environmental matters totaled $70 million and we capitalized an additional $7 million for environmental projects mainly related to the improvement of air emissions, effluent treatment as well as remedial actions taken to address environmental compliance. In 2004, we expect to capitalize approximately $24 million for environmental projects, including Cluster Rules obligations.

Useful lives
      
Our property, plant and equipment are stated at cost less accumulated amortization, including asset impairment write-down. Interest costs are capitalized for capital projects in excess of $10 million and that have a duration in excess of 1 year. For timber limits and timberlands, amortization is calculated using the unit of production method. For all other assets, amortization is calculated using the straight-line method over the estimated useful lives of the assets.

64   Management’s Discussion and Analysis

On a regular basis, we review the estimated useful lives of our property, plant and equipment. Assessing the reasonableness of the estimated useful lives of property, plant and equipment requires judgment and is based on currently available information. Changes in circumstances, such as technological advances, changes to our business strategy, changes to our capital strategy or changes in regulation can result in the actual useful lives differing from our estimates. Revisions to the estimated useful lives of property, plant and equipment constitute a change in accounting estimate and are dealt with prospectively by amending amortization rates. A change in the remaining estimated useful life of a group of assets, or their estimated net salvage value, will affect the amortization rate used to amortize the group of assets and thus affect amortization expense as reported in our results of operations. A change of one year in the composite estimated useful life of our fixed asset base would impact annual depreciation expense by approximately $20 million.

In 2003, we recorded a total amortization expense of $384 million (or $608 million when including unusual items pertaining to write-downs in the value of property, plant and equipment as a result of an impairment charge and closure costs) compared to $398 million in 2002 (or $425 million when including unusual items pertaining to closure costs). As at December 31, 2003, we had property, plant and equipment of $6,887 million, net of accumulated amortization of $2,347 million ($7,719 million in 2002, net of accumulated amortization of $2,332 million).

With the write-downs in the value of property, plant and equipment recorded in the fourth quarter of 2003, our future amortization expense is expected to be reduced by approximately $20 million on an annual basis.

Impairment of long-lived assets
      
We review the carrying amount of long-lived assets when events or changes in circumstances indicate that the carrying value of the assets may not be recoverable through future operations. This is accomplished by determining whether projected undiscounted future cash flows from operations exceed the net carrying amount of the assets as of the assessment date. Impaired assets are recorded at fair value, determined principally by using discounted future cash flows expected from their use and eventual disposition. Estimates of future cash flows and fair value require judgment and may change.

During the fourth quarter of 2003, as a result of operating losses at our Lebel-sur-Quevillon pulp mill and our Wood Products Group, we conducted impairment tests of the long-lived assets of these business units. In addition, due to the decision to close one paper machine at our Vancouver paper mill and the potential impact that a weaker U.S. dollar may have on the results of operations of our Canadian pulp and paper mills, we also conducted impairment tests of the long-lived assets of our Vancouver paper mill and other Canadian pulp and paper mills. As a result of these tests, we recorded an impairment loss, in December 2003, of $201 million ($135 million net of income taxes or $0.59 per common share) related to the impairment of our Lebel-sur-Quevillon pulp mill.

The impairment tests were conducted in accordance with the recommendations in Section 3063 of the CICA Handbook “Impairment of Long-Lived Assets”. These recommendations indicate that the carrying amount of a long-lived asset is not considered recoverable if the carrying amount exceeds the sum of the undiscounted future cash flows expected to result from its use and eventual disposition (also referred to as “Step I”). In the event that the carrying amount exceeds the sum of the undiscounted future cash flows, the recommendations require the asset to be written down to its fair value and a corresponding impairment loss be recorded in the results of operations for the period (also referred to as “Step II”). To determine the fair value of our Lebel-sur-Quevillon pulp mill, we used the present value of the estimated future cash flows of the mill.

The results of the Step I test for our Wood Products Group, our Vancouver paper mill and our other Canadian pulp and paper mills concluded that it was not required to record an impairment loss for these business units. However, the sum of the undiscounted future cash flows for the Wood Products Group and the Vancouver paper mill exceeded by only 21% and 14%, respectively, the carrying amount of $376 million and $119 million, respectively, of the long-lived assets of these business units as at December 31, 2003. Given the sensitivity of certain key assumptions used in the Step I test, there is a measurement uncertainty for these two business units because it is reasonably possible that changes in future conditions in the

Domtar Inc. 2003 Annual Report   65

near term, as explained below, could require a material change in the recognized amount of the long-lived assets when we reperform the Step I test.

