**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


Washington,
      D.C. 20549





**FORM
      10-KSB**








**[X]
      ANNUAL REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF**


**1934**





**FOR
      THE FISCAL YEAR ENDED JULY 31, 2006**








OR





**[_]
      TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT**


**OF
      1934**





**FOR
      THE TRANSITION PERIOD FROM ________ TO________**





*COMMISSION
      FILE NUMBER 0-29248*





**SMARTIRE
      SYSTEMS INC.**





(Name
      of
      small business issuer in its charter)





YUKON
      TERRITORY, CANADA  N/A


(State
      or
      other jurisdiction of  (I.R.S.
      Employer


incorporation
      or organization)  Identification
      No.)





**#150
      - 13151 VANIER PLACE**


**RICHMOND,
      BRITISH COLUMBIA, CANADA V6V 2J1**


(Address
      of principal executive offices) (Zip Code)





604-276-9884


(Issuer's
      telephone number)





**SECURITIES
      REGISTERED UNDER SECTION 12(B) OF THE EXCHANGE ACT: NONE**





**SECURITIES
      REGISTERED UNDER SECTION 12(G) OF THE EXCHANGE ACT:**





**COMMON
      STOCK**





(TITLE
      OF
      EACH CLASS)





Check
      whether the issuer is not required to file reports pursuant to Section 13 or
      15(d) of the Exchange Act. |_|





*Note
      - Checking the box above will not relieve any registrant required to file
      reports pursuant to Section 13 or 15(d) of the Exchange Act from their
      obligations under those Sections.*





Check
      whether the issuer (1) filed all reports required to be filed by Section 13
      or
      15(d) of the Exchange Act during the past 12 months (or for such shorter period
      that the registrant was required to file such reports), and (2) has been subject
      to such filing requirements for the past 90 days. |X| Yes |_| No





Check
      if
      there is no disclosure of delinquent filers in response to Item 405 of
      Regulation S-B is not contained in this form, and no disclosure will be
      contained, to the best of registrant's knowledge, in definitive proxy or
      information statements incorporated by reference in Part III of this Form 10-KSB
      or any amendment to this Form 10-KSB. | |





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Act). Yes |_| No |X|





The
      issuer’s revenues for the fiscal year ended July 31, 2006 were $3,455,649.





At
      September 29, 2006, the aggregate market value of common stock held by
      non-affiliates was approximately $12,631,000 based upon the closing price of
      $0.04 reported for such date on the OTC Bulletin Board.





The
      number of shares outstanding of our Company's common stock at September 29,
      2006
      was 315,774,656.





Transitional
      Small Business Disclosure Format (check one):


|_|
      Yes
      |X| No














INDEXPage
            
            
            PageNumber
            
            
            NumberPART
                IItem
                1.
            Description
                of Business
            1Item
                2.
            Description
                of Property
            6Item
                3.
            Legal
                Proceedings
            7Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            7PART
                IIItem
                5.
            Market
                for Common Equity, Related Stockholder Matters
            7and
                Small Business8Item
                6.
            Management's
                Discussion and Analysis or Plan of Operation13Item
                7.
            Financial
                StatementsItem
                8.
            Changes
                In and Disagreements With Accountants onAccounting
                and Financial Disclosure
            13Item
                8A.
            Controls
                and Procedures
            14Item
                8B.
            Other
                Information
            14PART
                IIIItem
                9.
            Directors,
                Executive Officers and Control Persons; compliancewith
                Section 16(a) of the Exchange Act
            14Item
                10.
            Executive
                Compensation
            16Item
                11.
            Security
                Ownership of Certain Beneficial Owners and Managementand
                Related Stockholder Matters
            20Item
                12.
            Certain
                Relationships and Related Transactions
            22PART
                IV
            Item
                13.
            Exhibits
            22Item
                14.
            Principal
                Accounting Fees and Services
            27








**CAUTIONARY
      STATEMENT REGARDING FORWARD-LOOKING INFORMATION**





THIS
      ANNUAL REPORT ON FORM 10-KSB, INCLUDING EXHIBITS THERETO, CONTAINS
      FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES
      ACT OF 1933, AS AMENDED, AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF
      1934,
      AS AMENDED. THESE FORWARD-LOOKING STATEMENTS ARE TYPICALLY IDENTIFIED BY THE
      WORDS "ANTICIPATES", "BELIEVES", "EXPECTS", "INTENDS", "FORECASTS", "PLANS",
      "FUTURE", "STRATEGY", OR WORDS OF SIMILAR MEANING. VARIOUS FACTORS COULD CAUSE
      ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE EXPRESSED IN THE FORWARD-LOOKING
      STATEMENTS, INCLUDING THOSE DESCRIBED IN "RISK FACTORS" IN THIS FORM 10-KSB.
      THE
      COMPANY ASSUMES NO OBLIGATIONS TO UPDATE THESE FORWARD-LOOKING STATEMENTS TO
      REFLECT ACTUAL RESULTS, CHANGES IN ASSUMPTIONS, OR CHANGES IN OTHER FACTORS,
      EXCEPT AS REQUIRED BY LAW.





**PART
      I**





As
      used
      in this annual report on Form 10-KSB, "we," "us," "our," "SmarTire" and "our
      Company" refer to SmarTire Systems Inc. and our subsidiaries, unless the context
      otherwise requires.





**ITEM
      1. DESCRIPTION OF BUSINESS**





**Overview**




We
      develop, subcontract our manufacturing, and market technically advanced tire
      pressure monitoring systems (“TPMSs”), which monitor tire pressure and tire
      temperature in a wide range of vehicles. Our TPMSs are designed to improve
      vehicle safety, performance, reliability and fuel efficiency. We currently
      sell
      TPMSs for trucks, ,buses, recreational vehicles, passenger cars and motorcycles.
      In fiscal year 2006, revenues from the sale of TPMSs for passenger cars
      accounted for 40% of our revenues (compared to 60% in fiscal year 2005), as
      we
      reported an increase in the percentage of our revenues related to our bus,
      recreational and truck TPMSs. Based on market demand, we anticipate during
      fiscal 2007 an increase in our total revenues and a continued increase in the
      percentage of our revenues from sales of our TPMSs for the bus, recreational
      and
      truck markets.




We
      have
      three wholly-owned subsidiaries: SmarTire Technologies Inc., SmarTire USA Inc.
      and SmarTire Europe Limited. SmarTire Technologies Inc. was incorporated on
      June
      3, 1988 under the laws of the Province of British Columbia, and was the original
      developer of our patented technology. SmarTire USA Inc., a Delaware corporation
      incorporated on May 16, 1997, is our exclusive marketing agent for SmarTire
      in
      North America. SmarTire Europe Limited, a United Kingdom corporation
      incorporated on February 25, 1998, manages exclusively our sales and
      distribution operation for Europe.




We
      are a
      "foreign private issuer," as such term is defined in Rule 3b-4 under the
      Securities Exchange Act of 1934, and a “small business issuer,” as such term is
      defined in Rule 12b-2 under the Securities Exchange Act of 1934 . We
      file
      Annual Reports on Form 10-KSB, Quarterly Reports on Form 10-QSB and Current
      Reports on Form 8-K with the SEC.




Our
      goal
      is to become a leading provider of wireless sensing and control systems for
      the
      vehicle industry. We are selling our products under the brand “SmartWave” and
“SmarTire.” We anticipate that the increasing penetration of the wireless
      technology will provide us with multiple benefits, including the
      following:




·
            increase
                the overall value of our technology and the competitiveness of our
                products;




·
            create
                opportunities for revenue growth beyond tire pressure monitoring
                (“TPM”);
                and




·
            increase
                the barrier for other companies to enter the market for
                TPM.







We
      plan
      to develop at least one additional application in the next year that can be
      integrated into our receiver module.





**Corporate
      History**





We
      were
      incorporated under the laws of the Province of British Columbia as TTC/Truck
      Tech Corp. on September 8, 1987. We were initially formed to develop and market
      remote data sensing, transmission and processing products incorporating patented
      technologies to satisfy emerging market requirements in the transportation
      industry.





On
      February 6, 2003, our company resolved to continue its corporate existence
      under
      the Business Corporations Act of the Yukon Territory. As a result, our
      Memorandum and Articles that constituted our organizational documents were
      superseded and replaced by Articles of Continuance filed with the Yukon
      Registrar of Corporations under section 190 of the Business Corporations Act
      (Yukon Territory) and Bylaw No. 1 adopted by our Board of Directors. Our
      continuance as a Yukon corporation was approved by special resolution adopted
      by
      our shareholders at the annual and extraordinary general meeting held on
      December 12, 2002. Effective December 10, 2004, we filed a Certificate of
      Amendment with the Yukon Registrar of Corporations to our Articles of
      Incorporation to increase the number of our authorized shares of common stock
      from 300,000,000 shares to an unlimited number of shares. On March 18, 2005,
      we
      filed articles of amendment to our articles of incorporation which set forth
      all
      the rights and preferences of the series A 5% convertible preferred stock.





We
      completed our initial public offering on the Vancouver Stock Exchange (now
      the
      TSX Venture Exchange) on September 11, 1989. On April 13, 1995, we changed
      our
      name to UniComm Signal Inc. On December 24, 1997, we changed our name to
      SmarTire Systems Inc. and effected a reverse stock split pursuant to which
      our
      common stock was consolidated on a 1 for 8 basis. On December 16, 1998, our
      common stock commenced trading on the Nasdaq SmallCap Market. On March 12,
      1999,
      we voluntarily delisted our common stock from the Vancouver Stock Exchange.
      On
      May 28, 2003, our common stock ceased trading on the Nasdaq SmallCap Market
      to
      be quoted on the OTC Bulletin Board.





On
      December 6, 1996, we acquired the Low Tire Pressure Warning Division of EPIC
      Technologies, Inc., based in Norwalk, Ohio. The assets that we acquired from
      EPIC Technologies included specialized testing equipment, patents and certain
      contractual rights, including the rights under a production program that EPIC
      had established with Ford Motor Company. Under that production program, the
      Low
      Tire Pressure Warning System that we acquired from EPIC Technologies was offered
      by Ford Motor Company as an option on Lincoln Continentals models until the
      end
      of December 2001 when that particular model was discontinued.





Our
      acquisition of EPIC Technologies' Low Tire Pressure Warning Division accelerated
      our entry into the passenger car market. Recognizing the emerging demand for
      TPMSs in passenger cars and light trucks, we modified the new car version of
      the
      technology that we had acquired from EPIC Technologies for use in existing
      vehicles. This product was launched into the automotive aftermarket in June
      1997
      to support the market introduction of run-flat tires. Automotive aftermarket
      products are sold as optional add-on products for automobiles and are produced
      by third-party suppliers such as our company. The aftermarket consists of
      retailers including tire retailers, automotive electronic stores and accessory
      shops, which sell products directly to consumers. Aftermarket products are
      distinguishable from OEM products that are sold as options offered directly
      by
      or through the manufacturer of the automobile. OEM products may be produced
      by
      third party suppliers as well, but are sold to automobile manufacturers rather
      than to end-users. The TPMSs that we supplied to Ford Motor Company for use
      on
      Lincoln Continentals is an example of an OEM product.




On
      April
      20, 1998, we established a strategic alliance with TRW Inc., a large U.S.-based
      automotive parts supplier. The strategic alliance was based on four agreements
      between the parties: an Equity Agreement, a Cooperation Engineering Agreement,
      an Original Equipment Manufacturer License Agreement and a Manufacturing
      Agreement. The agreements provided for joint engineering and development
      activities between the parties, and TRW was granted exclusive marketing and
      distribution rights for some of our products. In addition, TRW had exclusive
      rights in the original equipment market for any tire monitoring products that
      it
      developed jointly with us and we had exclusive rights in the automotive
      aftermarket.


-1-


Effective
      August 31, 2001, we restructured our strategic alliance with TRW. As a result
      of
      the restructuring, most of the agreements that we had entered into with TRW
      in
      1998 were terminated. However, TRW retained its equity position in our company.
      By terminating our joint development obligations with TRW and each party’s
      exclusive rights to the products developed, the restructuring effectively
      provided us with immediate access to all levels of the global automotive and
      transportation industries.





In
      December 2002, we entered into an eight-year supply commitment letter for TPMSs
      to be offered as part of the OEM package on certain vehicles produced by Aston
      Martin. We are committed to supply the systems in response to purchase orders
      submitted by Aston Martin from time to time. Aston Martin initially installed
      TPMSs on the V12 Vanquish. In September 2004, Aston Martin began purchasing
      TPMSs for installation on its DB9 model that went into production in 2004.
      Aston
      Martin recently began purchasing TPMSs for installation on its V8 Vantage that
      went into production in 2005.




We
      completed the development and launch of our second generation TPMSs for the
      passenger car and light truck market during the fiscal year ended July 31,
      2001.
      We introduced our motorcycle TPMSs for sale into the aftermarket in September
      2002. In February 2004, we introduced a substantially improved second generation
      motorcycle TPMSs, which we began shipping to our customers in May 2004.
      Responding to changing market conditions, we have now shifted our focus to
      commercial vehicles, buses and recreational vehicles.





In
      February 2003, we signed a manufacturing, co-marketing and development agreement
      with Hyundai Autonet Company, Ltd. ("HACO") an established Korean automotive
      electronics supplier. Under this agreement, HACO and our company agreed to
      co-develop, manufacture and distribute tire monitoring products to HACO original
      equipment vehicle manufacturers and the automotive aftermarket in Korea. The
      agreement provided for the payment to us by HACO of a total of $300,000 in
      fees,
      to cover the cost to develop a receiver and transmitter that can be used in
      the
      Korean and Japanese markets. As of July 31, 2006, we had received payments
      under
      this agreement in the approximate amount of $232,500. In September, 2006 we
      negotiated and received a final settlement payment of $54,000. Additional
      revenues will accrue if HACO wins supply agreements from its target customers.





In
      October 2003, we signed a contract manufacturing services agreement with HACO.
      Under the terms of the agreement, HACO agreed to manufacture our proprietary
      line of TPMSs for sale and distribution globally by SmarTire. On
      November 21, 2005, we and HACO mutually terminated our contract manufacturing
      agreement. This termination was caused by HACO's acquisition by Hyundai Motor
      Company. The termination has not impacted our business nor did we incur any
      costs of termination.





On
      September 5, 2005 we achieved registration to ISO/TS 16949:2002, the quality
      management standard for the automotive and commercial vehicle industry
      industries. The certification applies to our design and manufacture of wireless
      sensing and control systems for the global transportation industry. We were
      registered to ISO/TS 16949:2002 by VCA, an organization with more than 30 years
      of automotive industry experience and a client base that includes the major
      North American automotive companies and many of their Tier 1
      suppliers.




This
      registration positions us to meet the quality requirements of new and existing
      OEM customers. The cornerstone of the ISO/TS 16949:2002 registered system is
      the
      recognition of our ability to meet customer requirements throughout all levels
      of the organization.





On
      October 12, 2005, we entered into a seven year Marketing and Distribution
      agreement with DANA Corporation through its Heavy Vehicle Technology and Systems
      Group. Under the contract Dana will market and sell SmarTire’s tire monitoring
      systems to OEM and aftermarket customers throughout North America, Mexico,
      Australia and New Zealand. The companies will collaborate on marketing
      opportunities to meet the needs of their global customers and markets. DANA
      is a
      leading Tier I supplier in the design and manufacture of commercial vehicle
      drive train components for medium and heavy duty vehicles for sale to original
      equipment manufacturers and associated original equipment service and the
      independent aftermarket.




On
      November 21, 2005, we entered into a manufacturing agreement with Vansco. Under
      the agreement, Vansco manufactures key subsystems for SmarTire’s wireless
      gateway family of products. Vansco specializes in the design and manufacture
      of
      electronic, electro-mechanical and electro-hydraulic controls and
      instrumentation and offers engineering design expertise in system integration,
      hardware, software, wire harness and electronics packaging. Vansco was founded
      in 1978 by Ed and Terry Van Humbeck in Winnipeg, Canada. Focused on the global
      heavy equipment market, it has more than 1000 employees and more than $200
      million in sales. With the recent addition of the Morton, Illinois, plant,
      Vansco will support its customer base from three North American plants and
      from
      a more recent acquisition of a plant in Forssa, Finland. Vansco provides global
      sales, applications engineering, design, manufacturing and service support.
      In
      2004, Vansco was acquired by Kilmer Capital Partners and Borealis Private
      Equity. Vansco serves a strong customer portfolio of top-tier, OEMs, many of
      which are international leaders in their respective markets.





During
      fiscal 2006, several bus manufacturers in North America and Europe selected
      us
      to supply TPMSs for installation on new and existing buses. In addition, certain
      RV manufacturers in the United States selected us to supply TPMSs for
      installation on new vehicles and we increased our sales to the recreational
      vehicle (“RV”) aftermarket mainly as a result of a new relationship with Camping
      World.




**Corporate
      Information**




Our
      principal executive offices are located at 150-13151 Vanier Place, Richmond,
      British Columbia, V6V 2J1, and our telephone number is (604) 276-9884. Our
      website is located at www.smartire.com. Our SEC filings are available to the
      public from our website or at www.sec.gov.





**Government
      Regulations**





Our
      products are subject to regulation by the government agencies responsible for
      radio frequencies in each country that our TPMSs will be sold. For example,
      in
      the United States approval must be received from the Federal Communications
      Commission for each product. Some countries require additional governmental
      approvals in certain circumstances. For example, in the United Kingdom, all
      electronic equipment to be installed in emergency and police vehicles must
      be
      approved by the Vehicle Installation Development Group, a governmental body.
      Also, as a practical matter, certain non-governmental approvals may be necessary
      for market acceptance of our products in certain countries. For example, the
      approval of TUV (an independent testing company) is considered necessary to
      market our TPMSs in Germany.





We
      believe that we have all of the necessary governmental approvals for our current
      TPMSs in our intended market countries. As each new TPMSs is introduced to
      the
      market, we intend to apply for the necessary approvals.





During
      our fiscal year ended July 31, 2001, the United States government enacted the
      Transportation Recall Enhancement, Accountability, and Documentation Act of
      2000, commonly known as the TREAD Act. This new legislation was implemented
      to
      address perceived safety concerns resulting from poor tire maintenance, tread
      separation and tire blowouts. The TREAD Act, among other things, requires that
      the NHTSA, develop rules and regulations that require all new passenger cars,
      light trucks and multipurpose passenger vans sold after November 1, 2003 to
      have
      TPMSs installed as standard equipment. The TREAD Act requires that TPMSs must
      be
      capable of warning drivers if a tire is significantly under-inflated. The
      mandated rules and regulations were scheduled to be finalized in November 2001
      for implementation in 2003.




On
      April
      7, 2005 the NHTSA released their final rule. The NHTSA lead time and phase
      in
      schedule are described below.





The
      initial compliance date with the final rule was October 5, 2005. Subject to
      the
      special provisions discussed below, the phase-in schedule is as follows:





·
            20%
                of a vehicle manufacturer's light vehicle production is required
                to comply
                with the standard during the period from October 5, 2005, to August
                31,
                2006;





·
            70%
                must comply during the period from September 1, 2006 to August 31,
                2007;
                and





·
            100%
                of all light vehicles built on or after September 1, 2007 must comply.





-2-


However,
      the NHTSA has deferred vehicle manufacturers' compliance with the new system
      malfunction indicator light requirements until September 1, 2007. This
      requirement is discussed below.





·
            The
                NHTSA has excluded multi-stage manufacturers and alterers from the
                requirements of the phase-in and has extended by one year the time
                for
                compliance by those manufacturers (i.e., until September 1, 2008).





·
            The
                final rule also excludes small volume manufacturers (i.e., manufacturers
                producing less than 5,000 vehicles for sale in the U.S. market in
                one
                year) from the phase-in, requiring vehicles produced by such manufacturers
                to comply with the standard on September 1, 2007.





Our
      direct measurement TPMSs generally exceeds the standard for tire pressure
      monitoring established by the NHTSA. Accordingly, we believe the auto
      manufacturers must accelerate their implementation plans in order to meet these
      new NHTSA regulations, which will create additional opportunities to market
      our
      products to OEMs in the automobile industry. In addition, although the TREAD
      Act
      only applies to passenger automobiles, we expect that other motor vehicles,
      including medium and heavy trucks, buses and motorcycles will be impacted by
      this legislation in subsequent years. We also expect that compliance with the
      TREAD Act by European, Japanese, Chinese and other automakers will accelerate
      the adoption of TPMSS globally.





It
      is
      difficult to predict the magnitude of the expected sales increase or the exact
      timing of the increase since our products will continue to face competition
      from
      other TPMSs manufactured by our competitors, and the timing of additional
      legislative initiatives on tire safety, if any, in the United States and abroad
      remains uncertain. We expect that as TPMSs become standard equipment for new
      passenger vehicles, demand for TPMSs as dealer installed options and aftermarket
      products will gradually decline.





**Strategic
      Alliances**





Our
      strategy includes the establishment of alliances to assist in the development
      and marketing of our products and technologies. Our existing strategic alliances
      include the following:





Dana
      Corporation. On October 12, 2005 we entered into a seven year Marketing and
      Distribution agreement with Dana Corporation through its Heavy Vehicle
      Technology and Systems Group. Under the contract Dana will market and sell
      SmarTire’s tire monitoring systems to OEM customers throughout North America,
      Mexico, Australia and New Zealand. The companies will collaborate on marketing
      opportunities to meet the needs of their global customers and markets. Dana
      is a
      leading Tier I supplier in the design and manufacture of commercial vehicle
      drive train components for medium and heavy duty vehicles for sale to original
      equipment manufacturers and associated original equipment service and the
      independent aftermarket.





Vansco
      electronics LP. On September 12, 2003, we entered into a development and supply
      agreement with Vansco Ltd. This agreement provided for the combination of
      Vansco's vehicle communication expertise with our proven radio frequency
      technology to create a high sensitivity, weatherproof, J1939 controller area
      network ("CAN"), chassis-mounted receiver. Vansco manufacturers this receiver
      for us.





GE
      Nova
      Sensor. In 2004, our application specific integrated sensor ("ASIS") procurement
      strategy was refined to begin procuring the high and low pressure ASIS’s from GE
      Novasensor.





Alligator
      Ventilfabrik GmbH. On December 10, 1999, we entered into an agreement to develop
      valve stem designs and tire monitoring electronic packaging for new market
      applications and new tire monitoring technologies with Alligator Ventilfabrik
      GmbH ("Alligator"). Based in Giengen, Germany, Alligator currently supplies
      us
      with valve stems that allow the attachment of tire monitoring sensors inside
      the
      tire.




**Products**




Our
      active tire monitoring systems generally include several key components,
      including pressure and temperature sensor/transmitters mounted inside the tires,
      a receiver module mounted either on the vehicle chassis and cab that collects
      the information from the sensor/transmitters wirelessly, and a display device
      that communicates tire temperature and pressure information, alert conditions
      and location of alerts to the driver. We have developed tire monitoring systems
      for the passenger car, motorcycle, recreational, bus and the commercial vehicle
      market sector.




**Passenger
      Car**




Using
      sophisticated in-wheel sensors, advanced displays and state-of-the-art wireless
      technology, we have developed tire monitoring products for cars, light trucks,
      sport utility vehicles and multi purpose vans. We offer three display options
      to
      suit a variety of vehicles styles, dashboard configurations and consumer needs.
      Our full function displays can also be individually programmed to suit specific
      vehicle applications.




Our
      products come with four tire transmitters, one for each wheel position. The
      lightweight transmitter is secured on the wheel with a steel strap and is
      identified by color-coded rings on the tire valve. The transmitters are uniquely
      programmed to transmit to our receiver that has four color-coded warning lights
      corresponding to the color-coded valve rings. Installation of our transmitters
      should be done by qualified tire professionals.




Valve
      mount transmitters are also available for original equipment and car accessory
      applications.




We
      offer
      a basic display that provides two levels of pressure loss warnings to the driver
      through both an audible alarm and a red illuminated light indicating the
      affected tire. For drivers wanting more detailed tire monitoring data, we offer
      a full function display or a full function remote display. These products offer
      digital pressure and temperature information through a fully programmable liquid
      crystal display ("LCD"). The full function displays automatically identify
      the
      nature and location of pressure or temperature irregularities and allows the
      driver to read the tire temperature and pressure status by scrolling through
      each tire position.




**Recreation
      Vehicles (RV) and Bus**




SmarTire
      RV is a TPMS specifically designed to meet the unique needs of RVs. It
      constantly monitors your tires and warns of a tire problem before it becomes
      dangerous. Our high pressure sensor/transmitters are mounted securely to the
      rim
      using stainless steel straps.




The
      graphic display is mounted in view of the driver providing real-time tire
      information. If a problem occurs, both an audible and visual warning alerts
      the
      driver of the condition. Towed vehicle or trailer tires can be monitored by
      simply adding low pressure sensors to the wheels. In-wheel sensors constantly
      monitor tire pressure and temperature. Tire data is transmitted wirelessly
      to
      the receiver. The receiver can monitor up to 20 wheel positions and is able
      to
      handle the most complex RV and towed vehicle/trailer
      configurations.




The
      product is sold in both preconfigured kits for aftermarket installation as
      well
      as in bulk quantities to support OEMs.




**Commercial
      Vehicles including Trucks and Trailers**




The
      SmartWave brand will apply to all products developed under our wireless gateway
      architecture focused on the commercial vehicle industry. Under the SmartWave
      brand, the company has introduced a complete system including sensors, a
      receiver, configuration software and maintenance and support tools. to meet
      the
      varying needs of fleet customers. Market research has played a key role in
      determining the system functionality and we are confident that market demand
      will be met with this release. We are evaluating additional wireless sensing
      and
      control applications that will use the same architecture to provide value where
      traditional wired solutions are not competitive or are difficult to implement.
      The system is available in component form for OEM supply as well as
      pre-configured kits for sale through aftermarket channels.


-3-


We
      believe SmartWave creates revenue-generating opportunities for OEMs and their
      dealer channels. SmartWave is a wireless platform based on industry standard
      tools, service platforms and pre-defined system components that we believe
      will
      increase the OEMs value to their customers.




**Motorcycle**




Our
      TPMS
      for motorcycles acts as an early warning device by actively monitoring a
      motorcycle's tire pressure and temperature.




Our
      display is small, weatherproof and very easy to see. The ultra bright alert
      icon
      warns of a tire problem before it becomes dangerous.




Our
      strap
      mounted sensors use advanced wireless technology to transmit temperature and
      pressure data while the motorcycle is in motion. The sensors are light weight
      and do not affect the normal balancing of the tire.




The
      display can be mounted virtually anywhere on the bike in easy view of the
      rider.




**Product
      Development**




Our
      technology provides drivers with real time information regarding tire pressure
      and temperature changes. This information provides the consumer and commercial
      markets with improved vehicle safety, performance and fuel economy. Our products
      have been engineered and designed for universal application. The
      sensor/transmitter can be installed on virtually any tire and wheel combination.
      Each sensor/transmitter contains a custom application specific integrated sensor
      (“ASIS”) . A receiver unit and optional display modules mounted in the vehicle
      provides appropriate alarm indications with optional graphical
      readout.




The
      custom ASIS is a single micro-electronic package containing pressure and
      temperature sensing elements and a digital logic state machine that functions
      as
      the brains of the sensor/transmitter. This chip is robust in design, optimizes
      battery life and provides various modes of sensing and communicating that ensure
      faster transmission of data when problems occur. Packaged on a miniaturized
      circuit board with the ASIS are various components and our radio frequency
      technology. Using this wireless radio frequency technology, the data is
      transmitted through the tire to a remote receiver.




Our
      products feature transmitter options providing different installation choices
      for various applications. A strap-mounted transmitter attached to the wheel
      offers the most universal installation for a wide range of tire and wheel
      assemblies. A valve-mounted transmitter attached to the base of the valve offers
      an adjustable, secure in-tire installation for specific wheel/rim profiles.
      Once
      installed, the sensor/transmitters do not require ongoing maintenance. The
      sensor/transmitters communicate to remote receivers and the data is displayed
      inside the vehicle. Various display options have been developed for the
      aftermarket as well as telltale lights, switch blanks and digital displays
      for
      OEM applications.




We
      introduced our motorcycle TPMSs for sale into the aftermarket in September
      2002.
      We introduced a substantially improved second generation motorcycle TPMS at
      the
      Indy Motorcycle Dealers Show, held in Indianapolis, Indiana in mid-February
      2004. In May 2004, we began shipping the product to our customers. We
      encountered a component defect issue as well as an application issue with curved
      rims and initiated a recall in September 2004. We have corrected the component
      defect issue and are currently shipping TPMSs for motorcycles that address
      the
      issue of rims with curved drop center wells **.**




On
      September 12, 2003, we entered into a development agreement with Vansco Ltd.
      This agreement provides for the merging of Vansco’s vehicle communication
      expertise with our proven radio frequency technology to create a high
      sensitivity, weatherproof, J1939 CAN, chassis-mounted receiver. The J1939 CAN
      is
      the most widely used communication standard in commercial vehicles today,
      allowing for multiplexing, receiving and transmitting of signals from various
      sources. When CAN technology is combined with our high pressure sensors, has
      resulted in a new TPMS targeted directly at OEMs of commercial trucks, buses,
      agricultural, construction and recreational vehicles. In November 2004, design
      validation testing and the initial pilot build of 300 units was completed.
      The
      product has completed design validation testing and has received regulatory
      radio approvals in Europe and North America. Production validation testing
      has
      now been completed. Vansco has now begun to manufacture the product for us.
      We
      currently sell this product to our lead customer for this product, Motor Coach
      Industries. In addition, several major OEM’s are currently conducting field
      trials of this product.




Our
      recreational vehicle and bus TPMSs consist of strap mounted transmitters mounted
      inside the tires, rugged receivers mounted in the cab or on the chassis, stand
      alone graphical displays or warning lights, and antennas mounted on the chassis.
      Our system can also be integrated with existing OEM in- vehicle
      displays.




On
      October 10, 2003, we entered into a Co-Marketing and Development Agreement
      with
      Haldex Brake Products Ltd., and a related Supply Agreement with Haldex. Under
      the terms of the Co-Marketing and Development Agreement, we agreed to engage
      in
      a joint development program to integrate our TPMSs with Haldex's brake systems,
      for the purposes of creating a commercial high pressure TPMS for marketing
      and
      resale by Haldex. We anticipated that any new products that result from our
      collaboration with Haldex would be targeted at both OEMs and aftermarket
      applications for trailers. Thereafter, Haldex requested a hold in the joint
      development program until the end of October 2005, alleging a lack of technical
      resources on their part and the fact that the agreement between our companies
      had changed scope considerably since its inception. We asked for a release
      from
      the current contract, and provided Haldex with a termination notice on September
      20, 2006.





**Marketing**





SmarTire
      USA Inc. and SmarTire Europe currently market our TPMSs in North America,
      Europe, South Africa and Australia.





The
      TREAD
      Act, which requires tire monitoring for all new passenger cars, is accelerating
      the acceptance of wireless systems for the vehicle industry. We expect the
      convergence of wireless and wired networks to enable SmarTire’s wireless
      technology to interface with existing wired vehicle networks, particularly
      in
      commercial vehicles including trucks, buses, recreational and off-road vehicles.
      We anticipate this legislation to be expanded to cover these vehicles. Based
      on
      discussions with our customers, including Dana Commercial Systems, we anticipate
      the use of wireless technology to rapidly expand from tire pressure monitoring
      to applications such as brake monitoring, alarm and security systems, vehicle
      maintenance and other sensing and control applications.





Our
      current marketing strategy focuses on sales of our TPMSs for OEM applications
      in
      the commercial, recreational and industrial markets. Although our ultimate
      goal
      is to position ourselves as a wireless gateway system provider of multiple
      applications beyond TPMS, our selling proposition to the OEM’s is currently
      focused on TPMSs. Our strategy is to provide high quality products to the OEM
      market which incorporate the highest level of technology possible, at a
      competitive price.We
      also
      plan to supply the OEM aftermarket through strategic channel
      partnerships.





**Competition**





Tire
      monitoring products can generally be divided between two basic types: direct
      technology and indirect monitoring technologies. As described in the National
      Highway Traffic Safety Administration's report, direct tire monitoring
      technology such as that employed in our products currently provides substantial
      advantages over indirect monitoring technology. However, several of our
      competitors and potential competitors have long and established relationships
      with automobile OEMs and suppliers, which may make it more difficult for us
      to
      compete in the OEM market.





-4-


Our
      main
      competitors with respect to direct TPMSs include the following companies:





Schrader
      Bridgeport is allegedly the world's largest producer of tire valves and
      tire-pressure measurement equipment with over $140 million in annual sales.
      Schrader has been in the passenger car TPMSs market since 1996 and their systems
      have been used by various OEMs. As a transmitter supplier, Schrader has mainly
      teamed with separate receiver suppliers to acquire OEM contracts. Current TPMSs
      business appears to be restricted to the passenger car OEMs.





BorgWarner
      acquired BERU in February 2005. Beru previously acquired Doduco and its tire
      monitoring technology. The Company has been supplying TPMSs primarily as an
      option to vehicle manufacturers based mainly in Germany. To our knowledge,
      the
      system requires the use of transmitters attached to the valve stem (inside
      the
      tire/wheel assembly), receiving antennas at each of the wheel wells, wiring
      harness for conveying data to the receiver and some form of in-dash display.
      This system has been developed primarily for the OEM market for passenger car
      applications. BorgWarner has recently started promoting a commercial vehicle
      TPMSs.





Pacific
      Industrial Co. Ltd., a Japanese company, has developed a product that measures
      the air pressure in each tire and sends the data to a receiver mounted inside
      a
      vehicle. The products are available on a few vehicles manufactured in Asia,
      some
      of which are imported into North America. We believe that Pacific Industrial's
      products resemble the BorgWarner approach to tire monitoring with additional
      antennas and wiring harnesses.




TRW
      Automotive U.S. LLC is a producer of safety and security systems for the global
      automotive market. It supplies advanced technology products and services to
      the
      automotive markets. From December 1998 to August 2001, we and TRW jointly
      developed advanced tire monitoring technology and each has access to this
      technology, which encompasses some of our current products. During this period,
      we and TRW jointly developed a common application specific integrated sensor
      chip which we use for some of our existing products. To our knowledge TRW is
      not
      marketing a TPMS for the commercial market.




Siemens
      Automotive AG is a producer and large supplier of high-tech automotive
      electronic systems. Siemens Automotive's product portfolio focuses on electronic
      modules and systems including anti-lock brake systems and airbag electronics.
      Siemens Automotive has entered the market and offers direct TPMSs to OEMs.
      Although previously restricted to the automotive markets Siemens has recently
      announced it’s intention to develop a TPMS for the commercial
      market.





Wabco
      is
      a producer of ABS braking products for the commercial vehicle industry. Wabco
      jointly developed their IVTM system with Michelin for commercial vehicles.
      The
      system consists of externally mounted wheel-fitted modules which regularly
      measure and transmit tire inflation pressure, via an electronic control unit,
      to
      an in-cabin dashboard display monitor. Equipped with visual and acoustic warning
      signals, the display can warn drivers of abnormally low tire pressure, slow
      leaks and punctures.





**Our
      Competitive Strengths**





Our
      competitive strengths include the following:




·
            we
                can leverage on over 400 man years of experience dedicated specifically
                to
                tire monitoring, which we believe is greater than any other company
                in the
                world;




·
            we
                believe that our tire monitoring solutions are installed on a greater
                variety of automobiles, trucks, industrial and agricultural equipment
                and
                other types of vehicles than any other company in the world;




·
            our
                experience in OEM and aftermarket give us unmatched knowledge and
                expertise in end customer issues and reliability concerns;




·
            we
                believe we are the established leader in tire monitoring performance
                technology;




·
            we
                have a strong patent portfolio complemented by access to all required
                intellectual property;




·
            Our
                customers have advised that we have the best in Class transmitter
                radio
                frequency ("RF") performance;




·
            based
                on our field data, we have the best in class transmitter power management
                technology;




·
            we
                have the ability to measure tire temperature as well as pressure;




·
            we
                provide flexible sensor mounting solutions;




·
            we
                are able to optimize the RF output characteristics during rotation
                of
                wheel assembly which provides consistent radiation patterns;




·
            we
                have the ability to interface with existing commercial vehicle
                communication networks which allows our system to easily integrate
                with
                OEM commercial vehicles;




·
            our
                technology prevents RF collision at start-up and minimizes potential
                interference from other transmitters; and




·
            we
                provide consistent life performance even at low temperatures and
                we can
                reduce the risk of chemical volatility at higher temperatures.