In the Step I test, estimates of future cash flows used to test the recoverability of a long-lived asset incorporated our internal 2004 budget adjusted for the following key assumptions: trend prices for the products sold by these business units, the long-term forecasted exchange rate for the U.S. dollar, the estimated remaining useful life of the long-lived assets and, for the Wood Products Group only, the effect of the ongoing softwood lumber dispute with the United States.

The trend prices were based on a consensus of analysts of normalized pricing over a business cycle for the pulp, paper and wood products at the mills subjected to the impairment test in Step I.

The forecasted Canadian-U.S. foreign exchange rate assumptions were based on management’s best estimate as well as independent market information. The average rate over the last five years has been CAN$1.00 = US$0.68. Short-term economic forecasts estimate a rate of CAN$1.00 = US$0.71 to CAN$1.00 = US$0.83. We have used CAN$1.00 = US$0.75 in 2004 and CAN$1.00 = US$0.72 for the years thereafter.

The useful lives of the machinery and equipment was estimated to be between 10 and 12.5 years, excluding future capital expenditures that would increase their service potential.

Duties on softwood lumber were established using various probabilities that average to 15.5% in 2004 and 5% in each of the years thereafter.

In the Step II test, performed on our Lebel-sur-Quevillon pulp mill only, the assumptions used to determine the discounted future cash flows (fair value) of the business unit were the same as those used in the Step I tests, except that future cash flows used were on an after-tax basis and were discounted at our risk-adjusted weighted average cost of capital.

Although each of the key assumptions may have a significant impact on the impairment tests, management has determined that the greatest uncertainty in the near future, when we reperform the Step I tests, resides in the assumptions of foreign exchange rates and the resolution of the softwood lumber dispute with the United States. Had we failed the Step I test for our Wood Products Group and our Vancouver paper mill, based on management’s best estimates, an additional impairment loss of between $125 million and $150 million, equal to the difference between the fair value of the long-lived assets of our Wood Products Group and our Vancouver paper mill and their respective carrying value, would have been recognized. We do not believe that this additional impairment loss would have had a material impact on our bank covenants.

Goodwill
      
Goodwill is not amortized and is subject to an annual impairment test, or more frequently if events or changes in circumstances indicate that it might be impaired. Testing for impairment is accomplished mainly by determining whether the fair value of a segment, based upon discounted future cash flows, exceeds the net carrying amount of that segment as of the assessment date. If the fair value is greater than the carrying amount, no impairment is necessary. In the event that the carrying amount exceeds the sum of the discounted future cash flows, a second test must be performed whereby the fair value of the segment’s goodwill must be estimated to determine if it is less than its carrying amount. Fair value of goodwill is estimated in the same way as goodwill was determined at the date of acquisition in a business combination, that is, the excess of the fair value of the segment over the fair value of the identifiable net assets of the segment. Estimates of future cash flows and fair value require judgment and may change.

Pension and other employee future benefit plans
      
Domtar contributes to several defined contribution, multi-employer and 401(k) plans. The pension expense under these plans is equal to Domtar’s contribution and represented $19 million in 2003 ($20 million in 2002). Domtar also has several defined benefit pension plans covering substantially all employees, including one closed plan for certain non-unionized employees in Canada. Non-unionized employees in Canada joining Domtar after January 1, 2000 participate in defined contribution plans. The pension expense and the obligation related to the defined benefit plans are actuarially determined using management’s most probable assumptions.

We account for pension and other employee future benefits in accordance with CICA recommendations. As such, assumptions are made regarding the valuation of benefit obligations and performance of plan assets. Deferred recognition of differences

66   Management’s Discussion and Analysis

between actual results and those assumed is a guiding principle of these recommendations. This approach allows for a gradual recognition of changes in benefit obligations and plan performance over the expected average remaining service life of the active employee group covered by the plans.

Pension and other employee future benefit assumptions include the discount rate, the expected long-term rate of return on plan assets, the rate of compensation increase, health care cost trend rates, mortality rates, employee early retirements and terminations or disabilities. Changes in these assumptions result in actuarial gains or losses which, in accordance with CICA recommendations, we have elected to amortize over the expected average remaining service life of the active employee group covered by the plans only to the extent that the unrecognized net actuarial gains and losses are in excess of 10% of the greater of the accrued benefit obligation and the market-related value of plan assets as at the beginning of the year. The future effect on our results of operations is dependent on economic conditions, employee demographics, mortality rates and investment performance.