**Indirect
      Competition**




One
      potential future development that could affect the market for both passenger
      car
      and commercial vehicle tire monitoring is the development of a "smart chip".
      This is a computer chip that could transmit data and would be manufactured
      into
      tires. We believe that Goodyear and Bridgestone/Firestone have both completed
      some development of such a computer chip.





**Raw
      Materials and Principal Suppliers**





We
      contract the manufacture of our products to third parties. These manufacturers
      normally provide turnkey operations whereby the manufacturer is responsible
      for
      purchasing the component parts for our TPMSs. Presently, Vansco provides turnkey
      operations with respect to the manufacture of our commercial transmitters and
      receivers and we purchase component parts for other products and deliver them
      to
      our contract manufacturers. We also purchase component parts on our own account
      for engineering and prototype development purposes. Certain of the components
      and raw materials used in our products are difficult to obtain and/or require
      purchase commitments far in advance of the manufacturing date. At present,
      our
      relationships with our current suppliers are generally good and we expect that
      the suppliers will be able to meet the anticipated demand for our products
      through fiscal year 2007.





-5-


**Dependence
      on Certain Customers**





Due
      to
      the early stage development of the tire pressure market in general and for
      our
      Company, we are still dependent on major customers. During fiscal 2006 we earned
      62% of our revenue (2005-53%, 2004-29% ) from 3 (2005-2, 2004-1) customers
      representing 10% or more of our total sales . We expect that this dependence
      will be reduced as we start to realize sales through our relationships with
      new
      customers and through our strategic alliances, including our alliance with
      Dana
      Corporation.




**Proprietary
      Protection**




Our
      intellectual property is important to protecting our competitive advantage
      and
      expanding our TPMSs market share. We rely on a combination of patents, trade
      secret laws, confidentiality procedures and contractual provisions to protect
      our intellectual property.





We
      hold
      several patents for our current technologies, which are listed below:





·
            United
                States Patent 5,231,872 addresses the technology in our tire monitoring
                product. It was issued on August 3, 1993 and expires August 3, 2010.





·
            United
                States Patent 5,285,189 addresses the technology in our abnormal
                tire
                condition warning system. It was issued on February 8, 1994 and expires
                February 8, 2011. We purchased this patent from EPIC Technologies,
                Inc. in
                December 1996.





·
            United
                States Patent 5,335,540 addresses the technology in our tire monitoring
                product. It was issued on August 9, 1994 and expires August 9, 2011.





·
            United
                States Patent 5,559,484 addresses certain technology in our data
                logging
                tire monitor with condition predictive capabilities and integrity
                checking. It was issued on September 24, 1996 and expires September
                24,
                2013. We purchased this patent from EPIC Technologies in December
                1996.





·
            United
                States Patent 5,945,908 addresses certain other technology in our
                data
                logging tire monitor with condition predictive capabilities and integrity
                checking. It was issued on August 31, 1999 and expires on August
                31, 2016.
                We purchased this patent from EPIC Technologies in December 1996.





·
            United
                States Patent 6,357,883 addresses the technology for a wheel component
                with a cavity for mounting a housing for measurement apparatus. It
                was
                issued on March 19, 2002 and expires March 19, 2019.





·
            United
                States Patent 6,805,000 addresses the technology for a wheel component
                with a cavity for mounting a housing for measurement apparatus. It
                was
                issued on October 25, 2004 and expires October 25, 2021.





In
      addition to our patents, we also have access to a number of other patents under
      our license agreements with TRW.





We
      restructured our strategic alliance with TRW effective August 31, 2001. As
      part
      of the restructuring, we received a royalty-free license from TRW to utilize
      technology developed during the term of the Cooperative Engineering Agreement
      that is patented, now or in the future, by TRW. We have granted a parallel
      royalty-free license to TRW.




**Research
      and Development**





We
      spent
      the following amounts on engineering, research and development activities during
      the fiscal years ended July 31, 2006, 2005 and 2004:





2006
      -
      $1,891,961 ($3,161,647 excluding non-cash compensation recovery)





2005
      -
      $3,297,011 ($1,949,078 excluding non-cash compensation expense)





2004
      -
      $1,654,690





We
      expect
      to continue to invest in research and development activities as we integrate
      our
      current products into vehicle platforms of various OEMs seeking to satisfy
      the
      needs of their customers and as we initiate work on new products that complement
      our wireless gateway strategy.





**Costs
      of compliance with any environmental laws**





Although
      we are required to comply with environmental laws regarding the disposal of
      certain hazardous, the cost of compliance is not significant. While not
      required, we plan to become ISO 14001:2004 registered by the middle of calendar
      2007 (Environmental System Registration) to comply with the requests of our
      customers. We anticipate the cost of registration will be $100,000-$200,000.





**Number
      of Total Employees and Number of Full-time Employees**





At
      September 29, 2006, we had 55 full-time employees, one temporary employee and
      2
      consultants, 11 of who are in marketing, 35 of whom are in engineering, research
      and development and 12 of whom are administrative and executive personnel.
      There
      is no collective bargaining agreement in place.





**ITEM
      2. DESCRIPTION OF PROPERTY**





**Facilities**





Our
      principal executive offices are located at #150 - 13151 Vanier Place, Richmond,
      British Columbia, V6V 2J1. On March 23, 2005, we extended the term of our lease
      to August 31, 2010 and expanded our 15,364 square foot facility by approximately
      4,000 square feet. The lease modification includes a CDN$100,000 tenant
      improvement allowance. We have the right to terminate the lease on September
      1,
      2008 provided that we are not in default on our obligations under the lease
      and
      we provide 180 days' prior written notice to our landlord. This facility
      consists of an office and administration area, an engineering department, a
      prototype production facility and a warehouse.





-6-


Our
      subsidiary, SmarTire Europe Limited, leases a 9,069 square foot facility at
      Park
      34, Didcot, Oxfordshire, United Kingdom OX11 7WB for a 15 year term ending
      February 20, 2016. This facility consists of an office and administration area
      and a warehousing area.





We
      expect
      that our current facilities will be sufficient for the foreseeable future.
      To
      the extent that we require additional space in the near future, we believe
      that
      we will be able to secure additional leased facilities at commercially
      reasonable rates.





**ITEM
      3. LEGAL PROCEEDINGS**




On
      January 30, 2006, Travel Technology Innovations LLC ("TTI") provided us with
      a
      demand for arbitration. TTI alleges we have breached the sales and distribution
      agreement with them dated March 14, 2005 by seeking to prematurely terminate
      the
      agreement in violation of its terms, thereby damaging TTI through lost profits.
      On March 21, 2006, TTI amended their claim from $1 million to an amount greater
      than $1 million but not more than $5 million. Although we are vigorously
      defending ourselves, we cannot determine the likely outcome of this action
      or
      whether the arbitrators will grant TTI's claim. We are
      currently negotiating a settlement with TTI. However, it is possible that we
      will not reach a settlement and that arbitration will be required to settle
      the
      dispute.





**ITEM
      4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**





There
      was
      no matter submitted during the fourth quarter of the fiscal year covered by
      this
      report to a vote of security holders, through the solicitation of proxies or
      otherwise.




**PART
      II**





**ITEM
      5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS**





**MARKET
      FOR COMMON STOCK**





Our
      outstanding common stock is traded over-the-counter and quoted on the OTC
      Bulletin Board (OTCBB) under the symbol "SMTR.OB".




Until
      May
      28, 2003, our common stock was quoted on the Nasdaq SmallCap Market under the
      symbol "SMTR". The following quotations obtained from Bloomberg.com to reflect
      the high and low bids for our common stock based on inter-dealer prices, without
      retail mark-up, mark-down or commission and may not represent actual
      transactions. The high and low bid prices of our common stock for the periods
      indicated below are as follows:




QUARTER
                ENDED
            HIGH
            LOWJuly
                31, 2006
            $0.083
            $0.044April
                30, 2006
            $0.084
            $0.050January
                31, 2006
            $0.099
            $0.059October
                31, 2005
            $0.13
            $0.075July
                31, 2005
            $0.18
            $0.09April
                30, 2005
            $0.24
            $0.02January
                31, 2005
            $0.04
            $0.03October
                31, 2004
            $0.09
            $0.03




The
      closing bid and ask prices of our common stock on September 29, 2006, were
      $.039
      and $.040, respectively, as reported on the OTCBB. The OTCBB prices are bid
      and
      ask prices that represent prices between broker-dealers and do not include
      retail mark-ups and mark-downs or any commissions to the broker-dealer. The
      prices do not reflect prices in actual transactions.





Our
      common shares are issued in registered form. Pacific Corporate Trust Company
      (10th Floor, 625 Howe Street, Vancouver, British Columbia, V6C 3B8 (telephone:
      (604) 689-9853, facsimile (604) 689-8144) is the registrar and transfer agent
      for our common shares.





The
      OCTBB
      is a registered quotation service that displays real-time quotes, last sale
      prices and volume information in over-the-counter (OTC) securities. An OTC
      equity security generally is any equity that is not listed or traded on NASDAQ
      or a national securities exchange. The OTCBB is not an issuer listing service,
      market or exchange. Although the OTCBB does not have any listing requirements,
      per se, to be eligible for quotation on the OTCBB, issuers must remain current
      in their filings with the SEC or applicable regulatory authority.





As
      of
      September 29, 2006, we had 315,774,656 shares of common stock outstanding and
      477 stockholders of record.





**DIVIDEND
      POLICY**





We
      have
      never declared or paid dividends on our common stock, and we do not anticipate
      that we will do so in the foreseeable future. We intend to retain future
      earnings, if any, for use in our operations and the expansion of our business.





RECENT
      SALES OF UNREGISTERED SECURITIES




The
      following change in our securities occurred during
      the three months ended July 31, 2006 and from August 1, 2006 to September 29,
      2006:


-7-




·
            By
                conversion notice dated May 4, 2006, Cornell Capital Partners elected
                to
                convert $80,000 of its 5% convertible debenture into common shares
                of the
                Company. In response we issued 2,857,143 shares of our common stock
                pursuant to Rule 506 of Regulation D under the Securities Act.





·
            By
                conversion notice dated June 15, 2006, Cornell Capital Partners elected
                to
                convert 719 Class A preferred shares into common shares of the Company.
                In
                response we issued 11,504,000 shares of our common stock pursuant
                to Rule
                506 of Regulation D under the Securities Act.





·
            By
                conversion notice dated August 21, 2006, Cornell Capital Partners
                elected
                to convert 204 Class A preferred shares into common shares of the
                Company.
                In response we issued 3,264,000 shares of our common stock pursuant
                to
                Rule 506 of Regulation D under the Securities Act.




**ITEM
      6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION**





The
      following discussion of our financial condition, changes in financial condition
      and results of operations for the fiscal years ended July 31, 2006 and 2005
      should be read in conjunction with the audited annual financial statements
      and
      the notes thereto.




**RESULTS
      OF OPERATIONS**





**Fiscal
      Year Ended July 31, 2006 vs. Fiscal Year Ended July 31, 2005**





**Revenue**





Gross
      revenue for the fiscal year ended July 31, 2006 increased to $3,455,649 from
      $1,463,460 in our fiscal year ended July 31, 2005. This breakdown of the sources
      of our gross revenue is as follows:





·
            Sales
                of TPMSs to OEMs for installation on new and existing buses increased
                to
                $900,538 in fiscal year 2006 from $23,533 in fiscal year 2005. The
                increase in sales was due to the increase in the number of our customers
                in both fiscal 2006 and fiscal 2005. Although we anticipate sales
                of this
                product to the OEM bus market to increase, it is difficult for us
                to
                predict what the volume of sales will be as this will depend primarily
                on
                market acceptance.





·
            Sales
                of TPMSs to the aftermarket for buses increased to $52,286 in fiscal
                year
                2006 from $42,430 in fiscal year 2005. Although we anticipate sales
                of
                this product to the OEM bus aftermarket to increase, it is difficult
                for
                us to predict what the volume of sales will be as this will depend
                primarily on market acceptance.





·
            Sales
                of TPMSs to OEMs for new passenger cars increased to $1,143,554 in
                fiscal
                year 2006 from $572,485 in fiscal year 2005. The increase was primarily
                due to an increase in sales to Aston Martin, Ford's flagship division.
                As
                Aston Martin now supplies our TPMSs on all three of their platforms,
                we do
                not anticipate sales of this product to the OEMs to increase unless
                Aston
                Martin increases their production of vehicles as our sales and marketing
                efforts are focused on the commercial or truck, bus, recreational
                and
                off-road industrial vehicle markets.





·
            Sales
                of TPMSs to the aftermarket passenger car market decreased to $240,676
                in
                fiscal year 2006 from $307,347 in fiscal year 2005. As our sales
                and
                marketing efforts are not focused on this market, it is difficult
                for us
                to predict what the volume of sales of this product will be.





·
            Sales
                of TPMSs to OEMs for new recreational vehicle TPMSs increased to
                $254,095
                in fiscal year 2006 from $230,216 in fiscal year 2005. Although we
                anticipate sales of this product to the OEM recreational vehicle
                (RV)
                market to continue to increase, it is difficult for us to predict
                what the
                volume of sales of this product will be as this will depend primarily
                on
                market acceptance.





·
            Sales
                of TPMSs to the RV aftermarket increased to $616,223 in fiscal year
                2006
                from $128,739 in fiscal year 2005. The increase was mainly due to
                the
                increase in our customer base curing fiscal 2006. We anticipate sales
                of
                this product to the RV market to increase. However it is difficult
                for us
                to predict what the volume of sales will be as this will depend primarily
                on market acceptance.





·
            Sales
                of TPMSs to the commercial/truck OEM market increased to $58,589
                in fiscal
                year 2006 from $nil in fiscal year 2005. The majority of these systems
                are
                currently being used for customer evaluation purposes. As interest
                in this
                product is very high, we anticipate this market will eventually be
                our
                largest source of revenue. However, it is difficult for us to predict
                the
                timing and volume of sales, as this will depend primarily on market
                acceptance.





·
            Sales
                TPMSs to the commercial/truck aftermarket were $11,901 in fiscal
                year 2006
                from $5,717 in fiscal year 2005. Sales of this product in fiscal
                2006 were
                for test purposes and interest in this product is very high. However,
                although we anticipate a significant increase in sales of TPMSs to
                this
                market, it is difficult for us to predict what the volume of sales
                will
                be, as this will depend primarily on market acceptance.





·
            Sales
                of TPMSs to the industrial OEM market increased to $18,002 in fiscal
                year
                2006 from $0 in fiscal year 2005. We anticipate sales of this product
                to
                the industrial OEM market to increase based on the new customers
                the
                increase in our customer base. However it is difficult for us to
                predict
                what the volume of sales will be as this will primarily depend on
                market
                acceptance.





·
            Sales
                of TPMSs to the industrial aftermarket increased to $38,187 in fiscal
                year
                2006 from $0 for the nine months ended April 30, 2005. It is difficult
                for
                us to predict the volume of sales will be to this market as our primary
                sales and marketing efforts in this market are focused on the
                OEMs.





·
            Sales
                of aftermarket motorcycle TPMSs decreased to $31,244 in fiscal year
                2006
                from $111,875 in fiscal year 2005. As discussed above, our sales
                and
                marketing efforts are not focused on this product. As such, it is
                difficult for us to predict what the volume of sales will be in this
                market.





·
            Sales
                of miscellaneous products and services increased to $90,054 in fiscal
                year
                2006 from $41,118 in fiscal year 2005.





**Gross
      Margin**





Gross
      margin on product sales increased to 8.5% in fiscal year 2006 from -11.7% in
      fiscal year 2005. Net of respective inventory write-downs of $700,000 for slow
      moving aftermarket passenger car TPMSs and motorcycle TPMSs in fiscal year
      2006
      and $500,000 for slow moving aftermarket passenger car TPMSs in fiscal 2005,
      gross margin on product sales increased to 28.8% from 22.5%.





The
      increase in gross margin in fiscal year 2006 resulted as the product mix of
      systems sold in fiscal year 2006 had higher gross margins than the product
      mix
      of systems sold in fiscal year 2005. We anticipate that as sales volumes
      increase in fiscal 2007 that our gross margin will also increase.




**Expenses**





Expenses
      decreased to $7,099,128 in fiscal year 2006 from $12,288,528 in fiscal year
      2005. Excluding
      a stock-based compensation recovery of
      3,087,145 in fiscal year 2006 and a stock-based
      compensation expense of
      $4,279,653 in fiscal year 2005, operating expenses increased to 10,186,273 from $8,008,875 in fiscal year 2005. The
      stock-based compensation recovery recorded for fiscal year 2006 resulted as
      the
      market value of our vested employee stock options decreased during fiscal year
      2006 as compared to a stock-based compensation expense during fiscal year 2005
      which resulted due to an increase in the value of our vested employee stock
      options as discussed in note 3 (o) to the financial statements.


-8-


Engineering,
      research and development expenses decreased to $1,891,961 in fiscal year 2006
      from $3,297,011 in fiscal year 2005. Excluding a stock-based
      compensation recovery of $1,269,686 in fiscal year 2006 and
      a stock-based
      compensation expense of 1,347,933
      in fiscal year 2005, engineering,
      research and development expenses increased by $1,212,569 to $3,161,647 in fiscal year 2006. The
      increase, excluding the stock-based compensation recovery in fiscal 2006 and
      the
      stock based compensation expense in fiscal 2005, was mainly due an increase
      in
      wage expense which resulted from an increase in the number of engineering
      related employees, the termination of our VP of Engineering and the loss in
      value of the US dollar versus the Canadian dollars as the majority of our
      engineering-related employees are paid in Canadian dollars. In addition, the
      increase was due to an increase in travel as application engineering services
      were required to support new OEM customers, to meet with engineers from
      prospective new OEM customers and to set up manufacturing in the US with Vansco.
      We also incurred higher rent and utility expenses as we leased additional space
      to accommodate the additional engineering related employees.





Marketing
      expenses decreased to $1,535,160 in fiscal year 2006 from $2,540,730 in fiscal
      year 2005. Excluding
      a stock-based compensation recovery of $263,122 in fiscal year 2006 and a
      stock-based compensation expense of $813,545 in fiscal year 2005, marketing
      expenses increased by $71,097 to $1,798,282 in fiscal year 2006. The increase,
      excluding the stock-based compensation recovery in fiscal 2006 and the stock
      based compensation expense in fiscal 2005, was mainly due to higher advertising
      and promotion costs. The decrease was partially offset by lower wage expense
      which resulted due to fewer sales and marketing employees in fiscal
      2006.





General
      and administrative expenses decreased to $2,368,118 in fiscal year 2006 from
      $4,953,537 in fiscal year 2005. Excluding
      a stock-based compensation recovery of $1,554,337 in fiscal year 2006 and a
      stock-based compensation expense of $2,118,175 in fiscal year 2005, general
      and
      administrative expenses increased by $1,087,093 to $3,922,455 in fiscal year
      2006. The increase, excluding the stock-based compensation recovery in fiscal
      2006 and the stock based compensation expense in fiscal 2005, was mainly due
      to
      an increase in director fees, professional fees and investor relations costs.
      The increase in professional fees was primarily due to the cost of legal
      services incurred to defend against a lawsuit from a debenture holder, the
      cost
      of restructuring both our $30 million 10% convertible debentures issued on
      June
      23, 2005 by us to Cornell Capital Partners, LP and our $160 million equity
      line
      of credit entered into in June 2005, issued to us by Cornell Capital Partners,
      LP., which was replaced with a new $100 million Standby Equity Distribution
      Agreement on December 30, 2005 and the cost of filing a registration statement
      on January 11, 2006 and amended registration statements on February 27, 2006
      and
      April 18, 2006 with the Securities and Exchange Commission to register our
      debentures.





**Depreciation
      and amortization**





Depreciation
      and amortization expense increased to $1,303,889 in fiscal year 2006 from
      $1,497,250 in fiscal year 2005. Depreciation and amortization expense is
      expected to decrease next year with the full amortization of our OEM rights
      to
      the commercial market.





**Interest
      and finance charges**





Interest
      and finance charges increased to $24,262,542 in fiscal year 2006 from $3,779,151
      in fiscal year 2005. Interest and finance charges in fiscal year 2006 included
      non-cash interest of $23,207,528 compared to non-cash interest of $3,573,475
      in
      fiscal year 2005. Non-cash interest expense in fiscal year 2006 includes a
      $16
      million fee paid on June 23, 2005 for our $160 million standby equity
      distribution agreement with Cornell Capital Partners, which was replaced by
      a
      $100 million standby equity distribution agreement on December 30, 2005, plus
      related professional fees and interest accretion on our convertible debentures.





**Interest
      Income**





Interest
      income increased to $222,332 in fiscal year 2006 from $39,241 in fiscal year
      2005. This increase was due to higher cash balances maintained during fiscal
      year 2006.





**Loss
      on settlement of debt**





A
      loss on
      the settlement of debt of $214,274 was incurred in fiscal year 2006 as compared
      to $0 in fiscal year 2005. The loss on settlement of debt represents the
      aggregate consideration provided less the face value of the debt.





**Gain
      on settlement of debt**





A
      gain on
      settlement of convertible debt of $0 was incurred in fiscal 2006 as compared
      to
      $42,346 (restated) in fiscal 2005. The gain arose as on December 15, 2004,
      we
      issued a $2.5 million convertible debenture for gross proceeds of $2.5 million
      and net proceeds of $2.2 million. On issuance of the debenture, we calculated
      the intrinsic value of the beneficial conversion feature as $671,642 and
      recorded it as additional paid in capital with the remaining value classified
      as
      a liability.





On
      March
      22, 2005, the debenture was repaid for $2.5 million from the proceeds from
      the
      issuance of 25,000 mandatory redeemable, convertible preferred stock for which
      we received gross proceeds of $4 million. No redemption warrants were issued
      as
      the preferred shares were issued to the same investor as the $2.5 million
      convertible debenture.





**Derivative
      instrument income:**





A
      derivative instrument income of $2,521,841 was incurred in fiscal year 2006.
      The
      derivative instrument income arose due to mark to market adjustments on
      derivative instruments as explained in note 11 to the financial statements.





**Foreign
      exchange gain/loss**





A
      foreign
      exchange loss of $292,220 was incurred in fiscal year 2006 as compared to a
      foreign exchange gain of $37,194 in fiscal year 2005. Our operating expenses
      are
      adversely impacted by a lower US dollar against the Canadian dollar and Pound
      Sterling as a significant portion of our operations are paid in Canadian dollars
      and Pound Sterling. Foreign exchange gains or losses are due to fluctuations
      in
      currency exchange rates and are impossible to predict.





**LIQUIDITY
      AND CAPITAL RESOURCES**




**CURRENT
      POSITION**




We
      have
      continued to finance our activities primarily through the issuance and sale
      of
      securities. We have incurred losses from operations in each year since
      inception. As at July 31, 2006, we had an accumulated deficit of $103,967,579.
      Our net loss for fiscal year 2006 was $28,829,105 compared to $16,120,218 for
      fiscal year 2005. As of July 31, 2006, our stockholders' equity (capital
      deficit) was $28,025,653 and we had working capital of $1,134,868.




Our
      cash
      position at July 31, 2006 was $1,988,420 as compared to $10,059,763 at July
      31,
      2005. This decrease was due to the net decrease from our operating, financing
      and investing activities as described below.




-9-


Our
      net
      loss of $28,829,105 for fiscal year 2006 includes non-cash charges of $1,303,889
      for depreciation and amortization, a stock based compensation recovery of
      $3,087,145, an unrealized gain on derivative instrument of $2,521,841, an
      inventory write-down of $700,000, a loss on settlement of debt of $214,274,
      $47,070 for warrants issued for services rendered and $23,207,528 for interest
      and finance charges as disclosed above under interest and finance charges.
      Increases in non-cash working capital during this period amounted to $1,088,787.
      Non-cash working capital changes included increases in accounts receivable,
      prepaid expenses and accounts payable and accrued liabilities and a decrease
      in
      inventory. The net cash used in operating activities in fiscal year 2006 was
      $7,876,553. Of this amount, $1,000,000 (including $100,000 of withholding taxes)
      was paid in interest expense on our 10% convertible debentures and $250,000
      (including $22,000 of withholding taxes) was paid as partial compensation to
      settle our dispute with a debenture holder. As it is uncertain whether we will
      be able to access our $100 million Standby Equity Distribution Agreement when
      required, we plan to enter into subsequent financings to meet our operating
      cash
      flow requirements.




During
      fiscal 2006, we also purchased certain capital assets at an aggregate cost
      of
      $246,575.




During
      fiscal year 2006, we realized aggregate gross cash proceeds of $171,800 as
      follows:




·
            On
                October 20, 2005, a warrant holder exercised 1,100,000 warrants at
                an
                exercise price of $0.10 for gross proceeds of $110,000.




·
            During
                fiscal year 2006, 2,060,000 stock options were exercised for gross
                proceeds of $61,800.




On
      June
      30, 2005, we closed a $30 million securities purchase agreement with Cornell
      Capital Partners, Highgate House Funds, Ltd. and LCC Global Limited. In
      accordance with the securities purchase agreement, we issued, for a purchase
      price of $30 million,




(i)
            a
                10% convertible debenture due June 23, 2008, with a principal balance
                of
                $20 million, to Cornell Capital Partners, in trust for LCC
                Global;




(ii)
            a
                10% convertible debenture due June 23, 2008, with a principal balance
                of
                $8 million, to Cornell Capital Partners, in trust for LCC Global,
                and
                (iii) a 10% convertible debenture due June 23, 2008, with a principal
                balance of $2 million, to Highgate House Funds, in trust for LCC
                Global.
                We paid to Yorkville Advisors LLC, the general partner of Cornell
                Capital
                Partners, a cash structuring fee of $3 million in connection with
                this
                transaction.




On
      December 30, 2005, we, Starome Investments Limited, Xentennial Holdings Limited,
      Staraim Enterprises Limited, Cornell Capital Partners, Highgate House Funds
      and
      LCC Global entered into Amendment No. 1 to the Securities and Purchase Agreement
      pursuant to which we amended and restated the 10% convertible debentures in
      an
      aggregate principal amount of $30 million. We amended and restated the 10%
      convertible debentures to




(i)
            modify
                the terms of such 10% convertible
                debentures;




(ii)
            effect
                the transfer by (A) Cornell Capital Partners and LCC Global to Starome
                Investments, a corporation organized under the laws of Cyprus, of
                the 10%
                convertible debenture with the principal balance of $20 million,
                (B)
                Cornell Capital Partners and LCC Global to Xentennial Holdings, a
                corporation organized under the laws of Cyprus, of the 10% convertible
                debenture with the principal balance of $8 million; and




(iii)
            effect
                the transfer by Highgate House Funds and LCC Global to Staraim
                Enterprises, a corporation organized under the laws of Cyprus, of
                the 10%
                convertible debenture with the principal balance of $2 million ((i),
                (ii)
                and (iii) above being referred to as the "restructuring").




The
      following material amendments were made to each of the 10% convertible
      debentures in connection with the "restructuring":




The
      holders of the 10% convertible debentures agreed to eliminate our obligation
      to
      make recurring payments in cash of principal and interest during the term of
      the
      10% convertible debentures. Such holders may convert outstanding principal
      and
      accrued and unpaid interest under the 10% convertible debentures at any time
      into shares of our common stock, subject to a 4.9% beneficial ownership
      limitation, which may be waived provided the holders of 10% convertible
      debentures provide us with 65 days notice. On June 23, 2008, any outstanding
      principal and accrued and unpaid interest under the 10% convertible debentures
      must be converted by the holders of the 10% convertible debentures into shares
      of our common stock; provided, however, that to the extent such conversion
      would
      cause any holder to exceed the 4.9% beneficial ownership limitation, we must
      pay
      such excess amount in cash. Holders of the 10% convertible debentures are not
      entitled to receive cash payments of interest during their term.




We
      agreed
      to change the conversion price of the outstanding principal under the 10%
      convertible debentures from a fixed price of $0.1125 to a price equal to the
      lesser of




(i)
      $0.1125 (subject to adjustment); and




(ii)
      95.5% of the lowest closing bid price of our common stock during the five
      trading days immediately preceding the conversion.




The
      conversion price of accrued and unpaid interest under the 10% convertible
      debentures is 95.5% of the average of the closing bid prices of our common
      stock
      for the five trading days immediately preceding the conversion of any such
      interest by a holder into shares of our common stock.




The
      holders of the 10% convertible debentures agreed to permit us to redeem at
      any
      time all or any portion of the outstanding principal and accrued interest under
      the 10% convertible debentures provided that the closing bid price of our stock
      is less than $0.1125. We must pay a 20% redemption premium on any amounts being
      redeemed and must issue to the holder of the 10% convertible debenture being
      redeemed a five-year warrant to purchase $1 million shares of our common stock
      for every $100,000 redeemed. The "redemption warrant" will be exercisable on
      a
      cash basis at an exercise price of 110% of the closing bid price of our common
      stock on the date we provide notice of our intent to redeem.




On
      December 30, 2005, we and Cornell Capital Partners terminated the $160 million
      standby equity distribution agreement, originally entered into on June 23,
      2005,
      and replaced it with a new $100 million standby equity distribution agreement.
      We may not request advances under the $100 million standby equity distribution
      agreement until the underlying shares of our common stock are registered with
      the SEC.




On
      January 11, 2006, we filed a registration statement on Form SB-2 with the SEC
      registering, among other shares of our common stock, the shares of common stock
      underlying the amended and restated 10% convertible debentures and our $100
      million equity line of credit. In response to comments from the SEC, we
      subsequently filed amendments to this registration statement on February 27,
      2006 and April 12, 2006. On September 20, 2006, after receiving default waivers
      from all of the holders of our 10% convertible debentures, we withdrew the
      registration statement.




The
      term
      of the $100 million standby equity distribution agreement will commence on
      the
      date a registration statement covering the underlying shares becomes effective
      and will expire five years after such date. Under the old $160 million standby
      equity distribution agreement, Cornell Capital Partners was entitled to retain
      5% of each advance requested by us. In consideration for the reduction of the
      amount available to us under the new $100 standby equity distribution agreement,
      Cornell Capital Partners agreed to reduce this 5% advance fee to 2.5% of each
      advance.




-10-


With
      respect to the $1.5 million 5% convertible debenture due May 20, 2006 issued
      to
      Cornell Capital Partners, principal will be due and payable in 12 equal
      installments. The installments of principal were due and payable commencing
      on
      October 1, 2005 and subsequent installments were due and payable on the first
      day of each calendar month thereafter until the outstanding principal balance
      is
      paid in full. However, Cornell Capital Partners granted us an extension
      to November 1, 2006 to commence making these principal and interest
      payments. Interest on the outstanding principal balance is due and payable
      monthly, in arrears, commencing on August 1, 2005 and will continue to be
      payable on the first day of each calendar month thereafter that any amounts
      under the convertible debenture remain payable.




However,
      although we have a $100.0 million standby equity distribution with Cornell,
      there are certain factors that may prevent us from drawing down on it. As such,
      due to the uncertainty of our ability to meet our current operating and capital
      expenses, in their report on the annual consolidated financial statements for
      fiscal year 2006, our independent auditors included additional comments in
      their
      Auditors' report indicating the existence of substantial doubt about our ability
      to continue as a going concern. Our consolidated financial statements contain
      additional note disclosures describing the circumstances that led to this going
      concern uncertainty. The consolidated financial statements do not include any
      adjustments that might result from the outcome of this uncertainty.





As
      the
      continuation of our business is dependent upon the conversion by certain holders
      of our outstanding convertible debentures into shares of our common stock or,
      if
      such conversions do not occur or are not sufficient to significantly decrease
      our outstanding repayment obligation, our ability to drawn down on our $100.0
      million equity line of credit, successful and sufficient market acceptance
      of
      our current products and any new products that we may introduce, the continuing
      successful development of our products and related technologies, and, finally,
      achieving a profitable level of operations. The issuance of additional equity
      securities by us could result in a significant dilution in the equity interests
      of our current stockholders. Obtaining commercial loans, assuming those loans
      would be available, will increase our liabilities and future cash commitments.




**Fiscal
      Year Ended July 31, 2005**





We
      have
      continued to finance our activities primarily through the issuance and sale
      of
      securities. We have incurred losses from operations in each year since
      inception. As at July 31, 2005, we had an accumulated deficit of $75,138,474.
      Our net loss for fiscal year 2005 was $16,120,218 compared to $10,987,026 for
      fiscal year 2004. As of July 31, 2005, our stockholders' equity was $10,383,957
      and we had working capital of $7,582,878.





Our
      cash
      position at July 31, 2005 was $10,059,763 as compared to $76,670 at July 31,
      2004. This increase was due to the net increase from our operating, financing
      and investing activities as described below.





Our
      net
      loss of $16,120,218 in fiscal year 2005 includes non-cash charges of $1,497,250
      for depreciation and amortization, $4,279,653 for compensation expense, $500,000
      for an inventory write-down, $3,573,475 for interest and finance charges and
      a
      gain on settlement of debt of $42,346. Decreases in non-cash working capital
      during this period amounted to $507,809. Non-cash working capital changes
      included increases in inventory and accounts receivable and decreases in prepaid
      expenses and in accounts payable and accrued liabilities. The net cash used
      in
      operating activities in fiscal year 2005 was $6,819,995. We may require
      subsequent financings to meet our operating cash flow requirements.





During
      fiscal year 2005, we realized aggregate gross cash proceeds of $42,595,017
      as
      follows:





We
      issued
      78,887,710 shares of common stock to Cornell Capital Partners LP pursuant to
      nine draw downs totaling $2,725,000 from our $15.0 million equity line of
      credit, which is described below.





On
      May
      19, 2004, we entered into a Standby Equity Distribution Agreement with Cornell
      Capital Partners, an accredited investor, in connection with a 24-month, $15.0
      million equity line of credit facility. This agreement was terminated on May
      20,
      2005 and replaced with a $30.0 million equity line of credit facility. The
      $30
      million agreement was terminated on June 23, 2005 and replaced with a $160.0
      million equity line of credit facility. The new Standby Equity Distribution
      Agreement (SEDA) contemplates the potential future issuance and sale of up
      to
      $160.0 million of our common stock to Cornell Capital Partners over five years
      subject to certain restrictions and other obligations. On June 2, 2005, we
      issued 75,188 shares at an effective price of $0.133 per share as payment for
      a
      $10,000 placement agency fee related to the SEDA. On each advance date we shall
      pay to the Investor, directly from the gross proceeds held in escrow, an amount
      equal to five percent (5%) of the amount of each advance.





In
      addition we paid to Yorkville Advisors Management, LLC a cash fee of $16 million
      directly from the gross proceeds held in escrow from the closing of the
      convertible debentures dated June 23, 2005. Yorkville Advisors Management,
      LLC
      is the general partner of Cornell Capital Partners. This cash fee was payment
      for the $160 million equity line of credit facility.





Aggregate
      warrant proceeds of $618,217 were realized as follows:





On
      September 24, 2004, we and holders of the discounted convertible debentures
      signed an agreement which provided for an immediate exercise of 18,226,274
      warrants at $0.03 for gross proceeds of $546,788.





On
      May 5,
      2005, a warrant holder exercised 714,286 warrants at an exercise price of $0.10
      for gross proceeds of $71,429.





On
      November 16, 2004 we received gross proceeds of $250,000 upon the issuance
      of an
      unsecured short-term promissory note to an accredited investor. The note bears
      interest at a rate of 12% per annum and is repayable within 30 days of issuance
      with accrued interest.





On
      November 30, 2004 we received gross proceeds of $275,000 upon the issuance
      of an
      unsecured short-term promissory note to an accredited investor. The note bears
      interest at a rate of 12% per annum and is repayable within 30 days of issuance
      with accrued interest. As a commitment fee to loan the Company money, the holder
      of the note received $27,500.





On
      February 9, 2005 we received gross proceeds of $350,000 upon the issuance of
      an
      unsecured short-term promissory note to an accredited investor. The note bears
      interest at a rate of 10% per annum and is repayable within 30 days of issuance
      with accrued interest. As a commitment fee to loan the Company money, the holder
      of the note received $35,000.





On
      December 15, 2004, we received gross proceeds of $2,695,000 upon the issuance
      of
      a three-year $2,500,000 5% convertible debenture and five two-year 5%
      convertible debentures aggregating $195,000. Principal under the five 5%
      convertible debentures that aggregate $195,000 may be converted by the holder
      in
      whole or in part and from time to time at a conversion price equal to the lesser
      of:





(i)
      $0.036 or;


(ii)
      an
      amount equal to 80% of the lowest closing bid price of our common stock, as
      quoted on Bloomberg, L.P., for the 5 trading days immediately preceding the
      conversion date, subject to adjustment as provided for in the debentures.





The
      outstanding principal under the convertible debentures bears interest at the
      rate of 5% per annum, calculated on the basis of a 360-day year. Interest on
      the
      debentures aggregating $195,000 is payable semi-annually beginning June 15,
      2005
      and every subsequent six month period that the principal balance remains unpaid.





On
      March
      22, 2005, we issued 5% convertible preferred stock for gross proceeds of
      $4,000,000. The proceeds were used to repay the $2,500,000 convertible debenture
      entered into on December 15, 2004 and a $350,000 promissory note entered into
      on
      February 9, 2004. Additional expenses related to this offering were $20,000.





-11-


On
      May
      20, 2005, we issued a $1,500,000 one-year 5% convertible debenture convertible
      at the option of the holder at $0.028 per share. Between April 25 and April
      29,
      2005, $1,100,000 of the convertible debenture was placed in escrow with our
      lawyer. From escrow, $457,999 was paid on April 27, 2005 to two debenture
      holders to redeem their convertible debentures. In addition, between May 2,
      2005
      and May 23, 2005, we entered into release, redemption and settlement agreements
      whereby we redeemed $675,615 of discounted convertible debentures. Consideration
      consisted of $402,930 and the issuance of 9,738,759 shares of common stock
      which
      were issued at an effective conversion price of $0.028 per share.





On
      June
      23, 2005, we entered into a $160.0 million Standby Equity Distribution Agreement
      and a $30 million Securities Purchase Agreement that resulted in net proceeds
      of
      $10.95 million to us. We paid Yorkville Advisors Management a cash fee of $16
      million in connection with the Standby Equity Distribution Agreement, and we
      paid Cornell Capital Partners a cash fee of $3 million, and a cash structuring
      fee of $50,000 to Yorkville Advisors Management, in connection with the
      Securities Purchase Agreement, out of the purchase price paid by Cornell Capital
      Partners for the convertible debentures purchased pursuant to the Securities
      Purchase Agreement. Refer to "Description of Securities" for more details
      regarding the Standby Equity Distribution Agreement and the Securities Purchase
      Agreement. We also issued 62.5 million warrants exercisable at $0.16 per share
      (subject to adjustment pursuant to adjustment as described below) with an expiry
      period of five years. Although we have cash of approximately $10.1 million
      at
      July 31, 2005, as discussed below under "FUTURE OPERATIONS", we may require
      up
      to $12.1 million in financing through the next twelve months in order to
      continue in business as a going concern.





At
      January 31, 2005 and April 30, 2005, we were in violation of all existing
      convertible debenture agreements. As a result of this violation, the Company
      accreted interest to adjust the carrying value of all existing convertible
      debentures to their redemption value.





As
      at
      April 30, 2005, we were in violation of a preferred share agreement as a
      registration statement was not filed with the Securities and Exchange Commission
      on the date specified in the agreement. We received an extension from the
      preferred shareholders to file a registration statement by June 30, 2005 and
      received a waiver for any penalties.





As
      we
      filed a registration statement on July 22, 2005, we were not in violation of
      any
      existing convertible debenture or preferred share agreements, other than one
      holder of a discounted debenture in the amount of $91,726 who provided us with
      notice of a summons with the Supreme Court of the State of New York. However,
      as
      of September 23, 2005 we were in violation of the other convertible debenture
      and preferred share agreements as we withdrew our registration statement. We
      received a waiver from the debtholders, other than the one debtholder who
      provided us with the notice of summons with the Supreme Court of the State
      of
      New York, and preferred shareholders that we are not in default pending the
      filing of a new registration statement and the principal holder waives its
      rights under the default provisions affected by this non-compliance.





During
      fiscal year 2005, we also purchased certain capital assets at an aggregate
      cost
      of $73,511.





**FUTURE
      OPERATIONS**





Presently,
      our revenues are not sufficient to meet operating and capital expenses. We
      have
      incurred operating losses since inception, and this is likely to continue for
      the foreseeable future.





At
      July
      31, 2006, we had cash of approximately $2.0 million. As our management projects
      that we will require a minimum of $4.6-$17.9 million to fund our debt repayment,
      ongoing operating expenses, working capital requirements and potential
      litigation settlement through July 31, 2007, as detailed below, we may we may
      require up to $17.9 million in financing through the next twelve months in
      order
      to continue in business as a going concern.




Estimated
                  RangeMarketing
              
              $
              1,800,000
              
              $
              2,200,000Engineering,
                  research and development
              
              
              3,200,000
              
              
              3,800,000General
                  and administrative
              
              
              2,800,000
              
              
              3,400,000Capital
                  Purchases
              
              
              500,000
              
              
              1,100,000Debt
                  repayment (1)
              
              
              600,000
              
              
              6,400,000Litigation
                  settlement (2)
              
              
              -
              
              
              5,100,000General
                  Working Capital (3)
              
              
              (2,300,000
              )
              
              (2,100,000
              )TOTAL
              
              $
              6,600,000
              
              $
              19,900,000




(1)
      Principal payments on all of our outstanding debt and interest payable,
      excluding $500,000 of interest payable in cash under our 10% convertible
      debentures is convertible into shares of our common stock.





(2)
      Legal
      dispute includes maximum settlement of $5,000,000 plus attorney fees with
      distributor that provided us with a demand for arbitration action.





(3)
      Our
      working capital requirements are impacted by our inventory requirements.
      Therefore, any increase in sales of our products will be accompanied not only
      by
      an increase in revenues, but also by an increase in our working capital
      requirements.





The
      continuation of our business is dependent upon obtaining further financing,
      market acceptance of our current products and any new products that we may
      introduce, the continuing successful development of our products and related
      technologies, and, finally, achieving a profitable level of operations.





We
      plan
      to raise any additional capital required to meet the balance of our estimated
      funding requirements through July 31, 2007, primarily through the issuance
      of
      either convertible debt or equity and if possible, the draw down of our $100.0
      million standby equity distribution agreement entered into on June 23, 2005.





The
      issuance of additional equity securities by us could result in a significant
      dilution in the equity interests of our current stockholders. Obtaining
      commercial loans, assuming those loans would be available, will increase our
      liabilities and future cash commitments.





**APPLICATION
      OF CRITICAL ACCOUNTING POLICIES**





Our
      consolidated financial statements and accompanying notes are prepared in
      accordance with generally accepted accounting principles in the United States.
      Preparing financial statements requires management to make estimates and
      assumptions that affect the reported amounts of assets, liabilities, revenue,
      and expenses. These estimates and assumptions are affected by management's
      application of accounting policies. We believe that understanding the basis
      and
      nature of the estimates and assumptions involved with the following aspects
      of
      our consolidated financial statements is critical to an understanding of our
      financials.





**Going
      Concern**





The
      Company has incurred recurring operating losses and has a deficit of
      $103,967,579 and working capital of $1,134,868 as at July 31, 2006. During
      the
      year ended July 31, 2006, the Company used cash of $7,876,553 in operating
      and
      investing activities.


-12-


During
      fiscal 2006, the Company realized gross cash proceeds of $171,800 (2005 -
      $42,595,017) from financing activities.





The
      ability of the Company to continue as a going concern is in substantial doubt
      and is dependent on achieving profitable operations, and obtaining the necessary
      financing in order to achieve profitable operations. The outcome of these
      matters cannot be predicted at this time. The Company’s future operations are
      dependent on the market’s acceptance of its products in order to ultimately
      generate future profitable operations, and the Company’s ability to secure
      sufficient financing to fund future operations. There can be no assurance that
      the Company’s products will be able to secure market acceptance. Management
      plans to obtain additional financing to enable the company to achieve profitable
      operations as a lthough
      the Company has a $100 million Standby Equity Distribution Agreement with
      Cornell Capital Partners, it is uncertain when the Company will be permitted
      to
      draw down on the Standby Equity Distribution Agreement during the period that
      the outstanding principal and accrued and unpaid interest under the 10%
      convertible debentures remain outstanding as drawdowns are subject to an
      effective Registration statement. As a result, the Company may require
      additional financing to fund its operations. These consolidated financial
      statements have been prepared on the going concern basis which assumes that
      adequate sources of financing will be obtained as required and that the
      Company’s assets will be realized and liabilities settled in the ordinary course
      of business. Accordingly, these consolidated financial statements do not include
      any adjustments related to the recoverability of assets and classification
      of
      assets and liabilities that might be necessary should the Company be unable
      to
      continue as a going concern.




**Inventory**





Inventory
      of raw materials is recorded at the lower of cost, determined on a first-in,
      first-out basis, and net realizable value. Inventory of finished goods and
      work-in progress are recorded at the lower of average cost and net realizable
      value. Average cost is determined using the weighted-average method and includes
      invoice cost, duties and freight where applicable plus direct labour applied
      to
      the product and an applicable share of manufacturing overhead. A provision
      for
      obsolescence for slow moving inventory items is estimated by management based
      on
      historical and expected future sales and is included in cost of goods sold.





**Warranty
      Obligations**





On
      an
      ongoing basis, we record our best estimate of our warranty obligations and
      product returns related to products sold. These estimates are made after the
      consideration of contractual warranty obligations and historical experience.
      Unforeseen events, including increased technological difficulties with products,
      could occur that have not been anticipated in estimating the warranty provision.
      Additional costs or estimates will be recognized as determinable.





**Revenue
      Recognition**





We
      recognize revenue when there is persuasive evidence of an arrangement, goods
      are
      shipped and title passes, collection is probable, and the fee is fixed or
      determinable. Provisions are established for estimated product returns and
      warranty costs at the time the revenue is recognized. We record deferred revenue
      when cash is received in advance of the revenue recognition criteria being
      met.
      Revenue from engineering services is recognized on services as they are rendered
      and pre-defined milestones are achieved. Engineering services revenue for the
      year were $0 (2005-$0 and 2004-$94,800).





**Other
      Assets**





Other
      assets are recorded at cost and are being amortized over five years on a
      straight line basis. Other assets are comprised of licenses to manufacture
      and
      sell TPMSs to the original equipment manufacturers. On an ongoing basis,
      management assesses whether the expected net recoverable amount of the licenses
      exceeds the book value of the licenses. The net recoverable amount is determined
      on a projected cash flow basis, undiscounted at an appropriate rate. Our belief
      is based on an undiscounted cash flow analysis of management's current best
      estimate of projected annual sales to the passenger vehicle and light truck
      OEM
      market plus management's projected sales to the heavy truck OEM market. Although
      we expect to generate cash flow from sales to the original equipment
      manufacturer market place, it is possible that we will not generate cash flow
      from sales to the original equipment manufacturer marketplace in excess of
      net
      book value, or that we will generate cash flow from sales to the original
      equipment manufacturer market in future years after the other assets have been
      fully amortized.





**Off-Balance
      Sheet Arrangements**





We
      have
      not entered into any transaction, agreement or other contractual arrangement
      with an entity unconsolidated with us under which we have:




·
            an
                obligation under a guarantee contract;




·
            a
                retained or contingent interest in assets transferred to the
                unconsolidated entity or similar arrangement that serves as credit,
                liquidity or market risk support to such entity for such assets;




·
            an
                obligation, including a contingent obligation, under a contract that
                would
                be accounted for as a derivative instrument; or an obligation, including
                a
                contingent obligation, arising out of a variable interest in an
                unconsolidated entity that is held by, and material to, us where
                such
                entity provides financing, liquidity, market risk or credit risk
                support
                to, or engages in leasing, hedging, or research and development services
                with us.




**ITEM
      7. FINANCIAL STATEMENTS**




Our
      consolidated financial statements are included beginning immediately following
      the signature page to this report. See Item 13 for a list of the financial
      statements and financial statement schedules included.





**ITEM
      8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE**





On
      July
      14, 2006, KPMG resigned at our request as our independent registered public
      accounting firm. The Audit Committee made the decision to change independent
      accountants and that decision was approved, ratified and adopted by our Board
      of
      Directors. The audit report of KPMG on the consolidated financial statements
      as
      of and for the year ended July 31, 2004 did not contain an adverse opinion
      or
      disclaimer of opinion and was not qualified or modified as to uncertainty,
      audit
      scope, or accounting principles but was modified as to uncertainty due to
      substantial doubt regarding our ability to continue as a going concern. The
      audit report of KPMG on the consolidated financial statements as of and for
      the
      year ended July 31, 2005 did not contain an adverse opinion or disclaimer of
      opinion and was not qualified, but was modified as to uncertainty due to
      substantial doubt regarding our ability to continue as a going concern. In
      connection with their audits for the years ended July 31, 2004, July 31, 2005
      and in the subsequent interim periods through July 14, 2006, there have been
      no
      disagreements with KPMG on any matter of accounting principles or practices,
      financial statement disclosure, or auditing scope or procedure, which
      disagreements, if not resolved to the satisfaction of KPMG, would have
      caused them to make reference thereto in its reports on financial
      statements for such years.





On
      July
      28, 2006, we engaged BDO as our independent registered public accounting firm
      for the fiscal year ending July 31, 2006, and to perform procedures related
      to
      the financial statements included in the Company’s quarterly reports on Form
      10-QSB, beginning with, and including, the quarter ended October 31, 2006.
      The
      Audit Committee made
      the
      decision to engage BDO and that decision was approved, adopted and ratified
      by
      our Board of Directors. We have not consulted with BDO during our two most
      recent fiscal years or during any subsequent interim period prior to its
      appointment as auditor regarding either (i) the application of accounting
      principle to a specified transaction, either completed or proposed; or the
      type
      of audit opinion that might be rendered on our consolidated financial
      statements, and neither a written report was provided to us nor oral advice
      was
      provided that BDO concluded was an important factor considered by us in reaching
      a decision as to the accounting, auditing or financial reporting issue; or
      (ii) any matter that was either the subject of disagreement (as defined in
      Item 304(a)(1)(iv) of Regulation S-B and the related instructions).




In
      deciding to select BDO, the Audit Committee considered BDO’s experience and
      expertise related to public companies traded on the Over-the-Counter Bulletin
      Board as well as reviewed auditor independence issues and existing commercial
      relationships with BDO. The Audit Committee concluded that BDO has no commercial
      relationship that would impair its independence and had the appropriate
      expertise that we required regarding its current operations.


-13-


**ITEM
      8A. CONTROLS AND PROCEDURES**





(a)
            Restatements 
 The
        Company has effected a restatement of its financial results for the periods
        ended April 30, 2005, October 31, 2005, January 31, 2006 and the year ended
        July
        31, 2005 (the “Restatements”).
 
 The
        Restatements were effected to correct errors in the Company’s accounting
        treatment of:
  (i)
            its
                outstanding convertible debentures that have warrants and conversion
                features with respect to Statement of Financial Accounting Standards
                (“SFAS”) No. 133 and Emerging Issues Task Force (“EITF”)
                00-19; 
 (ii)
            the
                gain recorded upon the extinguishment of
                its $2.5 million, 5% convertible debenture with respect to guidance
                in
                EITF 00-27, Issue 12(b) as the conversion price used in the calculation
                of
                the accounting gain to reflect that of the closing bid price of the
                Company’s common stock on the date of
                extinguishment. 
 As
        a
        result of the Company’s review of these transactions, the effect on the amended
        accounting for the (non-cash) gain on extinguishment of debt on the Company’s
        consolidated statement of operations for the year ended July 31, 2005 was
        a
        decrease in the gain on extinguishment of debt of $1,828,357 which resulted
        in
        an increase in the Company’s net loss of $1,828,357 and a reduction in the
        charge to deficit relating to the extinguishment of the debenture. Basic
        and
        diluted loss per share for the year ended July 31, 2005 increased by $0.01
        to
        $0.07 per share. The effect on the Company’s consolidated balance sheet as of
        July 31, 2005 was an increase in its additional paid in capital and accumulated
        deficit of $6,324.
 
 In
        addition, the warrants and conversion features relating to certain of the
        Company’s outstanding convertible debentures have been amended to account for
        these items as a derivative instrument in liabilities, rather than as equity
        and
        accordingly, have been bifurcated from the debt hosts and accounted for
        separately as a derivative instrument liabilities.
 
 (b)
            Evaluation
                of disclosure controls and procedures and
                remediation 
 In
        connection with the Restatements, under the direction of the Company’s
        management, we have reevaluated certain disclosure controls and procedures
        and
        internal control over financial reporting. In connection with the Restatements,
        we identified a material weakness in our internal controls and procedures
        relating to the accounting treatment of our convertible debentures and related
        warrants.
 
 To
        our
        knowledge, as of the date of this filing, we have remediated such material
        weakness in our internal controls and procedures .
 
 In
        connection with this Form 10-KSB, under the direction of our Chief Executive
        Officer, we have evaluated our disclosure controls and procedures as of July
        31,
        2006, including the remedial actions discussed above, and we have concluded
        that, as of July 31, 2006, our disclosure controls and procedures are
        effective.
 
 It
        should
        be noted that while our management believe our disclosure controls and
        procedures provide a reasonable level of assurance, they do not expect that
        our
        disclosure controls and procedures or internal controls will prevent all
        error
        and all fraud. A control system, no matter how well conceived or operated,
        can
        provide only reasonable, not absolute, assurance that the objectives of the
        control system are met. Further, the design of a control system must reflect
        the
        fact that there are resource constraints, and the benefits of controls must
        be
        considered relative to their costs. Because of the inherent limitations in
        all
        control systems, no evaluation of controls can provide absolute assurance
        that
        all control issues and instances of fraud, if any, within the Company have
        been
        detected. These inherent limitations include the realities that judgments,
        in
        decision making can be faulty, and that breakdowns can occur because of simple
        error or mistake. Additionally, controls can be circumvented by the individual
        acts of some persons, by collusion of two or more people, or by management
        override of the controls. The design of any system of internal control is
        based
        in part upon certain assumptions above the likelihood of future events, and
        there can be no assurance that any design will succeed in achieving its stated
        goals under all potential future conditions. Over time, controls may become
        inadequate because of changes in conditions, or the degree of compliance
        with
        the policies or procedures may deteriorate. Because of the inherent limitations
        in a cost-effective control system, misstatements due to error or fraud may
        occur and not be detected.


**ITEM
      8B. OTHER INFORMATION**





None.





**PART
      III**





**ITEM
      9. DIRECTORS, EXECUTIVE OFFICERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION
      16(a) OF THE EXCHANGE ACT**





The
      following table shows the positions held by our board of directors and executive
      officers, and their ages as of September 29, 2006:







Name
            Age
            PositionRobert
                Rudman(1)
            59
            Director,
                Chairman of the BoardLeif
                Pedersen
            57
            President
                and Chief Executive OfficerJeff
                Finkelstein
            45
            Chief
                Financial OfficerDave
                Warkentin
            48
            Vice
                President, Sales and MarketingShawn
                Lammers
            39
            Vice
                President, EngineeringWilliam
                Cronin(1)(2)
            59
            DirectorMartin
                Gannon(1)(2)
            54
            DirectorJohnny
                Christiansen(2)
            51
            Director





(1)
      Member of the Audit Committee





(2)
      Member of the Compensation Committee





**Business
      Experience and Principal Occupation of Directors, Executive Officers and
      Significant Employees**





The
      following is a brief discussion of the business experience of our current
      directors and executive officers and key employees during the past five
      years:




William
      Cronin




Mr.
      Cronin has been a director since June 2001 and previously served as a director
      from November 17, 1995 to April 25, 1998. Since 1986, Mr. Cronin has been the
      owner of Madison Financial Services, a registered investment adviser firm
      located in Madison, Connecticut, specializing in tax, pension investing planning
      strategies and portfolio management.




Martin
      Gannon




Mr.
      Gannon joined our Company as a director on February 3, 2003. Mr. Gannon has
      been
      a Certified Public Accountant since 1973. He has been a partner and the vice
      president of the accounting firm of Barron Gannon & Co., P.C. since 1982. In
      his advisory role to his clientele, he has assisted companies from their
      inception to maturity.




Johnny
      Christiansen




Mr.
      Christiansen joined our company as a director on August 14, 2003. Mr.
      Christiansen resides in Norway. Mr. Christiansen is presently the President
      and
      Chief Executive Officer of IQ Medical Corp. (PK: IQMC), a U.S. public company.
      Mr. Christiansen is also a business consultant to Visionaire, AS Norway, a
      private Scandinavian company. He has a strong knowledge of our business and
      industry as he served as the President of SensoNor ASA from 1999-2002. SensoNor
      is a Norwegian company and a leading provider of tire monitoring, airbag and
      rollover sensors for the automotive industry. During Mr. Christiansen's tenure
      as its President, SensoNor raised more than $100 million in financing and signed
      contracts for more than $400 million. Before 1999, Mr. Christiansen served
      as a
      director of various companies, including Davis AS, Kongsberg Norcontrol Systems,
      Norcontrol Training AS and Norcontrol Automation AS.




-14-


Robert
      Rudman





Mr.
      Rudman has been a director since September 1993. Mr. Rudman joined our company
      in March 1993 as the Chief Financial Officer after serving as an independent
      financial consultant for several months. He was appointed our Chief Executive
      Officer on January 19, 1996 and served as our President from January 19, 1996
      to
      June 4, 1999, when he was appointed Chairman of the Board. Mr. Rudman was
      reappointed our President effective April 1, 2000. He resigned as President
      and
      Chief Executive Officer on June 30, 2005. Mr. Rudman currently acts as a
      consultant to our company in addition to his role as non-executive Chairman
      of
      the Board. In addition, Mr. Rudman is a member of the Board of Directors and
      serves as the Chief Financial Officer, Secretary and Treasurer of IQ Medical
      Corp. (PK: IQMC), a U.S. public company. Mr. Rudman is a Chartered Accountant
      with over 17 years of experience assisting public companies listed primarily
      on
      the Vancouver Stock Exchange (now the TSX Venture Exchange). Prior to joining
      our company, Mr. Rudman was manager of a California-based sales contract
      financing firm. Previously, he was a partner in a consulting firm providing
      professional assistance to publicly traded companies. Mr. Rudman became a
      Chartered Accountant in 1974 and worked with Laventhol & Horwath and Price
      Waterhouse & Co. in Winnipeg, Manitoba.




Leif
      Pedersen





Effective
      October 20, 2006, Mr. Leif Pedersen resigned as our President and Chief
      Executive Officer. Effective as of April 12, 2006, Mr. Pedersen was appointed
      as
      our President and Chief Executive Officer. From late 2001 through 2005, Mr.
      Pedersen, a Norwegian citizen, was the managing director of Consilium GmbH
      in
      Hamburg, Germany, responsible for marketing, sales, support and service for
      a
      line of technical products for the maritime industry including radar, speed
      logs
      and various monitoring and detection systems. Before joining Consilium Mr.
      Pedersen was program director for SensoNor ASA, a company specializing in the
      development and production of micro sensors, particularly for the automotive
      applications. SensoNor is one of the largest sensor suppliers within its niche
      in the automotive industry. Mr. Pedersen’s earlier experience also includes a
      variety of sales and marketing and executive positions with Norcontrol AS,
      The
      Marine Group, Inc. and Kongsberg Norcontrol AS. He holds a master’s degree in
      electronics from the Technical University in Trondheim, Norway, and has a degree
      in business administration from the Bedriftsokonomisk Institutt in Norway.
      He
      also earned an export candidate certificate from the Norwegian Export School.
      Mr. Pedersen has studied cybernetics, electronics, sales and marketing and
      leadership training. Fluent in English, Norwegian and German, Mr. Pedersen
      has
      held several director positions and is at this time a director of Consilium
      Sevoteknikk AS in Oslo, Norway.




Jeff
      Finkelstein





Mr.
      Finkelstein was formally appointed as our Chief Financial Officer in October
      2002. He is a Chartered Accountant and is responsible for all financial and
      related internal control functions for our company, including finance, treasury,
      accounting, taxation, legal, and administration. Mr. Finkelstein was promoted
      to
      Acting Chief Financial Officer of our company in May 2002, after serving as
      our
      controller since February 22, 1999. From 1996 to 1999, he served as controller
      of Golden Knight Resources Inc., a Toronto Stock Exchange listed public company,
      and Silver Standard Resources, a Nasdaq listed public company. From 1993 to
      1995, he served as controller of a private distribution company after eight
      years as a public accountant.




Shawn
      Lammers





Mr.
      Lammers has been with our company since its inception. He currently serves
      as
      our Vice President Engineering and is responsible for the development of the
      patented remote sensing technology utilized in our products. He has been the
      chief engineer in respect to the design, development and production of our
      passenger car tire monitoring system, our commercial vehicle tire monitoring
      system and our industrial equipment tire pressure monitoring systems (TPMS).
      He
      has developed software for MS-DOS, Windows, UNIX Workstations and Amiga
      platforms.




David
      Warkentin





Effective
      October 20, 2006, Mr. Dave Warkentin was appointed as our President and Chief
      Executive Officer. Mr. Warkentin joined our company on August 8, 2005, as Vice
      President of Sales and Marketing. During 2004 and 2005, Mr. Warkentin was the
      Vice President of Sales of Intrinsyc Software International, Inc. (TSX: ICS),
      a
      Canadian public company that provides engineering services to wireless mobile
      device makers as well as licensable software for the wireless telephone handset
      market. From 2000 until 2004, Mr. Warkentin was the Director of Sales for Silent
      Witness Enterprises Ltd., a Canadian company that manufactures security cameras
      and digital video recorders targeted to the financial, educational and
      corrections markets. Also during 2000, Mr. Warkentin was the North American
      Sales Manager for Digital Dispatch Systems, and was responsible for a sales
      team
      selling mobile dispatch hardware and software solutions directly to
      end-users.





**Family
      Relationships**





There
      are
      no family relationships between any of our directors or executive officers.





**Involvement
      In Certain Legal Proceedings**





None
      of
      our directors, executive officers, promoters or control persons have been
      involved in any of the following events during the past five years:





·
            any
                bankruptcy petition filed by or against any business of which such
                person
                was a general partner or executive officer either at the time of
                the
                bankruptcy or within two years prior to that time;





·
            any
                conviction in a criminal proceeding or being subject to a pending
                criminal
                proceeding (excluding traffic violations and other minor offences);





·
            been
                subject to any order, judgment, or decree, not subsequently reversed,
                suspended or vacated, of any court of competent jurisdiction, permanently
                or temporarily enjoining, barring, suspending or otherwise limiting
                his
                involvement in any type of business, securities or banking activities;
                or





·
            been
                found by a court of competent jurisdiction (in a civil action), the
                Commission or the Commodity Futures Trading Commission to have violated
                a
                federal or state securities or commodities law, and the judgment
                has not
                been reversed, suspended, or vacated.





**Audit
      Committee Financial Expert**





Our
      Board
      of Directors has determined that Martin Gannon, a member of the audit committee,
      qualifies as an "audit committee financial expert" as such term is defined
      by
      Regulation S-B of the Securities Exchange Act of 1934, as amended. Our Board
      of
      Directors has also determined that Mr. Gannon is independent as such term is
      used in Item 7(d)(3)(iv) of Schedule 14A under the Securities Exchange Act
      of
      1934, as amended.





-15-


**Section
      16(a) Beneficial Ownership Reporting Compliance**





Section
      16(a) of the Securities Exchange Act of 1934 requires our officers and
      directors, and persons who own more than 10% of our common stock, to file
      reports of ownership and changes in ownership with the SEC. Officers, directors
      and greater than 10% shareholders are required by SEC regulations to furnish
      us
      with copies of all Section 16(a) forms they file.





Based
      solely on our review of the copies of such forms received by us, or written
      representations from certain reporting persons, we believe that during the
      year
      ended July 31, 2006, all filing requirements applicable to our executive
      officers and directors and greater than 10% shareholders were complied with.





Form
      4’s
      filed on January 5, 2006 for our officers and directors were filed two days
      late.





**Code
      of Ethics**





Our
      Board
      of Directors has adopted a Code of Ethics that applies to our Chief Executive
      Officer and Chief Financial Officer, as well as other members of our senior
      management and senior financial team. Such Code of Ethics complies with the
      requirements of the Sarbanes Oxley Act of 2002 and the rules thereunder for
      codes of ethics applicable to such officers. Our Board of Directors will
      continue to evaluate its role and responsibilities with respect to new
      legislative and other requirements of the SEC  A
      copy of
      our Code of Business Conduct and Ethics was filed with the Securities and
      Exchange Commission as an exhibit to our Quarterly Report on Form 10-KSB on
      October 16, 2003. We will also provide a copy of the Code of Business Conduct
      and Ethics to any person without charge, upon request. Requests can be sent
      to
      SmarTire Systems Inc., #150 - 13151 Vanier Place, Richmond, British Columbia,
      Canada V6V 2J1 or via e-mail at info@smartire.com.





**ITEM
      10. EXECUTIVE COMPENSATION**





The
      following table sets forth, for the years indicated, particulars of compensation
      awarded to, earned by or paid to:





·
            our
                chief executive officer;





·
            each
                of our four most highly compensated executive officers who were serving
                as
                executive officers at the end of the most recently completed fiscal
                year
                and whose total salary and bonus exceeds $100,000 per year; and





·
            any
                additional individuals for whom disclosure would have been provided
                immediately above but for the fact that the individual was not serving
                as
                an executive officer of our company at the end of the most recently
                completed fiscal year; (the Named Executive Officers) are set out
                in the
                summary compensation table below.





During
      fiscal 2006, six individuals served as our executive officers at various times:
      Leif Pedersen, Al Kozak, Jeff Finkelstein, Dave Warkentin, Erwin Bartz and
      Shawn
      Lammers.





-16-


**Summary
      Compensation Table**




SUMMARY
                  COMPENSATION TABLEAnnual
                  Compensation
              
              Long
                  Term CompensationAwards
              
              
              
              
              
              PayoutsName
                  and
              
              Year
              
              
              Salary
              
              
              Bonus
              
              
              
              
              Other
              
              Securities
              
              
              Restricted
              
              
              LTIP
              
              
              All
                  OtherPrincipal
              
              
              
              
              
              
              
              
              
              
              
              
              Annual
              
              Underlying
              
              
              Shares
                  or
              
              
              Payouts
              
              
              CompensationPosition
              
              
              
              
              
              
              
              
              
              
              
              
              Compen-
              
              Options/
              
              
              Restrictedsation
              
              SARs
                  Share(1)
              
              Granted(#)Leif
                  Pedersen
              
              2006
              
              $
              73,000
              
              $
              -
              
              (2)
              
              $
              -
              
              -
              
              $
              -
              
              $
              -
              
              $
              45,050
              
              (3)President
                  and
              
              2005
              
              $
              N/A
              
              
              -
              
              
              
              
              -
              
              -
              
              
              -
              
              
              -
              
              
              -Chief
              
              2004
              
              $
              N/A
              
              
              -
              
              
              
              
              -
              
              -
              
              
              -
              
              
              -
              
              
              -ExecutiveOfficerAl
                  Kozak
              
              2006
              
              $
              135,727
              
              $
              -
              
              (4)
              
              $
              -
              
              1,750,000
              
              $
              -
              
              $
              -
              
              $
              206,277
              
              (4)Former
                  President and
              
              2005
              
              $
              177,162
              
              $
              44,495
              
              (5)
              
              $
              -
              
              4,540,000
              
              $
              -
              
              $
              -
              
              $
              -Chief
              
              2004
              
              $
              164,983
              
              $
              -
              
              
              
              $
              -
              
              683,000
              
              $
              -
              
              $
              -
              
              $
              -ExecutiveOfficerJeff
              
              2006
              
              $
              150,449
              
              $
              -
              
              
              
              $
              -
              
              1,200,000
              
              $
              -
              
              $
              -
              
              
              -Finkelstein
              
              2005
              
              $
              125,748
              
              $
              30,338
              
              (7)
              
              $
              -
              
              3,000,000
              
              $
              -
              
              $
              -
              
              $
              -Chief
              
              2004
              
              $
              97,490
              
              $
              -
              
              
              
              $
              -
              
              329,610
              
              $
              -
              
              $
              -
              
              $
              -FinancialOfficerDave
                  Warkentin
              
              2006
              
              $
              116,187
              
              $
              -
              
              (6)
              
              $
              -
              
              3,600,000
              
              $
              -
              
              $
              -
              
              $
              20,125
              
              (6)Vice-
              
              2005
              
              $
              N/A
              
              $
              -
              
              
              
              $
              -
              
              -
              
              $
              -
              
              $
              -
              
              $
              -President,
              
              2004
              
              $
              N/A
              
              $
              -
              
              
              
              $
              -
              
              -
              
              $
              -
              
              $
              -
              
              $
              -Sales
                  andMarketingShawn
                  Lammers
              
              2006
              
              $
              134,366
              
              $
              -
              
              
              
              $
              -
              
              1,000,000
              
              $
              -
              
              $
              -
              
              $
              -Vice-
              
              2005
              
              $
              120,452
              
              $
              30,338
              
              (7)
              
              $
              -
              
              3,000,000
              
              $
              -
              
              $
              -
              
              $
              -President,
              
              2004
              
              $
              108,739
              
              $
              -
              
              
              
              $
              -
              
              332,600
              
              $
              -
              
              $
              -
              
              $
              -EngineeringErwin
                  Bartz
              
              2006
              
              $
              90,864
              
              $
              -
              
              
              
              $
              -
              
              1,000,000
              
              $
              -
              
              $
              -
              
              $
              139,791
              
              (8)Former
                  Vice-
              
              2005
              
              $
              130,053
              
              $
              88,991
              
              (7)
              
              $
              -
              
              3,000,000
              
              $
              -
              
              $
              -
              
              $
              -President,
              
              2004
              
              $
              121,113
              
              $
              -
              
              
              
              $
              -
              
              390,000
              
              $
              -
              
              $
              -
              
              $
              -ProductManagement




*
      The
      average of the closing foreign exchange rates for fiscal 2006, as calculated
      by
      using the reported daily rates posted by the Federal Reserve Bank of New York,
      was CDN$1.1553 to every US$1.00. For the purposes of this table, executive
      compensation paid in Canadian currency to the Named Executive Officers has
      been
      converted into United States currency at the rate of CDN$1.1553 to every US$1.00


(1)
            The
                value of perquisites and other personal benefits, securities and
                property
                for the Named Executive Officers that do not exceed the lesser of
                $50,000
                or 10% of the total of the annual salary and bonus is not reported
                herein.





(2)
            Represents
                consulting fees of $73,000 paid to Logistikk Service a.s. for executive
                management services performed by Mr. Pedersen. This amount was paid
                pursuant to a July 2006 oral agreement between our Company and Logistikk
                Serivices a.s. $20,000 per month in return for Mr. Pedersen's services.
                We
                are currently negotiating the terms of a contract with Logistikk
                Service
                a.s. related to Mr. Pedersen in his position as our President and
                Chief
                Executive Officer and will disclose such terms after finalization
                of the
                contract. No
                options have been issued as of September 29,
                2006.