We set our expected rate of return on plan assets annually to reflect the current view of long-term investment returns, including consideration of asset mix, equity risk premium, plan expenses and active investment management premium. A rate of return on plan assets of 7.7% was considered appropriate by our management and is supported by reports issued by third party advisors. Pension and other employee future benefit costs for 2004 will be based on this 7.7% expected rate of return on plan assets in order to reflect our current view of long-term investment returns.

We set our discount rate assumption annually to reflect the rates available on high-quality, fixed income debt instruments, with a duration that is expected to match the timing and amount of expected benefit payments. High-quality debt instruments are corporate bonds with a rating of AA or better. The discount rate, as at December 31, 2003, was estimated at 6.1%.

The rate of compensation increase is another significant assumption in the actuarial model for pension (set at 3.8%) and other employee future benefits (set at 3.5%) and is determined based upon our long-term plans for such increases.

For measurement purposes, a 7.8% weighted average annual rate of increase in the per capita cost of covered health care benefits was assumed for 2004, based on external data and our own historical trends for health care costs. The rate was assumed to decrease gradually to 4.1% for 2012 and remain at that level thereafter.

The following table provides a sensitivity analysis of the key weighted average economic assumptions used in measuring the accrued pension benefit obligation, the accrued other employee future benefit obligation and related net periodic benefit cost for 2003. The sensitivity analysis should be used with caution as it is hypothetical and changes in each key assumption may not be linear. The sensitivities in each key variable have been calculated independently of each other.

Domtar Inc. 2003 Annual Report   67

Sensitivity Analysis

The assets of the pension plans are held by a number of independent trustees and are accounted for separately in the Domtar pension funds. Based on the fair value of the assets held at December 31, 2003 the plan assets are comprised of 3% in cash and short-term investments, 47% in bonds and 50% in Canadian, U.S. and foreign equities. The long-term asset allocation percentages are not expected to differ materially from the current composition.

The latest actuarial valuations were conducted as at December 31, 2002 for plans representing 25% of total plan asset fair value and as at December 31, 2001 for plans representing 63% of total plan asset fair value. These valuations indicated a funding deficiency. Our funding policy is to contribute annually the amount required to provide for benefits earned in the year and to fund past service obligations over periods not exceeding those permitted by the applicable regulatory authorities. Past service obligations primarily arise from improvements to plan benefits. We expect to contribute for a total amount of $78 million in 2004, compared to $73 million in 2003.

Income taxes

We use the asset and liability method of accounting for income taxes. Under this method, future tax assets and liabilities are determined according to differences between the carrying amounts and tax bases of the assets and liabilities. The change in the net future tax asset or liability is included in earnings and “Accumulated foreign currency translation adjustments” account in “Shareholders’ equity”. Future tax assets and liabilities are measured using enacted or substantively enacted tax rates and laws expected to apply in the years in which assets and liabilities are expected to be recovered or settled. For these years, a projection of taxable income and an assumption of the ultimate recovery or settlement period for temporary differences are required. The projection of future taxable income is based on management’s best estimate and may vary from actual taxable income.

On an annual basis, we assess the need to establish a valuation allowance for future tax assets and, if it is deemed more likely than not that our future tax assets will not be realized based on these taxable income projections, a valuation allowance is recorded. As at December 31, 2003, we expect that our future tax assets will not be fully recovered from future taxable income and therefore, we have set up a valuation allowance of $1 million.

68   Management’s Discussion and Analysis

Our future tax assets are mainly composed of temporary differences related to accounting provisions for acquisitions, restructuring, environmental matters, as well as loss carryforwards. The majority of these accruals will be utilized or paid out over the next five years. Our future tax liabilities are mainly composed of temporary differences pertaining to plant, equipment and others. Estimating the ultimate settlement period, given the amortization rates in effect are based on information as it develops, requires judgment and our best estimates. The reversal of timing differences is expected at future substantially enacted tax rates which could change due to changes in income tax laws or the introduction of tax changes through the presentation of annual budgets by different governments. As a result, a change in the timing and the income tax rate at which the components will reverse could materially affect future tax expense as recorded in our results of operations. A one percentage point change in our reported effective income tax rate would have the effect of changing the income tax expense by approximately $15 million.