(3)
            Represents
                consulting fees of $45,050 paid to Logistikk Service a.s. for services
                primarily performed by Mr. Pedersen prior to the appointment of Mr.
                Pedersen as our President and Chief Executive
                Officer.




-17-
 
 (4)
                Represents
                    vacation pay of $6,329 and severance of $199,948. The severance
                    has been
                    expensed and is being paid over one year. To the end of July,
                    2006 $44,623
                    ($CDN $69,300) had been paid to Mr.
                    Kozak.
 (5)
                Represents
                    the market value of 1,483,181 common shares issued as a stock
                    bonus.


(6)
              Represents
                  sales commissions of $ 20,125 earned by Mr. Warkentin during the
                  year.
  (7)
            Represents
                the market value of 1,011,260 common shares issued as a stock bonus.





(8)
            Represents
                severance of $139,791. The severance has been expensed and is being
                paid
                over one year. To the end of July, 2006 $48,927 ($CDN $56,525) had
                been
                paid to Mr. Bartz.


The
      following table sets forth for each of the Named Executive Officers certain
      information concerning stock options granted to them during fiscal year 2006.
      We
      have never issued stock appreciation rights. We grant options to
      employees that generally vest evenly over a two-year period and to
      directors that vest immediately at an exercise price equal to the fair market
      value of a share of common stock as determined by its closing price on the
      OTC
      Bulletin Board. Until May 28, 2003, the exercise price was determined by its
      closing price on the Nasdaq Capital Market. The term of each option granted
      is
      generally five years from the date of grant. Options may terminate before their
      expiration dates if the optionee's status as an employee is terminated or upon
      the optionee's death or disability.


**Options/SAR
        Grants in the Last Fiscal Year**


Number
                  of Securities
              %
                  of TotalName
              Underlying
              Options/SARS
                  GrantedOptions/SARS
                  Granted
              to
                  Employees in
              Exercise
                  Price(#)
              Fiscal
                  Year
              ($/share)
              
              Expiration
                  DateLeif
                  Pedersen
              Nil
              N/A
              N/AAl
                  Kozak
              1,750,000
              6.14%
              $0.10
              
              December
                  29, 2010Dave
                  Warkentin
              2,000,000
              7.02%
              $0.11
              
              August
                  10, 20101,100,000
              3.86%
              $0.10
              
              December
                  29, 2010500,000
              1.75%
              $0.10
              
              May
                  29, 2011Jeff
                  Finkelstein
              1,200,000
              4.21%
              $0.10
              
              December
                  29, 2010Shawn
                  Lammers
              1,000,000
              3.51%
              $0.10
              
              December
                  29, 2010Erwin
                  Bartz
              1,000,000
              3.51%
              $0.10
              
              December
                  29, 2010




The
      following table sets forth for each Named Executive Officer certain information
      concerning the number of shares subject to both exercisable and unexercisable
      stock options as of July 31, 2006. The values for "in-the-money" options are
      calculated by determining the difference between the fair market value of the
      securities underlying the options as of July 31, 2006 ($0.142 per share) and
      the
      exercise price of the individual's options. Al Kozak was the only Executive
      Officer who exercised options during fiscal 2006.




-18-


**Aggregated
        Option/SAR Exercises in Last Fiscal Year and FY-End Option/SAR Values**
 Name
                Shares
                Value
                Number
                    of Securities
                Value
                    of UnexercisedAcquired
                    on
                Realized
                    Underlying
                Unexercised
                In-the-Money
                    Options/SARs atExercise
                    (#)
                ($)
                Options/SARs
                    at FY-End (#)
                FY-End
                    ($)Exercisable/Unexercisable
                Exercisable/UnexercisableLeif
                    Pedersen
                None
                None
                0
                00
                0Al
                    Kozak
                900,000
                27,000
                4,566,000
                54,600Exercisable1,750,000
                0UnexercisableJeff
                    Finkelstein
                None
                None
                3,405,000
                45,000Exercisable1,200,000
                0UnexercisableDave
                    Warkentin
                None
                None
                1,000,000
                0Exercisable2,600,000
                0UnexercisableErwin
                    Bartz
                None
                None
                3,445,000
                45,000Exercisable1,000,000
                0UnexercisableShawn
                    Lammers
                None
                None
                3,447,700
                45,000Exercisable1,000,000
                0Unexercisable




Directors
      and executive officers have received from time to time incentive stock options
      to purchase Common Shares as awarded by the Board of Directors in consultation
      with the Compensation Committee.




Effective
      November 2, 2004 the Company revised its formal directors' compensation policy
      whereby directors are compensated for all meetings that they attend in person
      at
      the rate of $1,500 per day, which includes travel time to and from each meeting,
      and for all meetings that they participate by teleconference or other electronic
      means at the rate of $500 per day. Directors who participate in a meeting of
      any
      committee of the Board of Directors are entitled to compensation at the rate
      of
      $500 per day for attendance in person, and at the rate of $300 per day for
      participation by teleconference or other electronic means. Such fees are payable
      only if the meeting of the Board or of a committee of the Board, as the case
      may
      be, is more than one-half hour in duration. Directors are also entitled to
      reimbursement for reasonable travel and other out-of-pocket expenses incurred
      in
      connection with attendance at meetings of the Board of Directors.




Effective
      March 27, 2006 the Company supplemented its formal directors' compensation
      policy whereby effective for fiscal 2006 year, non-employee directors are paid
      $35,000 as a base retainer, $5,000 for acting as a member of a committee,
      $10,000 for acting as the chair of a committee, $15,000 for acting as the chair
      of the audit committee and $50,000 for acting as the chairman of the Board
      of
      Directors.




The
      Company's Board of Directors may award special remuneration to any director
      undertaking any extraordinary services on behalf of the Company other than
      services ordinarily required of a director. Other than as indicated below,
      no
      director received and/or accrued any compensation for his services as a
      director, including committee participation and/or extraordinary
      assignments.




Pursuant
      to a consulting agreement, Mr. Rudman provided certain specified consulting
      services to us for a monthly fee of $20,000 per month until June 30, 2006 when
      the monthly fee was reduced to $10,000 per month. The consulting agreement
      will
      terminate on June 30, 2007 unless renewed by mutual agreement of the
      parties.




There
      are
      no arrangements or plans in which the Company provides pension, retirement
      or
      similar benefits for directors or executive officers.





**Employment
      Contracts and Termination of Employment and Change-in-Control
      Arrangements**





Effective
      as of April 12, 2006, Al Kozak left our Company. As per his management
      agreement, we agreed to pay him one year severance. This amount will be paid
      over twenty-six (26) pay periods. We will continue to provide benefits coverage,
      excluding long-term disability, until the earlier of April 12, 2007 or until
      such time as Mr. Kozak is eligible for benefits coverage under another plan.
      In
      addition, until May 12, 2007, Mr. Kozak may continue to exercise any vested
      stock options that have been granted to him. Any unvested stock options that
      have been granted to Mr. Kozak will immediately vest at the date of his final
      severance payment. Thirty days after his final severance payment, any
      unexercised stock options will be forfeited.





Effective
      as of March 24, 2006, we terminated Erwin Bartz and agreed to pay him one year
      severance as per his management agreement. This amount will be paid over
      twenty-six 26) pay periods. We provided benefits coverage, excluding long-term
      disability, until June 30, 2006. In addition, until April 24, 2007, Mr. Bartz
      may continue to exercise any vested stock options that have been granted to
      him.
      Any unvested stock options that have been granted to Mr. Bartz will immediately
      vest at the date of his final severance payment. Thirty days after his final
      severance payment, any unexercised stock options will be forfeited.





Effective,
      October 20, 2006, Leif Pedersen resigned from our Company as our President
      and
      Chief Executive Officer.





Effective,
      October 20, 2006 Dave Warkentin was appointed as our President and Chief
      Executive Officer.


-19-


**ITEM
        11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
        STOCKHOLDER MATTERS**
  The
        following table sets forth, as of September 29, 2006, certain information
        with
        respect to the beneficial ownership of shares of our common stock by each
        person
        known by us to be the beneficial owner of more than 5% of the shares of our
        common stock, by each person known by us to be the beneficial owner of more
        than
        10% of the shares of our common stock and by each of our current directors
        and
        executive officers. Each person has sole voting and investment power with
        respect to the number of shares shown, except as may be otherwise indicated.
        Beneficial ownership consists of a direct interest in the Common Shares,
        except
        as otherwise indicated.
  Amount
                  and Nature of
              PercentageName
                  and Address of Beneficial Owner
              Beneficial
                  Ownership
              of
                  Class(1)William
                  Cronin
              2,914,746
                  (2)
              *180
                  Concord DriveMadison,
                  Connecticut, USA 06443Martin
                  Gannon
              2,685,000
                  (3)
              *1275
                  Post RoadFairfield,
                  Connecticut, USA 06824Johnny
                  Christiansen
              2,050,000
                  (4)
              *Spurvestien
                  243189
                  Horten, NorwayRobert
                  Rudman
              10,780,411
                  (5)
              3.32%#40
                  - 5740 Garrison RoadRichmond,
                  BC V7C 5E7Leif
                  Pedersen
              Nil
              *Jeff
                  Finkelstein
              4,422,010
                  (6)
              1.38%3460
                  Regent StreetRichmond,
                  BC V7E 2N1Shawn
                  Lammers
              4,460,479
                  (7)
              1.39%3460
                  Regent StreetRichmond,
                  BC V7E 2N1David
                  Warkentin
              1,000,000
                  (8)
              *20580
                  Powell Ave.Maple
                  Ridge, B.C. V2X 3G1Directors
                  and Executive Officers as a Group
              28,312,646
                  (9)
              8.23%Cornell
                  Capital Partners, L.P.
              16,270,138
                  (10)
              4.90%101
                  Hudson St., Suite 3606Jersey
                  City, NJ 07302


Staraim
                    Enterprises Limited
                16,270,138
                    (11)
                4.90%Athalassas,
                    472nd
                    Floor, Flat/Office 202Strovolos,
                    P.C. 2012Nicosia,
                    CyprusXentennial
                    Holdings Limited
                16,270,138
                    (12)
                4.90%Athalassas,
                    472nd
                    Floor, Flat/Office 202Strovolos,
                    P.C. 2012Nicosia,
                    CyprusStarome
                    Investments Limited
                16,270,138
                    (13)
                4.90%Athalassas,
                    472nd
                    Floor, Flat/Office 202Strovolos,
                    P.C. 2012


*
      Represents less than 1% of the shares or our outstanding common stock


-20-


(1)
            Based
                on 315,774,656 shares of our common stock issued and outstanding
                as of
                September 29, 2006. Beneficial ownership is determined in accordance
                with
                the rules of the Securities and Exchange Commission and generally
                includes
                voting or investment power with respect to securities. Except as
                otherwise
                indicated, we believe that the beneficial owners of shares of our
                common
                Stock listed above, based on information furnished by such owners,
                have
                sole investment and voting power with respect to such shares, subject
                to
                community property laws where applicable.





(2)
            Includes
                options to acquire up to 2,827,500 shares of our Common stock, exercisable
                within sixty days.





(3)
            Includes
                options to acquire up to 2,685,000 shares of our Common stock, exercisable
                within sixty days.





(4)
            Includes
                options to acquire up to 2,050,000 shares of our Common stock, exercisable
                within sixty days.





(5)
            Includes
                10,257 shares of our common stock that are owned by Mr. Rudman's
                wife over
                which Mr. Rudman has sole voting and dispositive power, and options
                to
                acquire up to an additional 8,501,500 shares of our common stock
                exercisable within sixty days.





(6)
            Includes
                options to acquire up to 3,405,000 shares of our common stock, exercisable
                within 60 days.





(7)
            Includes
                of options to acquire up to 3,447,700 shares of our common stock,
                exercisable within 60 days.





(8)
            Includes
                options to acquire up to 1,000,000 shares of our common stock, exercisable
                within 60 days.





(9)
            Includes
                options to acquire up to 23,906,800 shares of our common stock,
                exercisable within 60 days.





(10)
      Includes only 16,270,138 shares of our common stock beneficially owned by
      Cornell Capital Partners L.P. The total number of shares of our common stock
      owned by Cornell Capital Partners L.P. includes: (i) 3,855,680 shares of our
      common stock that could be issued upon the conversion of 3,855,680 5% series
      A
      convertible preferred shares, (ii) 226,666,667 shares of our common stock that
      could be issued upon the conversion of a10% convertible debenture issued by
      our
      company in the original principal amount of $8,000,000, (iii) 56,666,667 shares
      of our common stock that could be issued upon the conversion of a 10%
      convertible debenture issued by our company in the original principal amount
      of
      $2,000,000, (iv) 53,571,429 shares of our common stock that could be issued
      upon
      the conversion of a 5% convertible debenture issued by our company in the
      original principal amount of $1,500,000, at a conversion price of $0.028 per
      share, (v) 16,668,750 shares of our common stock that could be issued upon
      the
      exercise of 16,668,750 common share purchase warrants issued to Xentennial
      Holdings Limited expiring June 23, 2010 at an exercise price of $0.16 per share
      and (vi) 4,162,500 shares of our common stock that could be issued upon the
      exercise of 4,162,500 common share purchase warrants issued to Staraim
      Enterprises Limited expiring June 23, 2010 at an exercise price of $0.16 per
      share. The 5% and 10% convertible debentures and the share purchase warrants
      all
      contain a contractual restriction on beneficial share ownership that limits
      Cornell Capital Partners L.P. to beneficial ownership, at any one time, of
      4.9%
      of our outstanding shares. Cornell Capital Partners L.P. and its affiliates,
      in
      the aggregate, cannot own more than 4.9% of our outstanding shares of common
      stock except upon providing us with not less than 65 days prior notice. Because
      Staraim Enterprises Limited and Xentennial Holdings Limited are wholly owned
      by
      Cornell Capital Partners L.P., Cornell Capital Partners L.P. is deemed to
      beneficially own all shares of our common stock held by them. Also, because
      Staraim Enterprises Limited and Xentennial Holdings Limited are affiliates
      of
      Cornell Capital Partners, Staraim Enterprises Limited, Xentennial Holdings
      Limited and Cornell Capital Partners cannot, collectively, beneficially own
      in
      excess of 4.9% of our outstanding shares of common stock. Yorkville Advisors,
      the general partner of Cornell Capital Partners L.P., may also be deemed to
      beneficially own the securities of our company that are owned by Cornell Capital
      Partners L.P. Mark A. Angelo, the founder and President of Cornell Capital
      Partners, has sole voting and dispositive power over the securities of our
      company that are beneficially owned by each of Cornell Capital Partners,
      Xentennial Holdings Limited and Staraim Enterprises Limited.





(11)
            Includes
                only 16,270,138 shares of our common stock beneficially owned by
                Staraim
                Enterprises Limited. The total number of shares of our common stock
                beneficially owned by Staraim Enterprises Limited includes (i) 56,666,667
                shares of our common stock that could be issued upon the conversion
                of the
                10% convertible debenture issued by our company in the original principal
                amount of $2,000,000, which matures June 23, 2008, and (ii) 4,162,500
                shares of our common stock that could be issued upon the exercise
                of
                4,162,500 common share purchase warrants. The 10% convertible debenture
                and the share purchase warrants all contain a contractual restriction
                on
                beneficial share ownership that limits Staraim Enterprises Limited
                to
                beneficial ownership, at any one time, of 4.9% of our outstanding
                shares.
                Staraim Enterprises Limited and its affiliates, in the aggregate,
                cannot
                own more than 4.9% of our outstanding shares of common stock except
                upon
                providing us with not less than 65 days prior notice. These shares
                of our
                common stock are held by either Staraim Enterprises Limited, a Cyprus
                company, or its wholly-owned subsidiary, Staraim Enterprises Limited,
                a
                New Brunswick corporation. Cornell Capital Partners L.P. owns all
                of the
                issued and outstanding securities of Staraim Enterprises Limited,
                and has
                voting and dispositive authority over all of the shares of common
                stock of
                our company that are owned by Staraim Enterprises Limited. Mark A.
                Angelo,
                the founder and President of Cornell Capital Partners L.P., is deemed
                to
                control Cornell Capital Partners L.P. and therefore is deemed to
                be the
                beneficial owner of the securities of our company that are held by
                Staraim
                Enterprises Limited. Mark Angelo disclaims beneficial ownership of
                these
                shares. Cornell Capital Partners L.P. and its affiliates, in the
                aggregate, cannot own more than 4.9% of our outstanding shares of
                common
                stock. As Staraim Enterprises Limited and Xentennial Holdings Limited
                are
                affiliates of Cornell Capital Partners L.P., Staraim Enterprises
                Limited,
                Xentennial Holdings Limited and Cornell Capital Partners L.P. cannot,
                collectively, own in excess of 4.9% of our outstanding shares of
                common
                stock.





(12)
            Includes
                only 16,270,138 shares of our common stock beneficially owned by
                Xentennial Holdings Limited. The total number of shares of our common
                stock beneficially owned by Xentennial Holdings Limited includes:
                (i)
                226,666,667 shares of our common stock that could be issued upon
                conversion of the 10% convertible debenture issued by our company
                in the
                original principal amount of $8,000,000 and (ii) 16,668,750 shares
                of our
                common stock that could be issued upon exercise of 16,668,750 share
                purchase warrants issued by our company to Xentennial Holdings Limited.
                The 10% convertible debenture and the stock purchase warrants contain
                contractual restrictions on beneficial share ownership limiting Xentennial
                Holdings Limited's beneficial ownership to 4.9% of our outstanding
                shares
                of common stock except upon providing us with not less than 65 days
                prior
                notice. The shares shown and the shares proposed to be sold are held
                directly by either Xentennial Holdings Limited, a Cyprus company,
                and/or
                its wholly-owned subsidiary, Xentennial Holdings Limited, a New Brunswick
                corporation. All of the issued and outstanding securities of Xentennial
                Holdings Limited are owned by Cornell Capital Partners L.P., and
                Cornell
                Capital Partners is therefore deemed to have voting and dispositive
                authority over the shares of our company owned by Xentennial Holdings
                Limited. Mark A. Angelo, the founder and President of Cornell Capital
                Partners L.P., is deemed to control Cornell Capital Partners L.P.
                and
                therefore is deemed to be the beneficial owner of the securities
                of our
                company that are held by Xentennial Holdings Limited. Mark Angelo
                disclaims beneficial ownership of these shares. Cornell Capital Partners
                L.P. and its affiliates, in the aggregate, cannot own more than 4.9%
                of
                our outstanding shares of common stock. As Staraim Enterprises Limited
                and
                Xentennial Holdings Limited are affiliates of Cornell Capital Partners
                L.P., Staraim Enterprises Limited, Xentennial Holdings Limited and
                Cornell
                Capital Partners L.P. cannot, collectively, own in excess of 4.9%
                of our
                outstanding shares of common stock.





-21-


(13)
      Includes only 16,270,138 shares of our common stock beneficially owned by
      Starome Investments Limited. The total number of shares of our common stock
      beneficially owned by Starome Investments Limited includes: (i) 566,666,667
      shares of our common stock that could be issued upon the conversion of all
      principal and interest due under our $20 million 10% convertible debenture,
      maturing on June 23, 2008, and (ii) 41,668,750 shares of our common stock that
      could be issued upon the exercise of 41,668,750 common share purchase warrants.
      The 10% convertible debenture and the common share purchase warrants contain
      contractual restrictions on beneficial share ownership limiting Starome
      Investments Limited's beneficial ownership to 4.9% unless Starome Investments
      Limited waives such limitation by providing us with 65 day notice. The 10%
      convertible debenture and the share purchase warrants are held directly by
      either Starome Investments Limited, a Cyprus company, and/or its wholly-owned
      subsidiary, Starome Investments Limited, a New Brunswick corporation. Prentice
      Capital Management, L.P. serves as investment manager to a number of investment
      funds (including Prentice Capital Partners, LP, Prentice Capital Partners GP,
      LP
      and Prentice Capital Offshore, Ltd.) and manages investments for certain
      entities in managed accounts with respect to which it has voting and dispositive
      authority over 100% of the shares of Starome Investments Limited. Michael
      Zimmerman is the Managing Member of (a) Prentice Management GP, LLC, the general
      partner of Prentice Capital Management and (b) Prentice Capital GP, LLC, the
      general partner of certain investment funds. As such, he is deemed to control
      Prentice Capital Management and certain of the investment funds and therefore
      may be deemed to be the beneficial owner of the securities of our company that
      are held by Starome Investments Limited. Each of Michael Zimmerman and Prentice
      Capital Management disclaims beneficial ownership of these securities of our
      company.





**EQUITY
      COMPENSATION PLAN INFORMATION**





The
      following table provides certain information with respect to all of our
      Company's equity compensation plans in effect as of July 31, 2006.




Number
                  of SecuritiesNumber
                  of Securities to be
              
              be
                  Remaining Available forIssued
                  Upon Exercise of
              Weighted-Average
                  Exercise
              Future
                  Issuance UnderOutstanding
                  Options,
              Price
                  of Outstanding
              Equity
                  Compensation PlansWarrants
                  and Rights
              Options,
                  Warrants and
              (Excluding
                  SecuritiesRights
              Reflected
                  in Column (a))Plan
                  Category
              (a)
              (b)
              (c)Equity
                  compensation plans
              7,652,600
              $0.10
              6,761,400approved
                  bysecurityholdersEquity
                  compensation plans
              123,228,943
              $0.13
              6,374,290not
                  approved bysecurityholdersTotal
              130,881,543
              $0.12
              13,135,690




E quity
      compensation plans not approved by security holders consists of 64,858,141
      warrants and stock options granted under the plans not approved by security
      holders. The options currently outstanding under the “2005 US Stock Incentive
      Plan” and the “2005 Stock Incentive Plan” vest over two years, except options
      granted to directors, which vest immediately.





The
      options currently outstanding under the "2003 and 2004 US Stock Incentive Plan"
      and the "2003 and 2004 Stock Incentive Plan" generally vest immediately. The
      options currently outstanding under the "2000 and 2002 Stock Incentive Plan"
      have vested as at July 31, 2006. The exercise price of each option is generally
      based on the fair value of the common stock at the date of grant. These options
      have a five year term.





**ITEM
      12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**




The
        services of Mr. Robert Rudman, a director, are provided pursuant to a consulting
        agreement dated July 1, 2005 and the renewal and amendment agreement dated
        August 9, 2006. For further detail concerning Mr. Rudman’s consulting
        agreements.
  The
        services of Mr. Leif Pedersen, our former President and Chief Executive Officer,
        were provided pursuant to a July 2006 oral consulting agreement between our
        company and Logistikk
        Service a.s. pursuant
        to which we paid Logistikk Service a.s. $20,000 per month in return for Mr.
        Pedersen’s services .
  The
        services of Mr. Shawn Lammers, our Vice President of Engineering, are provided
        pursuant to a management agreement dated August 1, 1999.
  The
        services of Mr. Jeff Finkelstein, our Chief Financial Officer, are provided
        pursuant to a management agreement dated October 23, 2002.
  The
        services of Mr. David Warkentin, our Vice President of Sales and Marketing,
        are
        provided pursuant to a management agreement dated August 8, 2005.
  Effective
        April 12, 2006, Al Kozak left our Company. As required by the terms of his
        management agreement, we are required to pay him severance compensation equal
        to
        one year’s income in 26 equal payments over (26) pay periods. We will continue
        to provide benefits coverage, excluding long-term disability, to Mr. Kozak
        until
        the earlier of April 12, 2007 or the date upon which Mr. Kozak becomes eligible
        for benefits coverage under another plan. In addition, until May 12, 2007,
        Mr.
        Kozak may continue to exercise any vested stock options. Any stock options
        that
        had not vested to Mr. Kozak on or before April 12, 2007 will automatically
        vest
        on the date we pay him his final severance payment. Thirty days after we
        pay Mr.
        Kozak his final severance payment, all unexercised stock options held by
        him
        will expire.
  Effective
        March 24, 2006, we terminated our management agreement with Erwin Bartz.
        As
        required by the terms of his management agreement, we are required to pay
        Mr.
        Bartz severance compensation equal to one year’s income in 26 equal payment over
        26 pay periods. We provided Mr. Bartz with benefits coverage, excluding
        long-term disability, until June 30, 2006. In addition, until April 24, 2007,
        Mr. Bartz may continue to exercise any vested stock options. Any stock options
        that had not vested to Mr. Bartz on or before April 24, 2007 will automatically
        vest on the date we pay him his final severance payment. Thirty days after
        we
        pay Mr. Bartz his final severance payment, all unexercised stock options
        held by
        him will expire.
  Mr.
        Christiansen, a director of our company is a principal in Visionaire A.S.
        During
        the year ended July 31, 2005, we incurred expenses of $60,000 for a research
        report prepared by Visionaire A.S. on various sensor applications.
  Other
        than as listed below, we have not been a party to any transaction, proposed
        transaction, or series of transactions in which the amount involved exceeds
        $60,000, and in which, to our knowledge, any of our directors, officers,
        five
        percent beneficial security holders, or any member of the immediate family
        of
        the foregoing persons has had or will have a direct or indirect material
        interest.


**PART
      IV**




**ITEM
        13. EXHIBITS**
 
 (a)
            The
                following documents are filed as part of this report: 
 Consolidated
        Financial Statements. See "Index" on Page F-1;
 
 Auditors'
        Report, dated September 29, 2006;
 
 Consolidated
        Balance Sheets at July 31, 2006 and July 31, 2005;
 
 Consolidated
        Statements of Operations and Deficit for the Years Ended July 31, 2006, July
        31,
        2005 and July 31, 2004;
 
 Consolidated
        Statements of Stockholders' Equity and Comprehensive Income (Loss) for the
        Years
        Ended July 31, 2006, July 31, 2005 and July 31, 2004;
 
 Consolidated
        Statements of Cash Flows for the Years Ended July 31, 2006, July 31, 2005
        and
        July 31, 2004; and
 
 Notes
        to
        Consolidated Financial Statements.
  (b)
              Exhibits.
                  See "Exhibit Index".
 -22-
   EXHIBITNUMBER
              DESCRIPTION3.1
              Certificate
                  of Incorporation of TTC/Truck Tech Corp. dated September 8, 1987
                  (1)3.2
              Memorandum
                  and Articles of TTC/Truck Tech Corp. (1)3.3
              Memorandum
                  of TTC/Truck Tech Corp. dated September 2, 1987 (1)3.4
              Altered
                  Memorandum of TTC/Truck Tech Corp. dated October 25, 1991
                  (1)3.5
              Certificate
                  of Change of Name from TTC/Truck Tech Corp. to UniComm Signal Inc.
                  dated
                  April 13, 1994.(1)3.6
              Certificate
                  of Change of Name from UniComm Signal Inc. to SmarTire Systems
                  Inc. dated
                  December 24, 1997.(1)3.7
              Special
                  Resolution and Altered Memorandum of UniComm Signal Inc. dated
                  October 28,
                  1994.(1)3.8
              Special
                  Resolution and Altered Memorandum of SmarTire Systems Inc. dated
                  November
                  17, 1995.(1)3.9
              Special
                  Resolution and Altered Memorandum of UniComm Signal Inc. dated
                  January 17,
                  1997.(1)3.10
              Special
                  Resolution and Altered Memorandum of SmarTire Systems Inc. dated
                  January
                  16, 1998.(1)3.11
              Special
                  Resolution and Altered Memorandum of SmarTire Systems Inc. dated
                  December
                  5, 2000.(4)3.12
              Substituted
                  Articles of SmarTire Systems Inc. adopted December 5,
                  2000.(4)3.13
              Articles
                  of Continuance, dated January 29, 2003 and effective February 6,
                  2003.(7)3.14
              Certificate
                  of Amendment issued to SmarTire Systems Inc. by the Yukon Registrar
                  of
                  Corporationseffective
                  December 15, 2003 and attached Articles of Amendment of SmarTire
                  Systems
                  Inc. datedDecember
                  11, 2003.(4)3.15
              Certificate
                  of Registration of Restated Articles issued to SmarTire Systems
                  Inc. by
                  the Yukon Registrar ofCorporations
                  effective December 15, 2003, and attached Restated Articles of
                  Incorporation of SmarTire SystemsInc.
                  dated December 11, 2003.(19)3.16
              By-Law
                  No. 1, dated February 6, 2003.(7)10.1
              Forbearance
                  and Escrow Agreement dated as of September 24, 2004.(5)10.2
              Promissory
                  note dated as of November 16, 2004 with Cornell Capital Partners,
                  LP.(6)10.3
              Promissory
                  note dated as of November 16, 2004 with Cornell Capital Partners,
                  LP.(6)10.4
              Form
                  of Subscription Agreement and Prospective Purchaser Questionnaire
                  of
                  SmarTire Systems Inc.(7)10.7
              Form
                  of 5% Convertible Debenture SmarTire Systems Inc.(7)10.8
              Form
                  of Redemption Warrant of SmarTire Systems Inc.(7)10.9
              Securities
                  Purchase Agreement dated December 15, 2004 by and between SmarTire
                  Systems, Inc. and CornellCapital
                  Partners, L.P.(7)10.10
              Registration
                  Rights Agreement dated December 15, 2004 by and between SmarTire
                  Systems,
                  Inc. and CornellCapital
                  Partners, L.P.(7)10.11
              Securities
                  Purchase Agreement dated December 15, 2004 by and between SmarTire
                  Systems, Inc. andCornell
                  Capital Partners, L.P.(7)10.12
              Registration
                  Rights Agreement dated December 15, 2004 by and between SmarTire
                  Systems,
                  Inc. and CornellCapital
                  Partners, L.P.(7)10.13
              Form
                  of Common Stock Purchase Warrant of SmarTire Systems
                  Inc.(7)10.14
              2004
                  Non-US US Stock Incentive Plan of SmarTire Systems
                  Inc.(7)10.15
              Amendment
                  Agreement dated February 3, 2005 between SmarTire Systems Inc.
                  and Robert
                  Rudman (8)10.16
              Amendment
                  Agreement dated February 3, 2005 between SmarTire Systems Inc.
                  and Allan
                  Kozak (8)10.17
              Amendment
                  Agreement dated February 3, 2005 between SmarTire Systems Inc.
                  and Jeff
                  Finkelstein (8)10.18
              Amendment
                  Agreement dated February 3, 2005 between SmarTire Systems Inc.
                  and Erwin
                  Bartz (8)




-23-




10.19
              Amendment
                  Agreement dated February 3, 2005 between SmarTire Systems Inc.
                  and Shawn
                  Lammers (8)10.20
              Amendment
                  Agreement dated February 3, 2005 between SmarTire Systems Inc.
                  and William
                  Cronin (8)10.21
              Amendment
                  Agreement dated February 3, 2005 between SmarTire Systems Inc.
                  and Martin
                  Gannon (8)10.22
              Amendment
                  Agreement dated February 3, 2005 between SmarTire Systems Inc.
                  and Johnny
                  Christiansen (8)10.23
              Registration
                  Rights Agreement dated as of March 22, 2005 by and between SmarTire
                  Systems, Inc. andCornell
                  Capital Partners, L.P.(9)10.24
              Investment
                  Agreement dated as of March 22, 2005 by and between SmarTire Systems,
                  Inc.
                  and Cornell CapitalPartners,
                  L.P. (9)(10)10.25
              Termination
                  Agreement dated as of March 22, 2005 by and between SmarTire Systems,
                  Inc.
                  and Cornell CapitalPartners,
                  L.P.(9)10.26
              Redemption,
                  settlement and release agreement dated April 27, 2005 by and between
                  SmarTire Systems Inc. andPalisades
                  Master Fund, L.P.and PEF Advisors, Ltd.(11)10.27
              Redemption,
                  settlement and release agreement dated May 2, 2005 by and between
                  SmarTire
                  Systems Inc. andGamma
                  Opportunity Partners. (11)10.28
              Redemption,
                  settlement and release agreement dated May 4, 2005 by and between
                  SmarTire
                  Systems Inc. andAlpha
                  Capital Aktiengesellschaftt, L.P.(11)10.29
              Redemption,
                  settlement and release agreement dated May 13, 2005 by and between
                  SmarTire Systems Inc. andCrescent
                  International Ltd.(11)10.30
              Redemption,
                  settlement and release agreement dated May 23, 2005 by and between
                  SmarTire Systems Inc. andGoldplate
                  Investment Partners.(11)10.31
              Registration
                  Rights Agreement dated as of May 22, 2005 by and between SmarTire
                  Systems
                  Inc. and CornellCapital
                  Partners, LP (11)10.32
              Standby
                  Equity Distribution Agreement dated as of May 22, 2005 by and between
                  SmarTire Systems Inc. andCornell
                  Capital Partners, LP (11)10.33
              Investor
                  Registration Rights Agreement dated as of May 22, 2005 by and between
                  SmarTire Systems Inc. andCornell
                  Capital Partners, LP (11)10.34
              Amended
                  and Restated Convertible Debenture dated as of June 10, 2005 by
                  and
                  between SmarTire Systems Inc.and
                  Cornell Capital Partners, LP (11)10.35
              Securities
                  Purchase Agreement dated as of May 22, 2005 by and between SmarTire
                  Systems Inc. and CornellCapital
                  Partners, LP (11)10.36
              Waiver
                  Letter from Cornell Capital Partners to SmarTire Systems Inc. dated
                  October 7, 2005 (15)10.37
              Waiver
                  Letter from Crescent International Ltd. to SmarTire Systems Inc.
                  dated
                  October 20, 2005 (15)10.38
              Waiver
                  Letter from Cornell Capital Partners to SmarTire Systems Inc. dated
                  October 31, 2005 (15)10.39
              Marketing
                  and distribution agreement with DANA Corporation dated as of October
                  12,
                  2005 (13)10.40
              Investor
                  Relations Agreement between AGORA Investor Relations Corp and SmarTire
                  Systems Inc. dated asof
                  November 1, 2005 (14)10.41
              Agreement
                  for Electronic Manufacturing Services, dated November 16, 2005,
                  between
                  Vansco Electronics LPand
                  SmarTire Systems Inc.(13)10.42
              Amendment
                  No. 1 to Securities Purchase Agreement, dated as of December 30,
                  2005,
                  among SmarTire Systems Inc.,Cornell
                  Capital Partners, LP, Highgate House Funds, Ltd., LCC Global Limited,
                  Starome Investments Limited,Xentennial
                  Investments Limited and Staraim Investments Limited
                  (14)10.43
              Amended
                  and Restated Investor Registration Rights Agreement, dated as of
                  December
                  30, 2005 among SmarTireSystems,
                  Starome Investment Limited, Xentennial Investments Limited and
                  Staraim
                  Investments Limited (14)10.44
              Amended
                  and Restated Convertible Debenture, dated as of December 30, 2005,
                  with a
                  principal balance of $20 million,issued
                  by SmarTire Systems Inc. to Starome Investments Limited
                  (14)10.45
              Amended
                  and Restated Convertible Debenture, dated as of December 30, 2005,
                  with a
                  principal balance of $8 million,issued
                  by SmarTire Systems Inc. to Xentennial Investments Limited
                  (14)




-24-


10.46
              Amended
                  and Restated Convertible Debenture, dated as of December 30, 2005,
                  with a
                  principal balance of $2 million,issued
                  by SmarTire Systems Inc. to Staraim Investments Limited
                  (14)10.47
              Amended
                  and Restated Warrant to purchase 41,668,750 shares of common stock,
                  dated
                  as of December 30, 2005issued
                  by SmarTire Systems Inc. to Starome Investments Limited
                  (14)10.48
              Amended
                  and Restated Warrant to purchase 16,668,750 shares of common stock,
                  dated
                  as of December 30, 2005issued
                  by SmarTire Systems Inc. to Xentennial Investments Limited
                  (14)10.49
              Amended
                  and Restated Warrant to purchase 4,162,500 shares of common stock,
                  dated
                  as of December 30, 2005 issuedby
                  SmarTire Systems Inc. to Staraim Investments Limited
                  (14)10.50
              Standby
                  Equity Distribution Agreement of December 30, 2005 between SmarTire
                  Systems Inc. andCornell
                  Capital Partners, LP (14)10.51
              Termination
                  Agreement $160 million Standby Equity Distribution Agreement of
                  December
                  30, 2005 betweenSmarTire
                  Systems Inc. and Cornell Capital Partners, LP (14)10.52
              Registration
                  Rights Agreement of December 30, 2005 between SmarTire Systems
                  Inc. and
                  Cornell Capital Partners,LP
                  '(14)10.53
              Agreement
                  for Electronic Manufacturing Services dated November 16, 2005 between
                  SmarTire Systems andVansco
                  Electronics L.P. (15)10.54
              Placement
                  Agent Agreement dated December 30, 2005 amongst SmarTire Systems
                  Inc.,
                  Newbridge SecuritiesCorporation,
                  SmarTire Systems Inc., Newbridge Securities Corporation and Cornell
                  Capital Partners, LP (15)10.55
              Amended
                  and Restated Convertible Debenture, with a principal balance of
                  $2
                  million, issued by SmarTireSystems
                  Inc. to Staraim Investments Limited dated April 4, 2006
                  (16)10.56
              Amended
                  and Restated Convertible Debenture, with a principal balance of
                  $8
                  million, issued by SmarTireSystems
                  Inc. to Xentennial Investments Limited dated April 4, 2006
                  (16)10.57
              Extension
                  letter regarding Amended and Restated Convertible Debenture dated
                  as of
                  June 10, 2005 by andbetween
                  SmarTire Systems Inc. and Cornell Capital Partners, LP
                  (16)10.58
              Settlement
                  Agreement and Mutual Release dated January 5, 2006 between SmarTire
                  Systems Inc.andBristol
                  Investment Fund Ltd. (14)10.59
              Waiver
                  Letter from Starome Investments Limited to SmarTire Systems Inc.
                  dated
                  April 6, 2006 (16)10.60
              Waiver
                  Letter from Xentennial Investments Limited to SmarTire Systems
                  Inc. dated
                  April 6, 2006 (16)10.61
              Waiver
                  Letter from Staraim Investments Limited to SmarTire Systems Inc.
                  dated
                  April 6, 2006 (16)10.62
              Waiver
                  Letter from Starome Investments Limited to SmarTire Systems Inc.
                  dated
                  April 6, 2006 (16)10.63
              Waiver
                  Letter from Xentennial Investments Limited to SmarTire Systems
                  Inc. dated
                  April 6, 2006 (16)10.64
              Waiver
                  Letter from Staraim Investments Limited to SmarTire Systems Inc.
                  dated
                  April 6, 2006 (16)10.65
              Extension
                  letter regarding Amended and Restated Convertible Debenture dated
                  as of
                  July 31, 2005 by andbetween
                  SmarTire Systems Inc. and Cornell Capital Partners, LP
                  **10.66
              Waiver
                  Letter from Cornell Capital Partners, Starome Investments Limited,
                  Xentennial Investments Limited andStaraim
                  Investments Limited to SmarTire Systems Inc. dated July 31, 2006
                  **10.67
              Consulting
                  Agreement by and between Robert Rudman and SmarTire Systems dated
                  June 30,
                  2005 **10.68
              Renewal
                  and Amendment Agreement by and between Robert Rudman and SmarTire
                  Systems
                  dated August 9, 2006 **10.69
              Management
                  Agreement between SmarTire Systems and David Warkentin dated October
                  20,
                  2006 (17)14.1
              Code
                  of Business Conduct and Ethics Compliance Program. (15)21.1
              Subsidiaries
                  of Small Business Entity**23.1
              Consent
                  of BDO Dunwoody LLP **23.2
              Consent
                  of KPMG LLP**31.1
              Certification
                  pursuant to section 302 of the Sarbanes-Oxley Act of
                  2002**




-25-




31.2
              Certification
                  pursuant to section 302 of the Sarbanes-Oxley Act of
                  2002**32.1
              Certification
                  pursuant to 18 U.S.C. section 1350 as adopted pursuant to section
                  906 of
                  the Sarbanes-Oxley Act of 2002**32.2
              Certification
                  pursuant to 18 U.S.C. section 1350 as adopted pursuant to section
                  906 of
                  the Sarbanes-Oxley Act of 2002****
                  Filed herewith.(1)
              Incorporated
                  by reference to SmarTire Systems Inc.'s Form 10-KSB filed with
                  the
                  Securities and Exchange Commissionon
                  August 18, 1998.(2)
              Incorporated
                  by reference to SmarTire Systems Inc.'s definitive Proxy Statement
                  and
                  Information Circular on Schedule14A
                  filed with the Securities and Exchange Commission on October 31,
                  2000.(3)
              Incorporated
                  by reference to SmarTire Systems Inc.'s Form SB-2 filed with the
                  Securities and Exchange Commissionon
                  January 23, 2003.(4)
              Incorporated
                  by reference to SmarTire Systems Inc.'s Form 8-K filed with the
                  Securities
                  and Exchange Commission onDecember
                  23, 2003.(5)
              Incorporated
                  by reference to SmarTire Systems Inc.'s 8-K filed with the Securities
                  Exchange Commission on October 1, 2004.(6)
              Incorporated
                  by reference to SmarTire Systems Inc.'s Form 10-QSB filed with
                  the
                  Securities and Exchange Commissionon
                  December 14, 2004.(7)
              Incorporated
                  by reference to SmarTire Systems Inc.'s 8-K filed with the Securities
                  Exchange Commission on December 21, 2004.(8)
              Incorporated
                  by reference to SmarTire Systems Inc.'s 8-K filed with the Securities
                  Exchange Commission on February 9, 2005.(9)
              Incorporated
                  by reference to SmarTire Systems Inc.'s 8-K filed with the Securities
                  Exchange Commission on March 29, 2005.(10)
              Incorporated
                  by reference to SmarTire Systems Inc.'s 8-K filed with the Securities
                  Exchange Commission on April 1, 2005,as
                  amended.(11)
              Incorporated
                  by reference to SmarTire Systems Inc.'s Form 10-QSB filed with
                  the
                  Securities and Exchange Commissionon
                  June 14, 2004.(12)
              Incorporated
                  by reference to SmarTire Systems Inc.'s 8-K filed with the Securities
                  Exchange Commission on June 30, 2005.(13)
              Incorporated
                  by reference to SmarTire Systems Inc.'s Form 10-QSB filed with
                  the
                  Securities Exchange Commission onDecember
                  15, 2005.(14)
              Incorporated
                  by reference to SmarTire Systems Inc.'s Form SB-2 filed with the
                  Securities Exchange Commission onJanuary
                  11, 2006.(15)
              Incorporated
                  by reference to SmarTire Systems Inc.'s Form SB-2/A filed with
                  the
                  Securities Exchange Commission onFebruary
                  27, 2006.(16)
              Incorporated
                  by reference to SmarTire Systems Inc.'s Form SB-2/A filed with
                  the
                  Securities Exchange Commission onApril
                  12, 2006.(17)
              Incorporated
                  by reference to SmarTire System Inc.'s 8-K filed with the Securities
                  and
                  Exchange Commission onOctober
                  26, 2006.






-26-


**ITEM
        14. PRINCIPAL ACCOUNTING FEES AND SERVICES.**





**Audit
      Fees**





For
      the
      fiscal year ended July 31, 2006, the aggregate fees estimated to be billed
      by
      our auditors, BDO Dunwoody LLP for professional services rendered for the
      audit of the Company's annual financial statements is $120,000.





**Audit-Related
      Fees**





None.





**Tax
      Fees**





For
      the
      fiscal years ended July 31, 2006 no fees were billed for tax compliance, tax
      advice and tax planning by BDO Dunwoody LLP.





**All
      Other Fees**





None.





**Pre-Approval
      Policies**





Effective
      May 6, 2003, the Securities and Exchange Commission adopted rules that require
      that before our auditors are engaged by the Company or its subsidiaries to
      render any auditing or permitted non-audit related service, the engagement
      be:





·
            approved
                by the Company's audit committee; or





·
            entered
                into pursuant to pre-approval policies and procedures established
                by the
                audit committee, provided the policies and procedures are detailed
                as to
                the particular service, the audit committee is informed of each service,
                and such policies and procedures do not include delegation of the
                audit
                committee's responsibilities to management.





The
      audit
      committee has pre-approved all services provided by the Company's independent
      auditor, has considered the nature and amount of the fees billed by our auditor,
      and believes that the provision of the services for activities unrelated to
      the
      audit is compatible with maintaining our auditors independence. The process
      the
      audit committee follows in pre-approving audit and non-audit services to be
      provided by the auditor in order to ensure independence of the auditor are
      as
      follows:





(1)
            Annually
                the auditor provides the audit committee with a list of the audit-related
                and non-audit services that are anticipated to be provided during
                the year
                for pre-approval. The audit committee reviews the services with the
                auditor and management considering whether the provision of the services
                is compatible with maintaining the auditor's independence.





(2)
            Upon
                pre-approval of the services on the initial list, management may
                engage
                the auditor for specific engagements that are within the definition
                of the
                pre-approved services.





(3)
            The
                audit committee delegates approval authority to the Chair of the
                audit
                committee for requests for services not previously presented to the
                audit
                committee for pre-approval. Any services approved by the Chair are
                reported to the full audit committee at the next meeting.





(4)
            A
                final detailed review of all public accounting services and fee amounts
                is
                performed by the audit committee prior to the audit opinion being
                issued
                at year end. At that time, the auditor provides the audit committee
                with
                the annual independence letter and the form and content of fees disclosure
                for the Company's annual report.








-27-


**SIGNATURES**





Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, the registrant has duly caused this report to be signed on its behalf
      by
      the undersigned thereunto duly authorized.





**SMARTIRE
      SYSTEMS INC.**





*By:
      /s/ Dave Warkentin*


*--------------------------------------*


*Dave
      Warkentin, President and Chief Executive Officer*




*Date:
      October 30, 2006*








Pursuant
      to the requirements of the Securities Exchange Act of 1934, this report has
      been
      signed below by the following persons on behalf of the registrant and in the
      capacities indicated on October 24, 2006:





**SIGNATURES**







*/s/
      Robert Rudman*


*----------------------------------------------------*


*Robert
      Rudman, Chairman*






*/s/
      Jeff Finkelstein*


*----------------------------------------------------*


*Jeff
      Finkelstein, Chief Financial Officer*


*(Principal
      Financial and Accounting Officer)*






*/s/
      Dave Warkentin*


*----------------------------------------------------*


*Dave
      Warkentin, President and Chief Executive Officer*


*(Principal
      Executive Officer)*






*/s/
      Martin Gannon*


*----------------------------------------------------*


*Martin
      Gannon, Director*






*/s/
      Johnny Christiansen*


*----------------------------------------------------*


*Johnny
      Christiansen, Director*






*/s/
      Bill Cronin*


*----------------------------------------------------*


*Bill
      Cronin, Director*










-28-


Consolidated
      Financial Statements


(Expressed
      in United States dollars)


(Prepared
      in accordance with U.S. generally accepted accounting principles)







**SMARTIRE
      SYSTEMS INC.**







Years
      ended July 31, 2006, 2005 and 2004










**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**





**To
      the Shareholders of SmarTire Systems Inc.**





We
      have
      audited the consolidated balance sheet of SmarTire Systems Inc. as at July
      31,
      2006 and the consolidated statements of operations, stockholders' equity
      (capital deficit) and comprehensive loss and cash flows for the year then ended.
      These financial statements are the responsibility of the Company's management.
      Our responsibility is to express an opinion on these financial statements based
      on our audit.





We
      conduct our audit in accordance with Canadian generally accepted auditing
      standards and the standards of the Public Company Accounting Oversight Board
      (United States). Those standards require that we plan and perform an audit
      to
      obtain reasonable assurance whether the financial statements are free of
      material misstatement. An audit includes examining, on a test basis, evidence
      supporting the amounts and disclosures in the financial statements. An audit
      also includes assessing the accounting principles used and significant estimates
      made by management, as well as evaluating the overall financial statement
      presentation.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the financial position of the Company as at July
      31,
      2006 and the results of its operations and its cash flow for the year then
      ended
      in accordance with U.S. generally accepted accounting principles.





*/s/
      BDO Dunwoody LLP*


*Chartered
      Accountants*





*Vancouver,
      Canada*


*September
      27, 2006*








**COMMENTS
      BY AUDITOR FOR U.S. READERS ON CANADA - U.S. REPORTING DIFFERENCE**





In
      the
      United States, reporting standards for auditors require the addition of an
      explanatory paragraph (following the opinion paragraph) when the financial
      statements are affected by conditions and events that cast substantial doubt
      on
      the Company's ability to continue as a going concern, such as those described
      in
      note 2 to the consolidated financial statements. Our report to the shareholders
      dated September 27, 2006 is expressed in accordance with Canadian reporting
      standards which do not permit a reference to such events and conditions in
      the
      report of independent registered public accounting firm when these are
      adequately disclosed in the financial statements.





*/s/
      BDO Dunwoody LLP*


*Chartered
      Accountants*





*Vancouver,
      Canada*


*September
      27, 2006*





-29-


**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**


To
        the
        Shareholders of SmarTire Systems Inc.
 
 
 We
        have
        audited the consolidated balance sheet of SmarTire Systems Inc. as at July
        31,
        2005 and the consolidated statements of operations, stockholders’ equity
        (capital deficit) and comprehensive loss and cash flows for the years ended
        July
        31, 2005 and July 31, 2004. These financial statements are the responsibility
        of
        the Company’s management. Our responsibility is to express an opinion on these
        financial statements based on our audits.
  We
        conducted our audits in accordance with Canadian generally accepted auditing
        standards and the standards of the Public Company Accounting Oversight Board
        (United States). Those standards require that we plan and perform an audit
        to
        obtain reasonable assurance whether the financial statements are free of
        material misstatement. An audit includes examining, on a test basis, evidence
        supporting the amounts and disclosures in the financial statements. An audit
        also includes assessing the accounting principles used and significant estimates
        made by management, as well as evaluating the overall financial statement
        presentation.
  In
        our
        opinion, the consolidated financial statements referred to above present
        fairly,
        in all material respects, the financial position of the Company as at July
        31,
        2005 and the results of its operations and its cash flows for the years ended
        July 31, 2005 and July 31, 2004 in accordance with U.S. generally accepted
        accounting principles.
  /s/
        KPMG
        LLP
 Chartered
        Accountants
 
 Vancouver,
        Canada
 September
        16, 2005, except for note 13 which is as of September 23, 2005,
 and
        note
        4 which is as of June 30, 2006




**COMMENTS
        BY AUDITOR FOR U.S. READERS ON**
 **CANADA
        - U.S. REPORTING DIFFERENCE**
 
 
 To
        the
        Shareholders of SmarTire Systems Inc.
  In
        the
        United States, reporting standards for auditors require the addition of an
        explanatory paragraph (following the opinion paragraph) when the financial
        statements are affected by conditions and events that cast substantial doubt
        on
        the Company’s ability to continue as a going concern, such as those described in
        note 2 to the financial statements. Our report to the shareholders dated
        September 16, 2005, except for note 13 which is as of September 23, 2005
        and
        note 4 which is as of June 30, 2006, is expressed in accordance with Canadian
        reporting standards which do not permit a reference to such events and
        conditions in the report of independent registered public accounting firm
        when
        these are adequately disclosed in the financial statements.
  /s/
        KPMG LLP
 Chartered
        Accountants
 
 Vancouver,
        Canada
 September
        16, 2005, except for note 13 which is as of September 23, 2005,
 and
        note
        4 which is as of June 30, 2006





-30-




**SMARTIRE
      SYSTEMS INC.**


Consolidated
      Balance Sheet


(Expressed
      in Unted States dollars)


(Prepared
      in accordance with U.S. generally accepted accounting principles)







2006
              
              
              2005(as restated -
                note 4)ASSETSCurrent
                  assets:Cash
                  and cash equivalents
              
              $
              1,988,420
              
              $
              10,059,763Receivables,
                  net of allowance for doubtful accountsof
                  $19,497 (2005 - $50,750)
              
              
              609,250
              
              
              275,789Inventory
                  (note 5)
              
              
              2,212,579
              
              
              2,798,747Prepaid
                  expenses
              
              
              196,668
              
              
              158,1885,006,917
              
              
              13,292,487Property
                  and equipment (note 6)
              
              
              780,039
              
              
              716,763Deferred
                  financing costs (note 14)
              
              
              1,692,094
              
              
              18,209,280Other
                  assets (note 7)
              
              
              75,275
              
              
              1,066,013$
              7,554,325
              
              $
              33,284,543LIABILITIES
                  AND STOCKHOLDERS' EQUITY (CAPITAL DEFICIT)Current
                  liabilities:Accounts
                  payable and accrued liabilities (note 8)
              
              $
              2,257,049
              
              $
              843,025Current
                  portion of convertible debentures (note 10)
              
              
              1,615,000
              
              
              4,866,5843,872,049
              
              
              5,709,609Convertible
                  debentures, net of amounts to be accreted of $8,567,424(2005
                  - $10,111,082) (note 10)
              
              
              21,432,576
              
              
              17,118,667Accrued
                  interest on convertible debentures (note 10 e))
              
              
              1,750,000
              
              
              -Derivative
                  financial instrument (note 11)
              
              
              8,043,225
              
              
              -Preferred
                  shares, subject to mandatory redemption net ofamounts
                  to be accreted of $3,665,485 (2005 - $3,999,999) (note 12)
              
              
              482,128
              
              
              72,310Stockholders'
                  equity (capital deficit):Share
                  capital (note 13)Common
                  shares, without par value:Unlimited
                  shares authorized311,610,656
                  shares issued and outstanding (2005 - 278,562,884)
              
              
              68,049,577
              
              
              66,695,717Additional
                  paid-in capital
              
              
              6,929,818
              
              
              18,697,821Accumulated
                  deficit
              
              
              (103,967,579
              )
              
              (75,138,474
              )Accumulated
                  other comprehensive loss
              
              
              962,531
              
              
              128,893(28,025,653
              )
              
              10,383,957$
              7,554,325
              
              $
              33,284,543


Going
                  concern (note 2)Commitments
                  and contingencies (note 20)See
                  accompanying notes to consolidated financial statements.Approved
                  on behalf of the Board/*s/
                  Robert Rudman*
              */s/
                  Martin Gannon*Robert
                  Rudman, Director
              Martin
                  Gannon, Director




-31-


**SMARTIRE
        SYSTEMS INC.**
 Consolidated
        Statement of Operations
 (Expressed
        in Unted States dollars)
 (Prepared
        in accordance with U.S. generally accepted accounting principles)


2006
              
              
              2005
              
              
              2004(as restated -
                note 4)Revenue
              
              $
              3,455,649
              
              $
              1,463,460
              
              $
              1,658,279Cost
                  of goods sold (including in the year endedJuly
                  31, 2006 and July 31, 2005 inventory write-downs of$700,000
                  and $500,000 respectively)
              
              
              3,160,763
              
              
              1,634,780
              
              
              1,445,563294,886
              
              
              (171,320
              )
              
              212,716Expenses:Depreciation
                  and amortization
              
              
              1,303,889
              
              
              1,497,250
              
              
              1,371,717Engineering,
                  research and development
              
              
              1,891,961
              
              
              3,297,011
              
              
              1,654,690General
                  and administrative
              
              
              2,368,118
              
              
              4,953,537
              
              
              2,338,758Marketing
              
              
              1,535,160
              
              
              2,540,730
              
              
              1,821,1227,099,128
              
              
              12,288,528
              
              
              7,186,287Loss
                  from operations
              
              
              (6,804,242
              )
              
              (12,459,848
              )
              
              (6,973,571
              )Other
                  earnings (expenses):Interest
                  income
              
              
              222,332
              
              
              39,241
              
              
              5,873Interest
                  and financing expense (note 15)
              
              
              (24,262,542
              )
              
              (3,779,151
              )
              
              (4,031,820
              )Gain/(loss)
                  on settlement of convertible debenture (note 10(b))
              
              
              (214,274
              )
              
              42,346
              
              
              -Unrealized
                  gain on derivative instrument income
              
              
              2,521,841
              
              
              -
              
              
              -Foreign
                  exchange gain (loss)
              
              
              (292,220
              )
              
              37,194
              
              
              12,492(22,024,863
              )
              
              (3,660,370
              )
              
              (4,013,455
              )Loss
                  for the year
              
              $
              (28,829,105
              )
              $
              (16,120,218
              )
              $
              (10,987,026
              )Accrued
                  dividends and accretion on preferred shares
              
              
              (554,138
              )
              
              -
              
              
              -Loss
                  available to common stockholders
              
              
              (29,383,243
              )
              
              (16,120,218
              )
              
              (10,987,026
              )Basic
                  and diluted loss per share
              
              $
              (0.10
              )
              $
              (0.07
              )
              $
              (0.13
              )Weighted
                  average number of common shares used inthe
                  computation of basic and diluted loss pershare
                  (note 19)
              
              
              292,196,901
              
              
              222,981,341
              
              
              83,356,095See
                  accompanying notes to consolidated financial statements.






-32-


**SMARTIRE
        SYSTEMS INC.**
 Consolidated
        Statement of Stockholders' Equity (Capital Deficit) and Comprehensive
        Loss
 (Expressed
        in Unted States dollars)
 (Prepared
        in accordance with U.S. generally accepted accounting principles)


Common
                  Shares
              
              
              Additional
              
              
              Accumulated
              
              
              Accumulated
              
              
              Stockholders'
              
              
              ComprehensiveShares
              
              
              Amount
              
              
              paid-in
              
              
              Deficit
              
              
              other
              
              
              equity
              
              
              losscapital
              
              
              
              
              
              comprehensive
              
              
              (Capitalloss
              
              
              Deficit
              )$
              $
              
              
              
              
              $
              $
              
              
              
              
              $
              $Balance
                  at July 31, 2003
              
              
              55,039,065
              
              
              48,204,995
              
              
              6,681,893
              
              
              (48,031,230
              )
              
              (568,354
              )
              
              6,287,304
              
              
              (9,505,692
              )Exercise
                  of stock options for cash
              
              
              79,400
              
              
              15,880
              
              
              -
              
              
              -
              
              
              -
              
              
              15,880
              
              
              -Intrinsic
                  value of beneficial conversion feature of convertible
                  debenturesplus
                  fair value of warrants issued
              
              
              -
              
              
              -
              
              
              2,457,023
              
              
              -
              
              
              -
              
              
              2,457,023
              
              
              -Conversion
                  of convertible debentures and accrued interest to commonshares
                  allocated pro-rata between additional paid-in-capital and
                  commonshares,
                  net of issuance costs of $156,133
              
              
              20,882,076
              
              
              5,344,961
              
              
              (2,788,277
              )
              
              -
              
              
              -
              
              
              2,556,684
              
              
              -Exercise
                  of warrants for cash, net of issuance costs of $78,370
              
              
              12,463,231
              
              
              3,702,985
              
              
              (1,601,970
              )
              
              -
              
              
              -
              
              
              2,101,015
              
              
              -Issuance
                  of shares and warrants as fees for services received
              
              
              200,000
              
              
              34,800
              
              
              63,375
              
              
              -
              
              
              -
              
              
              98,175
              
              
              -Fair
                  value of agent's warrants issued on private placement of
                  convertibledebentures
              
              
              -
              
              
              -
              
              
              15,699
              
              
              -
              
              
              -
              
              
              15,699
              
              
              -Issuance
                  of shares as fees on equity line of credit
              
              
              3,605,769
              
              
              375,000
              
              
              (375,000
              )
              
              -
              
              
              -
              
              
              -
              
              
              -Cash
                  cost incurred for equity line
              
              
              -
              
              
              -
              
              
              (35,420
              )
              
              -
              
              
              -
              
              
              (35,420
              )
              
              -Shares
                  issued upon draw downs on equity line of credit, net of
                  issuancecost
                  of $60,601
              
              
              10,861,220
              
              
              689,399
              
              
              -
              
              
              -
              
              
              -
              
              
              689,399
              
              
              -Loss
                  for the period
              
              
              -
              
              
              -
              
              
              -
              
              
              (10,987,026
              )
              
              -
              
              
              (10,987,026
              )
              
              (10,987,026
              )Translation
                  adjustment
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              267,483
              
              
              267,483
              
              
              267,483Balance
                  as at July 31, 2004
              
              
              103,130,761
              
              
              58,368,020
              
              
              4,417,323
              
              
              (59,018,256
              )
              
              (300,871
              )
              
              3,466,216
              
              
              (10,719,543
              )See
                  accompanying notes to consolidated financial statements.




-33-




SMARTIRE
        SYSTEMS INC.
 Consolidated
        Statement of Stockholders' Equity (Capital Deficit) and Comprehensive
        Loss
 (Expressed
        in Unted States dollars)
 (Prepared
        in accordance with U.S. generally accepted accounting principles)
  
 Common
                    Shares
                
                
                Additional
                
                
                Accumulated
                
                
                Accumulated
                
                
                Stockholders'
                
                
                ComprehensiveShares
                
                
                Amount
                
                
                paid-in
                
                
                Deficit
                
                
                other
                
                
                equity
                
                
                losscapital
                
                
                
                
                
                comprehensive
                
                
                (Capital(loss)
                    income
                
                
                Deficit
                )$
                $
                
                
                
                
                $
                $
                
                
                
                
                $
                $Balance
                    at July 31, 2004
                
                
                103,130,761
                
                
                58,368,020
                
                
                4,417,323
                
                
                (59,018,256
                )
                
                (300,871
                )
                
                3,466,216
                
                
                (10,719,543
                )Exercise
                    of stock options for cash (note 13(e))
                
                
                6,059,998
                
                
                787,800
                
                
                (606,000
                )
                
                -
                
                
                -
                
                
                181,800
                
                
                -Conversion
                    of convertible debentures and accrued interest to commonshares
                    allocated pro-rata between additional paid-in-capital and
                    commonshares
                    (note 10)
                
                
                51,340,389
                
                
                2,147,293
                
                
                (648,644
                )
                
                -
                
                
                -
                
                
                1,498,649
                
                
                -Intrinsic
                    value of beneficial conversion feature of convertible debt (note
                    10)
                
                
                -
                
                
                -
                
                
                11,005,243
                
                
                -
                
                
                -
                
                
                11,005,243
                
                
                -Settlement
                    of convertible debt (note 10 (c))
                
                
                -
                
                
                -
                
                
                (671,642
                )
                
                -
                
                
                -
                
                
                (671,642
                )
                
                -Intrinsic
                    value of beneficial conversion feature of preferred shares (note
                    12)
                
                
                -
                
                
                -
                
                
                3,999,999
                
                
                -
                
                
                -
                
                
                3,999,999
                
                
                -Financing
                    cost related to preferred shares (note 12)
                
                
                -
                
                
                -
                
                
                (145,000
                )
                
                -
                
                
                -
                
                
                (145,000
                )
                
                -Financing
                    cost related to convertible debenture (note 10)
                
                
                -
                
                
                -
                
                
                (1,038,037
                )
                
                -
                
                
                -
                
                
                (1,038,037
                )
                
                -Exercise
                    of warrants for cash, net of issuance costs of $46,872(note
                    13 (e)(ii))
                
                
                18,940,560
                
                
                1,588,643
                
                
                (1,017,299
                )
                
                -
                
                
                -
                
                
                571,344
                
                
                -Cashless
                    exercise of warrants (note 13 (f)(ii))
                
                
                13,364,073
                
                
                1,026,617
                
                
                (1,026,617
                )
                
                -
                
                
                -
                
                
                -
                
                
                -Shares
                    issued upon draw downs on equity line, net of issuance cost
                    of$515,170
                    (note 13(b))
                
                
                78,887,710
                
                
                2,505,766
                
                
                410,420
                
                
                -
                
                
                -
                
                
                2,916,186
                
                
                -Shares
                    issued as placement fees on equity line of credit (note
                    13(d))
                
                
                75,188
                
                
                10,000
                
                
                -
                
                
                -
                
                
                -
                
                
                10,000
                
                
                -Shares
                    issued as compensation for services (note 13(c))
                
                
                6,764,205
                
                
                261,578
                
                
                -
                
                
                -
                
                
                -
                
                
                261,578
                
                
                -Compensation
                    expense (note 3(o))
                
                
                -
                
                
                -
                
                
                4,018,075
                
                
                -
                
                
                -
                
                
                4,018,075
                
                
                -Loss
                    for the period
                
                
                -
                
                
                -
                
                
                -
                
                
                (16,120,218
                )
                
                -
                
                
                (16,120,218
                )
                
                (16,120,218
                )Translation
                    adjustment
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                429,764
                
                
                429,764
                
                
                429,764Balance
                    as at July 31, 2005 (as restated-Note 4)
                
                
                278,562,884
                
                
                66,695,717
                
                
                18,697,821
                
                
                (75,138,474
                )
                
                128,893
                
                
                10,383,957
                
                
                (15,690,454
                )Exercise
                    of stock options for cash (note 13(e))
                
                
                2,060,000
                
                
                267,800
                
                
                (206,000
                )
                
                -
                
                
                -
                
                
                61,800
                
                
                -Exercise
                    of warrants for cash (note 13(f))
                
                
                1,100,000
                
                
                110,000
                
                
                -
                
                
                -
                
                
                -
                
                
                110,000
                
                
                -Conversion
                    of convertible debentures and accrued interest to commonshares
                    allocated pro-rata between additional paid-in-capital and
                    commonshares
                    (Note 10)
                
                
                13,455,772
                
                
                607,871
                
                
                (216,509
                )
                
                -
                
                
                -
                
                
                391,362
                
                
                -Settlement
                    of convertible debt (Note 10 (b))
                
                
                2,000,000
                
                
                79,549
                
                
                (41,895
                )
                
                -
                
                
                -
                
                
                37,654
                
                
                -Amendment
                    and modification of convertible debentures (Note 10 (e) &
                    11)
                
                
                -
                
                
                -
                
                
                3,000,000
                
                
                -
                
                
                -
                
                
                3,000,000
                
                
                -Initial
                    valuation of derivative financial instrument (Note 11)
                
                
                -
                
                
                -
                
                
                (10,565,066
                )
                
                -
                
                
                -
                
                
                (10,565,066
                )
                
                -Conversion
                    of preferred shares into common shares (Note 12)
                
                
                14,432,000
                
                
                288,640
                
                
                (144,320
                )
                
                -
                
                
                -
                
                
                144,320
                
                
                -Stock-based
                    compensation recovery (Note 3 (o))
                
                
                -
                
                
                -
                
                
                (3,087,145
                )
                
                -
                
                
                -
                
                
                (3,087,145
                )
                
                -Issuance
                    of warrants for services (Note 13 (f))
                
                
                -
                
                
                -
                
                
                47,070
                
                
                -
                
                
                -
                
                
                47,070
                
                
                -Accrued
                    dividends and accretion on preferred shares (Note 12)
                
                
                -
                
                
                -
                
                
                (554,138
                )
                
                -
                
                
                -
                
                
                (554,138
                )
                
                -Loss
                    for the period
                
                
                -
                
                
                -
                
                
                -
                
                
                (28,829,105
                )
                
                -
                
                
                (28,829,105
                )
                
                (28,829,105
                )Translation
                    adjustment
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                833,638
                
                
                833,638
                
                
                833,638Balance
                    as at July 31, 2006
                
                
                311,610,656
                
                
                68,049,577
                
                
                6,929,818
                
                
                (103,967,579
                )
                
                962,531
                
                
                (28,025,653
                )
                
                (27,995,467
                )See
                    accompanying notes to consolidated financial statements.






-34-


SMARTIRE
      SYSTEMS INC. Consolidated
        Statement of Cash Flows
 (Expressed
        in Unted States dollars)
 (Prepared
        in accordance with U.S. generally accepted accounting principles)


2006
            
            
            2005
            
            
            2004(as
                restated -
              note
                4)Cash
                provided (used for):Operating
                activities:Loss
                for the year
            
            $
            (28,829,105
            )
            $
            (16,120,218
            )
            $
            (10,987,026
            )Items
                not affecting cash:Depreciation
                and amortization
            
            
            1,303,889
            
            
            1,497,250
            
            
            1,371,717Unrealized
                gain on derivative instruments
            
            
            (2,521,841
            )
            
            -
            
            
            -Stock-compensation
                expense (recovery)
            
            
            (3,087,145
            )
            
            4,279,653
            
            
            -Non-cash
                interest, penalties and finance charges
            
            
            23,207,528
            
            
            3,573,475
            
            
            3,842,107Inventory
                write-down
            
            
            700,000
            
            
            500,000
            
            
            -Issuance
                of shares and warrants for services received
            
            
            47,070
            
            
            -
            
            
            98,175Loss/(gain)
                on settlement of convertible debenture (note 10(b))
            
            
            214,274
            
            
            (42,346
            )
            
            -Change
                in non-cash working capital:Receivables
            
            
            (303,993
            )
            
            (44,507
            )
            
            170,127Inventory
            
            
            101,924
            
            
            (67,943
            )
            
            (2,391,749
            )Prepaid
                expenses
            
            
            (24,781
            )
            
            82,153
            
            
            (50,265
            )Accounts
                payable and accrued liabilities
            
            
            1,315,627
            
            
            (477,512
            )
            
            374,794Net
                cash used in operating activities
            
            
            (7,876,553
            )
            
            (6,819,995
            )
            
            (7,572,120
            )Investing
                activities:Purchase
                of capital assets
            
            
            (246,575
            )
            
            (73,511
            )
            
            (446,780
            )Net
                cash used in investing activities
            
            
            (246,575
            )
            
            (73,511
            )
            
            (446,780
            )Financing
                activities:Cash
                received on exercise of stock options
            
            
            61,800
            
            
            181,800
            
            
            15,880Cash
                received on exercise of warrants (note 13)
            
            
            110,000
            
            
            618,217
            
            
            2,179,385Proceeds
                from equity line of credit (note 13)
            
            
            -
            
            
            2,725,000
            
            
            750,000Proceeds
                from convertible debentures (note 10)
            
            
            -
            
            
            34,195,000
            
            
            2,725,000Proceeds
                from preferred shares (note 12)
            
            
            -
            
            
            4,000,000
            
            
            -Proceeds
                from promissory notes (note 9)
            
            
            -
            
            
            875,000
            
            
            1,500,000Settlement
                of convertible debentures (note 10 (b))
            
            
            (250,000
            )
            
            -
            
            
            -Repayment
                of convertible debentures (note 10)
            
            
            -
            
            
            (3,360,930
            )
            
            -Financing
                costs
            
            
            -
            
            
            (19,989,564
            )
            
            (626,696
            )Repayment
                of promissory notes (note 9)
            
            
            -
            
            
            (2,375,000
            )
            
            (305,715
            )Net
                cash provided by financing activities
            
            
            (78,200
            )
            
            16,869,523
            
            
            6,237,854Effect
                of exchange rate difference on cash and cash equivalents
            
            
            129,985
            
            
            7,076
            
            
            14,022Net
                increase (decrease) in cash and cash equivalents
            
            
            (8,071,343
            )
            
            9,983,093
            
            
            (1,767,024
            )Cash
                and cash equivalents, beginning of year
            
            
            10,059,763
            
            
            76,670
            
            
            1,843,694Cash
                and cash equivalents, end of year
            
            $
            1,988,420
            
            $
            10,059,763
            
            $
            76,670Supplementary
                information:Interest
                and finance charges paid
            
            $
            1,055,014
            
            $
            235,593
            
            $
            189,713Income taxes
                paid
            
            
            -
            
            
            -
            
            
            -Non-cash
                investing and financing activities:Conversion
                of convertible debentures and interest into common
                shares
            
            
            391,362
            
            
            1,498,649
            
            
            2,556,684Conversion
                of preferred shares to common shares
            
            
            144,320
            
            
            -
            
            
            -Settlement
                of convertible debt
            
            
            37,646
            
            
            -
            
            
            -Fair
                value of agents warrants issued in conjunction withprivate
                placements
            
            
            -
            
            
            -
            
            
            15,699Issuance
                of shares as consideration for equity line of credit
            
            
            -
            
            
            2,725,000
            
            
            375,000Financing
                costs included in accounts payable
            
            
            
            
            
            -
            
            
            52,859Shares
                issued for services
            
            
            -
            
            
            261,578
            
            
            -See
                accompanying notes to consolidated financial statements.