In addition, Canadian, American and international tax rules and regulations are subject to interpretation and require judgment that may be challenged by taxation authorities. We believe that, to the best of our knowledge, we have adequately provided for our future tax consequences based upon current facts and circumstances and current tax law.

For the year ended December 31, 2003, we recorded a total net tax recovery of $67 million (income tax expense of $56 million in 2002) of which $81 million was for future income tax recovery (expense of $31 million in 2002). Our net future tax liability as at December 31, 2003 was $502 million ($549 million in 2002).

Risks and Uncertainties

Product prices

Our financial performance is sensitive to the selling prices of our products. The markets for most paper, pulp, lumber and packaging products are cyclical and are influenced by a variety of factors beyond our control. These factors include periods of excess product supply due to industry capacity additions, periods of decreased demand due to weak general economic activity in North America or international markets, inventory de-stocking by customers and fluctuations in currency exchange rates. During periods of low prices, we have experienced in the past, and could experience in the future, reduced revenues and margins resulting in substantial declines in profitability and occasional net losses. See “Sensitivity Analysis”.

Operational risks

The activities conducted by our businesses are subject to a number of operational risks including competition, performance of key suppliers and distributors, renewal of collective agreements, regulatory risks, successful integration of new acquisitions, retention of key personnel and reliability of information systems. In addition, operating costs for our businesses can be affected by changes in energy and other raw material prices as a result of changing economic or political conditions or due to particular supply and demand considerations.

The Corporation has commodity swap agreements to manage a portion of our price risk associated with sales of NBSK pulp. These agreements fix the sales price of NBSK pulp for 36,000 tonnes in 2004, 33,000 tonnes in 2005 and 6,000 tonnes in 2006. The fair value of these instruments, as at December 31, 2003 represented an unrealized loss of $3 million (US$2 million).

The Corporation also has energy commodity swap agreements to manage a portion of the price risk associated with purchases of bunker oil. These agreements fix the purchase price of bunker oil for a commitment of 360,000 barrels in 2004 and 180,000 barrels in 2005. The fair value of these instruments as at December 31, 2003 represented an unrealized gain of $2 million (US$2 million).

Norampac also has commodity swap agreements to manage a portion of its price risk associated with sales of unbleached kraft linerboard and semi-chemical medium paper and purchases of old corrugated containers and electricity expiring in 2004 through 2007. The Corporation’s proportionate share of these derivative agreements fixes the sales price for 82,500 tonnes of kraft linerboard and 8,500 tonnes of semi-chemical medium paper, and fixes the purchase price for 387,000 tonnes of old corrugated

Domtar Inc. 2003 Annual Report   69

containers and 112,427 megawatts of electricity. The fair value of these instruments as at December 31, 2003 represented a net unrealized gain of $4 million.

Foreign exchange

Our revenues for many of our products are affected by fluctuations in the exchange rate between the Canadian dollar and the U.S. dollar, as was the case in 2003. Any decrease in the value of the U.S. dollar relative to the Canadian dollar reduces our profitability. The prices for many of our products, including those we sell in Canada, are generally driven by U.S. prices of similar products. Our U.S. dollar sales, net of U.S. dollar purchases for our operating activities, represent approximately US$1 billion annually. This amount is reduced by interest on our U.S. dollar denominated debt (approximately $0.1 billion annually). Exchange rate fluctuations are beyond our control and the U.S. dollar may continue to depreciate against the Canadian dollar in the future, which would result in lower revenues and margins. The Corporation has currency options sold totaling US$33 million maturing in 2004, which limit it from benefiting from a U.S. dollar trading above an average exchange rate of 1.60. In order to reduce the potential negative effect of a weakening U.S. dollar, we may hedge the value of a portion of our future U.S. dollar net cash inflows for periods of up to three years. The Corporation’s hedging arrangements as at December 31, 2003 included currency options purchased totaling US$250 million that give the Corporation the option to sell U.S. dollars at 1.34 in 2004. The fair value of these instruments as at December 31, 2003 represented a net unrealized gain of $12 million (US$9 million).

Environment

We are subject to American and Canadian environmental laws and regulations for effluent and air emissions, harvesting, sylviculture activities, waste management and groundwater quality, among others. These laws and regulations require us to obtain and comply with the permit and authorization requirements of the appropriate governmental authorities. Regulatory authorities exercise considerable discretion for permit issuances and their timing. In addition, changes in environmental laws and regulations and/or their application may require us to make significant expenditures that could negatively impact our financial results and financial condition.