-35-


**SMARTIRE
        SYSTEMS INC.**
 **Notes
        to Consolidated Financial Statements**
 (Expressed
        in United States dollars)
 (Prepared
        in accordance with U.S. generally accepted accounting principles)
 
 **Years
        ended July 31, 2006, 2005 and 2004**





**1.**
            **Operations:**





The
      Company and its subsidiaries develop and market products incorporating wireless
      data transmission and processing technologies, primarily for the automotive
      and
      transportation industries. The Company's primary product is a wireless tire
      monitoring system which it currently markets for use on trucks, recreational
      vehicles, buses, motorcycles, passenger vehicles, and other pneumatic tire
      applications. All sales of its product are made in this industry segment.








**2.**
            **Going
                concern:**





The
      Company has incurred recurring operating losses and has a deficit of
      $103,967,579 and working capital of $1,134,868 as at July 31, 2006. During
      the
      year ended July 31, 2006, the Company used cash of $7,876,553 in operating
      and
      investing activities.





During
      fiscal 2006, the Company realized gross cash proceeds of $171,800 (2005 -
      $42,595,017) from financing activities.





The
      ability of the Company to continue as a going concern is in substantial doubt
      and is dependent on achieving profitable operations, and obtaining the necessary
      financing in order to achieve profitable operations. The outcome of these
      matters cannot be predicted at this time. The Company’s future operations are
      dependent on the market’s acceptance of its products in order to ultimately
      generate future profitable operations, and the Company’s ability to secure
      sufficient financing to fund future operations. There can be no assurance that
      the Company’s products will be able to secure market acceptance. Management
      plans to obtain additional financing to enable the Company to achieve profitable
      operations as a lthough
      the Company has a $100 million Standby Equity Distribution Agreement with
      Cornell Capital Partners, it is uncertain when the Company will be permitted
      to
      draw down on the Standby Equity Distribution Agreement as drawdowns are subject
      to an effective Registration statement. As a result, the Company may require
      additional financing to fund its operations. These consolidated financial
      statements have been prepared on the going concern basis which assumes that
      adequate sources of financing will be obtained as required and that the
      Company’s assets will be realized and liabilities settled in the ordinary course
      of business. Accordingly, these consolidated financial statements do not include
      any adjustments related to the recoverability of assets and classification
      of
      assets and liabilities that might be necessary should the Company be unable
      to
      continue as a going concern.








**3.**
            **Significant
                accounting policies:**





(a)
            Basis
                of presentation:





These
      consolidated financial statements include the accounts of the Company and its
      wholly-owned subsidiaries, SmarTire USA Inc., SmarTire Europe Limited, and
      SmarTire Technologies Inc. All intercompany balances and transactions have
      been
      eliminated.




(b)
            Research
                and development costs:





Research
      and development costs are expensed as incurred. Equipment used in research
      and
      development is capitalized only if it has an alternative future use.





(c)
            Cash
                and cash equivalents:





Cash
      and
      cash equivalents includes investments in short-term investments with a term
      to
      maturity when acquired of 90 days or less.





(d)
            Inventory:





Inventory
      of raw materials is recorded at the lower of cost, determined on a first-in,
      first-out basis, and net realizable value. Inventory of finished goods and
      work-in progress are recorded at the lower of average cost and net realizable
      value. Average cost is determined using the weighted-average method and includes
      invoice cost, duties and freight where applicable plus direct labour applied
      to
      the product and an applicable share of manufacturing overhead. A provision
      for
      obsolescence for slow moving inventory items is estimated by management based
      on
      historical and expected future sales and is included in cost of goods sold.





(e)
            Property
                and equipment:





Property
      and equipment are recorded at cost. Depreciation of computer hardware and
      software and office and shop equipment is provided for on the declining balance
      basis at 30% per annum. Leasehold improvements are depreciated over the lesser
      of their useful lives or the term of the lease.





(f)
            Deferred
                financing costs:





Deferred
      financing costs include cash payments made by the Company in conjunction with
      various financing instruments and placements. The fees associated with the
      convertible debentures are amortized over the respective terms of the
      convertible debentures. As at July 31, 2005, the Company had deferred
      $16,084,086 of financing costs relating to its $160.0 million equity line of
      credit. As described in note 14, on September 23, 2005 the Company withdrew
      the
      Registration Statement previously filed on July 22, 2005 with the SEC. As a
      result of the withdrawal of the Registration Statement the Company did not
      have
      the ability to draw down on the $160.0 million equity line of credit. As further
      disclosed in note 14, it is currently not determinable when the Company will
      be
      able to draw down on the amended $100.0 million equity line of credit. For
      the
      year ended July 31, 2006, the Company has charged $16,517,186 (2005 - $197,326,
      2004 - $123,573) to the statement of operations as interest and financing
      expense.


-36-
 **SMARTIRE
          SYSTEMS INC.**
 **Notes
          to Consolidated Financial Statements**
 (Expressed
          in United States dollars)
 (Prepared
          in accordance with U.S. generally accepted accounting principles)
 
 **Years
          ended July 31, 2006, 2005 and 2004**


**3.**
              **Significant
                  accounting policies (continued):**


(g)
            Other
                assets:





Other
      assets include the license to manufacture and sell tire monitoring systems
      to
      the original equipment vehicle manufacturers (note 7). Other assets are recorded
      at cost and are being amortized over five years on a straight-line basis.




(h)
            Impairment
                of long-lived assets:





The
      Company monitors the recoverability of long-lived assets, based on estimates
      using factors such as expected future asset utilization, business climate and
      future undiscounted cash flows expected to result from the use of the related
      assets or to be realized on sale. The Company recognizes an impairment loss
      if
      the projected undiscounted future cash flows are less than the carrying amount.
      The amount of the impairment charge, if any, is measured equal to the excess
      of
      the carrying value over the expected future cash flows discounted using the
      Company's average cost of funds.





(i)
            Revenue
                recognition:





The
      Company recognizes revenue when there is persuasive evidence of an arrangement,
      goods are shipped and title passes, collection is probable, and the fee is
      fixed
      or determinable. Provisions are established for estimated product returns and
      warranty costs at the time the revenue is recognized. The Company records
      deferred revenue when cash is received in advance of the revenue recognition
      criteria being met. Revenue from engineering services is recognized on services
      as they are rendered and pre-defined milestones are achieved. Engineering
      services revenue for the year were nil (2005-nil and 2004 - $94,800).





(j)
            Loss
                per share:





Basic
      loss per share computations are based on the weighted average number of shares
      outstanding during the year. If in a period the Company has outstanding dilutive
      stock options and warrants, diluted loss per share is calculated using the
      treasury stock method.





(k)
            Income
                taxes:





The
      Company accounts for income taxes in accordance with the asset and liability
      method. Under this method, deferred income taxes are recognized for the future
      income tax consequences attributable to differences between the financial
      statement carrying amounts and their respective income tax bases and for loss
      and tax credit carryforwards. Deferred tax assets and liabilities are measured
      using enacted tax rates expected to apply to taxable income in the years in
      which temporary differences are expected to be recovered or settled. The effect
      on deferred income tax assets and liabilities of a change in tax rates is
      recognized in income in the period of enactment. Deferred income tax assets
      are
      evaluated and if their realization is not considered to be "more likely than
      not", a valuation allowance is provided.





(l)
            Warranty
                costs:





The
      Company accrues warranty costs upon the recognition of related revenue, based
      on
      its best estimates, with reference to past experience. See note 20(b).





(m)
            Foreign
                currency translation:





The
      Company's functional or primary operating currency is the Canadian dollar.
      The
      Company's financial statements are prepared in Canadian dollars before
      translating to the US dollar reporting currency. The Company translates
      transactions in currencies other than the Canadian dollar at the exchange rate
      in effect on the transaction date. Monetary assets and liabilities denominated
      in a currency other than the Canadian dollar are translated at the exchange
      rates in effect at the balance sheet date. The resulting exchange gains and
      losses are recognized in earnings.





Amounts
      reported in Canadian dollars have been translated into US dollars as follows:
      assets and liabilities are translated into US dollars at the rate of exchange
      in
      effect at the balance sheet date and revenue and expense items are translated
      at
      the average rates for the period. Unrealized gains and losses resulting from
      the
      translation into the reporting currency are accumulated in accumulated other
      comprehensive income, a separate component of stockholders' equity.





(n)
            Use
                of estimates:





The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America requires management at the
      date of the financial statements to make estimates and assumptions that affect
      the reported amounts of assets and liabilities and disclosure of contingent
      assets and liabilities at the date of the financial statements and the reported
      amounts to revenues and expenses during the reporting period. Significant areas
      requiring the use of estimates include estimating
      allowance for doubtful accounts, estimating
      the net realizable value of inventory, the future cash flows for assessing
      the
      net recoverable amount of long-lived assets, stock-based compensation, product
      returns and accrued liabilities. Actual results may differ from those estimates.




-37-


**SMARTIRE
        SYSTEMS INC.**
 **Notes
        to Consolidated Financial Statements**
 (Expressed
        in United States dollars)
 (Prepared
        in accordance with U.S. generally accepted accounting principles)
 
 **Years
        ended July 31, 2006, 2005 and 2004**


**3.**
              **Significant
                  accounting policies (continued):**


(o)
            Stock-based
                compensation:





The
      Company has elected under Statement of Financial Accounting Standards (“SFAS”)
      123, *Accounting
      for Stock-based Compensation* ,
      to
      account for employee stock options using the intrinsic value method. This method
      is described in Accounting Principles Board ("APB") Opinion No. 25, *Accounting
      for Stock Issued to Employees* ,
      and
      related interpretations. As the Company grants stock options with an exercise
      price not less than the market value of the underlying common shares on the
      date
      of grant, no compensation expense is required to be recognized under APB 25
      for
      fixed plan awards.





If
      the
      exercise price of an employee stock option award is not fixed in the functional
      currency of the Company or in the currency the employee is paid, the award
      is
      accounted for as a variable award until the award is exercised, forfeited,
      or
      expires unexercised. The Company measures compensation as the amount by which
      the quoted market value of the common shares of the Company's stock covered
      by
      the grant exceeds the option price, with changes in the market price included
      in
      the measurement of loss.





In
      accordance with SFAS 148, “ *Accounting
      for Stock-Based Compensation - Transition and disclosure and amendment of FASB
      Statement No. 123* ”
the
      following table illustrates the effect on net loss and net loss per share as
      if
      the Company had applied the fair value recognition provisions of FAS 123.
      Because most of the Company’s options vest over two years and additional option
      grants are expected to be made in future years, the pro forma results are not
      representative of the pro forma results for future periods.





SFAS
      123
      uses the fair value method of calculating the cost of stock option grants.
      Had
      compensation cost for employee stock options been determined by this method,
      net
      loss and net loss per share would have been as follows:


2006
              
              
              2005
                (as
                  restated
              )
              
              2004Net
                  loss:As reported
              
              $
              (28,829,105
              )
              $
              (16,120,218
              )
              $
              (10,987,026
              )Stock-based compensation expense/(recovery)recognized using intrinsic valuemethod (variable award)
              
              
              (3,087,145
              )
              
              4,279,653
              
              
              -Stock-based compensation expensedetermined under fair value basedmethod for all awards
              
              
              (651,079
              )
              
              (1,101,411
              )
              
              (1,291,736
              )Pro forma
              
              $
              (32,567,329
              )
              $
              (12,941,976
              )
              $
              (12,278,762
              )Basic
                  and diluted loss per share:As reported
              
              $
              (0.10
              )
              $
              (0.07
              )
              $
              (0.13
              )Pro forma
              
              $
              (0.11
              )
              $
              (0.06
              )
              $
              (0.15
              )




The
      Company recognizes compensation expense on a straight-line basis over the
      vesting period beginning on the date the stock option is granted.





The
      fair
      value of each option and warrant granted is estimated on the date of grant
      using
      the Black-Scholes option valuation model with the following range of weighted
      average assumptions:


2006
              2005
              2004Expected
                  dividend yield
              0%
              0%
              0%Expected
                  stock price volatility
              140-145%
              137-147%
              139-152%Risk-free
                  interest rate
              3.15-4.53%
              3.54-4.11%
              3.28-4.08%Expected
                  life of options and warrants
              5
                  years
              5
                  years
              3-5
                  years


Weighted-average
      fair values of options granted during the year are as follows:


2006
              2005
              2004Options
                  whose exercise price at date of grant:Equals the market price of stock
              $
                  -
              $
                  0.03
              $
                  0.07Exceeds the market price of stock
              0.06
              0.02
              0.16





The
      Company recognizes compensation expense for stock options, common stock and
      other instruments issued to non-employees for services received based upon
      the
      fair value of the equity instruments issued as the services are performed and
      the instrument is earned.


-38-
 **SMARTIRE
          SYSTEMS INC.**
 **Notes
          to Consolidated Financial Statements**
 (Expressed
          in United States dollars)
 (Prepared
          in accordance with U.S. generally accepted accounting principles)
 
 **Years
          ended July 31, 2006, 2005 and 2004**
 **3.**
                **Significant
                    accounting policies (continued):**


(p)
            Derivative
                Instruments:





SFAS
      133
“ *Accounting
      for Derivative Instruments and Hedging Activities* ”,
      requires all contracts which meet the definition of a derivative to be
      recognized in the Company’s consolidated financial statements as either assets
      or liabilities and recorded at fair value. Changes in the fair value of the
      derivative financial instruments are recognized periodically in the Company’s
      consolidated statement of operations. The estimated fair values of derivative
      instruments are determined at discrete points in time based on the relevant
      market information and are calculated with reference to the market rates using
      standard valuation techniques.





(q)
            Fair
                value of financial assets and liabilities:





Carrying
      amounts of certain of the Company's financial instruments, including cash and
      cash equivalents, receivables, accounts payable and accrued liabilities,
      approximate their fair value due to their short maturities. It was not
      practicable to estimate the fair value of the convertible debentures and the
      redeemable preferred shares, as they are not publicly traded or quoted and
      an
      active and liquid market does not exist for investments with similar terms,
      risks and other features. These instruments are convertible into the Company's
      common shares that currently trade in a limited volume relative to the number
      of
      shares that are issued and outstanding. The underlying value of the Company
      is
      dependent on future sales, income and product development that are, at least
      in
      part, outside of the Company's control. The existence of doubt about the
      Company's ability to continue as a going concern results in uncertainty about
      the future, and certain of the instruments are held by related parties.
      Information as to the terms, including the determination of carrying values,
      interest rates and maturity dates are set out in notes 10 and 12.





(r)
            Comprehensive
                income:





Under
      SFAS 130, Reporting Comprehensive Income, the Company is required to report
      comprehensive income, which includes net loss as well as changes in equity
      from
      non-owner sources. The other changes in equity included in comprehensive income
      for the periods presented comprise the foreign currency cumulative translation
      adjustments. Accumulated other comprehensive loss is presented in the
      consolidated statements of stockholders' equity (capital deficit) and
      comprehensive loss.





(s)
            Allowance
                for doubtful accounts:





Accounts
      receivables are presented net of an allowance for doubtful accounts. The
      allowance was $19,497 at July 31, 2006 (2005 - $50,750). Bad debt recovery
      was
      $28,630 for the year ended July 31, 2006 (2005 - expense of $51,327; 2004 -
      expense of $2,135).





The
      Company evaluates the collectibility of its accounts receivable balances based
      upon a combination of factors on a periodic basis. When the Company becomes
      aware of a specific customer’s inability to meet its financial obligations to
      the Company (such as in the case of bankruptcy filings or material deterioration
      in the customers’ operating results or financial position and payment
      experiences), the Company records a specific bad debt provision to reduce the
      customer’s related accounts.




(t)
            Recent
                accounting pronouncements:




SFAS
      No. 123 (R)




In
      December 2004, the SFAS issued Statement of Financial Accounting Standard No.
      123 (Revised 2004), “Share-Based Payment” (“SFAS No. 123R”) requires all public
      companies accounting for (a) equity instruments of the enterprise or (b)
      liabilities that are based on the fair value of the enterprise’s equity
      instruments or that may be settled by the issuance of such equity instruments
      to
      account for these types of transactions using a fair value based method. The
      Company currently accounts for share-based payments to employees using the
      intrinsic value method as set forth in APB No. 25 “Accounting for Stock Issued
      to Employees.” SFAS No. 123(R) eliminates the alternative to use APB No. 25’s
      intrinsic value method of accounting. Accordingly the adoption of SFAS No.
      123(R)’s fair value method will have an impact our results of operations. The
      impact of adoption of SFAS No. 123(R) cannot be predicted at this time because
      it will depend on levels of share-based payments granted in the future. SFAS
      No.
      123(R) permits companies to adopt its requirements using either a modified
      prospective method or a modified retrospective method. The Company has
      determined that it will adopt SFAS No. 123(R) using the modified prospection
      method. The provisions of SFAS No. 123(R) are effective for financial statements
      with the first interim or annual reporting period beginning after June 15,
      2005.
      However, the SEC announced on April 14, 2005 that it would provide for a
      phased-in implementation process for SFAS No. 123 (R). As a result, the Company
      will not be required to apply SFAS 123(R) until the period beginning August
      1,
      2006.




SFAS
      No. 154




In
      June
      2005, the FASB issued Statement of Financial Accounting Standard No. 154,
“ *Accounting
      Changes and Error Corrections, a replacement of APB Opinion No. 20,
      Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes
      in Interim Financial Statements* ”
(“SFAS
      154”). The Statement applies to all voluntary changes in accounting principle,
      and changes the requirements for accounting for and reporting of a change in
      accounting principle. SFAS 154 requires retrospective application to prior
      periods’ financial statements of a voluntary change in accounting principle
      unless it is impracticable. SFAS 154 requires that a change in method of
      depreciation, amortization, or depletion for long-lived, nonfinancial assets
      be
      accounted for as a change in accounting estimate that is affected by a change
      in
      accounting principle. Opinion 20 previously required that such a change be
      reported as a change in accounting principle. SFAS 154 is effective for
      accounting changes and corrections of errors made in fiscal years beginning
      after December 15, 2005. The adoption of this pronouncement is not expected
      to have a material impact on the Company’s financial statements.


-39-
 **SMARTIRE
          SYSTEMS INC.**
 **Notes
          to Consolidated Financial Statements**
 (Expressed
          in United States dollars)
 (Prepared
          in accordance with U.S. generally accepted accounting principles)
 
 **Years
          ended July 31, 2006, 2005 and 2004**
 **3.**
                **Significant
                    accounting policies (continued):**


SFAS
      No. 157




In
      September 2006, the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standard (“SFAS”) No. 157, “Fair Value
      Measurements” (“FAS 157”). FAS 157 defines fair value, establishes a framework
      for measuring fair value in accordance with generally accepted accounting
      principles, and expands disclosures about fair value measurements. The
      provisions of FAS 157 are effective for the fiscal year beginning November
      15,
      2007. The Company is currently evaluating the impact of the provisions of FAS
      157.




FIN
      48




In
      June 2006, FASB issued interpretation No. 48, “ *Accounting
      for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109
      (FAS No. 109)* ”
(“FIN
      48”). This interpretation prescribes a recognition threshold and measurement
      attribute for tax positions taken or expected to be taken in a tax return.
      This
      interpretation also provides guidance on de-recognition, classification,
      interest and penalties, accounting in interim periods, disclosure and
      transition. The evaluation of a tax position in accordance with this
      interpretation is a two-step process. In the first step, recognition, the
      Company determines whether it is more-likely-than-not that a tax position will
      be sustained upon examination, including resolution of any related appeals
      or
      litigation processes, based on the technical merits of the position. The second
      step addresses measurement of a tax position that meets the more-likely-than-not
      criteria. The tax position is measured at the largest amount of benefit that
      is
      greater than 50 percent likely of being realized upon ultimate settlement.
      Differences between tax positions taken in a tax return and amounts recognized
      in the financial statements will generally result in a) an increase in a
      liability for income taxes payable or a reduction of an income tax refund
      receivable, b) a reduction in a deferred tax asset or an increase in a deferred
      tax liability or c) both a and b. Tax positions that previously failed to meet
      the more-likely-than-not recognition threshold should be recognized in the
      first
      subsequent financial reporting period in which that threshold is met. Previously
      recognized tax positions that no longer meet the more-likely-than-not
      recognition threshold should be de-recognized in the first subsequent financial
      reporting period in which that threshold is no longer met. Use of a valuation
      allowance as described in FAS No. 109 is not an appropriate substitute for
      the de-recognition of a tax position. The requirement to assess the need for
      a
      valuation allowance for deferred tax assets based on sufficiency of future
      taxable income is unchanged by this interpretation. This Interpretation is
      effective for fiscal years beginning after December 15, 2006. The Company
      is currently evaluating the impact FIN 48 will have on the Company’s
      consolidated balance sheet and statement of operations.




EITF
      06-3




In
      March
      2006, the Emerging Issues Task Force published Abstracts No. 06-3,
“ *How
      Taxes Collected from Customers and Remitted to Governmental Authorities Should
      Be Presented in the Income Statement* ”
(“EITF
      06-3”) which requires a policy be adopted to present externally imposed taxes on
      revenue-producing transactions on either a gross or net basis. Gross or net
      presentation may be elected for each different type of tax, but similar taxes
      should be presented consistently. Taxes within the scope of this issue would
      include taxes that are imposed on a revenue transaction between a seller and
      a
      customer. EITF 06-3 is effective in interim and annual financial periods
      beginning after December 15, 2006. The adoption of EITF 06-3 is not
      expected to have a material impact on the Company’s financial statements.




SAB
      108




On
      September 13, 2006, the Securities and Exchange Commission (“SEC”) issued Staff
      Accounting Bulletin No. (“SAB 108”) which provides interpretive guidance on how
      the effects of the carryover or reversal of prior year misstatements should
      be
      considered in quantifying a current year misstatement. SAB 108 is effective
      for
      fiscal years ending after November 15, 2006. The Company is currently evaluating
      the effect, if any, that this pronouncement will have on its financial results.




**4.**
            **Restatement
                of previously issued financial
                statement:**




The
      Company has effected a restatement of its financial results for the year ended
      July 31, 2005.





The
      restatement was effected to correct an error in the Company’s accounting
      treatment of the gain recorded upon the extinguishment of its $2.5 million,
      5%
      convertible debenture with respect to guidance in EITF 00-27, Issue 12(b) as
      the
      conversion price used in the calculation of the accounting gain to reflect
      that
      of the closing bid price of the Company’s common stock on the date of
      extinguishment.





The
      effect of the amended accounting for the (non-cash) gain on extinguishment
      of
      debt on the Company’s consolidated statement of operations for the year ended
      July 31, 2005 was a decrease in the gain on extinguishment of debt of $1,828,357
      which resulted in an increase in the Company’s net loss of $1,828,357 and a
      reduction in the charge to deficit relating to the extinguishment of the
      debenture. Basic and diluted loss per share for the year ended July 31, 2005
      increased by $0.01 to $0.07 per share. The effect on the Company’s consolidated
      balance sheet as of July 31, 2005 was an increase in its additional paid in
      capital and accumulated deficit of $6,324.





**5.**
            **Inventory:**


2006
              2005Raw
                  materials
              $
                  701,661
              $
                  1,362,608Work
                  in progress
              232,517
              45,332Finished
                  goods
              1,278,401
              1,390,807$
                  2,212,579
              $
                  2,798,747
 -40-
 **SMARTIRE
            SYSTEMS INC.**
 **Notes
            to Consolidated Financial Statements**
 (Expressed
            in United States dollars)
 (Prepared
            in accordance with U.S. generally accepted accounting principles)
 
 **Years
            ended July 31, 2006, 2005 and 2004**


**6.**
            **Property
                and equipment:**


Accumulated
              Net
                  book**2006**
              Cost
              amortization
              ValueComputer
                  hardware and software
              $
                  953,549
              $
                  746,800
              $
                  206,749Office
                  and shop equipment
              1,773,674
              1,285,667
              $
                  488,007Leasehold
                  improvements
              243,754
              158,471
              $
                  85,283$
                  2,970,977
              $
                  2,190,938
              $
                  780,039Accumulated
              Net
                  book**2005**
              Cost
              amortization
              ValueComputer
                  hardware and software
              $
                  803,638
              $
                  623,123
              $
                  180,515Office
                  and shop equipment
              1,477,329
              1,027,230
              450,099Leasehold
                  improvements
              224,901
              138,752
              86,149$
                  2,505,868
              $
                  1,789,105
              $
                  716,763




**7.**
            **Other
                assets:**





On
      December 13, 2000, the Company entered into an Assignment and Amendment
      Agreement with TRW Inc. ("TRW") that transferred to the Company the license
      to
      manufacture and sell tire pressure monitoring systems to the original equipment
      vehicle manufacturers of most medium and heavy duty trucks. Consideration
      consisted of 490,072 shares of common stock valued at $1,337,500, based on
      the
      market value of the Company's stock at the date of purchase, plus cash of
      $400,000.





On
      August
      31, 2001, the Company and TRW entered into an agreement to restructure their
      strategic alliance. Under the terms of restructuring, the Company and TRW agreed
      to terminate a number of agreements. The Company has the right to manufacture
      and sell tire pressure monitoring systems to the original equipment vehicle
      manufacturers market ("OEM"). Consideration consisted of a promissory note
      of
      $2.8 million, carrying an interest rate of 6% per annum plus cash of $500,000.
      The balance of principal in the amount of $1,350,000 owed at July 31, 2002
      was
      repaid during fiscal 2003 and interest of $97,542 on this balance was forgiven
      by TRW.




The
      rights are being amortized over five years on a straight-line basis.


Accumulated
              Net
                  book2006
              Cost
              amortization
              ValueOEM
                  - most medium and heavy duty trucks
              $
                  1,737,500
              $
                  1,737,500
              $
                  -OEM
                  - all other vehicles
              3,300,000
              3,224,725
              75,275$
                  5,037,500
              $
                  4,962,225
              $
                  75,275Accumulated
              Net
                  book2005
              Cost
              amortization
              ValueOEM
                  - most medium and heavy duty trucks
              $
                  1,737,500
              $
                  1,574,381
              $
                  163,119OEM
                  - all other vehicles
              3,300,000
              2,397,106
              902,894$
                  5,037,500
              $
                  3,971,487
              $
                  1,066,013


-41-
 **SMARTIRE
          SYSTEMS INC.**
 **Notes
          to Consolidated Financial Statements**
 (Expressed
          in United States dollars)
 (Prepared
          in accordance with U.S. generally accepted accounting principles)
 
 **Years
          ended July 31, 2006, 2005 and 2004**


**8.**
            **Accounts
                payable and accrued
                liabilities:**


2006
                2005Accounts
                    payable
                $
                    928,726
                $
                    311,296Accrued
                    liabilities
                739,752
                232,629Interest
                    payable on convertible debentures
                588,571
                299,280$
                    2,257,049
                $
                    843,205


**9.**
            **Promissory
                notes:**





(a)
            During
                the year ended July 31, 2005, the Company received gross proceeds
                of
                $875,000 as follows:





i.
            On
                November 16, 2004, the Company received gross proceeds of $250,000
                upon
                the issuance of an unsecured short-term promissory note to an accredited
                investor. There were no fees on the note. The note bore interest
                at a rate
                of 12% per annum and was repaid on December 15, 2004.





ii.
            On
                November 30, 2004, the Company received gross proceeds of $275,000
                upon
                the issuance of an unsecured short-term promissory note to an accredited
                investor. The note bore interest at a rate of 12% per annum and was
                repaid
                on December 15, 2004. As a commitment fee, the holder of the note
                received
                $27,500.





iii.
            On
                February 9, 2005, the Company received gross proceeds of $350,000
                upon the
                issuance of an unsecured short-term promissory note to an accredited
                investor. The note bore interest at a rate of 10% per annum and was
                repaid
                on March 16, 2005. As a commitment fee, the holder of the note received
                $35,000.





(b)
            During
                the year ended July 31, 2005, the Company repaid all of its outstanding
                promissory notes. In total, the Company repaid $2,375,000 of principal,
                including $1,500,000 received from the issuance of two promissory
                notes
                during the year ended July 31, 2004 and $61,462 in interest on its
                promissory notes.





**10.**
            **Convertible
                debentures:**





The **** Company
      has entered into a number of convertible debt instruments. The following table
      denotes the face value of each of these convertible debentures and provides
      a
      summary of the balance of convertible debentures outstanding as at July 31,
      2006
      and July 31, 2005. Each convertible debenture is also described in detail as
      specified in the table below.


8
              %
              
              Discounted
              
              
              5
              %
              
              5
              %
              
              5
              %
              
              10
              %Note
                  10(a)
              
              
              Note
                  10(b
              )
              
              Note
                  10(c
              )
              
              Note
                  10(c
              )
              
              Note
                  10(d
              )
              
              Note
                  10(e
              )
              
              TotalOriginal
                  face value of convertible debenture
              
              $
              1,700,000
              
              $
              3,493,590
              
              $
              195,000
              
              $
              2,500,000
              
              $
              1,500,000
              
              $
              30,000,000
              
              $
              39,388,590Debt
                  component, as at July 31, 2004:
              
              
              1
              
              
              666,830
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              666,831Issued
              
              
              -
              
              
              -
              
              
              195,000
              
              
              2,500,000
              
              
              1,500,000
              
              
              30,000,000
              
              
              34,195,000Allocation
                  to additional paid-in capital on issuance
              
              
              -
              
              
              -
              
              
              (52,881
              )
              
              (677,966
              )
              
              (1,499,999
              )
              
              (8,774,399
              )
              
              (11,005,245
              )Interest
                  accretion
              
              
              274,999
              
              
              1,680,357
              
              
              52,881
              
              
              -
              
              
              -
              
              
              163,315
              
              
              2,171,552Redemptions,
                  repayments, and settlements
              
              
              -
              
              
              (860,929
              )
              
              -
              
              
              (1,822,034
              )
              
              -
              
              
              -
              
              
              (2,682,963
              )Conversion
                  of debt to common shares
              
              
              (160,000
              )
              
              (1,315,517
              )
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (1,475,517
              )Penalties
                  and other accrued amounts, net of witholding tax
              
              
              -
              
              
              115,592
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              115,592Debt
                  component, as at July 31, 2005
              
              
              115,000
              
              
              286,333
              
              
              195,000
              
              
              -
              
              
              1
              
              
              21,388,916
              
              
              21,985,250Less
                  current portion, as at July 31, 2005
              
              
              (115,000
              )
              
              (286,333
              )
              
              (195,000
              )
              
              -
              
              
              (1
              )
              
              (4,270,250
              )
              
              (4,866,584
              )Long
                  term portion of debt component, as at July 31, 2005
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              17,118,666
              
              $
              17,118,666Remaining
                  face value of convertible debenture as at July 31, 2005
              
              $
              115,000
              
              $
              286,333
              
              $
              195,000
              
              $
              -
              
              $
              1,500,000
              
              $
              30,000,000
              
              $
              32,096,333Debt
                  component, as at July 31, 2005
              
              $
              115,000
              
              $
              286,333
              
              $
              195,000
              
              $
              -
              
              $
              1
              
              $
              21,388,916
              
              $
              21,985,250Interest
                  accretion
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              1,499,999
              
              
              3,043,660
              
              
              4,543,659Modification
                  of terms of debenture
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (3,000,000
              )
              
              (3,000,000
              )Conversion
                  and settlements of debt to common shares
              
              
              (115,000
              )
              
              (286,333
              )
              
              -
              
              
              -
              
              
              (80,000
              )
              
              -
              
              
              (481,333
              )Debt
                  component, as at July 31, 2006
              
              
              -
              
              
              -
              
              
              195,000
              
              
              -
              
              
              1,420,000
              
              
              21,432,576
              
              
              23,047,576Less
                  current portion, as at July 31, 2006
              
              
              -
              
              
              -
              
              
              (195,000
              )
              
              -
              
              
              (1,420,000
              )
              
              -
              
              
              (1,615,000
              )Long
                  term portion of debt component, as at July 31, 2006
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              21,432,576
              
              $
              21,432,576Remaining
                  face value of convertible debenture as at July 31, 2006
              
              $
              -
              
              $
              -
              
              $
              195,000
              
              $
              -
              
              $
              1,420,000
              
              $
              30,000,000
              
              $
              31,615,000
 -42-
 **SMARTIRE
            SYSTEMS INC.**
 **Notes
            to Consolidated Financial Statements**
 (Expressed
            in United States dollars)
 (Prepared
            in accordance with U.S. generally accepted accounting principles)
 
 **Years
            ended July 31, 2006, 2005 and 2004**
 **10.**
                  **Convertible
                      debentures (continued):**


At
      January 31, 2005 and April 30, 2005, the Company was in violation of all
      existing convertible debenture agreements. As a result of this violation, the
      Company accreted interest to adjust the carrying value of all existing
      convertible debentures at the time to their redemption value. As at July 31,
      2005 and 2006, the Company was in compliance with all terms and conditions
      of
      all existing convertible debentures.





The
      Company filed a Registration Statement on Form SB-2 on January 11, 2006 and
      subsequently amended Registration Statement on Form SB-2/A on February 27,
      2006
      and April 11, 2006 to register the underlying securities. The Company
      subsequently withdrew the registration statement on September 19,
      2006.





(a)
            $1,700,000
                - 8% convertible debenture





On
      June
      17, 2003, the Company closed a private placement of 7% convertible debentures
      in
      three 8 tranches pursuant to Rule 506 of Regulation D under the Securities
      Act
      of 1933, for gross proceeds of $2,800,000. On July 17, 2003, the Company closed
      a private placement of 8% convertible debentures pursuant, for gross proceeds
      of
      $1,700,000. Net cash proceeds from the convertible debentures were $4,016,978.





In
      connection with the offering of the convertible debentures, the Company issued
      23,846,153 common share purchase warrants which were to expire between July
      17,
      2008 and November 10, 2008. These warrants were exercised during the year ended
      July 31, 2005. Advisors to the transactions received a cash commission of
      $360,000 and 180,000 share purchase warrants: 112,000 share purchase warrants
      for a period of five years, and 68,000 share purchase warrants for a period
      of
      three years. The fair value of these warrants at the date of grant was estimated
      at $77,640 using the Black-Scholes option valuation model using weighted average
      assumptions as disclosed in note 3(o). Additional expenses related to this
      offering were $123,022 plus 100,000 share purchase warrants exercisable at
      a
      price of $0.135 per share for a period of five years. The financing cost was
      to
      be amortized over the life of the convertible debentures.





Principal
      under the convertible debentures was convertible by the holder in whole or
      in
      part and from time to time at a conversion price of $0.13 per share, subject
      to
      the anti-dilution provisions as provided for in the debentures.





Interest
      on the debentures was payable quarterly on March 1, June 1, September 1 and
      December 1, and at maturity, in cash or, at the Company's option, in shares
      of
      the Company's common stock at an interest conversion price equal to 90% of
      the
      lesser of the average closing bid price during the 20 trading days immediately
      preceding the interest payment date, or the average closing bid price during
      the
      20 trading days immediately preceding the date on which the shares are issued
      if
      such shares are issued and delivered after the interest payment date. The
      Company's right to elect to pay accrued interest in shares of its common stock
      is subject to certain conditions, including the requirement that there shall
      be
      an effective registration statement qualifying the resale of the common stock
      to
      be issued to the holders of the convertible debentures in lieu of a cash
      interest payment. All overdue accrued and unpaid interest under the convertible
      debentures were to be subject to a late fee at the rate of 18% per annum.





For
      accounting purposes, the proceeds from the issuance of these convertible
      debentures were primarily allocated to the fair value of warrants issued and
      the
      beneficial conversion feature. The fair value of the warrants was calculated
      using the Black Scholes option model using assumptions as disclosed in note
      3(o). The remaining value of the proceeds of $3 was allocated to debt and was
      accreted to the redemption value of the convertible debentures over the period
      from the date of issuance to the initial maturity dates of May 19, 2005 and
      July
      16, 2006.





During
      the year ended July 31, 2004, $1,691,667 of principal and $41,270 of interest
      were converted into common shares resulting in the issuance of 13,601,799 common
      shares. Interest accretion of $1,732,935 was charged in the statement of
      operations as interest expense upon conversion of convertible debentures.





During
      the year ended July 31, 2005, $160,000 of principal and interest and were
      converted into common shares resulting in the issuance of 6,106,143 common
      shares. Interest accretion of $274,999 was charged in the statement of
      operations as interest expense upon conversion of the convertible debentures.





During
      the year ended July 31, 2006, the remaining $115,000 of principal and $19,627
      of
      accrued interest were converted into 4,286,665 common shares of the
      Company.





(b)
            $3,493,590
                - 11% discounted convertible debentures issued on December 24, 2003
                - On
                December 24, 2003, the Company closed a private placement of discounted
                unsecured convertible debentures in the aggregate principal amount
                of
                $3,493,590. The Company also issued 7,939,978 warrants exercisable
                at
                $0.25 (subject to adjustment pursuant to the anti-dilution provisions
                contained in the warrants) with an expiry period of 5 years. The
                Company
                issued the convertible debentures at a 22% original issue discount
                from
                the face principal amount (based on a notional interest rate of 11%
                per
                annum for each year of the two-year term of the debentures), resulting
                in
                gross proceeds of $2,725,000. The discount of $768,590 was netted
                against
                the face value of the debentures and was to be amortized over the
                maturity
                period. Advisors to the transaction received a cash commission of
                $218,000
                and 109,000 three year share purchase warrants exercisable at a price
                of
                $0.25 each (subject to adjustment pursuant to the anti-dilution provisions
                contained in the warrants). The fair value of these warrants at the
                date
                of grant was estimated at $15,699, using the Black-Scholes option
                valuation model using the volatility 141%, risk free interest rate
                3.28%,
                expected life of warrants 3 years. In addition, expenses of $46,894
                for
                professional fees related to this transaction were incurred. The
                discounted convertible debentures did not otherwise bear interest,
                and
                were to mature on April 1, 2006. The outstanding principal amount
                of each
                debenture was convertible at any time into shares of the Company's
                common
                stock, in whole or in part, at the option of the holder of the debenture
                at a set price of $0.22 per share (subject to adjustment pursuant
                to the
                anti-dilution provisions contained in the debentures). The Company
                was to
                make the monthly redemption payments of $145,566 over two years in
                cash
                unless during the twenty trading day prior notice period immediately
                prior
                to the applicable monthly redemption date the Company irrevocably
                notified
                the holder that it would issue underlying shares in lieu of cash
                at a
                conversion price equal to the lesser of:





i.
            the
                set price of $0.22 per share (subject to adjustment pursuant to the
                anti-dilution provisions contained in the debentures), and





ii.
            85%
                of the average of the closing prices of the Company's common stock
                for
                twenty days immediately preceding the applicable monthly redemption
                date,
                provided that certain conditions are met, including the condition
                that the
                underlying shares of common stock shall have been registered under
                the
                Securities Act of 1933, as amended.





In
      addition to the anti-dilution provisions, should the
      Company, at any time while these debentures are outstanding, offer, sell, grant
      any option to purchase or offer, sell or grant any right to reprice its
      securities, or otherwise dispose of or issue any common stock or any equity
      or
      equity equivalent securities (including any equity, debt or other instrument
      that is at any time over the life thereof convertible into or exchangeable
      for
      common stock) entitling any person to acquire common shares of the Company,
      at
      an effective price per share less than the set price of $0.22 per share, then,
      the set price shall be adjusted for such conversions.


-43-
 **SMARTIRE
            SYSTEMS INC.**
 **Notes
            to Consolidated Financial Statements**
 (Expressed
            in United States dollars)
 (Prepared
            in accordance with U.S. generally accepted accounting principles)
 
 **Years
            ended July 31, 2006, 2005 and 2004**
 **10.**
                  **Convertible
                      debentures (continued):**


For
      accounting purposes, the proceeds from the issuance of these convertible
      debentures were allocated to the fair value of the warrants issued and the
      intrinsic value of the beneficial conversion feature which amounted to $861,351
      and $1,595,672, respectively. The fair value of the warrants was calculated
      using the Black-Scholes option valuation model using assumptions consistent
      with
      those disclosed in note 3(o). The remaining proceeds of $266,977 was allocated
      to debt and was to be accreted to the redemption value of the convertible
      debentures over the maturity period. Monthly redemption payments for February,
      March, April and May 2004 were made in shares of the Company, except for one
      cash payment of $14,583. Monthly redemption payments of $145,566 for each of
      June and July 2004 were made in cash. During the year ended July 31, 2004,
      holders of discounted convertible debentures also converted $273,000 of
      convertible debentures into common shares. This resulted in additional interest
      accretion of $240,085. During the year ended July 31, 2004, interest accretion
      of $1,206,762 was charged to the statement of operations as interest expense.




During
      August 2004, the Company defaulted on payments to holders of its discounted
      convertible debentures. In response to the default, certain debenture holders
      filed legal actions against the Company. On September 24, 2004, the Company
      and
      holders of the discounted convertible debentures signed an agreement which
      provided for: withdrawal of legal action; an immediate exercise of 18,226,274
      warrants at $0.03 for gross proceeds to the Company of $546,788; conversion
      of
      $734,388 of discounted debentures into 24,479,630 common shares and a lock-up
      provision that established a daily limit on the number of shares that could
      be
      traded by the debenture holders. In addition, the holders of $308,444 of
      discounted debentures converted these debentures to common shares. Between
      April
      27, 2005 and May 23, 2005, the Company entered into redemption, release and
      settlement agreements with holders of the Company's discounted convertible
      debentures. Pursuant to such redemptions, the Company made cash payments of
      $860,929 (including a 20% premium amounting to $76,333), and issued 9,738,759
      shares of common stock which were issued at an effective conversion price of
      $0.028 per share.





During
      the year ended July 31, 2005, $2,631,033 of principal was converted into common
      shares resulting in the issuance of 45,234,246 common shares. Interest accretion
      of $1,680,357 was charged to the statement of operations as interest expense
      upon conversion of the discounted convertible debentures.





On
      April
      21, 2005, one holder of this discounted debenture in the amount of $91,726
      provided the Company with notice of a summons with the Supreme Court of the
      State of New York.





On
      December 24, 2005, the Company signed a Settlement Agreement and Mutual Release
      with a convertible debenture holder that had previously provided the Company
      with notice of a summons with the Supreme Court of the State of New York. The
      holder had alleged the Company had refused to honor its request to convert
      the
      value of the debt of $91,726 into 9,268,875 common shares of the Company.





In
      settlement of the $91,726 debt, the Company issued consideration of 2,000,000
      common shares of the Company, representing a partial exercise of the debenture
      at the set conversion price of $0.028 per share plus $250,000 (less withholding
      taxes of $22,000) payable to the holder of the debenture, representing payment
      of the balance of the debenture and other good and valuable consideration of
      interest and penalties of $18,346. For accounting purposes, the Company has
      recorded a loss on settlement of debt of $214,274, which represents the
      aggregate consideration provided less the face value of the debt.





In
      addition to the above settlement, during the year ended July 31, 2006, the
      remaining principal balance of $176,735 was converted into 6,311,964 common
      shares of the Company.





(c)
            $195,000
                - 5% convertible debentures and $2,500,000 - 5% convertible debenture
                issued on December 15, 2004.




On
      December 15, 2004 the Company closed two private placements of 5% convertible
      debentures, $195,000 maturing on December 15, 2006 and $2,500,000 maturing
      on
      December 15, 2007, for gross proceeds of $2,695,000 and net cash proceeds of
      $2,394,644. Advisors to the transactions received cash commissions of $279,250.
      Additional expenses related to these offerings were $21,106. The financing
      cost
      is amortized over the life of the convertible debentures.




Principal
      under the convertible debentures is convertible at the option of the holder in
      whole
      or in part and from time to time at a conversion price equal to the lesser
      of:




·
            $0.036
                or;




·
            an
                amount equal to 80% of the lowest closing bid price of our common
                stock,
                as quoted on Bloomberg, L.P., for the five trading days immediately
                preceding the conversion date, subject to adjustment as provided
                for in
                the debentures.





The
      Company also has the right to redeem the convertible debentures, in whole or
      in
      part, at 120% of the face value of each convertible debenture. For every
      $100,000 redeemed, the investor was to receive 50,000 redemption warrants.
      The
      redemption warrants, if issued, were to be exercisable at 120% of the closing
      bid price as reported by Bloomberg, L.P. for the trading day immediately
      preceding the Closing Date.





For
      accounting purposes, the Company calculated the intrinsic value of the
      beneficial conversion feature amounting to $730,847 ($677,966 relating to the
      $2,500,000 debenture and $52,881 relating to the $195,000 debenture) and
      recorded it as additional paid-in capital. The remaining value of $1,964,153
      ($1,822,034 relating to the $2,500,000 debenture and $142,119 relating to the
      $195,000 debenture) was recorded as a liability and was to be accreted to its
      aggregate face value of $2,695,000 over the maturity period.





On
      March
      22, 2005, the $2,500,000 debenture was repaid for $2.5 million from the proceeds
      from the issuance of 25,000 mandatory redeemable, convertible preferred stock
      for which the Company received gross proceeds of $4 million. No redemption
      warrants were issued as the preferred shares were issued to the same investor
      as
      the $2.5 million convertible debenture. The Company has accounted for this
      transaction as an extinguishment of debt under EITF 00-27, Issue 12(b). As
      at
      the date of extinguishment, management determined the intrinsic value of the
      conversion feature to be $671,642, which was the reacquisition price allocated
      to the conversion feature, and therefore the fair value of the debt on
      extinguishment date was $1,828,358. The carrying value of the debt at the date
      of extinguishment was 1,870,704 (which included $48,670 of accretion interest
      incurred during the year ended July 31, 2005). The difference between the
      carrying value of the liability and the fair value of the debt on the
      extinguishment date resulted in a net gain on extinguishment of the debenture
      of
      $42,346 and has been reported as a gain on settlement of convertible debentures
      for the year ended July 31, 2006.


-44-
 **SMARTIRE
            SYSTEMS INC.**
 **Notes
            to Consolidated Financial Statements**
 (Expressed
            in United States dollars)
 (Prepared
            in accordance with U.S. generally accepted accounting principles)
 
 **Years
            ended July 31, 2006, 2005 and 2004**
 **10.**
                  **Convertible
                      debentures (continued):**


Interest
      on the remaining principal under the convertible debentures that aggregate
      $195,000 is payable semi-annually beginning June 15, 2005 and every subsequent
      six month period that the principal balance remains unpaid. During the year
      ended July 31, 2005, the Company was in default on the loan as a result of
      not
      filing an effective registration statement for this convertible debenture.
      As a
      result of the default, the Company accreted the original assigned debt component
      to its full face value, resulting in interest expense of $52,881 being charged
      to the statement of operations during the year ended July 31, 2005.




(d)
            $1,500,000
                - 5% convertible debenture issued on May 20, 2005





On
      May
      20, 2005, the Company entered into a Securities Purchase Agreement to issue
      a
      $1,500,000 5% debenture convertible at the option of the holder at $0.028 per
      share that matures on September 1, 2006. Principal was to be due and payable
      in
      12 equal installments of $125,000 commencing October 1, 2005 and subsequent
      installments were to be due and payable on the first day of each calendar month
      thereafter until the outstanding principal balance is paid in full. Interest
      on
      the outstanding principal balance is due and payable monthly, in arrears,
      commencing on August 1, 2005 and will continue to be payable on the first day
      of
      each calendar month thereafter that any amounts under the convertible debenture
      remain payable. Between April 25 and 29, 2005, funds for $1,100,000 of the
      convertible debenture were placed in escrow with the Company's legal council.





During
      the year ended July 31, 2006, $80,000 of principal was converted into 2,857,143
      common shares.





For
      accounting purposes, the Company calculated the intrinsic value of the
      beneficial conversion feature amounting to $1,499,999 and recorded it as
      additional paid-in capital. The remaining $1 was recorded as a liability and
      was
      fully accreted to its face value of $1,500,000 as at July 31, 2006, as a result
      of being in default prior to receiving an extension on deferral of all principal
      and interest payments under this convertible debenture as described
      below.





As
      at
      July 31, 2006, the Company was in arrears on payments of principal and interest
      in the amount of $1,420,000 and $82,477 in principal and interest respectively.
      The Company has obtained an extension from the principal holder to defer all
      principal and interest payments under this convertible debenture until November
      1, 2006.




(e)
            $30,000,000
                - 10% convertible debentures issued on June 23, 2005





On
      June
      30, 2005, the Company closed a private placement of unsecured convertible
      debentures in the aggregate principal amount of $30.0 million. The Company
      paid
      a cash fee of $3.0 million for the convertible debentures and a cash structuring
      fee of $50,000 in connection with the Securities Purchase Agreement. The Company
      also issued 62.5 million warrants exercisable at $0.16 per share (subject to
      adjustment pursuant to adjustment as described below) with an expiry period
      of
      five years. For accounting purposes, the proceeds from the issuance of these
      convertible debentures were allocated to the fair value of the warrants issued
      and the intrinsic value of the beneficial conversion feature which amounted
      to
      $4,676,089 and $4,098,310 respectively. The fair value of these warrants was
      estimated using the Black-Scholes option valuation model using assumptions
      consistent with those disclosed in note 3 (o). The convertible debentures bear
      interest at 10% per annum, calculated on the basis of a 360-day year, and will
      mature on June 23, 2008. The outstanding principal amount of each debenture
      were
      to be convertible into shares of the Company's common stock, in whole or in
      part, at the option of the holder of the debenture at a set price of $0.1125
      per
      share (subject to a adjustment as described below).





On
      December 30, 2005, the Company amended certain of its terms and conditions
      relating to the $30,000,000, 10% convertible debentures entered into on June
      23,
      2005. Terms and conditions have been amended as follows:




i.
            Principal
                and interest payments due in cash are eliminated during the term
                of the
                debentures;




ii.
            Debentures
                are convertible into shares of Common Stock at the option of the
                Holder at
                the lesser of $0.1125 and a 4.5% discount to market. Market is based
                on
                the lowest Closing Bid Price of the Common Stock for the five (5)
                trading
                days immediately preceding the date the conversion notice is provided;




iii.
            If
                at the end of the three year term, the debentures are not fully converted,
                the debenture holders must convert the balance due into shares of
                the
                Company up to their beneficial ownership limitation of 4.9%. The
                remaining
                balance is due in cash by the
                Company;




iv.
            Interest
                is convertible into shares of the Company’s Common Stock and is calculated
                as ninety-five and one-half percent (95.5%) of the 5 day average
                of the
                Closing Bid Price of the Common Stock for the five (5) trading days
                immediately preceding the date the interest conversion is made. The
                holder
                may not receive shares of common stock as payment of interest hereunder
                to
                the extent such conversion or receipt of such interest payment would
                result in the holder beneficially owning in excess of 4.9% of the
                then
                issued and outstanding stock of the Company. All accrued but unpaid
                interest is due on June 23, 2008. As at July 31, 2006, the Company
                has
                accrued $1,750,000 in interest based on the terms of the amended
                convertible debenture;




v.
            The
                Company has the right to redeem all or any portion of the outstanding
                principal and accrued interest under the convertible debentures at
                a 20%
                premium prior to the Maturity Date provided that our Closing Bid
                Price as
                reported by Bloomberg, LP, is less than the Fixed Conversion Price
                at the
                time of the Redemption Notice. The Debenture holder shall receive
                a
                warrant to purchase one million (1,000,000) shares of the Company’s Common
                Stock for every One Hundred Thousand Dollars ($100,000) redeemed,
                pro rata
                (the “Warrant”). The Warrant shall be exercisable on a “cash basis” and
                have an exercise price of one hundred ten percent (110%) of the Closing
                Bid Price of the Company’s Common Stock on the date the Company provides
                the Redemption Notice.


-45-
 **SMARTIRE
            SYSTEMS INC.**
 **Notes
            to Consolidated Financial Statements**
 (Expressed
            in United States dollars)
 (Prepared
            in accordance with U.S. generally accepted accounting principles)
 
 **Years
            ended July 31, 2006, 2005 and 2004**
 **10.**
                  **Convertible
                      debentures (continued):**


The
      Company filed a Registration Statement on Form SB-2 on January 11, 2006 and
      subsequently amended Registration Statement on Form SB-2/A on February 27,
      2006
      and April 11, 2006 to register the underlying securities. The Company
      subsequently withdrew the registration statement on September 19, 2006.
      Previously, the Company had been in violation of certain terms of its original
      debentures due to the withdrawal of the Registration Statement on Form SB-2
      on
      September 23, 2005 which was filed on July 22, 2005 to register the underlying
      securities under the terms of the original debentures.




The
      Company has reviewed the amended terms of the $30 million convertible debentures
      under the provisions in EITF 00-19 and SFAS 133 and determined that the warrants
      issued in connection with the debt agreements should be accounted for as
      derivative instrument liability, rather than as equity, and the conversion
      options related to the debt, together with other embedded derivative
      instruments, have been bifurcated from the debt hosts and accounted for
      separately as derivative instrument liabilities (note 11).





In
      the
      event of any issuances of shares of common stock or rights, options, warrants
      or
      securities convertible or exercisable into common stock at a price per share
      of
      common stock less than the conversion price of the convertible debentures or
      exercise price of the warrants, the conversion price of such convertible
      debentures and warrants will be reduced to the lower purchase price. In
      addition, the conversion price of the convertible debentures and warrants will
      be subject to adjustment in connection with any subdivision, stock split,
      combination of shares or recapitalization. No adjustment will be made as a
      result of exercises of options, issued prior to June 23, 2005, to purchase
      shares of common stock issued for compensatory purposes pursuant to any of
      our
      stock option or stock purchase plans.




The
      10%
      convertible debentures provide for various events of default that would entitle
      the holders to require the Company to immediately repay 100% of the outstanding
      principal amounts, plus accrued and unpaid interest, in cash, or shares of
      the
      Company's common stock with a conversion price reduced to 20% of the volume
      weighted average price of the Company's shares of common stock on June 30,
      2005.
      If an event of default occurs, the Company may be unable to immediately repay
      the amount owed, and any repayment may leave the Company with little or no
      working capital in its business.





The
      Company will be considered in default of the 10% convertible debentures if
      any
      of the following events, among others, occurs:





i.
            Failure
                to pay any amount due under a convertible debenture and such failure
                to
                pay remains uncured for 10 days;





ii.
            Failure
                to observe or perform any other covenant, agreement or warranty contained
                in, or otherwise commit any breach or default of any provision of
                the 10%
                convertible debentures;





iii.
            The
                Company or any of its subsidiaries become bankrupt or insolvent;





iv.
            Breach
                any of the Company's obligations under any other debt or credit agreements
                involving an amount exceeding $250,000;





v.
            The
                Company's common stock ceases to be eligible for quotation on the
                principal market for its common stock (currently the OTC Bulletin
                Board),
                and fails to be quoted or listed for trading on another principal
                market
                (defined to mean the OTC Bulletin Board, the New York Stock Exchange,
                American Stock Exchange, the NASDAQ Small-Cap Market or the NASDAQ
                National Market) within 20 trading days;





vi.
            The
                Company or any subsidiary experiences a change of control;





vii.
            The
                Company fails to file a registration statement within 60 days from
                June
                23, 2005 with the Securities and Exchange Commission and such registration
                statement is not declared effective by the SEC within 120 days after
                filing;





viii.
            If
                the effectiveness of the registration statement lapses for any reason
                or
                the holder of the convertible debentures is not permitted to resell
                the
                underlying shares of common stock, in either case, for more than
                five
                trading days or an aggregate of eight trading days and;





ix.
            Failure
                to deliver common stock certificates to a holder prior to the fifth
                trading day after a conversion date or we fail to provide notice
                to a
                holder of our intention not to comply with requests for conversions
                of the
                convertible debentures; or failure to deliver the payment in cash
                pursuant
                to a `buy-in' within three days after notice is claimed delivered.
                A
                "buy-in" occurs if we fail to issue shares of Common Stock within
                five
                trading days after a notice of conversion is received and the holder
                requesting conversion purchases (in an open market transaction or
                otherwise) Common Stock to deliver in satisfaction of a sale by such
                holder of the underlying shares of Common Stock that the holder
                anticipated receiving upon such conversion.


-46-
 **SMARTIRE
            SYSTEMS INC.**
 **Notes
            to Consolidated Financial Statements**
 (Expressed
            in United States dollars)
 (Prepared
            in accordance with U.S. generally accepted accounting principles)
 
 **Years
            ended July 31, 2006, 2005 and 2004**
 **10.**
                  **Convertible
                      debentures (continued):**


The
      convertible debentures contain a contractual restriction on beneficial share
      ownership. They provide that the debenture holders may not convert the
      convertible debentures, or receive shares of the Company's common stock as
      payment of interest, to the extent that the conversion or receipt of the
      interest payment would result in the debenture holders, together with their
      respective affiliates, beneficially owning in excess 4.9% of the Company's
      then
      issued and outstanding shares of common stock, except upon providing the Company
      with not less than 65 days prior notice.





In
      connection with the execution of the Securities Purchase Agreement, on June
      23,
      2005, the Company entered into a Registration Rights Agreement with Cornell
      Capital Partners, Highgate House Funds, Ltd. and LCC Global Limited. In
      connection with the Restructuring on December 30, 2005, the Company, Starome
      Investments Limited, Xentennial Holdings Limited and Staraim Enterprises
      Limited, entered into an Amended and Restated Registration Rights Agreement.
      Pursuant to the Amended and Restated Registration Rights Agreement the Company
      agreed to prepare and file, no later than 30 days after the date of the Amended
      and Restated Registration Rights Agreement, with the SEC a registration
      statement on Form S-1 or SB-2 (or, if the Company is then eligible, on Form
      S-3)
      under the Securities Act of 1933, for the resale by the holders of the 10%
      convertible debentures of 850 million shares of the Company’s common stock to be
      issued upon conversion of the convertible debentures.





Of
      the
      total financing fee of $3,050,000, $2,165,500 was charged to deferred financing
      costs and $884,500 was charged to additional paid in capital, based on the
      Company’s determination of estimated costs of raising capital. The deferred
      financing costs are amortized over the life of the convertible
      debentures.





During
      the year ended July 31, 2006, the Company recorded $3,043,660 (2005 -
      $163,3 15,
      2004
      - nil) respectively of interest expense relating to interest accretion and
      charged it to the statement of operations.





**11.**
            **Derivative
                financial instruments:**





As
      a
      result of the amendment to the $30,000,000, 10% convertible debentures on
      December 30, 2005, described in Note 10(e), management of the Company determined
      the conversion feature and the 62,500,000 detachable warrants included in the
      agreement, no longer met the requirements of EITF Issue No. 00-19. Accordingly,
      the Company has accounted for the conversion feature and warrants as derivative
      financial instruments under FAS 133, and as of December 30, 2005 recorded as
      liabilities, the fair value of the conversion feature and warrants. Subsequent
      to December 30, 2005, such amounts are being re-measured on each balance sheet
      date based on the fair value of the conversion feature and the warrants with
      the
      adjustment charged to the statement of operations. The components of the
      derivative financial instrument liabilities are described separately
      below.





In
      accordance with EITF 96-19 and EITF 05-7, the Company compared the present
      value
      of the cash flows under the terms of the modified convertible debenture against
      the present value of the remaining cash flows at the time of modification under
      the terms of the original debenture. Included in the analysis was the change
      in
      the fair value of the embedded conversion option as required by EITF 05-7.
      The
      Company concluded that as the present values of the cash flows did not differ
      by
      more than 10%, the amended terms of the debentures are not considered
      substantially different than the original issued debentures, and thus was
      accounted as a modification of debt. Accordingly, the Company has concluded
      that
      the incremental fair value of the modified embedded conversion feature to be
      approximately $3,000,000. Therefore, the carrying value of the original
      debentures classified as a liability has been reduced by $3,000,000 and
      additional paid-in capital has been increased by the same. Interest accreted
      on
      the debentures will be increased in future periods as a result of this
      adjustment.





On
      December 30, 2005, the Company reclassified $7,000,000 from additional paid-in
      capital to derivative financial liability as this was the fair value of the
      conversion feature at the date of modification. The fair value of the conversion
      feature relating to the convertible debenture was estimated by the Company
      using
      valuation models based on the Company’s share price and other relevant
      assumptions. As at July 31, 2006, the Company revaluated the fair value of
      the
      conversion feature using the same valuation model and determined the revaluated
      fair value of this instrument to be $5,800,000, which is included in derivative
      financial instrument liability as at July 31, 2006. For the year ended July
      31,
      2006, the Company recorded a gain of $1,200,000 on the revaluation of liability
      for the conversion feature in the statement of operations and the amount is
      included in derivative instrument income. As at July 31, 2006, none of the
      holders of this convertible debenture had exercised their right to convert
      to
      common shares of the Company.





On
      December 30, 2005, the Company reclassified $3,565,066 from additional paid-in
      capital to derivative financial instrument liability as this was the fair value
      of the outstanding warrants discussed above at that date. The fair value of
      the
      warrants was estimated using the Black-Scholes option pricing model with the
      following assumptions as at December 30, 2005: dividend yield of 0%, expected
      volatility of 162%, risk-free interest rate of 3.9% and an expected life of
      4.5
      years. As at July 31, 2006, the Company revaluated the fair value of the
      outstanding warrants to $2,243,225. Similarly, the fair value of the warrants,
      as at July 31, 2006 was estimated using the Black-Scholes option pricing model
      with the following assumptions: dividend yield of 0%, expected volatility of
      157%, risk-free interest rate of 3.72% and an expected life of 4.0 years. For
      the year ended July 31, 2006, the Company recorded a gain of $1,321,841 on
      the
      revaluation of liability for warrants in the statement of operations and is
      included in derivative instrument income. As at July 31, 2006, none of the
      62,500,000 detachable warrants have been exercised by the holder.




-47-
 **SMARTIRE
            SYSTEMS INC.**
 **Notes
            to Consolidated Financial Statements**
 (Expressed
            in United States dollars)
 (Prepared
            in accordance with U.S. generally accepted accounting principles)
 
 **Years
            ended July 31, 2006, 2005 and 2004**
 **12.**
            **Preferred
                shares subject to mandatory redemptions:**





On
      March
      22, 2005, the Company closed a private placement of 25,000 5% convertible Class
      A preferred shares for gross proceeds of $4,000,000 and net cash proceeds of
      $3,865,000. Advisors to the transactions received a cash commission of $115,000.
      Additional expenses related to this offering were $20,000. Proceeds of
      $2,850,000 from this financing were used to settle a $2,500,000 convertible
      debenture entered into on December 15, 2004 (as described in note 10(c)) and
      a
      $350,000 promissory note entered into on February 9, 2004.





For
      accounting purposes, these preferred shares have both a conversion and
      redemption feature. The beneficial conversion feature was recorded at its
      intrinsic value of $3,999,999 as at the date of entering the agreement. The
      beneficial conversion feature value was initially recorded as additional paid-in
      capital and the remaining value of $1 was recorded as a mezzanine item on the
      balance sheet. The carrying value of the preferred shares is being accreted
      to
      its face value of $4,000,000, over a period from the date of issuance to its
      maturity date of December 22, 2006. The accretion is charged to additional
      paid-in capital. Total financing costs of $145,000 was charged to additional
      paid-in capital as substantially all the value of preferred shares is treated
      as
      equity.





Principal
      under the convertible preferred shares may be converted into common shares
      by
      the holder in whole or in part from time to time at a conversion price of $0.01.
      Upon providing 3 business days advance written notice to holders, during which
      time the holder may elect to convert up to all of their convertible preferred
      stock, the Company may redeem up to 80% of the convertible preferred stock,
      in
      whole or in part, at 120% of the face value.





The
      holders of the preferred shares are entitled to receive dividends or
      distributions on a pro rata basis according to their holdings of the preferred
      shares when and if declared by our board of directors, in the amount of 5.0%
      per
      year. Dividends will be paid in cash and are cumulative. As at July 31, 2006,
      no
      dividends have been declared by the Company’s board of directors. No declared
      and unpaid dividends will bear or accrue interest. Upon the Company's
      liquidation, dissolution, or winding-up, whether voluntary or involuntary,
      before any distribution or payment is made to any of the holders of common
      stock
      or any series of preferred stock, holders of the preferred shares are entitled
      to receive out of the Company's assets, an amount equal to $160 per share of
      the
      preferred share, plus all declared and unpaid dividends thereon, for each share
      of the preferred share held by the holder. As at July 31, 2006, the aggregate
      liquidation value of the preferred shares amounted to $4,147,613 (2005 -
      $4,072,309). Under the Registration Rights Agreements for the preferred shares,
      the Company would be considered in default of the preferred shares, if the
      Company failed to file a registration statement with the SEC within 30 days
      from
      the date of the agreement of March 22, 2005 and such registration statement
      is
      not declared effective by the SEC within 120 days after filing. As at July
      31,
      2006, the holders of the preferred shares temporarily agreed that the Company
      was not in default pending the filing of a new registration statement and that
      they waived their rights under the default provisions affected by this
      non-compliance.





During
      the year ended July 31, 2006, holders of the preferred shares converted 902
      Class A preferred shares, valued at $144,320, into 14,432,000 common shares
      of
      the Company. In conjunction with this conversion, the Company also reclassified
      $144,320, the pro-rata amount of the beneficial conversion feature initially
      recorded in additional paid-in capital to share capital. As at July 31, 2006,
      the balance of the preferred shares subject to mandatory redemption consisted
      of
      the initial allocation of $1 (2005 - $1) discussed above, cumulative, undeclared
      but accrued dividends of $291,933 (2005 - $72,309), and accumulated accretion
      of
      $190,194 (2005 - $Nil), net of amounts converted to common shares. During the
      year ended July 31, 2006, the Company recorded $334,514 (2005 - $Nil) of
      accretion on the preferred shares which was charged to additional paid-in
      capital. The
      balance of the remaining face value of the convertible preferred stock, being
      $3,855,680, is due and payable at maturity on December 22, 2006.





**13.**
            **Share
                capital:**





(a)
            Authorized:





On
      December 10, 2004, the Company's authorized common share capital was increased
      to an unlimited number of shares pursuant to a special resolution of the
      shareholders adopted at the annual and special annual meeting of the Company
      held on December 10, 2004. The Company also has 100,000 preferred shares
      authorized for issuance, of which 25,000 were issued during the year ended
      July
      31, 2005 (note 12).





On
      March
      18, 2005, the Company filed articles of amendment to its articles of
      incorporation that set forth all the rights and preferences of its series A
      5%
      convertible preferred stock.





(b)
            Common
                share and unit offerings:





During
      the year ended July 31, 2005, the Company received financing from the drawdown
      on its equity line as the Company issued 78,887,710 shares at effective prices
      ranging from $0.028 to $0.05 per share pursuant to its former $15 million
      Standby Equity Distribution Agreement for gross proceeds of $2,725,000 and
      net
      proceeds of $2,584,250. In addition, $78,484 was reclassified from additional
      paid-in capital to share financing expense to record the proportionate share
      of
      costs on the equity line against the gross amount of draw downs. The issuance
      of
      these shares reduced the set price that the holders of the discounted and 8%
      convertible debentures could convert the convertible debentures into common
      stock and the exercise price of 14,612,907 warrants outstanding to $0.028.





(c)
            On
                January 19, 2005, the Company issued 5,752,945 shares of common stock
                to
                certain members of senior management of the Company for services
                rendered.
                The fair value of the shares at the date of issuance based on the
                closing
                bid price quoted on the OTC Bulletin Board (OTCBB) was $0.03 per
                share
                amounting to $172,588. In addition, on June 21, 2005, the Company
                issued
                1,011,260 shares of common stock to a certain member of senior management
                of the Company for services rendered. The fair value of the shares
                at the
                date of issuance was $0.088 per share amounting to $88,990.





(d)
            Standby
                equity distribution agreements:





On
      June
      1, 2004, the Company filed a registration statement with the Securities and
      Exchange Commission to register its $15 million equity line of credit that
      was
      declared effective on June 14, 2004. On June 1, 2004, the Company issued
      3,605,769 shares at an effective price of $0.104 per share as payment for the
      $365,000 commitment fee and $10,000 placement agency fee related to the Standby
      Equity Distribution Agreement. The Company also incurred additional costs of
      $35,420 in fees to prepare and file the registration statement. During the
      year
      ended July 31, 2004, the Company effected three draw downs of $250,000 each
      at
      prices of $0.090, $0.065 and $0.059, which resulted in the issuance of
      10,861,220 common shares and net proceeds of $689,399. In addition, the Company
      incurred an additional $60,000 as a financing expense to advisors of the Standby
      Equity Distribution Agreement. On May 19, 2005, this $15.0 million Standby
      Equity Distribution Agreement was terminated by the parties.


-48-
 **SMARTIRE
              SYSTEMS INC.**
 **Notes
              to Consolidated Financial Statements**
 (Expressed
              in United States dollars)
 (Prepared
              in accordance with U.S. generally accepted accounting principles)
 
 **Years
              ended July 31, 2006, 2005 and 2004**
 **13.**
                    **Share
                        capital (continued):**


On
      May
      20, 2005, the Company entered into a Standby Equity Distribution Agreement
      with
      Cornell Capital which provides for the potential issuance and sale of up to
      $30.0 million of the Company's common stock to Cornell Capital. This $30.0
      million Standby Equity Distribution Agreement was terminated by the parties
      on
      June 23, 2005 and replaced with a $160.0 million equity line of credit.





In
      addition, the Company paid Yorkville Advisors Management, LLC, the general
      partner of Cornell Capital a cash fee of $16.0 million in connection with the
      $160.0 million Standby Equity Distribution Agreement.





On
      June
      2, 2005, the Company issued 75,188 shares at an effective price of $0.133 per
      share as payment for a $10,000 placement agency fee related to the Standby
      Equity Distribution Agreement. The Company also incurred additional costs of
      $74,086 to prepare and file the registration statement. These additional costs
      were accounted for as deferred financing costs as at July 31, 2005.





On
      June
      23, 2005, the Company entered into a $160 million equity line of credit with
      Cornell Capital. On September 23, 2005, the Company formally requested that
      the
      Registration Statement on Form SB-2 previously filed with the SEC on July 22,
      2005 be withdrawn. The Registration Statement was not previously declared
      defective by the SEC and no securities were sold pursuant to the Registration
      Statement.





On
      December 30, 2005, the Company entered into an agreement to terminate its $160.0
      million Standby Equity Distribution Agreement (“SEDA”) and enter into a new
      $100.0 million SEDA with Cornell Capital. Terms of the agreement which remained
      the same as the previous agreement are as follows:




i.
            Once
                the registration statement covering the underlying shares of common
                stock
                becomes effective, the Company may request an advance every seven
                trading
                days.




ii.
            The
                amount of each advance is subject to a maximum amount of $3 million
                every
                seven trading days.




iii.
            A
                closing will be held six trading days after such written notice at
                which
                time the Company will deliver shares of common stock and Cornell
                Capital
                Partners will pay the advance
                amount.




iv.
            For
                each share of common stock purchased under the equity line of credit,
                Cornell Capital Partners will pay 98% of the lowest closing bid price
                on
                the OTC Bulletin Board or other principal market on which the Company’s
                common stock is traded for the five days immediately following the
                notice
                date.




v.
            During
                the term of the $100 million Standby Equity Distribution Agreement,
                subject to certain exceptions for issuances resulting from prior
                commitments, the Company cannot, without the prior consent of Cornel
                Capital Partners:




a.
            Issue
                or sell any common stock or preferred stock with or without
                consideration;




b.
            Issue
                or sell any preferred stock, warrant, option, right, contract, call,
                or
                other security or instrument granting the holder thereof the right
                to
                acquire common stock with or without
                consideration;




c.
            Enter
                into any security instrument granting the holder a security interest
                in
                any of our assets; or




d.
            File
                any registration statements on Form
                S-8.