Failure to comply with the applicable environmental laws, regulations and permit requirements may result in fines, penalties or enforcement actions by the regulators, including regulatory or judicial orders enjoining or curtailing operations or requiring corrective measures, installation of environmental control equipment or remedial actions, any of which could entail significant expenditures and negatively impact our financial results and financial condition.

We continue to take remedial action under our Care and Control program at a number of former operating sites, especially in the wood preserving sector, due to possible soil, sediment or ground-water contamination. The investigation and remediation process is lengthy and subject to the uncertainties of changes in legal requirements, technological developments and the allocation of liability among potentially responsible parties.

Lumber export duties

Our Wood net sales represented 7% of our consolidated net sales in 2003 and we exported approximately 57% of our softwood lumber products to the United States.

The United States Department of Commerce announced that it had imposed cash deposit requirements on the Canadian softwood lumber industry with a final aggregate countervailing and antidumping rate of 27.22%, that is, 18.79% for countervailing and 8.43% for antidumping. Since May 22, 2002, based on a final decision by the United States International Trade Commission (ITC), we have made the required cash deposits on our exports of softwood lumber to the United States. The Canadian government has challenged both the countervailing and antidumping rates with the World Trade Organization (WTO) and the North American Free Trade Agreement (NAFTA). We are currently experiencing, and may continue to experience, reduced revenues and margins in our Wood business as a result of countervailing and antidumping duty applications or any new arrangements between the United States and Canada.

70   Management’s Discussion and Analysis

Legal proceedings
      
In the normal course of our operations, we become involved in various legal actions mostly related to contract disputes, patent infringement, environmental and product warranty claims, and labor issues. While the final outcome with respect to actions outstanding or pending as at December 31, 2003 cannot be predicted with certainty, it is our opinion that their resolution will not have a material adverse effect on our financial position, earnings or cash flows.

In April 2003, the Canadian Competition Bureau began an investigation of Canada’s major distributors of carbonless paper and other fine paper products, including Domtar. Although the investigation is continuing, no new information has been presented that would allow us to predict the outcome of this investigation or the impact, if any, it may have on us.

Sensitivity Analysis

Our operating profit, net earnings and earnings per share can be impacted by the following sensitivities:

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Outlook

We experienced a difficult year in 2003 and were impacted notably by a weaker U.S. dollar and lower demand, conditions that might continue to impact our results in the early part of 2004. While our current business environment is impacted by factors that are difficult to predict and beyond our control such as economic conditions, currency fluctuations, and high energy costs, we will maintain our efforts to reduce costs and improve efficiencies in pursuit of our goal of providing our shareholders with superior returns.

Accordingly, we will strengthen our profitability improvement programs. This is expected to entail a full review, by the end of the first quarter, of our Canadian pulp and paper operations to enable them to remain profitable when the Canadian dollar is valued at 75 cents to the U.S. dollar and prices are at cycle-low levels. In addition, we will accelerate efforts to manufacture our best-selling products at multiple facilities located in both Canada and the United States.

Internal Controls

As required by the Sarbanes-Oxley Act enacted by the U.S. Congress in July 2002 and the rules promulgated by the U.S. Securities and Exchange Commission (SEC) thereunder, we have filed with the SEC certificates relating to, among others, the accuracy of the financial information contained in Domtar’s 2003 annual MD&A and annual financial statements and notes thereto, and the adequacy of our procedures and controls relating to disclosure and financial reporting.

Additional information, including our Annual Information Form, is available on SEDAR at www.sedar.com and EDGAR at www.sec.gov/edgar.shtml.

COMMENTS BY AUDITORS FOR U.S. READERS
ON CANADA-U.S. REPORTING DIFFERENCES

In the United States, reporting standards for auditors require the addition of an explanatory paragraph following the opinion paragraph when there is a change in accounting principles that has a material effect on the comparability of the Corporation’s financial statements, such as the change implemented during the year 2003 with respect to impairment of long-lived assets described in Note 2 to the consolidated financial statements. Our report to the shareholders dated February 25, 2004 is expressed in accordance with Canadian reporting standards which do not require a reference to such a change in accounting principles in the auditors’ report when the change is properly accounted for and adequately disclosed in the financial statements.

/s/ PricewaterhouseCoopers LLP

Chartered Accountants

Montréal, Québec
February 25, 2004

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