Provided
      the Company provides Cornell Capital Partners two days prior written notice,
      the
      foregoing restrictions will exclude options, warrants of other securities
      convertible or exchangeable into shares of the Company’s common stock that were
      outstanding prior to December 30, 2005.




Cornell
      Capital Partners, and each of its directors, officers, partners, employees
      and
      agents, is entitled to customary indemnification from the Company for any losses
      or liabilities suffered by any such person based upon material misstatements
      or
      omissions from the $100 million Standby Equity Distribution Agreement,
      registration statement and the prospectus, except as they relate to information
      supplied by Cornell Capital Partners to us for inclusion in the registration
      statement and prospectus.




Under
      the
      $100 million Standby Equity Distribution Agreement, Cornell Capital Partners
      may
      not own more than 9.9% of the Company’s outstanding common stock at ay
      time.





Terms
      which have been changed from the $160 million Standby Equity Distribution
      Agreement are:


-49-
 **SMARTIRE
                SYSTEMS INC.**
 **Notes
                to Consolidated Financial Statements**
 (Expressed
                in United States dollars)
 (Prepared
                in accordance with U.S. generally accepted accounting principles)
 
 **Years
                ended July 31, 2006, 2005 and 2004**
 **13.**
                      **Share
                          capital (continued):**


i.
            The
                Company may continue to request advances until Cornell Capital Partners
                has advanced $100 million or 5 years have elapsed from the date a
                registration statement covering the underlying shares of common stock
                becomes effective.




ii.
            Term
                of the agreement is five years from the date of effectiveness from
                24
                months (or a five year period if the Company files an amendment to
                the
                then effective registration statement or a new registration statement
                is
                declared effective the 24thand 48thmonth after June 23, 2005);




iii.
            Fees
                on draw downs reduced to 2.5% from
                5%;




Based
      on
      extensive discussions with the staff of the SEC, the Company has not registered
      the equity line of credit. The Company may not request advances under the $100.0
      million equity line of credit until the underlying shares of its common stock
      are registered with the SEC and it is uncertain whether it will register such
      underlying shares until all of the outstanding principal and accrued and unpaid
      interest on the 10% convertible debentures have been either converted by the
      holders or paid in full by the Company, which must occur on or before July
      23,
      2008. Due to the uncertainty as to when the Company will be able to access
      its
      equity line, it has expensed fees related to the $160.0 million equity line
      of
      credit.





(e)
            Stock-based
                compensations plans:





At
      July
      31, 2006, the Company had ten stock-based compensation plans that are described
      below:





i.
            Under
                the "2000 US Stock Incentive Plan" the Company may grant options
                to its
                employees, directors and consultants for up to 200,000 common shares.




ii.
            Under
                the "2000 Stock Incentive Plan" the Company may grant options to
                its
                employees, directors and consultants for up to 800,000 common shares.




iii.
            Under
                the "2002 US Stock Incentive Plan" the Company may grant options
                to its
                employees, directors and consultants for up to 100,000 common shares.




iv.
            Under
                the "2002 Stock Incentive Plan" the Company may grant options to
                its
                employees, directors and consultants for up to 900,000 common shares.




v.
            Under
                the "2003 US Stock Incentive Plan" the Company may grant options
                to its
                employees, directors and consultants for up to 2,000,000 common shares.




vi.
            Under
                the "2003 Stock Incentive Plan" the Company may grant options to
                its
                employees, directors and consultants for up to 8,000,000 common shares.




vii.
            Under
                the "2004 US Stock Incentive Plan" the Company may grant options
                to its
                employees, directors and consultants for up to 3,000,000 common shares.




viii.
            Under
                the "2004 Stock Incentive Plan" the Company may grant options to
                its
                employees, directors and consultants for up to 50,000,000 common
                shares.




ix.
            Under
                the “2005 US Stock Incentive Plan” the Company may grant options to its
                employees, directors and consultants for up to 10,000,000 common
                shares.




x.
            Under
                the “2005 Stock Incentive Plan” the Company may grant options to its
                employees, directors and consultants for up to 25,000,000 common
                shares.





The
      options currently outstanding under the “2005 US Stock Incentive Plan” and the
“2005 Stock Incentive Plan” vest over two years, except options granted to
      directors, which vest immediately.





The
      options currently outstanding under the "2003 and 2004 US Stock Incentive Plan"
      and the "2003 and 2004 Stock Incentive Plan" generally vest immediately. The
      options currently outstanding under the "2000 and 2002 Stock Incentive Plan"
      have vested as at July 31, 2006. The exercise price of each option is generally
      based on the fair value of the common stock at the date of grant. These options
      have a five year term.


2006
              
              
              2005
              
              2004Weighted
              
              
              
              
              
              Weighted
              
              
              
              
              
              WeightedAverage
              
              
              
              
              
              Average
              
              
              
              
              
              AverageExercise
              
              
              
              
              
              Exercise
              
              
              
              
              
              ExerciseShares
              
              
              Price
              
              
              Shares
              
              
              Price
              
              
              Shares
              
              
              PriceOutstanding,
                  beginning of year
              
              
              41,972,802
              
              $
              0.13
              
              
              8,469,800
              
              $
              0.63
              
              
              1,714,400
              
              $
              2.54Options granted
              
              
              28,500,000
              
              
              0.10
              
              
              40,520,000
              
              
              0.03
              
              
              9,169,600
              
              
              0.20Options exercised
              
              
              (2,060,000
              )
              
              (0.03
              )
              
              (6,059,998
              )
              
              (0.03
              )
              
              (79,400
              )
              
              (0.20
              )Options forfeited
              
              
              (2,389,400
              )
              
              (0.64
              )
              
              (957,000
              )
              
              (1.01
              )
              
              (2,334,800
              )
              
              (0.38
              )Outstanding,
                  end of year
              
              
              66,023,402
              
              $
              0.10
              
              
              41,972,802
              
              $
              0.13
              
              
              8,469,800
              
              $
              0.63


-50-
 **SMARTIRE
                SYSTEMS INC.**
 **Notes
                to Consolidated Financial Statements**
 (Expressed
                in United States dollars)
 (Prepared
                in accordance with U.S. generally accepted accounting principles)
 
 **Years
                ended July 31, 2006, 2005 and 2004**
 **13.**
                      **Share
                          capital (continued):**


Options
                  outstanding
              
              
              Options
                  ExcercisableWeightedaverage
              
              
              Weighted
              
              
              
              
              
              Weightedremaining
              
              
              Average
              
              
              
              
              
              AverageRange
                  of
              
              
              Number
              
              
              contractual
              
              
              Exercise
              
              
              Number
              
              
              exerciseexercise
                  prices
              
              
              of
                  shares
              
              
              life
              
              
              Price
              
              
              exercisable
              
              
              price$0.03
                  - 0.04
              
              
              32,200,002
              
              
              3.41
              
              $
              0.03
              
              
              32,200,002
              
              $
              0.03$0.085
                  - 0.20
              
              
              32,875,800
              
              
              4.00
              
              
              0.12
              
              
              10,925,800
              
              
              0.15$0.52
                  - 1.00
              
              
              136,134
              
              
              1.46
              
              
              0.60
              
              
              136,134
              
              
              0.60$1.16
                  - 3.83
              
              
              811,466
              
              
              0.80
              
              
              2.21
              
              
              811,466
              
              
              2.21$0.03
                  - 3.83
              
              
              66,023,402
              
              
              3.67
              
              $
              0.10
              
              
              44,073,402
              
              $
              0.10




Where
      options issued after January 18, 2001 have an exercise price in a currency
      that
      is not either the (a) functional currency of the Company, or (b) the currency
      in
      which the employee is paid, the options are to be accounted for as variable
      plan
      options and compensation expense will be recorded equal to the changes in the
      market value of the underlying common shares at each reporting period. The
      Company normally grants options in U.S. dollars when the functional currency
      of
      the Company is the Canadian dollar. Most employees of the Company are paid
      in
      either Canadian dollars or British pounds sterling. Accordingly, these employee
      options are considered to be variable options.





The
      Company recognizes compensation expense for stock options, common stock and
      other instruments issued to non-employees for services received based upon
      the
      fair value of the equity instruments issued as the services are performed and
      the instrument is earned.





For
      the
      year ended July 31, 2006, the Company recorded a $3,087,145 (2005 - nil)
      recovery of stock compensation expense for variable awards which reduced
      engineering, research and development expenses by $1,269,686 (2005 - nil),
      general and administrative expenses by $1,554,337 (2005 - nil) and marketing
      expenses by $263,122 (2005 - nil). For the year ended July 31, 2005, the Company
      recorded a stock compensation expense for variable awards of $4,018,075, which
      increased engineering, research and development expenses by $1,273,100, general
      and administrative expenses by $1,975,925 and marketing expenses by
      $769,050.





(f)
            Warrants:





As
      at
      July 31, 2006, warrants outstanding were exercisable for 64,858,141 (2005 -
      64,988,141) common shares of the Company. The warrants entitle the holders
      to
      purchase common shares of the Company at prices ranging from $0.16 to $2.80
      per
      share and expire on various dates until June 22, 2010.





The
      exercise price of warrants issued were not less than the market price of the
      Company's common shares at the date of issuance.


2006
              
              
              2005
              
              
              2004Weighted-
              
              
              
              
              
              Weighted-
              
              
              
              
              
              Weighted-average
              
              
              
              
              
              average
              
              
              
              
              
              averageexercise
              
              
              
              
              
              exercise
              
              
              
              
              
              exerciseShares
              
              
              price
              
              
              Shares
              
              
              price
              
              
              Shares
              
              
              priceOutstanding,
                  beginning of year
              
              
              64,988,141
              
              $
              -
              
              
              37,483,485
              
              $
              0.20
              
              
              32,154,507
              
              $
              0.38Issued
              
              
              1,000,000
              
              
              0.16
              
              
              62,500,000
              
              
              0.16
              
              
              19,562,209
              
              
              0.21Exercised
              
              
              (1,100,000
              )
              
              0.10
              
              
              (34,884,744
              )
              
              0.03
              
              
              (12,463,231
              )
              
              0.25Expired
              
              
              (30,000
              )
              
              2.80
              
              
              (110,600
              )
              
              1.70
              
              
              (1,770,000
              )
              
              3.30Oustanding,
                  end of year
              
              
              64,858,141
              
              $
              0.16
              
              
              64,988,141
              
              $
              0.16
              
              
              37,483,485
              
              $
              0.20


-51-
 **SMARTIRE
                SYSTEMS INC.**
 **Notes
                to Consolidated Financial Statements**
 (Expressed
                in United States dollars)
 (Prepared
                in accordance with U.S. generally accepted accounting principles)
 
 **Years
                ended July 31, 2006, 2005 and 2004**
 **13.**
                      **Share
                          capital (continued):**


For
      the
      year ended July 31, 2004, the Company realized gross cash proceeds of $2,179,385
      and net cash proceeds of $2,101,015 from the exercise of warrants as follows:





i.
            On
                April 30, 2004, 500,000 warrants were exercised at $0.104 resulting
                in
                gross cash proceeds of $52,000 and net cash proceeds of $49,920.





ii.
            On
                October 27, 2003, the Company offered warrant holders who were issued
                warrants with an exercise price of $0.2645 on May 15, 2003 in connection
                with the convertible debenture a reduction in their exercise price
                to
                $0.20 plus one additional warrant at $0.20 if they exercised their
                warrants. A total of 3,290,596 warrants were exercised. In addition,
                the
                Company granted 194,000 additional warrants exercisable at a price
                of
                $0.20 per share for five years to a shareholder who also exercised
                their
                warrants. On November 6, 2003, the exercise price of the 7,478,635
                warrants initially granted at $0.2645 were reduced to $0.1771 and
                were
                exercised for gross proceeds of $1,324,466.





iii.
            During
                October and November 2003, the fair value of the 10,963,231 warrants
                of
                $1,601,970 initially recorded as additional paid in capital was
                reclassified to share capital on exercise of the warrants.





iv.
            On
                May 20, 2004, the Company realized gross cash proceeds of $120,000
                from
                the exercise of 1,000,000 warrants at an exercise price of $0.12
                per
                share.




On
      September 24, 2004, the holders of the discounted convertible debentures
      exercised 18,226,274 warrants at $0.03 for gross proceeds of $546,788, and
      net
      proceeds of $499,916. The fair value of these warrants of $1,017,299 initially
      recorded as additional paid-in-capital is reclassified to share capital on
      exercise of warrants. On May 5, 2005, a warrant holder exercised 714,286
      warrants at an exercise price of $0.10 for gross proceeds of $71,429. On
      November 4, 2005, a warrant holder exercised 1,100,000 warrants at an exercise
      price of $0.10 for gross proceeds of $110,000.





In
      addition, during the year ended July 31, 2005, the Company received notices
      of a
      cashless warrant exercise from certain holders of the convertible debentures
      to
      exercise their outstanding 15,944,184 warrants. The exercise price of these
      warrants ranged from $0.028 to $0.10, for a fair value of $1,026,617. In
      response, the Company issued 13,364,073 shares of common stock to the warrant
      holders.





On
      October 13, 2005, the Company realized gross cash proceeds of $110,000 from
      the
      exercise of 1,100,000 warrants at an exercise price of $0.10 per
      share.





During
      the year ended July 31, 2006, 1,000,000 share purchase warrants with an exercise
      price of $0.16 per share that vest on November 1, 2006 were issued for services
      received. The fair value at the date of grant was estimated at $62,760. The
      fair
      value of these warrants was estimated on the date of issuance using the
      Black-Scholes option valuation model using the weighted average assumptions
      consistent with those as described in note 3(o). The fair value of the warrants
      is being recognized over the vesting period and $47,070 was recorded as interest
      and finance expense during the year.





**14.**
            **Deferred
                financing costs:**




2006
              
              
              2005$100
                  million equity line of credit (note 13 (d))Commitment fee
              
              $
              16,000,000
              
              $
              16,000,000Professional fees
              
              
              74,086
              
              
              74,086Agent placement fee
              
              
              10,000
              
              
              10,00016,084,086
              
              
              16,084,086$30
                  million 10% convertible debentures (note 10(e))Commissions
              
              
              2,130,000
              
              
              2,130,000Professional fees
              
              
              35,500
              
              
              35,5002,165,500
              
              
              2,165,500Discounted
                  convertible debenture (note 10(b))Commissions
              
              
              218,000
              
              
              218,000Fair value of agents warrants
              
              
              15,699
              
              
              15,699Professional fees
              
              
              46,894
              
              
              46,894280,593
              
              
              280,59318,530,179
              
              
              18,530,179Amortization
              
              
              (16,838,085
              )
              
              (320,899
              )$
              1,692,094
              
              $
              18,209,280




The
      deferred charges related to the discounted convertible debentures are being
      amortized over the maturity period. During the year, $16,517,186 (2005 -
      $197,326) was amortized and charged to interest expense. As at
      July 31, 2005, the Company had deferred $16,084,086 of financing costs relating
      to its $160.0 million equity line of credit. As described in note 3(f), on
      September 23, 2005 the Company withdrew the Registration Statement previously
      filed on July 22, 2005 with the SEC. As a result of the withdrawal of the
      Registration Statement the Company did not have the ability to draw down on
      the
      $160.0 million equity line of credit. As further disclosed in note 10 (f),
      it is
      currently not determinable when the Company will be able to draw down on the
      amended $100.0 million equity line of credit. For the year ended July 31, 2006,
      the Company has charged $16,084,086 (2005 - nil) to the statement of operations
      as interest and financing expense.


-52-
 **SMARTIRE
                SYSTEMS INC.**
 **Notes
                to Consolidated Financial Statements**
 (Expressed
                in United States dollars)
 (Prepared
                in accordance with U.S. generally accepted accounting principles)
 
 **Years
                ended July 31, 2006, 2005 and 2004**


**15.**
            **Net
                interest and financing expenses:**




2006
            
            
            2005
            
            
            2004Interest
                accreted on convertible debentures
            
            $
            4,543,659
            
            $
            1,871,696
            
            $
            578,363Short-term
                debt interest expense and finance charges
            
            
            131,415
            
            
            112,274
            
            
            1,206,762Interest incurred on
                convertible debentures
            
            
            3,070,282
            
            
            942,892
            
            
            1,777,721Amortization
                of deferred financing fees
            
            
            16,517,186
            
            
            852,289
            
            
            468,974$
            24,262,542
            
            $
            3,779,151
            
            $
            4,031,820




**16.**
            **Financial
                instruments:**





(a)
            Credit
                risk:





The
      majority of the Company's activities are concentrated in the automotive industry
      and sales are primarily to a few major customers (note 21). To reduce credit
      risk, management performs ongoing credit evaluations of its customers' financial
      condition. The Company maintains reserves for potential credit losses based
      on a
      risk assessment of its customers.





(b)
            Foreign
                currency risk:





The
      Company operates internationally which gives rise to the risk that cash flows
      may be adversely impacted by exchange rate fluctuations. To July 31, 2006,
      the
      Company has not entered into derivatives or other hedging instruments to
      mitigate its foreign exchange risk.








**17.**
            **Related
                party transactions:**





(a)
            Cornell
                Capital is considered a related party from a financial perspective
                due to
                the number and size of the financial transactions that were entered
                into
                with the Company. Cornell Capital does not have influence over the
                Company's operating or investing activities. During the year ended
                July
                31, 2006, the Company paid $900,000 (net of $100,000 of withholding
                taxes)
                in interest payments to Cornell Capital for interest and financing
                fees
                due on its $30,000,000 convertible debentures (2005- $19,658,134)
                to
                Cornell Capital and its affiliates (2004-$571,500) and the Company
                had the
                following financial instruments outstanding with Cornell Capital
                as at
                July 31, 2006:




Financial
                  Instrument
              
              
              AmountStandby
                  equity distribution agreement
              
              
              100,000,000Preferred
                  shares
              
              
              3,855,680Convertible
                  debentures
              
              
              11,420,000




(b)
            During
                the year ended July 31, 2006, the Company paid $230,000 (2005 - nil)
                in
                consulting fees to the Company’s Chairman pursuant to a consulting
                agreement entered into on June 30,
                2005.





(c)
            During
                the year ended July 31, 2006, the Company incurred expenses of nil
                (2005 -
                $60,000; 2004 - nil) for a research report to a company in which
                a
                director of the Company has significant influence.


-53-
 **SMARTIRE
                SYSTEMS INC.**
 **Notes
                to Consolidated Financial Statements**
 (Expressed
                in United States dollars)
 (Prepared
                in accordance with U.S. generally accepted accounting principles)
 
 **Years
                ended July 31, 2006, 2005 and 2004**




**18.**
            **Income
                taxes:**





(a)
            Effective
                tax rate:





The
      effective income tax rates differ from the Canadian statutory rates for the
      following reasons:


2006
              
              
              2005
              
              
              2004Canadian
                  statutory tax rate
              
              
              34.1
              %
              
              35.6
              %
              
              36.4
              %Computed
                  tax expense
              
              $
              (9,830,725
              )
              $
              (5,738,798
              )
              $
              (3,999,277
              )Foreign
                  losses tax affected at lower rates
              
              
              30,007
              
              
              103,937
              
              
              5,162Reduction
                  in effective tax rates
              
              
              987,644
              
              
              -
              
              
              (339,481
              )Permanent
                  and other differences
              
              
              1,588,656
              
              
              3,591,989
              
              
              1,352,012Change
                  in valuation allowance
              
              
              7,224,418
              
              
              2,042,872
              
              
              2,981,584$
              -
              
              $
              -
              
              $
              -




**Included
      in other differences are tax affected loss carryforwards that expired in the
      year in the amount of $3,045,569 (2005 - $1,231,000; 2004 -
      $946,000).




(b)
            Deferred
                tax assets and liabilities:


2006
              
              
              2005Deferred
                  tax assets:Fixed
                  and other assets, accountingdepreciation in excess of tax
              
              
              5,587,832
              
              
              1,642,001Loss
                  carryforwards
              
              
              21,073,311
              
              
              17,812,576Scientific
                  research and development expenses
              
              
              428,823
              
              
              413,060Share
                  issue costs
              
              
              492,993
              
              
              721,844Others
              
              
              409,200
              
              
              178,261Total
                  gross deferred tax assets
              
              
              27,992,159
              
              
              20,767,742Valuation
                  allowance
              
              
              (27,992,159
              )
              
              (20,767,742
              )Net
                  deferred tax assets
              
              
              -
              
              
              -




In
      assessing the realizability of future tax assets, Management considers whether
      it is more likely than not that some portion or all of the future tax assets
      will be realized. The ultimate realization of the future tax assets is dependent
      upon the generation of future taxable income during the periods in which those
      temporary differences become deductible.





(b)
            Deferred
                tax assets and liabilities (continued):





For
      Canadian tax purposes, the Company has approximately $44,100,000 of non-capital
      losses for income tax purposes available at July 31, 2006 to reduce taxable
      income of future years. These losses will expire as follows:


2007
              
              $
              200,0002008
              
              
              5,100,0002009
              
              
              6,500,0002010
              
              
              5,700,0002011
              
              
              6,400,0002012
              
              
              3,500,0002013
              
              
              16,700,000$
              44,100,000
 -54-
 **SMARTIRE
                  SYSTEMS INC.**
 **Notes
                  to Consolidated Financial Statements**
 (Expressed
                  in United States dollars)
 (Prepared
                  in accordance with U.S. generally accepted accounting principles)
 
 **Years
                  ended July 31, 2006, 2005 and 2004**
 **18.**
                        **Income
                            taxes (continued):**


Additionally, for Canadian tax purposes, the Company has scientific research
        and
        development expenditures of $1,258,000 available to reduce future taxable
        income
        indefinitely.





For
      United States tax purposes, the Company has approximately $6,200,000 of net
      operating losses for income tax purposes available at July 31, 2006 to reduce
      taxable income of future years. These losses will expire as follows:


2012
              
              $
              100,0002013
              
              
              900,0002019
              
              
              1,800,0002020
              
              
              1,300,0002021
              
              
              400,0002022
              
              
              800,0002023
              
              
              300,0002024
              
              
              400,0002025
              
              
              100,0002026
              
              
              100,000$
              6,200,000




For
      United Kingdom tax purposes, the Company has approximately $12,600,000 of
      non-capital losses for income tax purposes available at July 31, 2006 to reduce
      taxable income of future years. These losses may be carried forward
      indefinitely.





**19.**
            **Earnings
                (loss) per share:**





The
      weighted average number of shares outstanding used in the computation of
      earnings (loss) per share were as follows:


2006
              
              
              2005
              
              
              2004Weighted-average
                  shares used in computation of
              
              
              292,196,901
              
              
              222,981,341
              
              
              83,356,095basic
                  earnings (loss) per sharePotentially
                  dilutive securities excluded incalculation
                  of loss per share
              
              
              1,622,563,244
              
              
              846,988,048
              
              
              98,697,014




Diluted
      loss per share has not been presented since the Company is in a loss position
      and the effect of the Company's stock options, debentures and warrants are
      anti-dilutive.





-55-
 **SMARTIRE
                SYSTEMS INC.**
 **Notes
                to Consolidated Financial Statements**
 (Expressed
                in United States dollars)
 (Prepared
                in accordance with U.S. generally accepted accounting principles)
 
 **Years
                ended July 31, 2006, 2005 and 2004**


**20.**
            **Commitments
                and contingencies:**





(a)
            The
                Company is committed to the following payments under operating leases,
                and
                service agreements for premises and certain equipment and consultants:


2007
              
              1,131,3232008
              
              
              478,2612009
              
              
              475,0632010
              
              
              475,0632011
              
              
              136,2862012
              
              
              2,771




Rent
      expense incurred during the year ended July 31, 2006 was $491,650 (2005 -
      $374,040, 2004 - $333,678).





(b)
            Product
                warranties:





The
      Company provides for estimated warranty costs at the time of product sale.
      Warranty expense accruals are based on best estimate with reference to
      historical claims experience. As warranty estimates are based on forecasts,
      actual claim costs may differ from amounts provided. An analysis of changes
      in
      liability for product warranties follows:


Balance,
                  August 1, 2004
              
              $
              89,860Provision
                  increase
              
              
              15,856Expenditures
              
              
              (55,276
              )Balance,
                  July 31, 2005
              
              
              50,440Provision
                  increase
              
              
              37,284Expenditures
              
              
              (12,494
              )Balance,
                  July 31, 2006
              
              $
              75,230


(a)
            Contingencies:


On
      January 30, 2006, the Company was served with a demand for arbitration by Travel
      Technology Innovations LLC (“TTI”). The demand for arbitration stems from the
      Company terminating on January 1, 2006, the Sales and Distribution agreement
      signed with TTI on March 12, 2005, and seeks damages for potential lost profits
      of $5,000,000. As of July 31, 2006, it is not possible to determine the outcome
      of the arbitration and no amount has been recorded in the financial statements
      as a potential liability.


-56-
 **SMARTIRE
                SYSTEMS INC.**
 **Notes
                to Consolidated Financial Statements**
 (Expressed
                in United States dollars)
 (Prepared
                in accordance with U.S. generally accepted accounting principles)
 
 **Years
                ended July 31, 2006, 2005 and 2004**


**21.**
            **Segmented
                information:**





The
      Company operates in the wireless tire monitoring technology industry. Management
      of the Company makes decisions about allocating resources based on this one
      operating segment. Geographic information is as follows:





Revenue
      from external customers:


Revenue
                  from external customers
              
              
              Revenue
                  from external customers2006
              
              
              2005
              
              
              2004United
                  Kingdom
              
              $
              1,149,149
              
              $
              746,889
              
              $
              225,517United
                  States
              
              
              2,120,325
              
              
              520,615
              
              
              651,089China
              
              
              -
              
              
              15,998
              
              
              514,365Other
              
              
              167,875
              
              
              179,958
              
              
              267,308$
              3,437,349
              
              $
              1,463,460
              
              $
              1,658,279





As
      at
      July 31, 2006, 84% (2005-52%) of the Company's fixed assets were in Canada,
      1%
      (2005-nil) were in the U.S., 15% (2005-18%) were in Europe and nil were in
      Korea
      (2005-30%).




Major
      customers, representing 10% or more of total sales, include:


2006
              
              
              2005
              
              
              2004Customer
                  A
              
              $
              1,079,074
              
              $
              546,423
              
              $
              <10
              %Customer
                  B
              
              
              696,388
              
              
              <10
              %
              
              <10
              %Customer
                  C
              
              
              368,380
              
              
              <10
              %
              
              <10
              %Customer
                  D
              
              
              <10
              %
              
              234,244
              
              
              <10
              %Customer
                  E
              
              
              <10
              %
              
              <10
              %
              
              484,433




**22.**
            **Subsequent
                events:**





(a)
            Subsequent
                to the year end, the holder of the preferred shares converted $32,640
                into
                3,264,000 common shares of the Company and 900,000 stock options
                were
                exercised.





(b)
      On
      September 20, 2006, after receiving default waivers from all of the holders
      of
      our convertible debentures and preferred shares to file a registration statement
      until November 1, 2006, the Company formally requested that a Registration
      Statement on Form SB-2 previously filed with the SEC on July 22, 2005 be
      withdrawn. The Registration Statement was not previously declared effective
      by
      the SEC and no securities were sold pursuant to the Registration Statement.





**23.**
            **Differences
                between Canadian and United States Generally Accepted Accounting
                Principles and Practices:**





These
      consolidated financial statements have been prepared in accordance with
      accounting principles and practices generally accepted in the United States
      ("U.S. GAAP") which differ in certain respects from those principles and
      practices that the Company would have followed had its consolidated financial
      statements been prepared in accordance with accounting principles and practices
      generally accepted in Canada ("Canadian GAAP").





(a)
            Under
                U.S. GAAP, the adoption of U.S. dollar in 2001 as reporting currency
                was
                implemented retroactively, such that prior period financial statements
                were translated under the current rate method using foreign exchange
                rates
                in effect on those dates. Under Canadian GAAP, a change in reporting
                currency is implemented by translating all prior year financial statement
                amounts at the foreign exchange rate on the date of change in reporting
                currency, which was July 31, 2001. As a result, there is a difference
                in
                share capital, deficit and cumulative translation adjustment amount
                under
                Canadian GAAP as compared to U.S. GAAP.





(b)
            Under
                U.S. GAAP, the Company has elected to continue to apply the guidance
                set
                out in Accounting Principles Board Opinion No. 25, "Accounting for
                Stock
                Issued to Employees" ("APB 25") and related interpretation in accounting
                for its employee stock option. As the Company grants options with
                an
                exercise price not less than the market value of the underlying common
                shares on the date of grant, no compensation expense is required
                to be
                recognized under APB 25. If the exercise price of employee stock
                option
                award is not fixed in the functional currency of the Company or in
                the
                currency the employee is paid, the award is accounted for as variable
                award until the award is exercised, forfeited, or expires unexercised.
                The
                Company measures compensation expense as the amount by which the
                quoted
                market value of the common shares of the Company's common stock covered
                by
                the grant exceeds the option exercise price, with subsequent changes
                in
                the market price of the common stock included in the measurement
                of loss.


-57-
 **SMARTIRE
                SYSTEMS INC.**
 **Notes
                to Consolidated Financial Statements**
 (Expressed
                in United States dollars)
 (Prepared
                in accordance with U.S. generally accepted accounting principles)
 
 **Years
                ended July 31, 2006, 2005 and 2004**
 **23.**
                      **Differences
                          between Canadian and United States Generally Accepted Accounting
                          Principles and Practices (continued):**


Prior
      to
      2003, under Canadian GAAP, no compensation was recorded for employee options.
      Subsequent to August 1, 2003, the Company elected to use the fair-value based
      method under Canadian GAAP, on a prospective basis, to record compensation
      expense for options as such there is no pro-forma stock based compenstation
      adjustment under Canadian GAAP in 2006.




(c)
            Under
                U.S. GAAP, the proceeds from the issuance of convertible debentures,
                which
                are considered to be conventional convertible debt as defined in
                EITF
                00-19, with detachable warrants are allocated to the fair value of
                warrants issued and intrinsic value of beneficial conversion feature.
                The
                remaining proceeds are allocated to debt which is being accreted
                to the
                redemption value of the convertible debentures over the maturity
                period.
                On the date of conversion of debt to equity, the difference between
                the
                carrying amount and redemption amount is charged to statement of
                operations as interest expense. Convertible debentures, which do
                not meet
                the definition of conventional convertible debt as defined in EITF
                00-19
                and any warrants issued in connection with the debt agreements are
                accounted for as derivative instrument rather than as equity, if
                it does
                not meet all the criteria to be classified as equity under EITF00-19.
                The
                conversion options related to the debt and the warrants, together
                with
                other embedded derivative instruments, have been bifurcated from
                the debt
                hosts and accounted for separately as derivative instrument in
                liabilities.





Under
      Canadian GAAP, the proceeds from the issuance of convertible debentures with
      detachable warrants are allocated to the warrants issued and beneficial
      conversion feature based on their fair values. The remaining proceeds are
      allocated to debt which is then being accreted to the redemption value of the
      convertible debentures over the maturity period. On the date of conversion
      of
      debt to equity, the carrying value of debt is reclassified to equity with no
      additional interest accretion. When the Company has the option of repaying
      the
      convertible debentures in cash or common shares the entire principal amount
      of
      it is recorded as equity. The principal equity is accreted to the redemption
      value of the convertible debentures over the maturity period and is charged
      to
      deficit.




(d)
            Under
                U.S. GAAP, the discount on convertible debt is netted against the
                value of
                debenture, and debt issuance cost is recorded as deferred financing
                cost
                and is amortized over the maturity period. Under Canadian GAAP, the
                discount is recorded as deferred financing cost and is being amortized
                over the maturity period. Debt issuance cost is charged to equity.





(e)
            For
                U.S. GAAP, on settlement of a debenture, a gain was recorded in the
                statement of operations of $42,346 (as restated) for the year ended
                July
                31, 2005 and a charge to retained earnings was recorded for the same
                amount (note 10(c)). For Canadian GAAP, no gain arises, since the
                carrying
                value of liability and equity component of the debenture is the same
                as
                the allocated fair values between liability and equity of the
                consideration paid.


-58-
 **SMARTIRE
                SYSTEMS INC.**
 **Notes
                to Consolidated Financial Statements**
 (Expressed
                in United States dollars)
 (Prepared
                in accordance with U.S. generally accepted accounting principles)
 
 **Years
                ended July 31, 2006, 2005 and 2004**
 **23.**
                      **Differences
                            between Canadian and United States Generally Accepted
                            Accounting
                            Principles and Practices (continued):**
  2006
              
              
              
              2005(as
                  restated)Consolidated
              
              
              Canadian
              
              
              
              
              
              Canadianbalance
                  sheets
              
              
              GAAP
              
              
              U.S.
                  GAAP
              
              
              GAAP
              
              
              U.S.
                  GAAPCurrent
                  assets
              
              $
              5,006,917
              
              $
              5,006,917
              
              $
              13,292,487
              
              $
              13,292,487Property
                  and equipment assets
              
              
              780,039
              
              
              780,039
              
              
              716,763
              
              
              716,763Deferred
                  financing costs (d)
              
              
              97,600
              
              
              1,692,094
              
              
              16,206,086
              
              
              18,209,280Other
                  assets
              
              
              75,275
              
              
              75,275
              
              
              1,066,013
              
              
              1,066,013Current
                  liabilities (c)
              
              
              3,872,049
              
              
              3,872,049
              
              
              1,577,381
              
              
              5,709,609Long
                  term convertible debentures (c)
              
              
              4,007,883
              
              
              21,432,576
              
              
              1,272,123
              
              
              17,118,667Accrued
                interest on convertible debentures
              
              
              1,750,000
              
              
              1,750,000
              
              
              -
              
              
              -Derivative
                  financial instruments
              
              
              -
              
              
              8,043,225
              
              
              -
              
              
              -Preferred
                  shares subject tomandatory redemption
              
              
              482,128
              
              
              482,128
              
              
              72,310
              
              
              72,310Stockholders'
                  capital (deficit)
              
              
              (4,152,229)
              
              
              (28,025,653)
              
              
              28,359,535
              
              
              10,383,957




2006
              
              2005
              
              2004Net
                  loss in accordance with US GAAP
              
              $
              (28,829,105
              )
              $
              (16,120,218
              )
              $
              (10,987,026
              )Effects
                  of difference in accounting for:Stock based compensation expense under US GAAP (b)
              
              
              (3,087,145
              )
              
              4,018,075
              
              
              -Stock based compensation(recovery) under Canadian GAAP (b)
              
              
              (651,079
              )
              
              (1,089,282
              )
              
              (1,130,170
              )Interest accretion and amortization of debenture financecosts recorded under US GAAP (c)(d)
              
              
              21,060,845
              
              
              2,689,712
              
              
              3,360,389Interest accretion and amortization of debenture financecost under Canadian GAAP (d)
              
              
              (2,116,405
              )
              
              (1,541,917
              )
              
              (325,574
              )Gain
                on settlement of convertible debt (d)
              
              
              -
              
              
              (42,346
              )
              
              -Unrealized gain on derivative instrument income (c)
              
              
              (2,521,841
              )
              
              -
              
              
              -Net loss in accordance with Canadian GAAP
              
              
              (16,144,730
              )
              
              (12,085,976
              )
              
              (9,082,381
              )Beginning deficit in accordance with Canadian GAAP
              
              
              (65,113,071
              )
              
              (51,971,332
              )
              
              (41,762,812
              )Interest on convertible debentures and amortization of
                financing charges (d)
              
              
              (16,517,186
              )
              
              (1,055,763
              )
              
              (1,126,239
              )Ending deficit in accordance with Canadian GAAP
              
              
              (97,774,987
              )
              
              (65,113,071
              )
              
              (51,971,432
              )Basic and diluted loss per share (in accordance with Canadian GAAP)
              
              
              (0.06
              )
              
              (0.05
              )
              
              (0.11
              )





**24.**
            **Comparative
                figures:**




Certain
      figures have been
      reclassified to conform to the financial presentation adopted for the current
      year   -59-